Sunday, January 6, 2013

6/1/2013: Houston, we've got a (US) problem?..


2013 biggest Grey Swan might be not China's slowdown or Euro area's continued debt crisis (although both are pretty much still on the books, although the former is less likely than the latter). It might not even be the Japanese economic implosion (albeit Japan is sick beyond any repair)... oh, no... the real Grey Swan of 2013 might be the markets starting to take a closer look at the US.

This might sound bizarre during the weekend following Friday, when the VIX index collapsed 39.1% - more than in any other trading day in its history, and when the US markets have ended the first week of the year with total gains almost equivalent to what some are projecting for the entire 2013... and yet... as some would say: "Houston, we've got a problem!"

The problem is best illustrated in the following three sets of chart, all comparing US fiscal performance to the peers.

Structural Deficits:



As two charts above highlight, the US Government structural deficits are massive. Since 2011, these are shallower than those of Japan (and Japan's figures in charts above are likely to become even worse following the latest Government appointment and their commitment to debase/in-debt the Japanese economy out of existence) but they are the worse in the entire G7 group save for Japan. More ominously:

  • The IMF is predicting the structural deficit to worsen once again starting in 2015
  • The above projections by the IMF do not reflect the disastrous consequences of the 'Fiscal Cliff' deal struck on December 31, 2012 (see here).
  • In 2013, US structural deficit is projected to be around 5.49% of GDP against the G7 average of 3.04%
  • In 2010-2017, according to the IMF projections, the US cumulated structural deficits will add up to 44.84% of GDP - against Japan's 58.53% and the G7 average of 24.97%. For 2013-2017, the same figures are: US 21.43%, Japan 33.31% and G7 average 10.48%. In other words, things are going to get worse in the US compared to G7 average in 2013-2017 than they were in 2010-2012. They will be worse still in Japan, but everyone expects Japan to remain the sickest member of G7, so there is little surprise or repricing that can be expected before the US risks are repriced.


Primary Deficits:



Ugly picture for the US vis G7 counterparts continues with primary deficits as well. Per above:

  • The US is the second weakest link in G7 in terms of primary deficits
  • In 2010-2017 period, the US is expected to generate cumulated primary deficits amounting to 37.65% of GDP and this is against Japan's 52.42%, but G7 average of 15.99%. In the period from 2013 though 2017, the US cumulated primary deficits are expected to come in at 14.21% of GDP against the G7 average of 3.54% of GDP and Japan's 25.73% of GDP. Once again, relative to G7 average, the US performance is expected to worsen in 2013-2017 compared to 2010-2012.

A table to summarise the above two sets of charts on a longer time horizon scale:

Government Debt:



The US is positioned as the third weakest G7 economy in terms of levels of Government debt it carries - after Japan and Italy. However, this analysis neglects the fact that according to the IMF projections, the US debt situation is expected to continue worsening through 2016 (when US debt is expected to peak at 114.19% of GDP), while Italian situation is expected to improve from 2013 peak of 127.85% of GDP into 2017. Similarly, compared to G7 average, the US debt dynamics post-2013 are unpleasantly convergent to the higher G7 average (driven by Japan's debt levels).

Stripping out Japan from debt analysis:

  • In 2001, US debt to GDP ratio stood at 11.83 ppt below G7 (ex-Japan) average. By 2012 this number has reversed into US debt overshoot of G7 average by 10.06 ppt. By 2017 the same overshoot is expected to rise to 19.57 ppt.
Table below summarises the long-range view of the charts above:


To summarise the above evidence, the US debt levels are not sustainable in the long run, even though current growth (above debt financing costs) and funding costs (exceptionally low yields on Government bonds and the printing press effect on these yields) are delivering short-term sustainability. However, as shown above, the US primary deficit ius huge and not abating fast enough. This implies debt to GDP ratio will be rising into 2016, if not after. Which, in turn, implies rising susceptibility of the US to risk-repricing in the markets.

It is worth contrasting the US case with that of Italy and Japan. In Italy's case, there is significant surplus on the primary balance and overall deficit due to high cost of funding even higher debt, compounded by economic growth well below the cost of funding the state debt pile. In Japan - there are severe problems across all parameters: high primary deficits, growth well below the cost of debt funding, and debt pile so large that structural deficits are alarming.

All of which means that all three economies can be severely tested by the markets. As long as global economic environment remains that of subdued economic activity, so that risk aversion remains high and monetary policies remain extremely accommodative, the US is out of the investors' crosshairs and Italy is in. Should these environments change, all bets are off for the US - at least in the medium- to longer-term.
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