It is long-term entitlement spending, rather than the short-term 'fiscal cliff', that could sweep away a US recovery, says Sebastian Radcliffe, manager of the Jupiter North American Income fund.
Many investors are worried about the US falling off the so-called 'fiscal cliff' (as temporary tax breaks expire at the end of 2012) and tipping back into recession.
However, US companies are typically more concerned about the implications of longer term 'entitlement' spending as the Baby Boomer generation demands payment of its pensions and long term care.
As Americans clear up the carnage caused by the latest hurricane to hit their country, media attention has swiftly returned to the Presidential election. There is much speculation as to the market’s reaction in the event of an Obama or a Romney victory and much ink has been spilt as to which areas of the country and economy will thrive or suffer as a result.
The fundamental issues
However, in my view, the situation is too fluid to attempt to predict market reaction, whoever wins. For example, many of the expectations that might usually be associated with a Democratic or Republican win (e.g. healthcare stocks falling or rising in anticipation of greater or lesser regulation) could in fact prove the opposite because of the complex situation in which the US finds itself.
Instead, I prefer to examine fundamental issues.
For example, while the fiscal cliff remains an issue in the short-term and could act as a drag on the economy in 2013, the US has one of the lowest spending programmes as a percentage of GDP in the developed world. Therefore there remains scope to narrow the deficit in a way not open to most European economies.
Commentators including the legendary Warren Buffett have suggested that the US could raise some taxes, such as capital gains tax, without significantly derailing GDP growth, and thereby pay down its deficit. Much of the latter is cyclical and amplified by discretionary spending, such as waging two wars.
On the other hand, at a municipal level, state spending has had to be cut to balance the books. This has hurt certain areas of the country, even as unemployment remains high. Local taxation is principally connected to property values. As these fell through the floor and foreclosures accelerated, local tax take suffered severely and spending had to be cut as a result.
For the first time in five years, however, the drag from layoffs at a local level appears to be reaching an inflection point at which there could be net job increases. This comes amid indications that the housing market is at last beginning to bottom out.
The US is rare among developed economies in having population growth. Before the housing downturn began in 2006/7, 1.3 million new households on average were formed every year (1).
Although this number has more than halved since the recession, the US population has continued to grow steadily and household formation should eventually return to normal. This could present investors with some very interesting opportunities.
Set against this is the potential for the sudden removal of tax breaks and the inevitable drag on economic growth this will cause.
Failure to address this scenario, thanks to political deadlock in Washington, could present problems, and explain the Federal Reserve’s recent launch of a third round of open-ended quantitative easing as an attempt to mitigate some of the effects.
Nonetheless, dropping off the cliff is likely to be cyclical and the effects short-term. More significant is the much bigger, long-term problem of 'entitlement' spending on boomer pensions and care which cannot be changed by a new president, only by a change in the law.
While immigration and a high birth rate mean that the US is not likely to suffer from the same demographic problems as other developed economies, e.g. Japan, the sheer number of boomers (roughly 28% of Americans, see chart 2 below) that have reached or are close to reaching retirement in the next few years means that spending on healthcare, in particular, is likely to increase significantly.
Only a quarter of all baby boomers have planned adequately for their requirement according to a report in 2007 by McKinsey, but many will continue to expect to maintain their current lifestyle.
If this situation remains unaddressed, we could see an explosion in welfare spending that will make US finances unsustainable.
Already this possibility is affecting US companies whose uncertainty as to what may happen politically and with regard to global growth is curbing their willingness to increase capital expenditure and investment.
If a deal is struck on future entitlements, however, and there is greater clarity on their cost, then in my view investment inhibitions could rapidly disappear and market values take off. Everything, as has been characteristic of recent crises, now depends on the politicians.
For information on Radcliffe's performance and latest portfolio breakdown click on Jupiter North American Income fund.