What Does The Market Say About The Fiscal Cliff?

Includes: DIA, SPY
by: Evan Schnidman

In the day after the presidential election U.S. equities markets declined by 2.5% and did not rebound by the end of the week. Hundreds of commentators have pointed to the Wall Street's disdain for President Obama as the root cause of this decline. Slightly more astute commentators have pointed to the impending fiscal cliff as the cause of the market drop. The trouble is that both of these events should have been priced in to the market already. The polling data strongly pointed to a solid Electoral College victory for the president and the fiscal cliff situation needed to be dealt with before year-end regardless of who won the election.

Troubles in Europe

The more direct cause of a softening stock market is almost definitely the continuing weak economic data from Europe. Greek unemployment continues to rise and every indication is that France is slipping (or has already slipped) into recession. Making matters worse, the Japanese economy continues to sputter.

The worst news for the global economy is not all of this negative data, but the continued bickering by European policymakers. Despite a vote providing short term resolution to the brinksmanship over the need for austerity measures in order to extend the Greek bailout, Greece still requires additional financing to meet its debt obligations. Meanwhile, indications are that Spain remains unwilling to be bailed out under the planned conditions. Adding to the political tensions are emerging stories that the strict conditions placed on a potential Spanish bailout are in part due to pressure by German Bundesbank President Jens Weidmann.

In addition to the political squabbles over bailout conditions in mainland Europe, the British government has recently shown opposition to a unified eurozone banking supervisor. Although a singular supervisor could reduce regulatory and compliance costs while also instilling greater consumer confidence, the British government fears that regulations heavily designed by Germany could infringe on the dominance of London as Europe's main banking center. Like so much else in the eurozone, this regulatory delay highlights the tense nature of policymaking between countries with long histories of conflict.

The Fiscal Precipice

While all of these details about the woes in Europe are important and are having an immediate impact on markets, the fiscal cliff remains important. Make no mistake about it, if Congress and the president can't agree to a plan, the fiscal cliff could and likely would trigger a recession in the United States. However, this situation is unlikely.

Both the president and Republican Congressional leaders have showed signs of willingness to work together (although not compromise) to avoid the fiscal cliff. Regardless of ideology or moral beliefs about long term debt, the data indicates that markets expect the cliff to be averted. Although the equity markets have dropped in recent days, bond and currency markets have shown great faith in the U.S. government; both the dollar and demand for Treasury bonds are up. While some of this is a reaction to European woes, the data still points to faith in the long term stability of the U.S. government, regardless of the fiscal cliff.

Investment Strategy

Despite incessant yammering about the market reaction to the election and fears about the fiscal cliff, the data points to Europe as a bigger drag on the economy. However, just as Europe has been and continues to be a drag, the Chinese economic outlook appears to be improving. That said, since the Chinese government targets growth and missing a growth target would be cause for loss of credibility just as they experience a leadership change, it is unlikely that Chinese officials would admit to missing growth estimates. So, the seemingly brighter Chinese economic picture should be viewed with healthy skepticism. This means that investors should continue to minimize their exposure to Europe and hedge on the possibility of inflated Chinese growth numbers by avoiding energy and manufacturing investments reliant on growing domestic Chinese demand. Perhaps most important, investors should avoid the media's doomsday predictions about the fiscal cliff and instead watch the Treasury and currency markets to gauge investor reaction about the likelihood of a fiscal compromise.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.