Asset Management

With holidays in sight, fiscal cliff deal remains elusive

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

December 21, 2012

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Equity market gains give way to sharp downturn by week’s end
Amid the competing rhetoric and ebb-and-flow of optimism regarding the fiscal cliff, U.S. equity markets were quite resilient for much of the past week. The S&P 500 Index was up 2.2% for the week through Thursday, December 20, and 2.1% for the month to date. Foreign developed and emerging stock markets were also strong during the week, and rose 4.0% and 4.6%, respectively, for the month to date through December 20, based on MSCI Indexes.

From its November low through December 20, the S&P 500 advanced 7%, while technically breaching its 200-, 60- and 30-day averages. Importantly, during this upward move, intra-stock correlations—the extent to which individual stocks in the index move in lockstep regardless of company fundamentals—fell significantly. These lower correlations suggest that during this period, the market had become less fearful of a failure to reach a fiscal cliff compromise.

Article Highlights

  • Equity markets are tethered to perceived fate of fiscal cliff negotiations.
  • It is still too early to gauge the likelihood of a resolution by year’s end.
  • Despite uncertainty, fixed-income markets are generally holding steady.
  • U.S. economy shows signs of further strengthening.
  • China continues to improve, while Japanese elections inspire hope for a return to growth.

Equities reversed course sharply on Friday, however, following news that House Speaker John Boehner’s alternative proposal to avert the fiscal cliff (“Plan B”) had been pulled just before being voted on, as it became clear there were not enough votes to pass it. At this writing, it appears unlikely that talks between Speaker Boehner and President Barack Obama will resume before Christmas. Lawmakers are scheduled to return to Capitol Hill on December 27 to resume discussions. It is still too early to determine whether or not a deal will be reached by year’s end.

Fixed-income markets appear to be weathering fiscal cliff turbulence
Although the prospect of “going over the cliff” has major implications for the economy, fixed-income markets have generally continued to hold steady. There has been little evidence of a “flight to safety” or “risk off” mentality that otherwise might be expected in such an uncertain environment. The yield on the bellwether 10-year Treasury, for example, closed at 1.78% at the beginning of the week and was barely changed at 1.77% as of mid-day Friday.

Meanwhile, “spread products” (non-Treasury, higher-yielding securities), which typically come under pressure during periods of heightened market anxiety, have continued to hold their own. In fact, demand for high-yield bonds has driven their prices up and yields down to new lows. Relative to historical norms, the spread in yields between Treasuries and high-yield bonds has remained narrow.

For the month to date through December 20, U.S. corporate high-yield bonds and global emerging-market bonds have returned 1.60% and 0.93%, respectively—outperforming the broad investment-grade bond market (-0.39%) and long-term Treasury bonds (-3.1%), based on Barclays indexes.

Contributing to the relative strength of spread products are stable to slightly higher inflation expectations and a strengthening U.S. dollar—two indicators that generally point to an improving economy. Overall, it appears that fixed-income markets see a better economy heading into 2013, despite the fiscal cliff risks. In the event a resolution is reached by year’s end, we could see spread products continue to rally into 2013, until valuations reach a point at which demand from yield-hungry investors diminishes.

U.S. economic releases remain generally positive
Although equity markets barely took notice, the past week brought a number of encouraging U.S. economic releases, including an upward revision of GDP growth.

GDP: Third-quarter GDP growth was revised upward to 3.1%, slightly higher than our expectation for 3% growth. Increases in consumer spending, residential housing, and state and local government spending were positive contributors. In addition, the trade deficit narrowed more than initially anticipated. Although a welcome sign, the revision does not fundamentally alter the current trajectory of the economy or our expectation for a fourth-quarter GDP reading of about 1.5%. Expectations for slower growth in the fourth quarter reflect a combination of factors: anticipation of fiscal cliff problems and the looming drag in government spending throughout the economy; the lingering impact of Hurricane Sandy (although that is diminishing); and the continued slowing of many other economies around the world.

Weekly jobless claims: First-time claims for unemployment insurance increased to 361,000, from 343,000 in the prior week. We continue to believe there is Hurricane Sandy-induced volatility in these numbers and are waiting for the improving trend to resume in early 2013. Meanwhile, the four-week moving average of claims declined this week. Although this average is typically better than a one-week snapshot as a gauge of the near-term health of the labor market, it is currently even more affected by Hurricane Sandy and thus is unreliable. We expect more normal patterns of claims to resume in the new year.

Housing market indicators: Existing home sales improved markedly last month, a sign that the housing market is getting steadily better. We also note that labor supply for new construction remains muted, leaving more room for sales in the existing market. This should also help push home prices higher in 2013, especially as the inventory of existing homes continues to diminish in quantity and quality. Meanwhile, a drop in housing starts in November was not unexpected, given the impact of Sandy and the season we are in. Building permits, an indicator of future construction activity, rose to their highest level in four years. In addition, homebuilder confidence, as measured by the National Association of Homebuilders/Well-Fargo Housing Market Index, hit a six-year high.

Other favorable readings included gains in personal income, consumer spending and durable goods orders. The Reuters-Thomson/University of Michigan consumer sentiment index fell sharply, however, due in part to concerns about the fiscal cliff.

Non-U.S. economic developments offer some encouragement
The past week also brought some reasons for optimism in Europe and Asia.

Europe: Conditions in Europe were neutral to slightly better, with both Spain and Greece returning to the lending markets over the past week and a half. Italy’s Prime Minister Mario Monti resigned after the Italian parliament passed a new austerity budget. Monti is widely considered to have done a reasonably good job at improving Italy’s fiscal situation during his short tenure.

China: The Chinese economy appears to be in a growth pattern that is “warm”—neither too hot nor too cold. This, in turn, could help set the stage for a 3% to 4% global growth rate with benign inflation—generally ideal weather for equity investing. Of potential concern is a November slowdown in an index of leading economic indicators published by The Conference Board.

Japan: The election of new Prime Minister Shinzo Abe indicates that more economic stimulus is on the way for Japan. In fact, the Bank of Japan implemented its third round of monetary stimulus in four months this past week, and the new government is expected to continue to tackle the country’s growth problems aggressively in the new year. Markets have reacted positively to these developments.

We will continue to monitor fiscal cliff developments closely over the coming holiday week. The next Weekly Market Update is scheduled to be published on December 28, 2012.