Beyond Bulls & Bears

The View From the Fiscal Cliff

Six months into 2012, investors whose New Year’s resolutions included a vow to hold strong through market dismay may be finding that the eurozone crisis and slowing global growth are testing their resolve. As we move into the second half of the year, sluggish growth and continued market uncertainty seem likely to be ongoing scenarios for the U.S., as the nation faces a fall presidential election and teeters on the edge of a precarious-sounding “fiscal cliff.” In this sobering Beyond Bulls & Bears post, Chris Molumphy, Executive Vice President and CIO of the Franklin Templeton Fixed-Income Group®, offers some cautiously optimistic mid-year perspective on the U.S. economy.

Molumphy’s thoughts, in brief:

  • “While there are certainly headwinds (in the U.S. economy), we feel that there is a reasonably solid base, and not a backdrop that appears likely to lead to a double-dip recession.”
  • “Although employment growth has stalled out a bit over the past several months, our view is that we would expect a gradual—and an emphasis on gradual—improvement over the coming months and quarters.”
  • “We don’t envision significant upside in the coming months and quarters in housing, but we think we finally may be seeing some stability in the overall market.”
  • “This could be the fourth year in a row for the U.S. to run a deficit in excess of $1 trillion, and as the total debt climbs, the U.S. could be in danger of further ratings downgrades come first quarter of next year without a realistic debt reduction plan in place.”

After an upbeat end to 2011, hopes were high for a continued economic recovery this year. The markets haven’t generally delivered on that hope in the first half of 2012. In the U.S., growth has stalled. First-quarter GDP came in at a sluggish pace of 1.9%, down from 3% in the fourth quarter of 2011.1 At the same time, the U.S. unemployment rate remains stubbornly high, at 8.2% in June.2 The IMF projected the eurozone will slip into recession this year, and dour chatter about a similar fate for the U.S. has surfaced. While he doesn’t deny the U.S. economy faces undeniable challenges, Molumphy isn’t buying into the “double-dip” recession talk. In his view, this listless pace of growth is par for the course in the wake of a financial crisis of the magnitude of the 2008 – 2009 meltdown.

Chris Molumphy

“Post large financial markets crises, much less one that also is accompanied by a real estate bubble that has burst, it is fairly typical for an economy to grow at a below-trend rate and do that for some period of time. That’s the framework that we see playing out currently in the economic environment. The global markets, and in particular Europe, are really dominating the short-term (U.S.) market movements, and in our view, short of an extreme scenario unfolding, the U.S. is likely to be somewhat insulated as it is still largely a domestic economy. While there are certainly headwinds, we feel that there is a reasonably solid base, and not a backdrop that would lead to a double-dip recession.”

Many countries that had become bloated with debt are now undergoing a somewhat painful deleveraging process. Molumphy explains that the same process has been taking place at the consumer level. As consumer spending represents roughly 70% of U.S. economic activity, the fact that U.S. consumers are finally getting control over their finances and are able to start spending again (potentially even within their means!) represents a positive step.

“The consumer has more work to do, but as we see it, is in a reasonably healthy condition at this point in time. We see evidence of this in discretionary purchases such as autos, which have been reasonably healthy to date in 2012. Now, the biggest driver of consumption is employment; we have moved from a high of about 10% unemployment in 2009, down to the current level of 8.2%. Although employment growth has stalled out a bit over the past several months, our view is that we would expect a gradual—and an emphasis on gradual—improvement over the coming months and quarters.”

Consumer spending and confidence were two casualties of the housing market collapse, but – incredibly – Molumphy sees signs housing may finally be bottoming.

“We don’t envision significant upside in housing in the coming months and quarters, but we think we finally may be seeing some stability in the overall market. So when you put all this together, our view is for continued fairly sluggish growth in the United States, something perhaps on the order of 2% plus or minus in the coming quarters.”

Turning to the corporate sector, Molumphy believes things look “reasonably solid.” Earnings growth certainly is slowing, but in his view, companies in general are fairly lean, and liquidity on balance sheets appears to be strong.

The Fiscal Cliff
Parts of Europe are in the process of addressing their debt problems with some painful proposed austerity measures, but so far, the U.S. Congress has delayed making the difficult decisions needed to address the mounting U.S. deficit. If other solutions aren’t found, under current law a combination of tax increases and spending cuts automatically go into effect in January 2013, an event dismayingly referred to as the “fiscal cliff.” The U.S. Congressional Budget Office estimated that the tax increases and spending cuts would reduce the federal budget deficit by $607 billion, or 4% of gross domestic product (GDP), between fiscal years 2012 and 2013.3

The phrase “fiscal cliff” implies something catastrophic or possibly terminal. While it is expected to dampen economic growth, it may only be for the short term. The CBO warned that U.S. GDP could fall 1.3% in the first half of 2013 if no other action is taken to modify the current course. Regardless of the outcome of the presidential election and congressional control, Molumphy says these are significant issues which will need to be addressed and are adding to the market’s uncertainty.

“Our current assessment is that we feel it’s extremely difficult to envision a significant fiscal contraction. The consequence of failing to act has significant ramifications on the U.S. overall national debt. The U.S. is on pace to run a deficit in excess of $1 trillion for the current fiscal year ending in September.4 This could be the fourth year in a row for the U.S. to run a deficit in excess of $1 trillion and as the total debt climbs, the U.S. could be in danger of further ratings downgrades come first quarter of next year without a realistic debt reduction plan in place. And as one could imagine this has potentially significant implications on longer-term rates. However, there is a risk this problem potentially will not get addressed.”

Whether the U.S. will go over the fiscal cliff or merely enjoy the view from its edge remains to be seen, but it’s probably safe to say it’ll be a bumpy road, either way.

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The information provided is not a complete analysis of every material fact regarding any country, region, market, industry or security. Because market and economic conditions are subject to change, comments, opinions and analyses are rendered as of the date of this posting and may change without notice. The analysis and opinions expressed herein may differ or be contrary to those expressed by other business areas, portfolio managers or investment management teams at Franklin Templeton Investments. Commentary is not intended as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy.

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1. Source: U.S. Department of Commerce.

2. Source: U.S. Bureau of Labor Statistics.

3. Source: U.S. Congressional Budget Office, May 2012.

4. Source: The White House Office of Management and Budget.