The events and information that have come to light in the past ten days have led me to the conclusion that there is a significant probability we are heading into ( if not already experiencing) a global recession. The depressed economic data spewing from the world’s largest economies combined with the continued drag on U.S. businesses found caught in the middle of four years of political and fiscal uncertainty coming to a boil as the fiscal cliff nears has left me deeply concerned about the economic prospects of 2013.
Individual businesses experience variability due to idiosyncratic reasons tied to their specific business, i.e. strategy, management, etc., and macroeconomic reasons affecting their industry and the economy at large. The percentage of variability tied to idiosyncratic vs. macro reasons fluctuates, but always adds up to 100%. Over the past few years, the macro reasons have taken a relatively larger share of that pie as global macro events, such as the European debt crisis, engulf the headlines. When this occurs, correlations across risky assets such as equities, commodities and currencies of smaller countries increase toward 1.00. When investors speak about “risk on” and “risk off,” this is what they mean. Capital moves out of the above mentioned “risky” assets to safe have assets such as the U.S. dollar, U.S., German and Japanese treasury bonds and gold. We are seeing this play out in the financial markets as the S&P 500 and WTI crude oil are both down around 5%, copper 7% and gasoline almost 10% since October 10th. A good deal of this began as the world recognized a global economic slowdown, however, the flight of optimism has accelerated since President Obama was re-elected and the focus shifted toward the impending fiscal cliff. Due to the above-mentioned points, this week’s edition will focus mostly on these macro issues followed by next week’s edition that will discuss in more depth the real-time effect this is having on the steel industry.
The fiscal cliff refers to the expiration of the Bush-era tax cuts and the elimination of a number of government spending programs, which translates to roughly $600 billion dollars. Last Thursday, the U.S. Congressional Budget Office (CBO) detailed its view that inaction will lead to an economic contraction of 0.5% and an unemployment rate of 9.1% in 2013. However, if politicians agree to “kick the can down the road” and postpone the fiscal cliff till a year from now, the CBO estimates the U.S. economy would grow by about 1.7% in 2013. According to the International Monetary Fund (IMF), inaction would lead to an economic contraction of 4% of this year’s U.S. GDP and estimate that would cost China, the world’s second largest economy, 1.2% of their GDP if their worst case scenario of U.S. GDP (-4.8%) is reached. Based on current political rhetoric from both sides, I believe the outcome will be one of the following: either (1) Washington will come to an agreement on tax and spending cuts or (2) the two sides will repeat the outcome of the mid-2011 budget negotiations (which led to the U.S. losing its triple-A credit rating if you recall) and we will head off the fiscal cliff. Assuming the CBO’s economic forecast and my expectations are right, we’re looking at growth somewhere south of 1.7% for 2013 depending on the budget agreement.
Japan, the world’s 3rd largest economy, reported a 3.5% rate drop in GDP for the 3rd quarter last week announcing their economy was dragged down by weakness in Europe and a drop in sales to a softening Chinese economy. Japan’s economic weakness reverberating through other Asian economies is a growing concern. On Thursday, November 8th, the 18th National Congress of the Communist Party of China began and outgoing party leader, Hu Jintao, outlined a deeply conservative vision for China’s future where the government will maintain their dominance over politics and the economy. Significant stimulus and infrastructure packages have been expected to accompany the new congress; however, Hu’s comments and action in Chinese bond markets reflect growing pessimism about the prospects of said government easing. Also last week, Europe’s official economists cut their 2013 growth outlook for the 17 country Eurozone to 0.1%. Germany, the world’s 4th largest economy had its 2013 growth outlook reduced to 0.7% from previous expectations of 1.7% by the European Commission six months prior. The accuracy of these estimates is yet to be seen, but taken as a whole, these forecasts point to anemic growth and little margin to absorb economic shocks due to natural disasters or geo-political events, which are plentiful with the Middle East in turmoil (Syria, Israel and Iran) and pro- independence movements and unemployment in Europe gaining steam. Events like these could quickly erode these growth forecasts from positive to negative; from growth to recession. Nevertheless, the event looming largest today is the outcome of the U.S. budget negotiations.
As outlined above, I see the two most likely outcomes to the “fiscal cliff” issue being an expiration of the policy leading to the eliminations of the Bush-era tax cuts and government spending cuts or some kind of agreement that includes government spending cuts and tax increases for “wealthy” Americans. The outcome of either of these two results will cut U.S. GDP and weaken an economy struggling to maintain growth. “Many businesses are holding back on capital spending, holding back on hiring plans, holding back on 2013 business plan formation all pending what happens with the fiscal cliff,” said Eaton Chief Economist James Meil (Wall Street Journal, 11/17/12 Paletta, Hilsenrath). Other reactions by business leaders, especially those in the defense, healthcare and financial service sectors have planned layoffs, slowed investment and decreased dividends. This could result in negative repercussions on industries tied to the consumer such as airlines, entertainment and industrials. Regardless of the outcome, the uncertainty surrounding the fiscal cliff has already affected business and shaken markets. A quick solution to the problem would be welcomed by business leaders and markets; however, it will come with a cost to growth. Based on history, I believe this is highly unlikely. I expect continued partisan political wrangling and horse trading through December when either a deal is agreed upon in the eleventh hour or a solution simply cannot be found and we go off the fiscal cliff.
In addition to the history of partisan politics of the past four years, the outcome of the presidential election showing an extremely divided country leads me to believe there will be numerous iterations of proposed solutions and continued bargaining through year end. Further, while both sides’ initial tone following the election was somewhat conciliatory, comments from both parties are starting to take a more combative tone. On Wednesday, November 14th, it was announced that President Obama would begin budget negotiations with congressional leaders Friday by calling for $1.6 trillion in additional tax revenue over the next decade. This is twice the amount proposed to Republican leaders in mid-2011 and far more than Republicans are likely to accept. President Obama’s administration and Congress are set to begin talks today, Friday, November 16th. Both sides seem to share the goal of negotiating a solution that will be less of a shock to the economy than the policies set to begin in January. However, both sides have extreme members of their caucus with diametrically opposed viewpoints. Significant compromise will be necessary on both ends and I expect this to take time. If this occurs, the uncertainty will cause business planning to remain on hold, demand to slow and risk to be taken off the table. It is reasonable to expect the continued turmoil and volatility in financial markets as a result. A number of economists see the U.S. headed into a recession in 2013 if the fiscal cliff is not averted. However, if an alternative plan is agreed upon, there will be costs tied to the spending cuts and tax increases in addition to the damage done by the continued uncertainty in the 4th quarter of 2012.
The extent of the slowdown is still very hard to determine, but the effect will likely crimp demand for steel around the world and could disrupt existing supply channels. Continued momentum in the nascent U.S. residential housing recovery is expected, especially with the Federal Reserve’s $40 billion of monthly residential mortgage securities purchases. The auto sector’s strength should continue as well, especially in the first quarter as manufacturers rebuild the large number of automobiles totaled in Hurricane Sandy. If we assume continued strength in those two sectors, but little to no growth overall, then other sectors have to weaken to balance the numbers. If there is no change in the economy, then it’s tough to expect much of an increase in steel demand, production and prices, especially when taking into account the overcapacity in Europe and China’s affinity for overproduction. I expect 2013 to look similar to 2012 with steel prices moving in cycles resembling those from 2012. As steel prices make dramatic moves attempting to discover equilibrium between supply and demand, the extreme volatility seen in 2012 should continue as market participants have to react to current business practices of holding thin inventory. High cost producers will struggle as there should be little room for inefficient business practices.
In next week’s edition, I will dive deeper into the current specifics of supply and demand for HRC, scrap and ore as in past editions of “The Feldstein.”