Macro, U.S.

Midyear Update: Can the U.S. Stay Uncoupled from the World

June 5th, 2012 | By Nick Sargen


  • Our call at the start of this year was that the U.S. economy would gain some traction, expanding at a 2%-3% pace, while the rest of the world slowed. So far, so good. However, fallout from a deepening recession in Europe and slowdowns in China, India, Brazil and other emerging economies will pose increasing challenges in the second half.
  • Two forces should help mitigate the dampening effect of weaker activity abroad: (i) lower oil and commodity prices will bolster consumers’ purchasing power; and (ii) the lure of the U.S. as a safe haven will keep borrowing costs low.
  • Policy actions in China, India and other Asian economies will help counter the slowdown in the Asia/Pacific region. However we are less confident that European policymakers can contain the crisis in the euro-zone, and the looming 2013 "fiscal cliff" in the U.S. will weigh on markets eventually.
  • With the euro-zone in peril and the U.S. elections likely to add to uncertainty, we are paring back risk in our investment portfolios for tactical reasons.

The U.S. Economy at Midyear

As midyear approaches, it’s an opportune time to take stock of developments around the world and their impact on the U.S. economy and financial markets. Based on newspaper headlines and media reports, it’s readily apparent the euro-zone is in the throes of recession, while China, India, Brazil and other emerging economies have slowed noticeably. Worries about a Greek exit from the euro-zone and a capital shortfall for European banks have spawned a flight to quality, with yields on German bunds, U.K gilts and U.S treasuries falling to record lows.

Yet, despite the adverse developments in Europe and Asia, there has been no noticeable softening of the U.S. economy thus far. Two sectors that normally lead the economy in a business cycle – autos and housing – are posting solid gains (auto sales) or are stabilizing (housing starts and new and existing home sales.) Moreover, consumers, who collectively account for 70% of GDP, spent at a healthy clip of 2.7% in the first quarter, and household confidence has been on a rising trend since last autumn. While overall GDP growth was softer in the first quarter, it mainly reflected cutbacks in government spending and a lull in investment spending.

The manufacturing sector has been a bright spot throughout the recovery, as U.S. manufacturers have benefited from high productivity growth, moderate wage increases and a cheap dollar. These factors have improved U.S. competitiveness, at a time when many overseas economies have become less competitive. Indeed, recent data on global manufacturing show declines in Europe back to the lowest levels since mid-2009, while the aggregate index for emerging markets has fallen by two index points from its February peak.

One area that may be signaling a U.S. slowdown is the jobs front, where the monthly average increase in nonfarm payrolls eased to 73,000 in April-May from 226,000 in the first quarter. Some of this appears to be related to an unusually mild winter, which pulled job creation forward, especially in construction. The latest readings, however, also raise the possibility that businesses may be turning more cautious in the wake of overseas developments. In this regard JPMorgan’s economists caution it is too early to form strong conclusions:

“Further signs that employment data are simply too erratic to drive substantial outlook changes can be seen in the household survey. In May, the unemployment rate rose to 8.2% from 8.1%, but rather than being a result of weak or declining employment, the rise was driven by a huge 422,000 jump in net hiring coupled with an even larger 642,000 surge in the labor force.” (U.S. Macro Flash, June 1, 2012)

We also take some comfort from the fact that four jobs reports in 2011 were initially reported below +60,000; yet monthly hiring for the year averaged more than 150,000 workers. My guesstimate for this year’s tally is that it will average about 175,000 workers per month, implying ongoing gradual improvement since recovery began three years ago.

Overcoming Slowdown Abroad

This begs an important question – namely, how has the U.S. been able to withstand the slowdown abroad, and will it be able to do so in the remainder of the year?

Our take is that several factors have enabled the U.S. economy to sustain moderate growth in the face of weakness abroad:

  • Recession in Europe has been mild thus far. Notwithstanding all the gloom and doom emanating from Europe, the euro-zone economy as a whole has proved to be fairly resilient. Newspaper and media headlines have focused on rising unemployment in the hardest hit economies – Greece, Portugal, Ireland, Spain and Italy – but the core economies such as Germany and France have continued to grow, albeit at a subdued pace. Moreover, with exports to Europe accounting for only 2% of U.S. GDP, the trade linkages between Europe and the United States are not a major source of drag.
  • The slowdown in Emerging Asia has been greater than expected, as the respective economies face strains from earlier policy tightening and softer exports to Europe. Forecasts for China’s growth in 2012-2013, for example, are being scaled back to 7% from 8% previously, and India’s economy slowed to 5.3% in the first quarter from 9.2% a year earlier. Fortunately, inflation in the Asia/Pacific region has lessened recently, which has enabled central banks to begin easing monetary policy. Also, the Chinese government reportedly is contemplating accelerating infrastructure spending to offset slowing investment in housing.
  • The recession in Europe and slowdown in emerging economies have contributed to significant declines in the price of oil and other commodities. The earlier run-up in oil prices, which was related to escalating tensions with Iran, has been completely reversed, and the latter should bolster purchasing power of U.S. consumers.
  • The United States has also benefited from its status as a safe haven, as borrowing costs for the U.S. treasuries have fallen to all-time lows. Previously, investors were pondering whether bond yields could be headed higher if the Fed does not pursue additional quantitative easing once its “operation twist” program expires. However, worries about a spike in treasury yields have lessened in the wake of the euro-zone angst.

Key Risks to the Outlook

Against this backdrop, there are two key risks that we are fixated on that could undermine the U.S. economy and unsettle financial markets. One is the possibility that Greece may exit the euro-zone, and that deposit flight from Greek banks will spread to other European countries. The other is the specter of a looming “fiscal cliff” in 2013 if Congress does not change legislation affecting taxes and government spending.

Regarding the euro-zone, the spotlight is on the Greek election on June 17, which could be pivotal for determining whether it remains a member country. If the leftist Syriza party wins and forms a new government, deposit flight from Greece is likely to accelerate further and would probably require some form of outside assistance that may not be forthcoming. Even if a centrist government emerges, it is possible that the German government may have concluded that an eventual exit is inevitable. Therefore, any market rally could be short-lived.

Our primary concern is whether capital flight from Greece will spread to countries such as Spain and Italy. They are much bigger economies than Greece and their banks are more closely integrated into the world’s financial system. Earlier this year, investors were comforted that the long-term repurchase operations (LTRO) of the European Central Bank would ensure that European banks had adequate liquidity. Today, however, in the wake of mounting problem real estate loans in Spain, investors are fixated on the need to recapitalize European banks when ongoing funding by national governments may not be sustainable. Thus, Spanish government bond yields have soared recently following injection of euro 19 billion of capital into Spain’s third largest bank.

Accordingly, we believe European policymakers either will have to inject capital from EU wide sources such as the European Stability Mechanism (ESM) or establish EU wide deposit guarantees to regain control of the situation. However, we are unsure when such action will be taken. Meanwhile, the situation is likely to deteriorate further, as worries about a breakup of the euro-zone heighten.

The biggest concern on the U.S. side is the outcome of the so-called 2013 “fiscal cliff.” The latest tally by the Congressional Budget Office (CBO) is that a series of measures set to begin in January would take more than $500 billion out of the U.S. economy in 2013 alone unless Congress passes new legislation. The measures include the expiration of the Bush tax cuts and protection of the middle class from the Alternative Minimum Tax, the onset of $1 trillion in sequestered spending cuts, and an end to payroll tax cuts, among others. According to CBO’s calculations, if Congress allows all these policies to take effect, real GDP growth next year would be around 0.5%, with recession likely in the first half of the year.

Market participants have not reacted to this prospect, thus far, mainly because it is widely assumed a compromise will be reached following the November elections. Meanwhile, however, investors must contend not only about the election outcome, but also about the nature of the compromise that will be reached afterwards. Clearly a lot is at stake, with reform of the entitlement system and tax code at the core of the debate. Failure to extend the Bush tax cuts, for example, could raise the marginal tax on dividends to 43.5% from 15% currently.

It is difficult to assess the outcome now, because the presidential and congressional elections are likely to be close. The uncertainty, moreover, may not diminish after the elections if the U.S. government remains divided and the two political parties cannot find common ground. The latter would raise the specter of a replay of last’s year debt ceiling debacle.

Investment Implications

The recovery from the 2008-09 financial crisis is now three years old, and in every year since then investors have had to contend with a crisis in the euro-zone that has become increasingly complex. Whereas in 2010 and 2011, European policymakers were able to concoct temporary solutions to the problems, the stakes are greater today: Policymakers must deal with a possible Greek exit at a time when worries about capital adequacy of European banks have escalated.

Only one European official – Mario Draghi, head of the ECB – has demonstrated strong leadership, and he has chided European governments about the need to take necessary actions to instill confidence in the euro-zone. Our sense is that action will be forthcoming soon; however, we lack confidence that it will resolve the region’s plight. Therefore, we are prepared for the recent market volatility to continue and possibly build as investors begin to focus on the U.S. elections and their ramifications.

Against this highly uncertain backdrop, we have implemented actions to pare back risk in our investment portfolios. With respect to equity portfolios, we have increased cash holdings closer to the limits of the respective investment guidelines. With respect to fixed income portfolios, we are paring back on high yield exposure. In both instances, we consider these moves to be tactical, as we regard U.S. equities and high yield bonds as being reasonably valued from a long-term perspective.