By Luca Paolini, chief strategist, Pictet Asset Management
The US presidential and congressional elections delivered a continuation of the status quo – for at least two more years, a Democrat President will work alongside a Democrat-controlled Senate and a Republican-dominated House of Representatives. While a Democrat administration appears less business friendly than a Republican one promised to be, the election result at least reduces uncertainty in the areas of US monetary, foreign and trade policy.
However, as far as fiscal policy is concerned, the election has produced one of the worst possible outcomes and the risks for investors remain as high as ever. With Republicans controlling the House, the political paralysis that characterised Obama’s first administration is likely to persist – it is anyone’s guess whether the President can achieve the bi-partisan support he requires to enact badly needed tax and welfare reforms. This has not been lost on the market – fears of a protracted political deadlock have undermined stocks since the election result was announced. The combination of a split Congress, a President lacking a strong mandate – Obama won the popular vote by a whisker – and a potentially more divided opposition (in some quarters, the Tea Party is blamed for the GOP’s defeat) increases the risk of Democrats and Republicans failing to reach agreement on key areas of fiscal policy. If a deal cannot be reached, automatic spending cuts and the expiration of the Bush-era tax cuts will result in a fiscal tightening equivalent to more than 4 per cent of GDP in the next fiscal year, enough to trigger a recession in the US that could potentially morph into a global one. We continue to expect an agreement to be reached just before year-end, limiting the net fiscal tightening to a more manageable 1.8% of GDP, which we estimate will reduce US output in 2013 by some 1.4 per cent. We expect any pact to include an extension of most of the Bush-era tax cuts, a reduction in discretionary spending and the expiration of the payroll tax cut, first introduced by Obama in 2011. However, there is always the possibility that the President may resort to brinkmanship to exploit perceived divisions in the Republican party; stringing out the negotiations to the very last minute will raise the pressure on the GOP to accept a compromise to avert a US recession. A similar tactic was used by President Clinton in 1995. Such a scenario would be negative for markets, however, as it may trigger a second US sovereign downgrade by the credit agencies before a deal on the debt ceiling and the budget is reached in the first quarter of 2013. Even though quantitative easing (QE) appears to be incrementally less effective – since the Fed announced its third phase of QE on September 12, the S&P 500 Index has shed some 5% – we believe it is better to have a President who is in favour of such a policy than a President who is ideologically opposed to it.
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