The US fiscal standoff should mean recession in Q2

Last Tuesday I updated you with my latest thinking about the twin fiscal debates on the debt ceiling and the remaining fiscal cliff items. I said then that the debt ceiling fight would come first and take precedence but that default on US public debt would be a step too far – and so Republicans would capitulate, forcing them to put their efforts into the sequester cuts that were delayed at the beginning of the year. The biggest change since then is that default looks to be off the table, making cuts during the debt ceiling standoff more likely.

Now the debt ceiling is still scheduled to become too much for even emergency spending measures to overcome by between “mid-February and early March of this year“. That means that we have about a month to reach an agreement on lifting the debt ceiling or default. As I wrote in my last post, Rand Paul has said that he wants the Republicans to push spending prioritisation as the only option available unless cuts are made. This effectively takes public debt default off the table. But it means an immediate and sharp slowdown in government spending. As Senator Paul put it, “we have tax receipts to pay for about 70 percent of the government and we’re running deficits of about 30 percent, so what I would say is pay for the 70 percent we would all keep going and stop paying the other 30 percent until we come to an agreement.”

Legal scholar Laurence Tribe wrote in the New York Times at the weekend that this option of prioritising spending if a debt ceiling agreement cannot be reached is the most obvious and likely one. President Obama has apparently signed up for this option too, having put aside the Platinum Coin option this past weekend and also apparently deciding against the 14th amendment option earlier today.

So this re-shuffles the deck and makes the most likely outcomes somewhat different. Now that President Obama has acceded to the priortised spending route, the onus is on him to come up with a deal to cut government spending because the most draconian repercussion of not getting a debt ceiling deal, default, is off the table. The Republicans have raised both payroll and income taxes. This makes them look weak, having negotiated a deal contrary to their professed ideal of fiscal conservatism and low taxes. Therefore, they will be looking for any excuse to rectify the situation in order to satisfy their base. When default was on the table, it made a debt ceiling deal a near certainty because default was unpalatable. But now that default is off the table, a deal is no longer a necessity.

I believe the Republicans are willing to take the route that Rand Paul wants in order to force the President to make concessions on spending. They believe that the President would be blamed for the economic consequences because of his intransigence, forcing him to the table. Because the President’s base is against social security and Medicare cuts and because the Republican base is against defense cuts, we are likely to see a deal that makes a large number of the sequester fiscal cliff cuts come into play. The likeliest outcome seems to be hitting the wall on debt ceiling emergency measures, followed by shutdown and the attendant fiscal cuts and then post-shutdown negotiation. These cuts in conjunction with the tax increases and the recession in Europe will throw the US into recession by Q2 at the latest as well. At this point, I see recession as the most likely scenario and so my baseline is now for a Q2 2013 recession. I am making this the first of my ten surprises for 2013. As the politics change, I will update you with how this affects the economics.

From an investing perspective, a recession is most unfavourable to the stocks of home builders and banks because of the effect on the nascent housing recovery. Cyclical stocks like basic materials and retail would also suffer. And given the low spreads in the corporate market, high yield would be the most vulnerable from a debt markets perspective. Any recession in the US would be disinflationary and therefore have a negative impact on oil prices and precious metals.

P.S. – I will try to look for the student debt problem as a catalyst to problems in the housing sector that reduces the demand for starter houses on the bottom rung of the property ladder. I am not sure if this thesis will hold though.