(By Mani) The likelihood of another U.S. recession is high if a fiscal cliff deal isn't reached. The U.S., however, has an interim advantage. As the safe haven, reserve currency, the U.S. can hold out longer economically, in part because, global fear contributes to lower U.S. interest rates.
So far, lower U.S. rates seem to be working to a degree. However, in this environment, the thing to be feared is a weakening U.S. economy when interest rates have very little room to fall further and when there is little room for additional, effective, fiscal stimulus.
"Another recession combined with the current, even larger, burden of debt we face, at present, would be extraordinarily serious," CIBC analyst Peter Gibson wrote in a note to clients.
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It is an unavoidable fact that western economies are struggling, in a long-term sense, to generate enough economic growth that will allow them to shoulder with their debt burdens even before creating the conditions for still better economic growth and better stock market investment opportunities.
"Trillions of dollars have been spent since the global financial panic of 2007/2008, and despite this unprecedented effort, corporate profitability is falling almost everywhere in the world as we measure it, which implies the outright risk of the global economy slipping back into recession," Gibson said.
Europe has its own very serious issues, and it remains to be seen whether the Euro will survive. Europe is already largely in recession and, as a result, the costs of saving the currency union grow by the day.
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Asia has to be treated on a case by case basis, but, in general, emerging economies are weak as well, and China must be careful not to experience an unwinding of the speculative excesses built-up in real estate and banking.
At present, U.S. bond yields are very low, and this implies that U.S. equities are undervalued, unfortunately, corporate profitability is also falling in the U.S., and the current rate of decline in S&P 500 return on equity suggests a growth recession/slowdown.
"If we focus on the U.S., however, it does not benefit us to have very low interest rates and yet experience another economic contraction," the analyst said.
U.S. interest rates are close to the lowest levels in 250 years, but low rates are not enough for the fragile U.S. recovery. The U.S. equity market requires low rates, in addition to profit growth. Currently, the "domestic" S&P 500 companies appear to be enduring the economic weakness.
"We are extremely concerned about the fiscal cliff as the U.S. is already in a fragile recovery; furthermore, the political divide seems to be holding the U.S. economy hostage," Gibson wrote.
There is no choice in finding a compromise that satisfies investors. It is likely though that any political inability to deal with the fiscal cliff will also be met with unprecedented attempts by the Fed to calm markets.
"In any other environment of the last 20 years, we would argue that a recession with lower interest rates would follow but we remain concerned that a U.S. recession now combined with the unprecedented levels of government and consumer debt would lead to a much more serious debt crisis," Gibson noted.
It could give an impression that even the U.S., the largest economy in the world could not generate enough growth to service its own debt.
Good leadership on the fiscal cliff issue should underpin another equity market rally into or during 2013. The time has come, however, for a new Manhattan project focused on new energy related technological innovation. It may be the only way the world can experience the urgent need for stronger GDP growth without the risk of higher inflation and higher bond yields.
If the U.S. falls into another recession, then raising taxes to service its debt burden at the same time can further undermine growth.
"The U.S., therefore, cannot afford to go down the same path as Europe without igniting a global debt crisis and so every effort must be made to avoid another U.S. recession," Gibson added.