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The US is experiencing a soft patch in its economic recovery
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With pressure from investors and rating agencies alike, US austerity measures are high on the agenda
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With QE2 coming to an end, QE3 seems unlikely unless the US economy contracts again
Paul Brain, manager of the Newton Global Dynamic Bond Fund, takes a look at the state of the US economy as QE2 nears its end.
With unemployment data disappointing once again in May, weak manufacturing numbers and the housing market still firmly in the doldrums, the US economy finds itself on a knife edge, and there are good reasons to suggest that fears of a double-dip recession are well founded. However, as Brain explains, this is very much the worst case scenario. "In reality, we believe the US economic recovery is simply going through a soft patch as a result of external events such as the natural disasters in Japan, bad weather conditions across the US, and the damaging effect on consumer and investor confidence of heightened commodity prices. Indeed, in recent times concerns over Japan have eased, and oil prices have fallen back from their highs, although it does seem likely that the housing market will continue to be a drag on growth for some time to come," he adds.
"Ultimately, the most pressing concern for the US is to establish, or at least begin planning the necessary austerity measures aimed at cutting the country's growing fiscal deficit. Indeed, in recent months both Moody's and S&P have highlighted the need for such action," says Brain. "Meanwhile, the US debt ceiling - the legal limit on its borrowing - reached its limited in May, and the US government has until August to either cut the government's debt, or, as will almost certainly be the case, raise its debt ceiling.
"In terms of possible austerity measures, the water has been muddied somewhat by the strong Republican showing at the mid-terms last November, meaning that both the Democrats and Republicans are going to have to compromise when coming to an agreement; the Republicans favour an approach based wholly on spending cuts while the Democrats are backing an approach which balances spending cuts with tax rises." He continues, "We expect measures to be put in place over the next six months to a year, but in the meantime, the lack of an agreed plan is having a negative effect on US Treasuries. However, as soon as agreement is reached, we would expect Treasuries to react positively. In our view, anything around the 70:30 (cuts:tax rises) mark - which the Democrats are pushing for - would be well received by markets."
The prospect of QE3...
With QE2 coming to an end, the prospects for a further round of quantitative easing, QE3, is being mooted. However, Brain doesn't believe that there is sufficient support for such a move, at present at least. "The US Federal Reserve has been criticised for implementing QE2, so it seems unlikely that they would embrace QE3 unless there was no alternative. It is very much the last weapon left in their armoury, and would only be used if the US economy fell back into recession, and even then, as a result of political pressure. Ultimately, QE2 was implemented to avoid a double-dip recession, so QE3 would only be used if that eventuality came about," he says.
"There's no doubt that the next few months will be anxious ones for US policymakers, with QE2 finished, and few tools left to deal with the threat of the dreaded ‘double-dip'. There are also real concerns that US dollar assets might become vulnerable, especially with the backdrop of weak growth and a burgeoning fiscal deficit. In terms of fund positioning, we have been selling US Treasuries in recent weeks, while we have been adding positions in selected Eurozone bonds. We have also reduced our US dollar exposure, and added to the euro, Swiss franc and Swedish krona," Brain concludes.
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