I recently — before the arrival of Hurricane Sandy — spent a quick 24 hours in Washington D.C. for the first time in a year or so, and I left a bit bemused about much of what I heard as it relates to the election.
For much of the past 12 months at Goldman Sachs Asset Management we have been getting more optimistic about the U.S. economy due to the combination of three forces: the turnaround in the housing market; the remarkable domestic energy story; and the beginnings of a possible revival in the competitiveness of U.S. manufacturing. At many of our regular CIO conference calls that I chair, we have often wondered what was needed to translate these forces into a stronger U.S. GDP growth and positive vibes that would come with it. Usually the answer, provided primarily by our U.S. equity portfolio managers’ interaction with corporate CEOs and their teams, are related to Washington providing less uncertainty about regulatory issues and future tax policies. It is against this background that we ponder the importance of the election itself in terms of the consequences for the U.S. and the rest of the world.
At one of our most recent calls, one of the fixed-income portfolio managers described the fiscal cliff issue as probably not too dissimilar to that of the Y2K issue back in the build up to 2000, in so far that all that worry and fear led to not much in the end. I mentioned this to one seasoned U.S. political figure on my trip, and his answer was as amusing and interesting as the analogy itself, suggesting that the only reason Y2K was a nonissue is because efforts undertaken to ensure so. Let’s hope this is the case with the fiscal challenges.
On the election outcome, I have returned assuming the most narrow of victories for the incumbent but with no real confidence in this view, and more broadly of the judgement that the electorate is not going to give a strong mandate to either. And in any case, unless there are big shifts in Congress, it is not clear that the new president will have the freedom for much away from them. A narrow victory for President Obama would seem to be, at least superficially, the more complicated of the outcomes, as a repeat of the policy stalemates of the past couple of years would probably ensue unless we see a very different Obama in a second term. But I am not so convinced that a narrow Romney victory leads to a dramatically different path unless we get a notable shift to the Republicans in the Senate too.
One of the reasons why it is all so difficult for the voters comes back to the same issue the politicians are struggling with: deficit issues are eating away at the underlying American Dream, especially with the more radical wings of the political parties having grabbed the media attention on the issues. Do the American people want higher permanent taxes to help pay for more government (which those in favor hope will ensure a better and more successful degree of government support)? Or do people want less government, paving the way for less taxation eventually and all the issues that go with it? Not surprisingly the 300 million American citizens seem somewhat split — or to be more accurate, those in the key marginal state battlegrounds seem to be. Against this background, whoever wins seems set to face the challenge of a messy compromise on the fiscal cliff to avoid the consequences of a sharp slowdown while maintaining some sort of fiscal credibility.
My own financial market experience leads me to wonder if, without pressure from the financial markets, policymakers can voluntarily come up with what is needed. From living through various global events since I started in the markets in 1982, I have observed that it is rare that governments solve tough fiscal choices without markets forcing them to. In this regard, I also find myself thinking that while it has been fashionable and understandable for many U.S. policymakers to worry about the potential spillovers from the euro zone crisis in 2012, it is not out of the bounds of possibility that if the Europeans ever solved their crisis this might result in closer global inspection of what is going on in U.S. fiscal affairs. Oddly, if the German elections in the autumn of 2013 leave the future of EMU with a clearer, more credible path, it may force the U.S. to face tougher choices (assuming that the underlying fiscal issues have not been dealt with by then).
There are two other big economic policy issues looming from the election: China and the stance of the broad Federal Reserve monetary policy framework. If Romney were to emerge as the next president, he has recently reiterated an intention to declare China as a currency manipulator. One wonders how he could shift from such a stance, as it seems not to be especially wise. Given the considerable adjustments taking hold in China — including a slower, better balance of growth — it seems inappropriate for an elevated degree of pressure from outside. Not least because there are growing signs that the RMB might not be so undervalued anymore. Given the strong rise of exports that the U.S. is enjoying, including to China, what is the benefit of such a stance? It might play well in marginal election battlefields, but it doesn’t make economic sense.
As for the Fed, Romney has also made it clear that he is not a supporter of Ben Bernanke’s stance on unconventional monetary policies, and appears to want to nominate a new chairperson who would take the Fed away from such laxity. With any luck, the positive private sector forces I mentioned earlier will remain sufficiently robust to overcome the consequences of post-election fiscal issues, and if so, it might be the case that the Fed chooses to shift away from its current stance anyway. But in the event that the economy will not be so robust, a new Fed leader probably wouldn’t take too kindly in such a strong outside view as to how they should or shouldn’t determine their monetary policy.
Translating these issues into financial markets, we find ourselves at GSAM thinking that the consequences for bond and currency markets might be at least as interesting as for those for the equity markets. If the markets have to rethink the idea of an earlier shift in policy from the Fed, then this would have probable negative consequences for the bond market, and in all likelihood, support for the dollar. Given the importance of interest rate differentials for the dollar’s movements against major currencies, any such shifts would probably strengthen it against a number of currencies. Ironically, this might also result in some strength against the RMB given that China tends to manage its currency on a trade-weighted basis, and would be unlikely to force additional RMB bilateral currency strength against the dollar if both the yen and euro were weakening.
Under a return of Obama, these market issues might be somewhat different, although of course, if the economy were to continue strengthening, then this would not be the case.
As for the equity market, because of the strong 2012 performance, our preferred long-term valuation framework suggests that U.S. equities are no longer cheap, and without the support of Fed liquidity they might have a bigger challenge appreciating in value further. In order to do so, equities will require a notable drop in the current risk premia, which can presumably only come about if a new administration succeeds in lifting the clouds hanging over business leaders. We are currently inclined to favor the view that this will happen, but it is not one that I have over confidence about and will be keeping on our toes more than usual.
One thing is for sure, as always, there are going to be no shortage of issues for us all to focus on.
Jim O’Neill is the chairman of Goldman Sachs Asset Management.
