Effects from Hurricane Sandy, the presidential election, and Thanksgiving were notable most in employment, consumer spending, and manufacturing. The interest rate outlook is the same (despite the FOMC’s decision to peg the exceptionally low federal funds rate to unemployment and inflation performance), consumer confidence seems solid with good reports on holiday sales, and in housing almost every measure continues to trend better. Chinese economic growth seems to have troughed and the European Central Bank (ECB) appears to have contained systemic risk. If the U.S. budget deficit and more general fiscal problems can be managed, then the economy looks poised to grow. A pent-up demand story is developing in the U.S. that will improve growth in the second half of 2013.
The combination of a healthy US recovery (post-cliff), supported by a housing rebound, real devaluation vis-a-vis China, corporate sector savings flowing into investment (over the medium-term) and abundant cheap domestic energy resources is almost too good to be true. US equities are increasingly catching the eye of some investors since the U.S. equity market already endured a meaningful correction this autumn, and deflation concerns are subsiding. In the event that the U.S. economy plunges over the fiscal cliff and enters a double-dip recession, global stocks will fall hard and safe-haven bonds will soar. This would most likely be a short-term stumble (and buying opportunity) and we would treat this nightmare scenario as a tail risk rather than a high-odds event. Investment strategy should take tail risk as a consideration, but not as a basic operative assumption.
The euro-area crisis has changed recently. Pre-August, it was about global investors betting against the likes of Italy and Spain, knowing these bets were almost self-fulfilling. Higher bond yields and lower equity prices compounded the pressure on those countries. It seemed possible some of the Mediterranean countries might lose market access and, in the absence of sufficiently large official support, be forced out of the euro. The ECB finally addressed this problem by making the one-way bet more symmetrical. The medium-term outlook hasn’t improved, but nobody is now willing to take on the ECB. Europe is in a better (but not exactly ‘good’) equilibrium. Mr. Draghi has restored some credibility to European policymaking; more likely, he has provided an excuse for euro-crisis-fatigued investors to move on and worry about something else instead.
This can’t be the end of the European crisis – current policies will spread recession, which can only lead to further trouble for the euro – but the ECB has certainly provided time for the politicians to come up with a plan for proper political integration. Optimists point to the development of a banking union as evidence this is happening. They claim this is actually a fiscal union pursued by stealth. If individual sovereigns can secure pan-European funds from the banking union, their future fiscal burdens will be smaller. In the extreme, German taxpayers could prop up weak banks, which in turn could prop up weak governments. And if the Europeans can agree on a comprehensive deposit guarantee scheme (like our FDIC, but fixed in euros) the surplus countries will effectively be underwriting the euro, ruling out bank runs driven by redenomination fears. Unfortunately, European politicians (particularly those who are required to fund it) have a totally different view of what the banking union should look like.
Avoidance of the fiscal cliff is not guaranteed. Expect unease in December as the market reacts to fiscal cliff jockeying and tough verbiage. Discussions of various tax and spending solutions will increase volatility across equities, Treasuries and municipal bonds. The global economic slowdown will continue to restrain US exports next year and a resurgence of the euro-zone crisis could shake US financial markets. Nevertheless, domestic demand growth should strengthen, particularly if the housing recovery continues to gather momentum and energy remains cheap.
Michael Ashley Schulman, CFA