Industrial countries are embarking on the most aggressive tightening of fiscal policy in more than four decades, led by the U.S. and Britain, as governments gamble they can pare debt without strangling an economic recovery.
Rich nations will reduce their primary budget deficits, excluding interest payments, by 1.6 percentage points next year, the most since the Organization for Economic Cooperation and Development began keeping records in 1970, according to JPMorgan Chase & Co. economists. The budget squeeze will lop 0.9 percentage point off growth in 2011.
Even as President Barack Obama warns his counterparts to be wary of derailing demand, U.S. gross domestic product will be reduced by 1.3 percentage points next year when his $787 billion stimulus program expires. That compares with a drag of 0.7 percentage point in the euro-area and 2.4 points in the U.K., JPMorgan calculates.
“There’s going to be a meaningful deceleration in growth, but it will still be solid,” said Bruce Kasman, the New York company’s chief economist. He forecasts the global economy will expand at a 2.8 percent annual pace in the first half of next year, down from 3.8 percent in the quarter that just ended.
While retrenchment may fortify countries by reducing government debt and lowering long-term interest rates, investors are selling stocks partly on concern that policy makers may repeat the mistakes of the 1930s and cut back too far, too fast. The MSCI World Index has fallen 16.5 percent to 1,036.62 on July 2, and the Standard & Poor’s 500 Index was down 16 percent to 1,022.58 from their year-to-date highs in April.
The S&P index will bounce back to 1,350 by the middle of next year as investors realize the recovery is on track and profits are rising, said David Bianco, head of U.S. equity strategy at BofA Merrill Lynch Global Research in New York.
“Right now, we’re in the worry season,” he told reporters June 28. “I look forward to moving into the earnings season.”
Investors should favor companies that export to faster- growing emerging markets instead of businesses exposed to local demand that may be pinched, said Ian Richards, an equity strategist in London at Royal Bank of Scotland Group Plc. That means corporations like London-based British American Tobacco Plc, Europe’s second-largest cigarette maker, and Leuven, Belgium-based Anheuser-Busch InBev NV, the world’s largest brewer, will probably outperform businesses such as U.K. car insurer Admiral Group Plc and Italian utility A2A SpA, he said.
Some companies already are coping with declining government demand. International Business Machines Corp. in Armonk, New York, the world’s largest computer-services provider, said on April 19 its public revenue was flat in the first quarter after rising 6 percent in the same period a year earlier. At the same time, the decline in industrial revenue was 2 percent compared with 15 percent.
Munich-based Siemens AG, Europe’s largest engineering company, last week predicted “continued strong profitability” in its third quarter as demand rebounds for its factory- automation gear, health-care products and light bulbs. Orders and sales for the quarter ended June 30 rose simultaneously for the first time in almost two years as customers restocked goods.
The last time developed economies saw primary deficits tumble was in 2006, when they fell by 1.5 percentage points, according to data from the Paris-based OECD. Industrial nations grew 3.1 percent that year, while the MSCI World Index rose 18 percent.
Need for Austerity
Obama and his fellow Group of 20 leaders agreed on June 27 to keep existing stimulus plans in place while pledging to halve their budget deficits by 2013. Their statement, issued after a summit in Toronto, bridged a gap between Obama, who wanted to focus on growth, and German Chancellor Angela Merkel, who stressed the need for austerity.
Obama’s push for more government spending in the U.S. this year has run into problems in Congress, where Senate Republicans oppose it, saying it will increase the deficit.
Much of the fiscal tightening in the U.S. next year will be what Kasman described as “passive” -- the result of ending the stimulus package Congress passed in February 2009, shortly after Obama took office. The government says it already has distributed $415 billion, or 53 percent, of the program, which includes tax cuts and expenditures on roads and other infrastructure projects.
The U.S. will probably reduce its budget deficit -- the difference between what it spends and what it takes in as taxes and revenue -- to $1.1 trillion in the fiscal year beginning Oct. 1 from $1.4 trillion this year, said Mark Zandi, chief economist at New York-based Moody’s Analytics. He predicts the total will fall to $900 billion in 2012 and $800 billion in 2013.
European governments, spooked by Greece’s debt crisis, are also implementing cuts. The U.K.’s new coalition government last month announced higher taxes and the deepest spending reductions since World War II to trim its deficit. Finance Minister Wolfgang Schaeuble proposed spending cuts on July 4 that will reduce Germany’s federal budget deficit by about 40 percent during the next five years.
Tighter fiscal policies will shrink the German deficit a percentage point of GDP in each of the next two years from 4.3 percent in 2010 and reduce the U.K.’s gap to 7.4 percent next year from 9.7 percent this year, economists at Barclays Capital predict.
Expansion in the euro area will slow by 1 percentage point next year, estimates Lars Tranberg Rasmussen, an analyst at Danske Bank A/S in Copenhagen. At the same time, the euro’s decline may add 0.8 percentage point to growth, and a decline in long-term interest rates could add another 0.2 point, he said. The euro zone contracted 4.1 percent in 2009.
“Fiscal policy cannot be neglected and there are some negative effects, but we don’t think tightening will mean another recession,” Rasmussen said.
One irony is, for all Merkel’s declarations that “it’s time to reduce deficits,” Germany is on track to get a boost from continued infrastructure spending and income-tax cuts. Europe’s largest economy will receive a 1.1 percentage-point fillip from the government during the next two years, estimates Gilles Moec, an economist at Deutsche Bank AG in London and former Bank of France official.
That will help cushion the blow of austerity programs in Europe’s so-called peripheral countries such as Greece, which Moec estimates will suffer a 4.3 percentage-point hit from its government’s efforts to avert a debt restructuring or default.
Smaller budgets may generate stock-market gains by limiting the amount governments need to borrow, freeing up access to funds for private companies, according to Ian Scott, a London- based strategist at Nomura Holdings Inc. Periods of high borrowing during the past 35 years in the U.K. were associated with relatively low stock valuations, he said.
The simultaneous tightening of fiscal policy by rich nations is nevertheless a “risky strategy,” according to Kasman. With short-term interest rates in the U.S., Europe and Japan already at or near zero, there’s little scope for the Federal Reserve and other central banks to respond with easier money if the budget squeeze undercuts the economy, he said.
Mohamed El-Erian, chief executive officer of Pacific Investment Management Co. in Newport Beach, California, likens the situation to driving a car without a spare tire over a bumpy road where further mishaps are possible. Fifty-nine percent of 440 executives in an RBC Capital Markets survey published last week believe governments in developed nations lack the firepower to spur credit if another financial crisis hits.
Falling Home Sales
The U.S. housing market is already suffering from the expiration of an $8,000 tax credit at the end of April, which pushed May purchases of new U.S. homes down 33 percent to the lowest level in records going back to 1963, the Commerce Department said. Sales for Lennar Corp., the third-largest U.S. homebuilder by revenue, were down 20 percent to 25 percent in June compared with a year earlier, the Miami-based company said June 24.
The chance of a relapse into recession in the U.S. will rise to one in three from one in four if Congress fails to extend unemployment benefits and provide federal aid to states as Obama has requested, Zandi said. Obama might also opt to phase in tax increases for the wealthy that are due to kick in next year to cushion their impact on the economy, he added.
There is a 30 percent chance of renewed recession in the U.K. and 35 percent risk in the euro-area, said Howard Archer, chief European economist at IHS Global Insight in London.
“A double-dip can’t be ruled out,” he said.