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2 Major Threats Facing the US Economy

February 1st, 2013

by Russ Koesterich

of iShares Blog

Financial markets dodged yet another bullet last week when the House of Representatives passed a bill suspending the debt ceiling until mid-May. The decision by House Republicans temporarily removes the (not so real) threat of a default or government shutdown.

While markets cheered the vote, the United States still faces two major risks, one near term and the other longer term.

  • The Near-Term Risk: Significant fiscal drag slows down the US economy and earnings more than expected. Earlier this month, I warned investors about two March fiscal cliff-related dates: when the sequester (automatic spending cuts Congress’ fiscal cliff deal delayed for two months) kicks in and when legislation funding various government entities expires.

I’m not as worried now about these dates’ immediate impact on markets because I expect Congress to pass small and temporary measures related to these issues that will be enough for the time being. Assuming, however, as I do, that Congress’ measures will include allowing some or all of the sequester to hit, the US economy is likely to experience fiscal drag – higher taxes and lower spending – equal to about 2% of gross domestic product this year.

While this is less drag than the United States was facing before the New Year’s Eve debt ceiling deal, it’s not a trivial amount, especially considering that the US economy is still struggling with the lingering effects of consumer deleveraging.

  • The Long-Term Risk: The United States’ fiscal position further deteriorates as Congress continues to kick the can down the road. Currently,nothing is being done to address the United States’ deteriorating fiscal position. Tax hikes will raise approximately $600 billion over the next decade, a relatively small sum compared with the country’s $10 trillion deficit. And the $600 billion sum is arguably overstated as current government budget projections assume some very unrealistic growth rates. If growth ultimately disappoints, revenue will come in below expectations and the deficit will come in above projections.

Even more troubling: none of Congress’ recent deals begin to tackle a dysfunctional and inefficient tax code or an increasingly strained entitlement system. These are both long-term drivers of the US deficit. Without a broad deal that addresses these issues, the country’s debt will continue to grow as a percentage of US GDP. This trend is only likely to worsen toward the end of this decade as an aging population drives healthcare and pension spending to unprecedented levels. Paradoxically, the fact that the United States is likely to get away with a massive deficit longer than other countries only intensifies the problem.

With such risks looming over the US economy, I continue to advocate that investors consider reducing any overweight positions they may have to US stocks as a whole. Instead, I’d advocate investors consider overweighting segments of the international market most levered to global growth and segments of the US market generally less sensitive to domestic growth. US mega caps, accessible through the iShares S&P 100 Index Fund (OEF) and the iShares S&P Global 100 Index Fund (IOO), are examples of the latter.

While these threats to the US economy aren’t likely to impact global markets in the near term (as long as the United States can borrow for the long term at 2%, markets are unlikely to be overly troubled by the deficit), a US fiscal position that continues to deteriorate represents a long-term systemic risk to the global economy as a whole. Ultimately, when the US debt bill finally comes due, it could be a very large one with global repercussions.

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.

The author is long IOO

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