How close are we to the fiscal cliff?

The following is excerpted from the iShares mid-year outlook report courtesy of BlackRock. To read the full version of the report, click here.

A specter is haunting Europe…
-Karl Marx
Marx was referring to communism, not the dissolution of the European Union, but the language could apply in the current environment. At the end of our 2012 outlook piece (see January Market Perspectives), we suggested that this was likely to be another year in which financial market fortunes would be largely driven by the effectiveness, or lack thereof, of policy makers. As of the end of May, the jury is still out as to whether the European Union can summon the necessary political will to address the euro’s structural flaws.
Despite positive growth in the United States and a few tentative signs of a soft landing in China, Europe continues to represent a significant threat to the global economy. As was the case in 2010 and 2011, marginal improvements in the global economy have been overshadowed by the threat of a disorderly Greek default and broader fears regarding the solvency and longevity of the entire European Economic and Monetary Union.
While the early months of 2012 looked better than expected and recent ones worse, so far 2012 has played broadly to the scenarios we laid out in our 2012 outlook. The US and global economies have chugged along at a positive, but uninspiring rate. Europe has, as was expected, been a drag on global growth—with the weakness disproportionately evident in the south. Inflation has remained muted, and while rates hit a new low in early June, they have spent most of the first half of the year stuck in the same range that has broadly defined the bond market since last September.
In terms of financial markets, our expectation for 2012 was for a decent but uninspiring year for stocks, which we expected to at least outperform bonds. Within equities, we favored dividend- paying mega capitalization stocks (mega caps), smaller devel- oped countries and emerging markets. In fixed income, we expected interest rates to remain contained, but for municipal and investment grade bonds to outperform.
On the whole, performance year-to-date has generally conformed to that view, with the notable exception of emerging markets. Equities are narrowly beating bonds and mega caps have outperformed both small and large caps. The one call which has not had much of an impact to date is our preference for emerging markets. Year-to-date, EM equities have performed in-line with those in developed markets.
On the bond side, we started the year with a particular focus on US investment grade debt and a continued preference for high grade municipals. So far, performance has been broadly in line with our comments, with both investment grade and municipals outperforming broader bond indices.
What is interesting is how narrow the differences among asset classes have been year-to-date: most are close to where they started the year, with few producing better than mid-single digit returns.
While the general economic and market environments have been broadly in line with our outlook, we have made at least one mid-course correction. The ever-present threat in Europe, coupled with what looked like investor complacency—no amount of rationalization justified the VIX Index in the mid-teens as recently as early May—caused us to adopt a more defensive posture in mid-April. At the time, we suggested that financial volatility was likely to rise, and equity markets were facing a correction.
Against that backdrop, with the market already experiencing a 10% correction, what are our expectations for the remainder of the year?
Economic outlook: 2% growth ad infinitum?
Absent a crisis in Europe, we would continue to expect economic growth in the second half of 2012 to be broadly in line with the first quarter—positive but subpar. In the United States that suggests growth of around 2%, while global growth should be roughly 3% to 3.5%.
In the United States, our preferred measure of economic activity—the Chicago Fed National Activity Index (CFNAI)— remains in the same range that has defined it since 2009. The CFNAI has been an exceptionally reliable indicator, historically explaining roughly 45% of the variation in next quarter’s GDP. It has kept us relatively measured in our expectations for economic growth through both the pathos of last summer and the prema- ture euphoria of earlier this year. Despite all the gyrations in sentiment, the CFNAI continues to oscillate somewhere around zero, which is consistent with GDP growth of 2% or slightly better. In the absence of an exogenous shock—Europe being the most likely, but not the only candidate—we would continue to expect the United States to grow at around 2% for the remainder of 2012 and into 2013.
Similar to the CFNAI, we find that the Global Purchasing Manag- ers Index (PMI) provides a reasonably accurate read of near-term global economic activity. Here we see the same picture as in the United States with the indicator suggesting that global growth is unlikely to collapse or accelerate in the near term. The Global PMI ended April at 52.2, well above its levels in 2008, early 2009 and last summer and indicative of growth, but down from the more robust levels of earlier in the year. Absent a collapse in Europe, the global economy should be able to limp along for the remainder of the year.
Even in China, the picture remains remarkably similar. Growth disappointed in the first quarter and is likely to be soft again in the second quarter; however, Chinese leading indicators suggest slow growth, but no meaningful deceleration.
While the data out of China has been decidedly mixed and difficult to interpret, our best guess is that China engineers a soft landing in the back half of the year, with growth settling at around 8%. After all, China has both the motivation and the means to do so. The motivation is the pending leadership transition in the fall, for which we believe Chinese officials will take whatever steps necessary to ensure a reasonably smooth transition, including keeping growth at a respectable rate. And as is the case with other emerging market countries—notably Brazil—China has the fiscal and monetary flexibility to provide further stimulus. In the run-up to the transition, we would expect additional steps, such as cuts in the reserve requirement and targeted stimulus aimed at consumption, to ensure a soft landing.
The ongoing global economic sluggishness begs a question: why is growth so weak nearly three years after the end of such a brutal recession, and how long is it likely to remain stuck in first gear? Leaving aside the risk associated with the European chaos, the US fiscal drag or higher oil prices, the answer is that the same headwinds that have inhibited the recovery since 2009 remain broadly in place. Debt levels in the developed world are still too high and the deleveraging process is likely to continue to exert a headwind for the foreseeable future. In the United States, in particular, consumer debt levels, while lower, are still extremely high by historical standards, and are unlikely to return to a more sustainable level until probably 2014.
In addition, consumers are also struggling with stagnant wage growth, which for hourly workers is at a record low, and negative in real terms. Even for the broader working population, income growth is barely keeping pace with inflation. One little-noticed develop- ment is that personal income growth has decelerated sharply over the past 12 months. Part of the reason for this is the slowdown in government transfer payments—direct payments such as unemployment benefits—which are no longer supporting personal
Will the United States plunge over the fiscal cliff?
A major threat to the above scenario of slow but positive growth is, of course, Europe. Before addressing Europe, it is worth reiterating that the United States also poses a significant, though less imminent, threat to the global recovery.
As has been well reported over the past several months, the United States is potentially facing the largest fiscal drag in decades. At the end of 2012, several tax hikes and spending cuts are scheduled to hit simultaneously. The cumulative impact will be more than $600 billion in fiscal drag, or the equivalent of roughly 4% of GDP. Given our view that under the current deleveraging trend growth in the United States is unlikely to be better than 2%, if the fiscal drag were to occur, we believe a double-dip recession becomes much more likely. This view has recently been echoed by the Congressional Budget Office, which now forecasts a contraction of more than 1% in the first half of next year unless current policy is amended.
The odds still favor an eleventh-hour compromise that is likely to delay part or all of the fiscal drag, but this is by no means assured. After all, despite widespread views that a compromise would be reached last year, Washington failed to reach a consensus on the US spending cuts, resulting in the sequester scheduled to take effect next year. Given that the upcoming election is likely to be highly bitter, and may very well increase the partisanship in both the House and Senate, a compromise is not certain. As of this writing, despite all the headlines, we believe that investors are placing a very low probability on the fiscal drag actually occurring. This is partly evidenced by the fact that 2013 growth forecasts have remained remarkably stable over the past nine months, despite the pending fiscal drag.
If in the run-up to the election a continuation of divided government starts to appear more likely, we believe that the market will come under pressure. At the very least, absent a clear consensus coming out of the election, November and December are likely to be marked by heightened volatility as investors grapple with the odds of a last-minute compromise.

Conclusion
Give me control of a nation’s money and I care not who makes her laws. —Mayer Amschel Rothschild
Over the coming weeks, months and years, Mayer Rothschild’s axiom is likely to be put to the test. While Germany continues to ultimately control Europe’s checkbook, this may be insufficient in the presence of rising anger in much of the periphery. If politicians cannot adopt a complement of pro-growth policies and address Europe’s fragile banking system, a broader European crisis becomes inevitable.
Actions by the ECB at the end of last year and again in February were a powerful palliative, but did nothing to resolve longer-term questions over Greek solvency, Spanish banks, longer-term growth or fiscal integration. Based on the market’s recent performance, outside of some modest reforms in Spain and Italy, 2012 has been little better.
That said, a European crisis is not preordained. Economic solutions do exist, although whether they are politically viable is still an open question. Nevertheless, in some respects—a growing awareness of the need for growth and tentative signs that Germany may accept eurobonds—Europe is stumbling toward a consensus. The big question is whether they will get there in time.
In the meantime, we expect volatility to remain elevated, partly due to Europe and partly due to the uncertainty surrounding US fiscal policy. In this environment, while equity markets can move higher, we would expect that move to be accompanied by a reasonable amount of volatility, certainly more than we experienced in the first quarter and early second quarter. Given that scenario, we would prefer the relatively low beta of high dividend stocks—both in developed and emerging markets—and to use any market weakness as an opportunity to add to longer-term positions in emerging markets. On the fixed income side, while high yield was the flavor of the month in the first quarter, we believe historically high spreads and less risk favor investment grade in the coming months.

Russ Koesterich is the global chief investment strategist for BlackRock’s iShares business.

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