Regardless of who wins the November 6 U.S. election, there is unlikely to be a major change to current economic policies in the very short term. Although there are different priorities between extending tax cuts and limiting spending cuts, both political parties probably want to avoid the “fiscal cliff” next year. Therefore, the near-term outlook is for large fiscal deficits under either party. As for monetary policy, Governor Romney has said that he will not reappoint Bernanke as chairman of the Federal Reserve when his current term expires on January 31, 2014. However, even if President Obama is re-elected, there is no guarantee that Bernanke will seek another term. Therefore, no matter who is in the White House, there could be a new Fed chairman in 2014. But from now until January 2014, the Fed’s balance sheet will continue to grow. Thus, the November 6 election is unlikely to result in any immediate material changes to U.S. macroeconomic policies. Large fiscal deficits will persist and the Fed’s balance sheet will continue to inflate.


None-the-less, uncertainty generated by last minute deals in Washington will temporarily undermine growth and contribute to market volatility even if the fiscal cliff is ultimately scaled back to a more manageable “hill”. U.S. investment grade and high yield bonds have benefited in recent months from an easing in sovereign debt concerns out of Europe, a jump in domestic confidence about economic growth prospects, and slightly reduced uncertainty regarding government economic policy. However, improvements in confidence might prove short-lived in the event that Congress reconvenes for the lame duck session without a desire to compromise; this scenario is entirely likely and markets may set up for a replay of the mid-2011 debt ceiling crisis. Risk assets sharply underperformed in that incident. Although aggressive monetary policy from the Fed acts as a firm tailwind for risk assets, be on high alert for fiscal policymakers to descend into a confidence-damaging negotiation that mutates into a major policy mistake and prompts a correction in risk assets.


Since the Great Recession, there has been a fierce clash between intense reflationary efforts on one side and strong deflationary tendencies in the world economy on the other. Reflective of this battle, global financial markets have also been stuck in a “binary” mode: investors have either collectively bet on policy reflation leading to better global growth (a.k.a., “risk on”) or they have run for the exit on fears of another meltdown (a.k.a., “risk off”). The frequent swings between reflationary hope and deflationary despair are the key reason why financial markets have become highly correlated. For instance, since 2008, not only has sector correlation within the S&P 500 been high, but the correlation among asset classes has also risen to its highest level ever. Throughout this period, various central banks’ quantitative easing programs have periodically assuaged market fears, allowing stock prices to rise and market correlations to fall temporarily. But more aggressive policy action has increased the possibility that correlations will now fall on a more sustainable basis. The ECB’s decision to backstop sovereign governments should be regarded as a watershed event because it has substantially reduced the tail risk of another “Lehman moment”. Asset correlations should continue to decline as a result.


The IMF estimates that the drag imparted by fiscal adjustment in the advanced economies will intensify slightly from 0.7% of GDP this year to 1.0% in 2013, but this is not all bad. While the fiscal drag is expected to intensify in the U.S. and, especially, Japan, the fiscal headwind will actually moderate in the euro zone. Budgets will be tightened further, but the IMF believes that the worst has passed for Europe in terms of the effect of austerity on real GDP growth. The bad news is that the U.S. has a lot of work ahead in terms of placing its public finances on a sustainable track over the long haul; the good news is that the U.S. has the luxury of stretching out the fiscal pain over several years rather than taking all its lumps at once.


Expect some negative surprises in October as we approach U.S. elections and heightened expectations. Expect Romney to maintain his momentum and for Obama to continue polling well. Newscasters will make this a very interesting photo finish race.



Michael Ashley Schulman, CFA

Managing Director