Asset Management

With election over, markets fixate on “fiscal cliff”

William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets

November 9, 2012

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In the wake of last Tuesday’s election, it became evident that fear of the looming “fiscal cliff” would be the dominant driver of equity market performance in the short term. The S&P 500 Index declined 2.3% on November 7, its second-worst one-day return this year. Non-U.S. markets fared slightly better during the week, but were still down 1.6% heading into Friday, based on the MSCI All Country World Index (excluding the U.S.).

Globally, markets were also jittery on renewed concerns about the European debt crisis. On Friday morning, the release of better-than-expected U.S. consumer sentiment data appeared to be tempering the market’s downward slide for the week.

In fixed-income markets, demand for U.S. Treasuries drove their prices up and yields down. On November 8, yields on the 10-year and 30-year Treasury securities closed at 1.62% and 2.77%, respectively — their lowest levels in two months.

Article Highlights

  • Investors fear continued gridlock as election produces little change in balance of power.
  • Risk aversion trumps economic data as market driver.
  • S&P 500 Index tumbles to its lowest level since mid-July.
  • Treasuries rally, while higher-yielding “spread products” sell off.
  • Markets likely to remain on edge in the near term.

Meanwhile, “spread products” (higher-yielding, non-Treasury sectors of the bond market) generally sold off, moving in sympathy with equities. Among spread sectors, investment-grade and high-yield corporate bonds fared worse than commercial mortgage-backed securities and asset-backed securities, which were essentially flat. Investor sentiment deteriorated even at the retail level, where weekly flows into investment-grade corporate bond funds turned negative for only the second or third time this year. High-yield bond funds saw outflows continue for the fourth consecutive week.

U.S. economic data: scant but generally positive

It was a light week in terms of U.S. economic releases, but what little data there was tended to be benign. The Citigroup Economic Surprise Index, which measures the degree of variation between actual data and consensus forecasts, moved up.

  • First-time unemployment claims fell by 8,000 last week, to 355,000. Although the drop in claims is an optimistic sign, the latest numbers were skewed by Hurricane Sandy, as loss of power and other storm-related difficulties likely suppressed filings.
  • Consumer sentiment in November rose to its highest level in five years, according to the University of Michigan/Thomson Reuters index. This was the latest in a number of recent confidence measures showing consumers feeling more hopeful than they have since before the onset of the 2008-2009 “Great Recession.”
  • Consumer credit increased more than expected in September, driven by demand for auto and student loans.
  • U.S. exports hit a record high in September, contributing to an unexpected decline in the trade deficit.

Europe continues to weaken

Developments in Europe were not reassuring. The impact of European events and data was relatively muted, however, as the U.S. election and fiscal cliff claimed the spotlight.

  • The composite Purchasing Managers Index (PMI) for the eurozone, which measures both manufacturing and service-sector activity, declined for the ninth consecutive month in October, to 45.7. Any reading below 50 indicates contraction.
  • Stronger, “northern tier” European economies have not been immune to the regional economic downturn. Germany’s composite output index fell to 47.7 in October, staying below 50 for the sixth month in a row. In France, activity in the service sector hit a 12-month low.
  • The Greek coalition government passed a new round of highly unpopular austerity measures, a required step to secure €31 billion ($39.4 billion) of additional bailout funds. Meanwhile, the unemployment rate in Greece rose to 25.4%, from 24.8%.

China’s economy shows signs of improvement

In contrast to the picture in Europe, several indicators supported the case that the slowdown in China’s economy is nearing an end, while lower inflation raised the prospects for continued monetary stimulus.

  • Industrial output (+9.6%) and retail sales (+14.5%) picked up in October, beating expectations.
  • Investment in fixed assets such as property, plants and equipment rose 20.7% in the first 10 months of the year compared to the same period in 2011.
  • Consumer price inflation cooled off, rising 1.7% in October, less than expected.

Against this economic backdrop, China launched the 18th Communist Party Congress on November 7, the official start of the process to select new leaders. The leadership transition may delay further monetary easing or other policy steps designed to stimulate the Chinese economy.

Focus on fiscal cliff to continue

The markets’ focus on the fiscal cliff is not likely to shift any time soon. Accordingly, we expect to see more volatility in the short term. That said, equity market sentiment has moved into a decidedly pessimistic zone, which may bolster the case for a year-end rally—despite the past week’s sharp post-election sell-off. In addition, the S&P 500 has not breached key support levels, and valuations are favorable, particularly relative to bond yields. Both of these factors are encouraging.

Moreover, the fiscal cliff is now so firmly embedded in the market’s consciousness — whether in broad market sentiment, the views of pundits, or even company earnings forecasts for next year — that even a slight hint of a compromise could potentially spark a powerful rally. Whether such a move would be short-lived or lead to a more sustainable trajectory is the key question.

Fixed-income markets will also remain volatile until there is greater clarity on how President Obama and Congress plan to tackle the fiscal cliff. Some bond market sectors may prove more resilient than others, benefiting from the tailwind of the Federal Reserve’s ongoing asset purchases. Currently, those purchases primarily involve mortgage-related securities, but the scope of the Fed’s program could expand to include Treasuries in the first quarter of 2013.