Washington Gridlock: Reduced Risk but still an Economic Drag 2/21/14

In recent years, Washington politics have been seen as a major threat to financial markets.  Concerns surrounding the soaring federal debt, fiscal austerity and political confrontations thwarted confidence.  Recently, these fears have diminished and Washington, though still politically gridlocked, is far less of a threat to investors going forward.  Generally speaking, political gridlock can be considered a good thing for investors in the short term as new “game changing” legislation is off the board, which creates a more predictable environment for CEOs and investors.  However, that does not mean political gridlock is benign.  There are numerous issues that a politically deadlocked Congress continues to avoid that will act as a weight on long term growth, including, tax reform, entitlement reform and immigration reform.  The failure of Washington to address these political issues will eventually diminish long-term economic growth and investment returns. 

The recent budget wars seem to have subsided for now as the federal budget deficit fell from 6.8% of GDP to 4.1% of GDP from fiscal 2012 and fiscal 2013, respectively.  This was a major cut in the deficit, but does still remain a significant drag on economic growth.  

According to the Congressional Budget Office, the deficit cuts of 2013 combined with an improving economy appears set to reduce the deficit to just 3.5% of GDP this fiscal year and 2.6% next year.  These deficits will, of course, add to the national debt.  However, at these deficit levels, the economy should be growing as fast as the debt so the debt-to-GDP ratio looks set to stabilize at roughly 72% of GDP throughout the next five years.  The fiscal drag from the debt will continue to hamper economic growth but the fears of it spiraling out of control should be put to rest.

Since the fiscal deficit appears to be manageable for the foreseeable future, the appetite for fiscal austerity in Washington has dissipated, and the economy should not have to endure further significant tax increases or spending cuts over the next few years. 

It appears that Republican leaders in the House of Representatives have acquiesced to the President’s demand for a clear debt ceiling bill and it appears that they agreed to no longer use the full faith and credit of the federal government as a hostage to push forward their political agenda.  So, eleventh hour debt ceiling deals should be behind us.

The U.S. economy is still in the midst of a cyclical recovery and if unemployment, housing and manufacturing continue to trend better, economic growth could achieve a respectable pace of 3% per year. 

However, while investors can cheer the diminished turmoil from Washington politics, it is well to remember the long-term cost of Washington inaction.  America needs to increase its supply of young skilled workers to replace the aging baby boomers that are heading into retirement.  The U.S. also needs tax reform to diminish illogical incentives and particularly to encourage corporations to repatriate foreign cash and invest in domestic plants and equipment.  There is approximately $1.8 trillion of U.S. corporate profits parked offshore at the moment and given that the U.S. corporate tax rate is 35%, one of the highest in the world, there is certain reluctance on the part of companies to bring their foreign profits back.  These profits could be invested in the U.S. economy in the form of capital expenditures, shareholder dividends, and share buybacks or even to reduce their debt. 

Most Americans agree that the U.S. needs entitlement reform that rewards work over unemployment, to encourage later retirement and to dismantle the poverty traps that make it so hard for low income individuals to improve their standard of living in a meaningful way by taking a job.

While most economists would agree that these steps could enhance both long-term economic growth and investment returns, immigration reform is currently stalled in Congress and tax and entitlement reform are not even on the agenda.

While Washington is certainly not doing anything to help the economy in the long-run, in the short-run the threat that Washington can derail this economic recovery has diminished. 

 

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