Investors fearing a stock market plunge if the US tumbles off the ‘fiscal cliff’ this week may want to relax.
One way or another Washington will come to an agreement to offset some effects of the cliff. The result will not be entirely satisfying, but it will be enough to satisfy investors
But they should be scared if a few weeks later Washington fails to reach a deal to raise the nation’s debt ceiling as that threatens a default, another credit downgrade and a financial markets panic.
Market strategists say that while falling off the cliff for any lengthy period – which would lead to automatic tax hikes and stiff cuts in government spending – would badly dent both consumer and business confidence, it would take some time for the US economy to slide into recession. In the meantime, there would be plenty of chances for lawmakers to make amends by reversing some of the effects.
That has been reflected in a US stock market that has still not shown signs of melting down. Instead, it has drifted lower and gotten more volatile.
In some ways, that has let Washington off the hook. In the past a plunge in stock prices forced the hand of Congress, such as in the middle of the financial crisis in 2008.
“If this thing continues for a bit longer and the result is you get a US debt downgrade... the risk is not that you lose two-and-a-half per cent, the risk is that you lose ten-and-a-half,” said Jonathan Golub, chief US equity strategist at UBS Equity Research in New York.
US Treasury Secretary Tim Geithner said last week that the United States will technically reach its debt limit at the end of the year.
The White House has said it will not negotiate the debt ceiling as in 2011, when the fight over what was once a procedural matter preceded the first-ever downgrade of the US credit rating, but it may be forced into such a battle again. A repeat of that war is most worrisome for markets.
Markets posted several days of sharp losses in the period surrounding the debt ceiling fight in 2011. Even after a bill to increase the ceiling passed, stocks plunged in what was seen as a vote of no confidence in Washington’s ability to function, given how close lawmakers came to a default.
Credit ratings agency Standard and Poor’s lowered the US sovereign rating to AA+, citing Washington’s legislative problems as one reason for the downgrade.
The benchmark S and P 500 dropped 16 per cent in a four-week period ending August 21, 2011.
“I think there will be a tremendous fight between Democrats and Republicans about the debt ceiling,” said Jon Najarian, a co-founder of online brokerage Trade Monster.com in Chicago.
“I think that is the biggest risk to the downside in January for the market and the US economy.”
There are some signs in the options market that investors are starting to eye the January period with more wariness. The CBOE Volatility Index, or the VIX, the market’s favoured anxiety indicator, has remained at relatively low levels throughout this process, though on Thursday it edged above 20 for the first time since July.
More notable is the action in VIX futures markets, which shows a sharper increase in expected volatility in January than in later-dated contracts. January VIX futures are up nearly 23 per cent in the past seven trading days, compared with a 13 per cent increase in March futures and an eight per cent increase in May futures. That’s a sign of increasing near-term worry among market participants.
Consumers don’t appear at all traumatised by the fiscal cliff talks, as yet. Helping to bolster consumer confidence has been a continued recovery in the housing market and growth in the labour market, albeit slow.
The latest employment picture will be out next Friday, and the Labour Department is expected to show jobs growth of 145,000 for December, in line with recent growth.
Consumers will see their paychecks affected if lawmakers cannot broker a deal and tax rates rise, but the effect on spending is likely to be gradual.
The US House of Representatives is set to convene today and continue working through the New Year. President Barack Obama has proposed maintaining current tax rates for all but the highest earners.
Options strategists have noted an increase in positions to guard against weakness in defence stocks such as General Dynamics, as those stocks would be affected by spending cuts set for that sector. Notably, though, the PHLX Defence Index is less than one per cent away from an all-time high reached on December 20.
This underscores the view taken by most investors and strategists: One way or another, Washington will come to an agreement to offset some effects of the cliff. The result will not be entirely satisfying, but it will be enough to satisfy investors.
“Expectations are pretty low at this point and yet the equity market hasn’t reacted,” said Carmine Grigoli, chief US investment strategist at Mizuho Securities USA. “You’re not going to see the markets react to anything with more than a five to seven per cent correction.”
Save for a brief 3.6 per cent drop in equity futures late on Thursday evening last week after House Speaker John Boehner had to cancel a scheduled vote on a tax-hike bill due to lack of Republican support, markets have not shown the same kind of volatility as in 2008 or 2011.
A gradual decline remains possible, Golub said, if business and consumer confidence continues to take a hit on the back of fiscal cliff worries. The Conference Board’s measure of consumer confidence fell sharply in December, a drop blamed in part on the fiscal issues.
“If Congress came out and said that everything is off the table, yeah, that would be a short-term shock to the market, but that’s not likely,” said Richard Weiss, a Mountain View, California-based senior money manager at American Century Investments.
“Things will be resolved, just maybe not on a good timetable. All else being equal, we see any further decline as a buying opportunity.”