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The Global Economy & The Fiscal Cliff





Possibly more so than at any other time in<br /> history, all<br /> parts of the world are simultaneously feeling the impact of what a<br /> globalized world we live in. The impact of the globalized economy to<br /> transmit shockwaves from one part of the world to another is<br /> unparalleled. As corporations have begun releasing their earnings for<br /> the first quarter of 2012, the markets are starting to get a sense of<br /> just where things sit with respect to the economy. As the economic<br /> recovery continues to wobble along, every negative eventseems to get<br /> magnified and ripples across the world.





Navigating a Sea of Opportunity

2012Q3
– Newsletter October 2012 – PDF Single Page



If the
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During
the past quarter, much of the
market’s collective attention was focused on whether or not the US
Federal Reserve would in fact turn to a third round of quantitative
easing (QE) or stimulus. QE is the term used to describe the US central
bank’s efforts to stimulate the economy by injecting money into the
banking system through the purchase of various types of bonds.
 
The
question was answered on September 13th when Federal Reserve Chairman
Ben Bernanke announced that the US central bank would begin buying $40
billion of mortgage backed securities. He also extended the Fed’s
commitment to keep interest rates low through most of 2015, an
extension of almost six months from prior policy. In short, the Fed
committed to keep interest rates “lower for longer”.
 

US Economy Leads the Way

 
This
move has taken monetary policy into uncharted territory by making
unemployment levels the focal point of  US monetary
policy. 
Essentially, the Fed hopes to force feed money into the US financial
system until a stronger, more durable economic recovery takes
root.  To underline this commitment, the Fed said that it
would
maintain its policies for a “considerable time after the economic
recovery strengthens”.
Under
its official charter, the Fed is tasked with the dual-mandate of price
stability (controlling inflation) and maximum employment.  But
this is the first time that the Federal Reserve has made jobs the
yardstick by which it will measure its success. However, the Fed’s
decision has once again fired up its critics, even within the Fed
itself.
 
Richard Fisher, the President of the Dallas Fed,
stated that “all the monetary accommodation in the world” would not get
businesses hiring again. He argues, and correctly so, that tax reform
and more policy certainty from the US federal government do more for
the economy than taking interest rates from extremely low to near zero.
In short, the political process needs to function again in Washington
and Europe.

Projected US Deficit in CBO's Baseline and Alternative Scenarios

Chart source: www.cbo.gov to view a larger version of the
above chart
click here.
Driving the Economy Over the “Fiscal Cliff”

 
As
the current US presidential election cycle heads into the home stretch,
the term “fiscal cliff” has been mentioned with increasing
frequency.   It refers to the large spending cuts and
tax
increases set to hit the economy at the end of 2012. When President
Obama had extended the 2001 Bush tax cuts until 2012, it was designed
to allow the economic recovery to gather momentum. In August 2011,
after the failure of the debt ceiling talks, Congress passed the Budget
Control Act of 2011 which provided for a bipartisan Supercommittee that
was tasked with coming up with a deficit reduction plan over 
a 10
year period. The plan was then to come up for a vote in both houses of
Congress, with no further amendments allowed.
 
The
Supercommittee failed to come to an agreement and under the Budget
Control Act, if there was a failure to come to an agreement, then
automatic spending cuts (sequestration) and tax increases will kick in
as of January 2013.  Complicating matters is the fact that
this is
an election year and neither side wants to give the other anything that
can be construed as a political victory. With Congress on recess until
after the November elections, it does not leave a lot of time to come
to an agreement.

Consequences of Going Over the Fiscal Cliff

According
to the Congressional Budget Office (CBO), the tax increases and
spending cuts would leave the budget deficit at about $641billion
versus the $1.03 trillion deficit without them. If the US were to go
over the fiscal cliff, it would act as a sizeable brake on the global
economy because it would remove a significant amount of
stimulus, 
therefore potentially halting the recovery even with QE3 in motion.

 

The
International Monetary Fund (IMF) has weighed in by warning that
“Growth would stall in 2013 with the full materialization of the cliff
and … would inflict large spillovers on major US trading partners and
also on commodity exporters”.  The IMF has recently reduced
its
expectations for global economic growth this year for a second time and
expects the economy to grow at about the same rate as 2009.

For
Canada, which relies on the US economy so strongly, the impact would be
significant. With over 70% of Canadian exports going to the US,
Canadians should be paying close attention to what happens with this
issue.

The most likely scenario is for both US political
parties to come to a “mini agreement” and leave the bigger issues until
after the election. This would be a partial “kick the can down the
road” approach. However, bond rating agency Moody’s has stated that if
no major deal is announced to deal with the debt and deficit then it
will react by joining Standard and Poor’s and also downgrade its rating
for US government bonds from AAA.
 
It is worth noting that
both Democrats and Republicans agree on much of the outstanding issues.
The biggest area of disagreement is whether the tax cuts for those
earning over $250,000 annually should be allowed to expire. Democrats
have said they would like to allow the tax rate for those higher income
earners to rise back to the levels that prevailed during the Clinton
years. 

Canada: No Longer Bucking the Global Trend

During
the last recession, Canada fared better than any of the other members
of the G7. Its reputation as a prudent fiscal manager and well
regulated banking system shone through and other world leaders sat up
and took notice. However, the afterglow has faded.

Recently, the
IMF admonished Canada for its high level of consumer debt and potential
problems arising from its housing market. It has reduced its forecast
for Canadian economic growth to 1.9% for 2012 and only 2.0% for 2013.
However, this is still second best in the G7 – marginally behind the US
economy.

Canadian Consumer Credit Growth YoY

Chart Source: Real Estate Chart Book to view larger version of this
chart
click here.

The housing market in Canada is starting to slow as
price increases have moderated and sales activity is starting to fall
in the hottest housing markets such as Vancouver and Victoria. Part of
this is due to mortgage reforms designed to tighten lending standards
and partly due to prices that do not make real estate appealing for
many buyers. The government has warned that further measures could be
imposed if the real estate sector proves resilient to policy measures.

Recovery in US Real Estate

Two
of the key sectors for the US economy are autos and real
estate. 
Autos have been a key contributor to the US economy’s ability to shake
off the recession and now real estate is helping to provide
momentum.  In fact, the US real estate sector is one of the
bright
spots for the global economy given its size and impact on a wide range
of other industries from lumber to household furnishings – and most
certainly employment in construction.  Furthermore, a
stabilizing
housing market provides a boost to US consumer confidence which is so
important to the world economy.

Risk & Rewards

As
an export oriented nation, the global economy has a significant impact
on Canada. As the IMF states in its most recent World Economic Outlook,
“… risks for recession in advanced economies (entailing a serious
slowdown in emerging market and developing economies) are alarmingly
high which is about a 15% probability for the US, 25% for Japan and 80%
for Europe”.

Offsetting
these risks are the unprecedented commitments by the US, Japan and
European central banks to provide seemingly limitless stimulus. They
recognize the challenges facing their respective nations and are
meeting them head on.  China has also begun to reverse its
tighter
monetary policies as it tries to provide a boost to slowing economic
growth there.

Risks
are always apparent and always present. In order to navigate the risks
effectively, a keen eye must be kept on how these risks are being
mitigated and dealt with. At present, the financial markets seem to be
discounting a successful resolution to the fiscal cliff issues and are
increasingly confident that European leaders will ultimately find a
combination of policies that will allow them to emerge from their
crises. While the monetary authorities have led the way forward, it is
now imperative for governments to provide the fiscal and legislative
reforms that will allow economic growth to flourish again.

Pacifica
Partners – Capital Management

Navigating
a Sea of Opportunity

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