US politicians will work out a solution to fiscal cliff

Barack Obama was greeted to the White House with classical risk aversion trades yesterday. Equities fell, with S&P 500 falling 2.3 percent; US treasury yields fell with 10-year benchmark yields falling by 5bps; commodity prices fell with oil dropping by 3.8 percent and the US Dollar (USD) strengthened by around 0.7 percent 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, which is growing at a sluggish 1.5-2 percent, with an unemployment rate of 7.9 percent, much above long-term average of 5.8 percent.

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[caption id=“attachment_519297” align=“alignleft” width=“380”]  The question is, will the fiscal cliff be allowed to happen? Reuters[/caption]

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 percent of GDP.

The question is, will the fiscal cliff be allowed to happen?

Commentators squarely blame politicians for the fiscal cliff. They bicker on everything under the sun, instead of fixing things. The fiscal cliff is not new. 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.

The markets conveniently forgot the existence of the event 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 put markets on tenterhooks. Now, everyone is focused on the fiscal cliff and hence the sell off in the markets.

The markets will not sell out in anticipation of the fiscal cliff taking effect. The risk is too high for a one-way trade. The situation is similar to that of the Greece exit from the eurozone. At one point in time, the markets were sure of Greece exiting the Eurozone 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 percent 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 with $40 billion of Mortgage Backed Securities (MBS) 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. The 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 the markets, equities will see a fresh rally starting January 2013. Play for the rally.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.