Will the US fiscal cliff crash markets?

We have noted a few times recently that the US economy faces a hiccup later this year and early next as its fiscal stimulus growth pulse crashes with year-on-year comparisons. This goes to the often overlooked fact that when it comes to GDP growth inputs, it is the rate of change in spending that matters not the absolute amount. There will be considerable growth offsets as the private economy roars back open and enjoys catch-up growth but the fiscal downdraft will be strong while we wait for the second round stimulus of the Biden infrastructure plan. Albert Edwards at Societe General has more:

With cyclical optimism so high, should investors look out for a ‘shock’ growth pause?

Reading the financial press, it seems that most commentators believe we are set for a repeat of the Roaring Twenties, most especially in the US. Optimism abounds that the consumer will unleash a wave of pent-up spending as economies reopen, backed by a handy stash of surplus savings. Combined with a new ‘can-do’ (or rather a ‘can-spend’) attitude of the fiscal authorities, all things economic and cyclical look tickety-boo – if not a tad frothy.

This optimism is backed up by some extraordinarily robust ISM data – again most particularly in the US. The surge in both the US manufacturing and services ISMs into the mid-60s brings them up to levels not seen since 1983 when the US economy charged out of a savage double-dip recession. Even in semi-shutdown Europe, the eurozone PMI output composite has hit its highest level since records began (in 1998). These are robust data indeed.

And markets have responded with heady abandon to this flood of strong economic data. (I always hesitate to use the words ‘good news’ to describe strong economic data. My own observation from almost four decades in the markets is that when economists and strategist sdescribe ‘good news’, they introduce a behavioural bias into their analysis because they then become reluctant to forecast ‘bad’ news – with some notable exceptions!)

As a result of this hope of a repeat of the Roaring Twenties (which admittedly didn’t end so well) investors may be riding a cyclical wave that may now be cresting. Hence, instead of strong growth and rising bond yields being the main threat to equities, might it be the reverse?!

These blockbuster ISMs should be treated with some caution – because if after an economy has been shut down every respondent thought things were getting even a little better, then the ISMs would register the 100% maximum. Indeed, other more methodical surveys of economic activity tell an alternative story. For example, the highly regarded Chicago Fed National Activity Index collates 85 US economic indicators into an aggregate measure. It is calibrated so that zero represents trend GDP growth. As you can see below, economic activity in February has fallen back to trend – only around 2% or slightly below. It may be this data is an anomaly but keep a very close eye on this as given the recent rally, the market is now very vulnerable to cyclical disappointment.

I am not overly concerned by the fiscal cliff and its impact on earnings and equities. As said, and as we have already seen in Australia, there are huge offsets to the fiscal retrenchment in the reopening of the private sector economy and its catch-up growth phase.

What is of more interest is what it will do to bond yields and forex. We still have a quarter of ripping data ahead which will drive inflation numbers much higher, again on annual base effects. I have assumed in my base case that this will drive another round of bond selling before we reach the fiscal tail-off.

But if there is one lesson of the past year it is that this cycle moves at the pace of lightning. The Amphetamine Cycle, as we have called it, cannot be underestimated as it lurches through factor rotations that generally take years in a matter of months and even weeks.

Rather than see an overall equity shock on such base effects, I wonder if we won’t see more of what we’ve seen in the past week. A violent rebound in market segments that had been hit to varying degrees by rising yields – tech, commodities EMs and AUD – briefly taking off again. This might be given even greater impetus if the US pause is matched by an acceleration in the European vaccine program and recovery. Though it is equally possible that the Chinese tightening begins to manifest in data by H2, which could weigh on all of the above with perhaps the exception of tech.

Judging which accelerated factor the market will react to versus ‘look through’ is virtually impossible at this juncture.

As such, any H2 US fiscal cliff might be viewed as another opportunity to position for what comes after in the longer cycle. Once the 2020 base effects clear, the prospect of 2022 is still US growth, inflation and yields exceptionalism. China will also slow materially in 2022 which will drag down Europe as well.

Rather than panic about it, it is better to view it as an opportunity, methinks.

David Llewellyn-Smith
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