America’s fiscal cliff may bring a new level of pain

THE term “fiscal cliff” may have only been coined as a phrase by Ben Bernanke as recently as eight months ago, but it’s likely to be used more frequently as we head into the year-end. If US legislators fail to act, a combination of sharp tax hikes and public spending cuts could have the potential to wreak havoc on the US economy, knocking back any emerging green shoots of recovery and threatening to plunge the world’s largest economy back into recession. So, the significance of falling off a fiscal cliff is certainly worthy of the dramatic name.

As we saw in August 2011, politicians in Washington aren’t averse to a degree of brinksmanship. Dragging out the resolution of the debt ceiling fiasco ultimately resulted in Standard and Poor’s downgrading the US. What’s more, the legislation that followed only seemed concerned with ensuring that politicians get re-elected next month. It’s probably time investors started looking around to see where the emergency exits are located.

Imposiing severe tax hikes, aiming to collect around half a trillion dollars in a single year – already labelled by some as “Taxmageddon” – will likely be the most obvious move from the government. The average US household will see annual taxes jump by $3,500 (£2,183) – money that will head into government coffers rather than into investments which would prop up stock markets, or into cash registers of retailers. The hikes will hit every household except the elderly, who are largely reliant on social security. But the overall tax take will only rise by 2 per cent, to 18 per cent of GDP – that’s around the rate that it averaged in the second-half of the last century.

The second aspect of the fiscal cliff is the accompanying raft of government spending cuts: employee layoffs and reductions in spending across the board – including some high profile areas, such as defence – will result in higher unemployment, reduced spending and lower levels of saving.

We should be bracing ourselves for a fallout in equity markets as equity prices slump in response to fewer inflows – be this a result of consumers not spending, or government contracts drying up. Bear in mind that the Dow Jones Industrial Average has been trading around five-year highs of late, largely driven higher by successive stimulus measures, including the suppressed tax rates in the domestic economy. There is certainly space for a degree of reversion here.

There is also an argument to suggest that failure to tackle the fiscal cliff could result in further downgrades from ratings agencies, on the basis that politicians aren’t giving the situation the due attention that it deserves.

Any resulting downside pressure to the dollar would help support the country’s export market (and maybe even put the brakes on imports too). Furthermore, any dollar weakness should be limited by the fact that for the first time in years, a sharp reduction in the deficit can be produced, in turn giving a little more credence to the fact the dollar isn’t on the verge of spiralling into obscurity.

As the world’s largest economy, the US has never been in the same risk bracket as some European states where the market loses confidence and borrowing costs spiral to unsustainable levels. But investors must be wary of the impact that this could have on US equities, although the story for the fortunes of the dollar could very well be different – certainly after any initial uncertainty is put to bed.