By Mark Holman, managing partner, TwentyFour Asset Management
Now that the US elections are out of the way, the markets have rightly focussed on the “fiscal cliff” and what that might mean for markets. In our opinion, a protracted debate on this issue is likely to hamper any further market progress while it is on-going but a successful resolution, particularly if this coincides with a disbursement of the latest tranche of Greek aid, would be supportive for risk assets. As this theme is going to gain momentum over the coming weeks, we thought it worth summarising what was at stake and how markets could digest the news.
By way of background the fiscal cliff was created last summer as the US once again reached its debt ceiling limit. Although most people refer to a potential US default from reaching the ceiling as theoretical, we did come perilously close to the point of no more dispersions from the US Treasury last August, which would have created at least a technical default. The concept of an official debt ceiling is one that goes back to 1917 when Congress first introduced the cap. It has then been periodically increased as required – this will be the 103rd time it has been raised. Raising the debt ceiling in itself is not really a problem as it is only natural that as the economy gets larger then it is able to support a larger debt burden, but 2011 was the year that “austerity” became the markets most desired fashion item, and even the US had to take part. Consequently a political battle took place on which austerity measures would have to be undertaken before the debt ceiling was raised. Last year there was a ‘grand fudge’, when the debt ceiling was raised to $16.394tn without an agreement on tax rises and spending cuts, but in its place came the fiscal cliff. The fiscal cliff as it is now affectionately known is a pre-determined programme of tax hikes (really a reversal of previous temporary tax cuts) and public spending cuts amounting to $650bn, which will be automatically triggered on 1 January 2013, unless an agreement between the parties can finally be reached on acceptable austerity measures. The recent US elections have not helped matters as we essentially have a continuation of the status quo, with the Democrats controlling the Senate and the Republicans controlling the House of Representatives. Hence, markets are now beginning to fret that the same protracted debate that contributed to the US downgrade last summer and that drove markets downwards, will once again take place. Should we go over the fiscal cliff, over $500bn of tax credits will expire along with nearly $150bn of spending cuts. The Congressional Budget Office (CBO) forecasts that going over the cliff will result in 3% less output and a spike in the unemployment rate to 9.1%, taking the US back into recession. Clearly today’s market levels are not consistent with such an event. One of the reasons that markets are currently willing to overlook some of Europe’s economic woes is the improving health of the US economy and hope in a bounce from China. Recession in Europe and in the US would throw markets back a long way indeed. So the discussions that are about to begin are very significant and must be concluded by December 31st. The debt ceiling itself is more of a sideshow. The limit is currently $16.394trn and is projected to be hit in the next few weeks, but by deploying a few extraordinary measures it can most likely be pushed out until February. Discussions between the two parties have not yet begun, but markets will be listening to every word from each party’s key negotiators. However this is one political event where words do not count. The markets need a solution and the longer we have to wait for it, the more that confidence will be eroded from the markets. It is understandable therefore why investors may want to consider a more cautious stance over the coming weeks.
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