Fiscal Cliff Hides The Elephant In The Closet

Obama v Boehner! 

On the first day of 2013, the US Congress finally settled the so called “Fiscal Cliff” issue that had hung over the markets in the dying days of 2012. The deal has, thus far, been seen as positive and markets have reacted very enthusiastically registering gains that have taken them back towards the highs of 2012 and in the US’ case – the all-time highs. But, even though the deal is a good start, the “elephant” – the level of US public debt – is still in the room… Politicians have quite simply decided to hide it in the closet for a few months. With this in mind, investors and spread betters should prepare for a turbulent first quarter.

As with the debt ceiling issue that weighed on the markets in August 2011, a solution to avert the fiscal cliff was only reached right at literally the very last minute, and again, it was only a partial one, kicking the problems forward for a couple of months.

At the table there were three main issues to solve: tax increases, spending cuts, and the debt ceiling. Unfortunately, Congress touched just one of them: tax increases. After weeks of attempts to solve the crisis, it wasn’t possible to find a serious compromise to fight the rising US public debt that currently sits near $16.4 trillion, near its capped value. Obama doesn’t want to cut public spending on social programs like the Medicare, and the Republicans want to extend indefinitely the tax cuts the Bush administration introduced for the wealthiest in the latter days of his administration.

In the end, the politicians agreed to increase the tax rate from 35% to 39.6% on individuals earning more than $400,000 per year and on couples earning more than $450,000 and they decided to extend some important benefits that mostly affect the middle class. But that is very short of what the current start debt reality really requires.

The decision taken, which Obama signed into law, is very limited in scope as it simply won’t make a scratch on the $16.4 trillion debt problem and it just delays the main decision and sets the stage for another scrap with the Republicans to March 1. Consequently, as we enter February, expect the market to get another case of the “jitters” as the political posturing starts the same merry go round again – after all, they are the same players and so why should they change their spots? There is too much ill will and bitterness between the respective parties to expect anything else.

Currently, the US public debt sits at an astonishing $16.4 trillion and, per law, they are almost out of the facility to borrow again – unless they increase the ceiling, again. The US Treasury will actually run out of cash before March and if nothing is done by mid February, the US Government will default on debt payments. Sound familiar? The debt ceiling debacle in 2011 led to one of the worst August months in history and to the downgrade of the US debt rating by S&P. We are taking up our Put spread positions whilst volatility is so low and the market is bouyant to hedge our long plays that we believe undervalued.

It looks like the Republicans will push for an index-ing of the debt ceiling and look for a commitment from Obama to cuts on Medicare and other social programs. Problem is Obama has already said that he is not willing to do much on those fronts… With the prospect for an intense political fight all over again, volatility in equity markets will likely rise and if they let this go right to the wire again then equities could take a hit and the US dollar and bonds too.

Whilst uncertainty is growing, it may be better to jump off the US main markets for a few weeks and bank the considerable gains, or follow our lead and build protective option positions. Remember, longevity in the markets is linked inextricably to risk management.