The US fiscal cliff is for now the major tail risk still on the table, says Valentijn van Nieuwenhuijzen, Head of Strategy at ING IM…
Although there is hope that a compromise may be reached before year-end, the uncertainty keeps US businesses and consumers as well as investors cautious. We therefore maintain our preference for European over US equities.
So far, this year was essentially about managing and assessing tail risks. Three tail risks have been dominant: The euro sovereign crisis, a Chinese hard landing and the US fiscal cliff. As the first two have diminished considerably, the latter is now the main tail risk still on the table.
The systemic risks of a euro break-up or a large bank falling over have largely been addressed by the crisis-fighting measures that have been put in place by the European Central Bank (ECB). This is undoubtedly the main reason why European equities in general and financial stocks in particular have outperformed since the summer of this year. Of course, the Eurozone is not out of the woods yet. The Greek Parliament recently passed the third Memorandum of Understanding on budget cuts and approved the budget for 2013. Greece will receive the next tranche of aid but this came at a large political cost to the ruling parties as their Parliamentary support is dwindling because of defections: the Greek government has lost a third of its majority in just five months. Hence, the risk of “Grexit” is pretty low in the next few months, but in the medium-term there remains a considerable probability that reform fatigue in Greece will prove to be fatal. Furthermore, Spain from its side remains reluctant to apply officially for help from the European Stability Mechanism (ESM).
We also notice that the economic data coming out of China are gradually improving. The latest data releases on industrial production, fixed asset investment and retail sales remain on a moderately accelerating trend. This has largely taken out the fear of a hard landing. In addition, further fiscal and monetary stimulus should limit these hard-landing risks further. Not surprisingly, this coincided with a more positive price and flow momentum in emerging market equities and bonds.
This leaves us with the fiscal cliff. The re-election of Barack Obama for a second term did take away the election uncertainty and increases the likelihood of continued accommodative monetary policy, something which could have become a source of uncertainty under a Romney win. As we already argued in the Marketexpress of last week, the probability that in early 2014 Fed Chairman Bernanke will be replaced by a new Chairman who is intent on tightening sooner rather than later has fallen dramatically. The effectiveness of US monetary policy rests crucially on the Fed's commitment to keep loosening until the real economy will have gained substantial traction. Hence, because of the Obama win, the credibility of this commitment remains very much intact. This is likely to have contributed to the rally in US 10-year bonds.
However, the most important risk factor - the fiscal cliff - has not decreased. The pre-election status quo is maintained because of which there remains a high risk of a stalemate between the Republicans and the Democrats.
Our base case is that the fiscal cliff will be avoided because it is not in the interest of either party to induce a recession. Recent speeches by Obama and Republican House Leader Boehner provide some increased degree of hope that a compromise may be reached before year-end. Both have indicated that the election outcome should be seen as a clear mandate for reaching a compromise. By definition this involves both spending cuts and revenue increases. As far as the latter are concerned, Boehner remains opposed to upper-income tax increases, but is willing to raise revenue by reforming the tax code and closing loopholes. Meanwhile, Obama is prepared to work on a bi-partisan compromise as he explicitly reached out to Romney in his acceptance speech by saying that he wants to involve him in thinking about ways to move the US forward.
Nevertheless, there is a non-negligible risk that the US will bungee jump off the cliff, i.e. if an agreement is not reached before January 1st there may be a temporary fiscal tightening of around 4% of gross domestic product (GDP). This - combined with the fact that the debt ceiling needs to be raised by early March at the latest - should then be enough of an incentive to reach a compromise. However, for as long this remains uncertain, this uncertainty alone may induce businesses and consumers to be more cautious in their spending decisions. In case of falling off the fiscal cliff, the US economy could fall into recession, dragging down the global economy with it. Simply said, this is not a US-only issue. A compromise would restore corporate confidence and may unleash pent-up capital expenditures that have been frozen. Combined with the improvement in the housing and labour market, US private consumption may get a boost.
The continuation of the uncertainty is very likely to weigh on the performance of US risky assets over at least the next couple of weeks. The converging risk dynamics between Europe (declined) and the US (increased), combined with a higher European risk premium form the basis of our overweight position in European equities and underweight position in US equities. This positioning is not carved in stone but we will keep it as long as these risk dynamics and/or risk premium differential persist.
Meanwhile, lingering political uncertainty causes investors to flee towards safety, as is visible in declining yields on (US) Treasuries. Ultimately, the upturn in the global business cycle that we see should cause yields to rise modestly (several tenths of percents) from current levels.