November 2, 2012 3:26 pm

Investors peer over the ‘fiscal cliff’

Stock market latest: heavy trading in metaphors for the looming combination of government spending cuts and tax rises in the US.

Shares in “fiscal cliff” have fallen sharply, with investors preferring “fiscal slope”, and even “fiscal bump”. But there has also been some buying of “sky dive” and “bungee jump”. Wall Street expects metaphor trading volumes to spike further after the presidential and congressional elections on Tuesday.

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That is when, after months of posturing, the political debate on what to do about the so-called fiscal cliff will finally crystallise. Unless laws are changed, tax cuts from the Bush era and from the post-credit crisis stimulus plan will expire at the end of December, at the same time as automatic federal budget cuts kick in, affecting swaths of government.

Clarity, though, could still be months away, making this a potentially treacherous period for investors.

“The fiscal cliff is the most important issue for investors as it will affect growth and the outlook for monetary policy,” says Zach Pandl, senior interest rate strategist at Columbia Asset Management. “Investors would like to take a more positive view on the economy, but are hesitant to do so until the cloud of the fiscal cliff has passed.”

The stakes are high. The Congressional Budget Office has estimated that this fiscal cliff could result in a drag of up to $600bn next year, or 4 per cent of gross domestic product. Both parties are agreed that laws have to be changed to prevent a fresh US recession, and both are agreed that alternative deficit-reduction measures have to be implemented instead. As for the details, though, agreement seems far off.

Wall Street has busied itself preparing alternative likely scenarios. A Romney victory, according to HSBC, Barclays and others, makes it easier to achieve a short-term delay to the tax rises and spending cuts, with room for a comprehensive deficit-reduction deal early in his presidency. An Obama victory perpetuates the status quo of partisan division between the White House and Congress, and rises the odds that a deal would not be agreed, at least not in time to prevent a huge fiscal contraction, according to the consensus.

Even though the polls suggest such a status quo outcome, investors are apparently sanguine, so far. The Vix, an index of market volatility, which normally rises in times of uncertainty, is quiescent.

We are worried that the low level of Vix in the equity market is a function of complacency

- Lisa Emsbo-Mattingly, Fidelity Investments

Lisa Emsbo-Mattingly, director of asset allocation research at Fidelity Investments, says: “If we see the level of dysfunction that typified the debate over raising the debt ceiling in August 2011, that could be very negative for the holiday spending season.

“The fiscal cliff is already affecting company spending and hiring plans. We are worried that the low level of Vix in the equity market is a function of complacency.”

One reason for this could be that investors are ignoring the warnings from Capitol Hill and expecting a deal in the “lame-duck” session of Congress before new members take their seats in January. The other possibility is that they do not believe December 31 is a “do-or-die” deadline, which would fit with the declining popularity of the fiscal cliff metaphor.

Charles Krueger of Guggenheim Partners, says there are in fact “2½ cliffs” staggered over several months. The expiry of the tax cuts does happen at year-end, though they could be retrospectively reinstated; there’s a “half cliff” showdown coming over raising the debt ceiling again, when the federal debt limit is reached around early February; and the automatic spending cuts for the calendar year do not have to be actually detailed by government departments until May.

It is too early to know how specific sectors will get hit, though the longer the spending cuts remain unaddressed, the greater the potential pressure on defence stocks in particular.

But gaming out the likely budget negotiations will begin as soon as the electoral votes are tallied, and the first place to look for market reaction will be in the Treasury market, says Barclays. The yield on 10-year Treasury notes could drop to 1.5 per cent in the event that President Barack Obama wins a second term, suggesting rancorous negotiations that drag out and hurt the economy, the bank predicts. A victory for Mitt Romney could see yields rise towards 2 per cent, as the risk of a fiscal accident is reduced.

Even an optimist such as Arthur Steinmetz, chief investment strategist for Oppenheimer Funds, thinks there is an outside chance that markets could take fright at the prospect of a failure to strike a deal, in which case the yield on the 10-year Treasury could tumble to 1 per cent or below. BlackRock calls that the “sky dive” scenario – or more likely the “bungee jump” scenario – since it would scare Congress into a deal.

But Mr Steinmetz for one has had enough of the metaphors. “The fiscal cliff is a poor metaphor, it suggests that once you go over it’s irrevocable.”

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