Ask Russ: How Bad Is The Sequester? Is Hyperinflation A Certainty?

by: Russ Koesterich, CFA

As the actions of policy makers continue to drive markets, many investors are wondering about the potential impact of both the ongoing fiscal drama in Washington and the Federal Reserve’s unprecedented monetary experiment.

In the fourth of my ongoing series of posts dedicated to questions I receive, I’ve compiled some of these queries from a recent call with clients, along with my answers. Also, check out the first, second and third installments of this series here, here and here.

Q: What do you see as the final impact of the potential budget sequester [automatic government spending cuts set to take effect on March 1] on the economy? At least one economist is estimating that if the full sequester goes into effect, it would be a negative 7% hit to gross domestic product. Do you think it’s that bad?

A: If the sequester hits, it will be a negative, but the economy can probably withstand it. The sequester number is about $85 billion for 2013. That’s certainly not a trivial number and it’s even worse when you consider that it’s on top of about $240 billion we’ve already seen in recent tax hikes and spending cuts. So the sequester clearly represents yet another headwind for the economy. That said, $85 billion doesn’t equate to 7% of the United States’ roughly $15 trillion GDP.

My best guess is that at least some of the sequester will hit as planned on March 1 and the resulting fiscal drag could be as high as about 0.5% of GDP. Again, this is not trivial, particularly in a slow-growth economy, but I don’t think it’s a game changer in itself, especially when you consider that Congress can mitigate some of the impact of spending cuts after the fact. However, when you add that potential fiscal drag to the fiscal drag likely from tax hikes and cuts already in place, the sequester does raise the risk of disappointing US 2013 growth and earnings. And as investors focus on this, I expect a bit more market volatility around the end of February.

Q: Some have been saying that US hyperinflation remains a virtual certainty over at least the long term. Your thoughts on whether inflation could get out of control?

A: First, I would take exception with the notion that anything on the economic front is a near certainty. It would be nice if any of us had that forecasting capability, but I’d be a little cynical about that. I think that hyperinflation depends how you define it. I suppose it’s possible we could go through a period of double-digit inflation. That would certainly hurt, and no asset class right now is prepared for that. But as I mention in a recent post about the Fed’s monetary policy and my inflation outlook, when I look toward 2014 and 2015, I’m more worried about the garden variety of inflation than about hyperinflation. In a world where very few asset classes are assuming any inflation over the next five or ten years (i.e. where long-dated Treasuries are yielding 3%), inflation of even the 4%, 5% or 6% garden variety would be a big wakeup call for many investors.

Q: What about inflation-linked government bonds in the United Kingdom and Germany? What are your thoughts on those? And what do you think about the inflation risk in the Eurozone? [I recently wrote about why investors concerned about inflation may want to consider avoiding Treasury Inflation-Protected Securities (OTC:TIPS) and opting instead for other inflation hedges]

A: Inflation-linked bonds in general look expensive. This is partly a function of the fact that the Fed is not the only central bank engaged in unusual monetary policy. For example, the Bank of England, by some measures, has been even more aggressive. So overall, the inflation-linked bond market looks pricey, though TIPS look the worst of all.

As for my outlook for international inflation, I don’t see much evidence of that except for in a few emerging markets – like India, Turkey and maybe Brazil. And Europe has probably even less of a risk of experiencing near-term inflation than the United States for three reasons:

1.) The European economy, as everyone knows, is struggling even more than the US economy and isn’t likely to post much growth this year.

2.) Unemployment, particularly in southern Europe, is rampant in the region, and it’s very hard to expect much wage inflation when you’ve got unemployment as high as 25%.

3.) One sector of the US economy that looks better than its European counterpart is financials. The European banks still need to deleverage and repair their capital. As a result, I expect credit creation in the United States to accelerate well beyond anything we’re likely to see in Europe. And without credit growth, we won’t see much of an accelerating money supply.

Source: Bloomberg

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