Fiscal Cliff: An Emerging Markets’ View
Now that the U.S. presidential election is over and President Barack Obama has been re-elected to serve a second four-year term, we’re able to do what we always do after a major election or regime change, and that’s examine the potential implications of policy changes on our investments. As our team sees it, there are two main factors for global investors to consider: the U.S. economy’s future health, and President Obama’s foreign policy stance toward key countries, particularly China.
Will the U.S. Fall off the Fiscal Cliff?
The biggest hot-button issue in the U.S. economy right now is impending “fiscal cliff,” a sweeping combination of tax hikes and government spending cuts which a then-deadlocked U.S. government put in place in 2011 as a last-ditch effort to reduce the nation’s US$1 trillion deficit. Unless the Republican-controlled House of Representatives can reach agreement on an alternate plan with the president and Democrat-controlled Senate, this fiscal cliff – the fallout from what’s formally called the Budget Control Act of 2011 – will go into effect in January 2013.
Some economists say that if the spending cuts and tax hikes contained in the Act go into effect, it will lead to a U.S. recession and the one-two punch of rising unemployment and reduced consumer spending. The U.S. Congressional Budget Office estimates a possible 4% hit to the U.S. GDP (negative growth) between fiscal years 2012 -2013. I think such turn of events could create an economic disaster, as a recession in the world’s largest economy would undoubtedly impact the global economy, particularly Asia’s export industries. If the U.S. goes “off the cliff” it could take other countries down with it.
We can hope for the best, but we also have to plan for the worst.
The good news for emerging markets investors? Dependence on exports to the U.S. has generally been declining in Asia and the emerging countries over the past decade. The absolute dollar figures for total exports have been rising, but emerging market countries have been diversifying their export base to include countries beyond the U.S. and Europe, the latter of which, as we know, has been suffering from a debt crisis of its own.
Today, China is the largest destination for exports from Japan, Korea, the Philippines, Vietnam, Thailand, Malaysia, Singapore and Indonesia. Nevertheless, it’s important to remember that the U.S. is the world’s largest single economy, with a GDP of about US$16 trillion, followed by China at US$8 trillion and Japan at US$6 trillion. China’s economy is so large that its exports to the U.S. represent only 5% of its GDP, but trade with the U.S. is obviously important, as China is the United States’ second largest trading partner. Most people probably think of China as an exporter but it also imports many goods from the U.S., totaling approximately US$100 billion in 2011.1 The bottom line is that from an investment standpoint, there could be negative implications to Asian companies which export to the U.S. and Europe, but we believe some of the stronger ones will likely survive.
Whatever the outcome on the fiscal policy side of the equation, on the monetary policy side, I think the Federal Reserve is likely to continue its “QE” monetary expansion, with the objective of preventing a severe slowdown in the American economy and, most significantly, of reducing unemployment. This stance is important for the entire world—particularly for stock markets—since increased liquidity can generally lead to higher stock prices. While it’s also likely to lead to higher inflation, good companies should be able to adjust their prices accordingly. The U.S. money expansion is forcing other countries to take similar monetary policy actions in order to prevent the U.S. dollar from becoming too weak against their own currencies, thus ruining their exports businesses. We thus see rapid expansion of money supply not only in the U.S. but in Europe, Japan, China and other countries to be likely. We’ll be watching the implications of this in the coming year.
On the foreign policy side, President Obama’s policies have been oriented toward an idea of “leading from behind” with more cooperation with allies and an open attitude toward dialogue with perceived “foes.”
The president has said that power alone cannot protect the U.S., and that it’s necessary to rely on alliances. In his words, “…power grows from its prudent use” and it is necessary to use “humility” and “restraint.” He seems to be looking to see changes in America’s global economic role in an era where partnerships are more important and negotiation is more effective than threats and exerting military power.
Overall, I think this attitude and policy stance will probably be positive for investments in Asia, since confrontation with China seems less likely and the offshore island disputes between Japan and China are likely to be handled gingerly by the president, despite the Japan-U.S. military alliance.
We still have a lot of unanswered questions, and I’m a realist about the risks, particularly in regard to the United States’ ability to solve its debt issues in short order. However, I’m still optimistic about the prospects for equity investments in emerging markets and in Asia in the coming year, whether the U.S. falls off the fiscal cliff or not.
Senior Vice President and CIO of the Franklin Templeton Fixed Income Group©, Christopher Molumphy, has more thoughts on the fiscal cliff. Read his perspective in our Beyond Bulls & Bears blog.