Fiscal cliff worries send US markets reeling

And so it seems that every man, woman, dog and debt rating agency are now barking at the Republican congress to co-operate with the democrats to change course away from the fiscal cliff and bring about a transition which will involve compromise.

Certain tax hikes will be swapped by the Republicans for no further cuts in the Defense budget. The debt ceiling may be raised if some of Obama’s social welfare spending is reined in. At the end of the day, the outcome will be worse than if both sides work together to produce a mutually acceptable outcome that will allow the nascent recovery being seen in the US to gain traction. After all the election was clearly won by the Democrats who now have a healthy majority in the Senate (but not Congress) which the Republicans cannot dispute. There will also be another Presidential election for four more years – which needless to say, is a long time.

Investors could be forgiven for thinking the election of Barack Obama is a bad outcome for Wall Street. The markets are now directly focused on the looming “fiscal cliff” for the US economy as stocks fell sharply yesterday closing around 2.4 percent lower. At one stage around mid morning the Dow was down more than 350 points but recovered modestly by the end.

Dow Jones 5 day chart

Not helping the weak session was debt rating agency Fitch commenting that Obama needs to move quickly to avoid the fiscal cliff that is threatening the recovery, adding that failure to do so would likely lead to a sovereign debt downgrade in 2013. What is interesting from that comment is that typically most rating agencies do not like more debt and mark ratings down accordingly. If the US goes over the fiscal cliff however, debt levels will rise probably even faster as GDP comes under pressure and the unemployment trend reverses to the upside.

Removing the political uncertainty now pushes the fiscal cliff issue to the front of the queue and once Washington resolves this, then the US equity markets should enjoy some “clear air” and hopefully positive sailing onto new highs. There is a lot to be encouraged by in the US economy assuming a successful navigation around the fiscal cliff.

As highlighted in previous notes, we think Washington will find a way around although we acknowledge given the thumping the republicans received in some US states, bruised egos may take a few days to recover. Mitt Romney’s speech in which he conceded the election to Barack Obama was very constructive calling for “bipartisan co-operation on both sides to resolve economic issues”.

If Germany could find a way to come to the table back in June this year, (and arguably the problems the Eurozone faced were inherently much more difficult to resolve transcending national borders) then so too will America. Near term however the US markets may not be so optimistic and further volatility to the downside is probably going to be the order of the day. 

US equities are now in correction mode, but we believe a bottom will be found in the next month or so and that downside may not be as bad as many fear with the next key support level at 12,800. The markets will likely cogitate and become highly sensitive to Washington rhetoric over the next few weeks until a likely outcome for the fiscal cliff issue can be gauged.

The one redeeming fact from history is that the US went over the mother of all “fiscal cliffs” in the 1930s when the US government raised taxes, interest rates, reduced fiscal spending to balance the budget, and let thousands of banks fail which wiped out the savings of millions. The response to the financial crisis in 2009 was handled well in our opinion and the fiscal cliff that the US economy now faces has historic precedent as a reminder of what will happen if political inertia becomes pervasive.

Hopefully that will keep the stock market out of the frying pan…and the fire.

Last but not least, we believe the geopolitical risks in the Middle East will now intensify with the US election out of the way. Obama has stated that he will not tolerate a “nuclear armed Iran”. However, where George Bush was arguably “trigger happy” when it came to deploying the US military, we believe Obama’s administration will tread more carefully in terms of resolving the issues and consequently be cautious towards engaging the US in another war. This will likely in our opinion, have positive implications for the markets over the medium term.