The final weeks of 2012 are likely to be a nervous period for financial and commodity markets as investors await the outcome of US lawmakers’ negotiations over the so-called fiscal cliff. However, the rally in global risk markets that was interrupted in mid-November could continue with more conviction early next year, once investor jitters over US fiscal policy are out of the way. This reflects improvements in some economic data from the US and China, and some signs of stabilisation in the European debt crisis.
Investors’ risk appetite over the past couple of years has fluctuated, in large part, in line with developments in the debt crisis in the euro zone. Perceptions of the risk of a break-up of the single currency, as well as of the prospects for lasting policy solutions to the euro’s crisis, will continue to be a driving factor in market shifts between “risk on” and “risk off” trades. However, policy in the US is at the centre of attention right now. While several rounds of quantitative easing by the US Federal Reserve have been significant for financial markets, boosting risk assets such as equities, the approach of the end-2012 fiscal cliff is overshadowing most other factors in determining perceptions of risk.
Much is at stake. A failure by US lawmakers to extend Bush-era tax cuts due to expire at end-2012, and to agree on measures to limit or delay spending cuts and other fiscal tightening measures also scheduled to start taking effect next year, would have a profoundly damaging effect on the global economy. Should no deal on the fiscal cliff materialise, we believe that the US would be pushed firmly into recession. This would mark a major change from our current forecast of just over 2% growth next year, which is predicated on the assumption that Congress will strike a last-minute deal that averts the worst of the fiscal tightening.
All else being equal, a holding pattern is likely in many financial and commodity markets until the outcome of fiscal cliff negotiations in the US is clear. This does not automatically imply that markets will remain flat, but it does suggest both that markets are likely to oscillate between “risk on” and “risk off” trades and that any gains as a result of positive market data will be constrained by recognition of the short-term risks that could still derail the rally.
Indeed, a rally has been under way for some months, but it may have further to run. Risk appetite is rising again after a brief, sharp downturn in mid-November. Many stockmarkets have strengthened, and the euro has appreciated to a six-week high against the US dollar. The latter suggests that recent measures by European policymakers—from the September launch by the European Central Bank (ECB) of its outright monetary transactions (OMT) programme to the recent softening of Greece’s debt-repayment terms as a prelude to unlocking more bail-out money—are supporting investor confidence. The yen has also weakened in the past few weeks, from around ¥78:US$1 in mid-September to ¥82:US$1 currently, to the great relief of Japanese exporters. A weakening of the yen, often sold off when investors bet on riskier assets via the carry trade, can be a sign of a broader increase in risk appetite. That said, in this case domestic factors such as very weak third-quarter Japanese GDP and expectations of looser monetary and fiscal policy may be the main reasons for the move in the yen.
Despite the generally positive signs for risk assets, the US fiscal cliff adds a note of uncertainty that will make it difficult for global markets to take a definitive direction. On the one hand, investors know that a fiscal deal by US lawmakers is almost certain before the end of 2012, even if negotiations go down to the wire and the resultant compromise is highly imperfect. This suggests that it would be a brave investor who made aggressive short bets on risky assets. On the other hand, until such an agreement materialises, the mere presence of the fiscal cliff is too large a risk to ignore.
Moreover, it is not so much the actual outcome of the fiscal cliff negotiations that poses the biggest obstacle to a continuation of the rally but rather the impact of the surrounding uncertainty on consumer, business and investor sentiment. For example, US companies may reduce hiring and investing until fiscal policy becomes clearer; if the outlook for corporate earnings weakens as a result of this holding pattern, this would undermine the case for equities.
Nonetheless, assuming that the US economy does not go over the fiscal cliff, a stronger rally in risk assets looks possible in early 2013. Yields on “safe” assets and cash are meagre and likely to remain so, encouraging investors to seek assets paying higher returns. Global macroeconomic fundamentals remain mixed, but there have been some positive developments. Revised data for US GDP growth in the third quarter of 2012, for instance, were much stronger than the government had previously estimated. While much of this improvement was down to a build-up of inventories, there have been a number of signs in recent months that the US economy is closer to sustainable modest growth. The housing market is on the mend, and recent job creation data have been encouraging.
Concerns about the mid-year slowdown in China’s economy, meanwhile, have been eased by a variety of manufacturing-related data, underlining our view that earlier stimulus is having a beneficial effect and that GDP growth will accelerate in the fourth quarter of 2012 and the first half of 2013. Stronger Chinese growth, combined with the easing of risks elsewhere in the world, could give a boost to commodity prices. Still, more sustained evidence of improvement in China is probably needed first.
An easing of financial jitters in the euro zone also plays into the risk-rally story. The growth outlook for the 17-country currency union remains dire, and has worsened in recent weeks as the German economy—hitherto relatively unscathed by the region’s downturn—has shown signs of weakness. But fears of a major financial shock such as a break-up of the euro have receded. Markets have been encouraged by the ECB’s OMT programme, among other things, and sovereign bond yields in key euro periphery countries are much lower than a few months ago—indicating a lower risk of default. Italian ten-year yields were at 4.45% on December 3rd, down from about 6.6% in mid-July and 7.4% about a year ago. Both the Italian and Spanish governments have been able to tap the markets at lower rates in recent weeks. The structural problems bedevilling Europe’s currency union have not gone away, so the underlying risk of a catastrophic financial event remains. But short-term risks of market turmoil have undeniably eased.
All these factors suggest that the risk rally could be extended once concerns over the US fiscal cliff have lifted. One further caveat is that uncertainty over US fiscal policy in the final weeks of 2012 could cause data to be weak for some time in early 2013, which in turn could dampen market sentiment. But for all the continuing risks, there still seems to be upside potential for markets in the New Year.