US politicians need to tread carefully

When it came down to the wire, politicians managed a compromise – albeit a temporary one – but investor sentiment regarding the fiscal cliff was particularly negative on the basis that if the tax rises and spending cuts were implemented as planned it would likely trigger a recession, according to estimates from the Congressional Budget Office.

Tim Drayson, senior economist at Legal & General Investment Management, says: “If they’d failed to reach agreement we would have seen an unprecedented amount of fiscal tightening. They’ve now postponed the vast majority of the fiscal restraint that would have come into effect.”

The deal, which came into effect on January 1 2013, saw taxes rise for individuals earning more than $400,000 (£253,207.56) a year and couples earning more than $450,000. According to Nabeel Mughal, manager of North American Strategy at Dalton Strategic Partnership, this means the tax cuts introduced by former president George Bush in 2001 “have become permanent for everyone except the richest 2 per cent of Americans”.

Other changes, however, will have a more damaging effect. Allowing the payroll tax cut introduced in 2010 to expire, for example, sees it increase from 4.2 per cent to 6.2 per cent and will result in a squeezing of consumption in the first half of 2013.

Mr Drayson notes: “Consumer [spending] is still two-thirds of the US economy so if consumption slows it is quite hard for the overall economy to grow robustly. We think growth will be coming into the 1-2 per cent range in the first part of the year as the household sector absorbs that tax increase.”

A week and a half away from the March 1 deadline, attention will turn to the world’s largest economy. If there is no agreement the so-called ‘sequester’ – automatic spending cuts of roughly 5 per cent across all departments – will be enacted. However, Mr Drayson says: “To some extent, the next deadline is not as traumatic as the December deadline. In practice, the amount of spending restraint will be fairly limited to begin with and will gradually build up over time, whereas the full fiscal cliff could have triggered outright recession.”

Mr Mughal adds the sequestration deadline is a concern as people do not want certain budgets affected, particularly defence. He explains: “Fourth quarter GDP growth disappointed at -0.1 per cent compared with expectations of 1.1 per cent and the main cause for the drop was a drop in military spending by 22 per cent. You can see the effect of such a dramatic drop in military spend, so if there is another dramatic cut coming forward it will have an impact on certain parts of the economy.”

The key issue will be how politicians handle the forthcoming fiscal issues. If they avoid protracted negotiations, market sentiment is likely to remain positive, but if the parties reach deadlock then the uncertainty could push the US out of favour with investors and potentially further down the credit rating scorecard.

Nyree Stewart is deputy features editor at Investment Adviser

FISCAL CLIFF

DECISION DEADLINES

August 2011 - Negotiations on debt ceiling pass deadline and S&P downgrade the US to AA in relation to the uncertainty of the fiscal outlook.

December 31 2012 - Fiscal cliff deadline discussions to agree package of tax rises and spending cuts to improve the US fiscal position. The American Taxpayer Relief Act of 2012 signs into law a deal on tax rises, but spending cut and debt ceiling discussions are postponed.

March 1 2013 - Deadline for agreement on the sequester - automatic spending cuts across all departments including defence.

March 27 2013 - Expiry date of the continuing resolution that currently provides operational funding for much of the government. If no additional appropriations are agreed then non-essential functions of the government will have to cease operations..

May 19 2013 - Deadline for a new agreement on the US debt ceiling, extraordinary measures could push the deadline into the summer if no deal looks likely.