Text published in Beleggers Belangen (Netherlands) on 9 November 2012.

According to Harry Reid, the Democrats’ leader in the US Senate, “it’s better to dance than to fight”. Few people will disagree, especially if the choice between dancing and fighting has to be made on the edge of a cliff, specifically the “fiscal cliff”. What he is trying to say is that after the hard election campaign, it is time for negotiation and compromise. Over the coming weeks we can expect to see a constant flow of news stories and analyses about the fiscal cliff. US politicians have created this cliff for themselves by voting for measures in the summer of 2011 that provide for higher taxes (by abolishing the temporary tax cuts) and lower spending. The cliff metaphor, which Wikipedia attributes to Ben Bernanke, reflects the view that doing nothing to avoid the cliff will inevitably push the economy over the edge into a recession. For instance, the ECB has calculated that the negative growth impact will be -1.3% in 2013 and -1.8% in 2014. As US economic expansion has been projected at around 2%, growth will be virtually nil. Moreover, the psychological shock would actually cause the economy to contract. What is really alarming is that essentially no policy instruments are available to deal with this recession: fiscal measures are out of the question because they have caused the recession in the first place, while the Fed printing more money will no longer have any effect either.

The conclusion has to be that it simply cannot come to that. From a rational perspective I agree, and the markets seem to have had the same idea for about 10 hours after Barack Obama’s election victory, until the stock markets started to fall heavily in the European afternoon of 7 November. In principle this is all part of the “game”: equity futures surged from around 4 o’clock in the European night of Tuesday to Wednesday because an Obama victory was becoming more likely. But in the afternoon they tumbled again. It was as if the markets suddenly discovered that there was a fiscal problem. That is nonsense, of course, because everyone has known since August 2011, for the past 15 months in other words, that a fiscal cliff has been looming. What we now see is the realization that things are getting serious.

So once the victory party is over and the empty champagne glasses have been cleared, it is time for complacency to make way for panic. Investors start to look at tail risks (this refers to the statistical distribution of potential revenues, with the left tail implying highly negative outcomes). That is exactly what is happening now. Even if we assume that an acceptable solution will be found, it is quite possible that this will only happen at the very last moment. Which is indeed what I expect, incidentally. Judging from the aggressiveness and polarization evident during the presidential election campaign, we can assume that both parties will protect their ‘sacred cows’ and will not be rushed into compromises. In this situation investors want to be safe rather than sorry. So government bonds will be in demand tactically as protection against the tail risk. We already saw this in the summer of 2011: the more intractable the debate on raising the debt ceiling became, the further bond yields fell. A technical factor is also at play here: it seems certain that capital gains tax on equities will go up next year, and this should trigger profit taking in December. Additional downward price pressure, in other words, so I do not foresee a year-end rally. For equity investors looking further ahead than the year end, this need not be too serious a cause for concern. On the contrary, they may well regard negative overreactions as buying opportunities, in anticipation of an eventual budget agreement that will not be too aggressive in an economy where consumer confidence has soared, the labour market is improving (albeit slowly) and business investment will rebound after the recent weakness, all this against an extremely accommodating monetary background.

 

William De Vijlder

Chief Investment Officer, Strategy and Partners

BNP Paribas Investment Partners