Obama was greeted to the White House with classical risk aversion trades. Equities fell with S&P 500 falling 2.3%, US treasury yields fell with ten year benchmark yields falling by 5bps, commodity prices fell with oil dropping by 3.8% and the US Dollar (USD) strengthened by around 0.7% against the majors. The reason for risk aversion trades post the US election is the spectre of the “Fiscal Cliff” looming ahead for the markets.
The “Fiscal Cliff” is the effect higher taxes and spending cuts will have on the US economy. The US economy is growing at a sluggish pace of 1.5% to 2% and unemployment rate at 7.9% is above long term average of 5.8%. The US economy cannot absorb higher taxes and spending cuts at one go and if the “Fiscal Cliff” is allowed to happen, the economy is likely to go into recession as the impact of the “Fiscal Cliff” is seen at around 3.5% of GDP.
The question is, will the “Fiscal Cliff” be allowed to happen? Listening to commentators on the US “Fiscal Cliff”, the stupidity of the “Fiscal Cliff” being allowed to happen comes out starkly. The blame is squarely on politicians, as they bicker on everything under the sun, instead of fixing things. The “Fiscal Cliff” phenomena is not new, the Fed chairman Ben Bernanke highlighted the issue many months ago. Obama will now have to hanker with the US policy makers on stemming the “Fiscal Cliff” and time is not on his side with January 2013 (the start of fiscal consolidation in the US) looming ahead.
Markets conveniently forgot the existence of the fiscal cliff as equity indices across the globe rallied to its highest levels for the calendar year in October 2012. The sudden realisation that January 2013 is less than a couple of months away have placed markets on tenterhooks. Everyone from writers of Firstpost.com to Wall Street traders is focused on the “Fiscal Cliff”. Hence the immediate sell off in markets post election.
Markets will not sell out in anticipation of the “Fiscal Cliff” taking effect. The risk is too high for a one way trade on “Fiscal Cliff”. The situation is similar to that of the Greece exit of Eurozone. At one point of time, markets were sure of Greece exiting the Euro Zone and when that did not happen the subsequent rally was sharp and long. Equities are trading at close to their highest levels over the last couple of years with many indices rallying over 13% from lows.
The fact that the consequence of the “Fiscal Cliff” is known, the urgency of the matter will make even the most dogmatic of politicians work towards a solution. The US politicians will work towards a solution though public posturing may not look like they are working towards a solution. The markets may want to take some money off the table as end of calendar year 2012 approaches but serious shorts on a directional trade of the “Fiscal Cliff” will not happen.
Investors will do best if they avoid the noise of the “Fiscal Cliff” and focus on fundamental factors driving the markets. The US Federal Reserve will go through its QE3 program with USD 40 billion of MBS (Mortgage Backed Securities) every month. The ECB has acknowledged that even Germany, which is the strongest economy in the Eurozone, is feeling the effects of the recession elsewhere in Europe. ECB is expected to lower interest rates and commence bond purchases in the face of weak Eurozone economy.
China is also electing a new leader this month and indications are that there will be cautious reforms from the Chinese government. Improving domestic consumption will be the primary aim of the government and its central bank is likely to ease rates going forward.
India will also see some monetary easing in 2013 as per the indications given by the RBI in its monetary policy review in October 2012. The government is making the necessary noises on reducing fiscal deficit and carrying out reforms to push up growth.
If the “Fiscal Cliff” plays out positively for markets, equities will see a fresh rally starting January 2013. Play for the rally.