US Congressional supercommittee fails to agree on plan to reduce deficit

At a time when contagion risk from the European debt crisis is still brewing, global economic momentum waning and confidence plunging, these Congressional leaders responsible for restoring confidence in the US state of fiscal health have decided to put politics ahead of the economy.

The failure does not mean that the US will not cut its deficits because there is an automatic spending cut or “sequester” rule that will start in January 2013 for ten years. It just means that both the Republicans and the Democrats have squandered a golden opportunity to strike a compromise to restore the country’s finances and also to demonstrate leadership to the world.

Under the sequester rules, roughly half of the spending cuts would come from defence and homeland security, and the other half from domestic programmes such as roads, education, energy and housing. An automatic cut from every federal agency is far from an ideal way to manage a budget, because it does not set priorities and largely exempts the major entitlements like Medicare and Medicaid. In other words, as President Obama has said, the deficit would be trimmed with a “hatchet instead of a scalpel.”   

So far rating agencies S&P and Moody’s have said they won’t lower ratings on the US despite the supercommittee’s failure and bond yields haven’t reacted much even though stocks continued to plummet. Perhaps from the go it was considered a long shot and optimism was never high that the panel would succeed given the proximity to the Presidential election next year. 

Still the outcome depressed market sentiment further at a time when confidence in political leaders to find solutions to the world’s problems is waning. In fact, in some countries, politicians are seen to be the problem. These feelings have given impetus to movements like the Arab Spring, Occupy Wall Street etc. to agitate change from the bottom up. In more democratic countries like Greece and Italy, incumbent administrations have made way for more technocratic governments.  

The world is in dire need of leaders who are operators with an understanding of economic issues and market solutions, and not mere career politicians. With economies slowing, unemployment high, workers taking to the streets, it is not far-fetched to imagine technocratic governments even in France and Germany in the near future. 

Or perhaps the fault lies with the system rather than the people. Democratic capitalism seems to be ill-placed to deal with the economic crises in both the US and Europe where politicians cannot see beyond their partisan stance for the greater good. Perhaps if either Europe or the US had an autocratic system, their leaders could have accomplished much more. This is only hypothetical and I do not want to start a debate about whether democracy or autocracy is the better model. Ultimately, it is about governance and it is about both the structure and the people in it.

To conclude, we believe that political risks and policy risks will remain elevated and continue to drive the markets into 2012. It is tough to be bullish in such an environment.

Greek Referendum Throws a Spanner in the Works

Greek Prime Minister George Papandreou's call for a referendum on the freshly minted bailout package rattled global financial markets as officials and investors panic over the possibility of a collapse of the euro-zone.

After what seemed like a Sisyphean task to hatch a comprehensive plan to deal with the sovereign debt crisis by European leaders, Greece’s shock decision late Monday to hold a referendum threatens to unravel all the goodwill mustered over the past few days.

Essentially, Mr. Papandreou is asking his countrymen to decide if they wish to accept the debt deal that will require Greece to implement all the austerity programmes forced upon it by the “troika” (EU, ECB and IMF) for at least a few years in return for continued funding. But effectively, the referendum amounts to a vote on Greece remaining a member of the euro-zone and could potentially lead to a disorderly default of its debt.

The referendum is not expected to be held before December and current opinion poll suggests 60% of Greeks oppose the deal. Many things can still happen between now and then. Mr. Papandreou is already facing revolt within his own Pasok Party and a confidence vote against him may be in the works. Or perhaps, he can persuade Greeks that their best option remains within the euro-zone.

This brings home the point that when push comes to shove, Greece can still reject the deal, exit the euro and reclaim their sovereignty. While this may not be such a bad option for Greece, coming at such a tense time could fuel concerns about the viability of the entire euro-zone.

In one broad stroke, Greece has lost the goodwill from European leaders and the bailout package is held hostage by Greek voters. The sixth tranche of the aid disbursement to Greece is now in jeopardy while countries such as China and Japan would surely have second thoughts about risking their taxpayers’ money to invest in any bailout fund.

Our recent upgrade of equities was premised on Europe avoiding a messy, disorderly default of Greece. We had that for a few days last week when leaders agreed to a 50% haircut on Greek debt, enlarging the EFSF to EUR1 trillion and forcing banks to recapitalise their core capital ratio to 9%.

With the Greek referendum on the cards, we are back to square one with the tail risk of a disorderly default on the radar again. Worse, this looks like a binary outcome and it is not in the hands of the politicians. Strange, for once, I’d rather it is in the hands of politicians. Now, it is down to a flip of the coin.

There may be some reprieve from the G-20 summit this weekend. But as long as the tail risk remains elevated, we will lighten up at every opportunity.

Is there a silver lining? Yes, but that’s a topic for another time.