The biggest threat to the US economy and what it means for your money

The US economy is slowing down.

On Friday, we learned that growth slipped to 1.5% in the second quarter. It was better than expected, but still down from the 1.9% annualised growth seen in the first quarter.

Perhaps more importantly, unless a deal on spending and taxes can be reached by the end of the year, massive spending cuts will take place. This is the so-called 'fiscal cliff' that everyone seems terrified of plunging over.

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Yet US shares have been surprisingly resilient so far. Can this continue? Or should you be looking to invest elsewhere?

Why is the US economy slowing down now?

Earlier this year, things seemed to be looking up for the US. An average of 225,000 jobs were added in the first three months of this year. Unemployment fell from 8.5% in December to 8.1% in April.

The picture from several of the key leading indicators was also positive. Consumer confidence reached a peak of 79.3 in May the highest since January 2008. Upbeat consumers normally spend more money, which suggested the strong run would continue.

However, things have taken a turn for the worse. Mean jobs growth fell to 75,000 in April, May and June, pushing unemployment back up to 8.2%. Consumer confidence has fallen back.

That saw second quarter growth slip to 1.5% - well below the rate needed to keep unemployment falling. Things look even grimmer if you take a closer look at the latest GDP statistics.

Durable goods orders (big ticket' items) fell by 1%, while inventories rose. This suggests that firms will have the option of running down stocks rather than ordering new goods. That in turn will drag on GDP in the third quarter.

Worst of all, demand seems to be dropping, with personal consumption growth falling by half.

So why have consumers stopped buying? Fears over the euro crisis may be one reason why Americans feel more inclined to save money rather than spend it. The 'flight to quality', prompted by fears about European banks and countries, has also pushed up the dollar, against the euro. It is now close to a two-year high. This has made exports dearer.

Weak Asian demand is also bad news for American firms trying to sell their goods and services abroad.

However, exports aren't the main reason for the slowdown. While export growth has slowed, exports to the eurozone are still up on last year. In any case, the eurozone crisis has been going on for the past 18 months, so it has limited value in explaining the sudden slowdown.

The chances of the US going over the fiscal cliff are higher than you might expect

The main factor worrying consumers may well be the looming 'fiscal cliff'.

Last summer, as you might remember, there was a major fight over the decision to increase the amount that the US government can legally borrow. While these fights are usually symbolic, some politicians in Congress refused to allow the debt limit to be increased, arguing that spending had got out of control.

At one point the US government came very close to either defaulting on its short-term debt, or temporarily shutting down the government.

In the end, a deal was done. But as part of it, both parties agreed a process whereby public spending would be reduced in 2013. Automatic cuts were set in place, to ensure some cutting was done even if politicians couldn't agree on where to trim. Tax cuts are set to expire at the same time.

Combined, these measures would reduce the US deficit (its annual overspend), by $500bn (it currently overspends by more than a trillion dollars a year). While this would improve the US finances, the cuts would also hit economic growth. Indeed, the economy could be pushed into recession.

A cynic might argue that much of this is pre-election posturing. Politicians being politicians, you'd expect them to eventually reach a deal that allows both parties to save face, while moderating both the hikes and the cuts. One solution, for example, would be to allow the top rate of tax to revert to its original higher level, while keeping all the other brackets the same.

However, the coming US election is likely to leave Congress split between the two parties. As a result, each side will have a veto over any solution. So far from being more open to compromise, the losing side is likely to dig in its heels, to show its supporters that it still means business.

Yes, some of the cuts, especially to the defence budget, may be moderated. However, the bottom line is that a sudden fiscal contraction is much likelier than you might think. And it seems that much of the weak growth in investment and consumer spending could well be due to consumers and businesses being unsure of how much money they should set aside for taxes.

US shares look too expensive here are some other options

Dylan Grice of Societe Generale also notes that things are looking bad for US firms. With US profit margins at or near record levels, you can "expect margins (and hence profits) to plunge lower". If this proves correct, then share prices will be hit hard.

Given that the S&P 500 is one of the more expensive global stock markets these days, we'd avoid the index for now. But we wouldn't advise you to go short. As we've pointed out before, Ben Bernanke pays close attention to the stock market. If prices plunge you can expect him to launch another round of money printing. The GDP data probably wasn't bad enough to justify a third batch of quantitative easing (QE)on their own, but Bernanke will be looking for an excuse.

Instead, we'd suggest you look at markets that are cheap. They'd still benefit from any fresh QE in the US, but they also look good value on their own. My colleague John Stepek has tipped the Italian stock market recently.

For those who aren't keen to touch the eurozone yet, you might want to think about Poland, which I looked at recently. The country is still enjoying catch-up growth and has its own currency, which gives it much more freedom than the eurozone members. It also has a good credit rating, which allows it much more fiscal leeway.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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