Asset Management

Fiscal cliff reactions lead to market ping-pong

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

December 28, 2012

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Equity markets finished lower during the first three trading days of the holiday-shortened week—a weakness we attribute primarily to the looming December 31 fiscal cliff deadline. Although overall U.S. economic activity remains strong, markets fear the combined effects of higher taxes and spending cuts scheduled to come into effect in January should the deadline expire without a resolution. The Chicago Board Options Exchange Volatility Index, or so-called “fear“ index, spiked to near 20 as of December 27, indicating heightened expectations of S&P 500 volatility.

Conflicting reports on fiscal cliff progress dominated headlines on Thursday, as some lawmakers returned to Washington, D.C. Markets whipsawed all day in quick reaction to various reports—first optimism at President Barack Obama’s earlier-than-planned return to the capital, then pessimism at Senate Majority Leader Harry Reid’s prediction that the nation is indeed headed over the cliff. During the final hour of trading on December 27, the markets were optimistic again on rumors that the House of Representatives plans to convene on Sunday evening, December 30.

Article Highlights

  • U.S. equity markets are down in reaction to fiscal cliff headlines.
  • U.S. economic data is mixed as unemployment and housing continue their positive streak, while holiday spending and consumer confidence lag.
  • Fixed-income market spreads widen as attention remains focused on fiscal cliff developments.
  • Asian markets continue their upward momentum.

These dramatic developments in the final days of 2012 brought an end to a turbulent year for equity markets. Although investors frequently flipped between “risk-on and risk-off” sentiments, markets generally appeared to be ending the year in positive territory. Equity markets in 2012 were led by Europe, with the MSCI EAFE up 17.7% for the year to date as of December 27. The strength of this index is due primarily to European countries’ positive steps toward debt reform and stronger European Central Bank monetary policy. U.S. markets were also up, with the S&P 500 rising 15.3% for the year to date as of December 27. Emerging markets followed, with the MSCI EM up 14.5% for the same time period.

Fixed-income spreads—the difference between yields on U.S. Treasuries and higher-yielding, non-Treasury securities—have begun to widen further, underscoring the market’s apprehension about fiscal cliff gridlock. Treasury returns rose as equity markets lost ground and investors sought safety. The benchmark 10-year note yield declined to 1.74% at Thursday’s close and touched 1.7%, the lowest level since December 14, 2012. Overall, 2012 was a positive year for fixed-income markets, with the Barclays US Aggregate Bond Index up 4.3% and the Barclays U.S. High-Yield Index up 15.8% for the year to date as of December 27.

Mixed US economic data reflects holiday circumstances, fiscal cliff concerns

The few economic announcements that came out during the holiday week showed mixed results. Better-than-expected weekly jobless claims and continually improving housing data were tempered by disappointing holiday sales and a drop in consumer confidence.

Weekly jobless claims fell to a seasonally adjusted 350,000 from a revised 362,000 in the previous week. This represents the lowest level in a year, although the decline may be exaggerated by short-term employment during the holiday season. Meanwhile, the one-month average of claims, which smoothes out weekly volatility, fell to 356,750, the lowest level since March 2008. The number of people applying for unemployment benefits has now fallen below the level before Hurricane Sandy, which caused a sharp, temporary increase in claims.

Housing continued its upward momentum as the S&P/Case-Shiller Home Price Index came in better than expected. The 20-city price index was up 4.3% in October, compared with a year earlier, versus expectations of a 3.7% gain. New home sales were also a positive indicator, jumping 4.4% in November to an annual rate of 377,000, from a downwardly revised 361,000 in October. Compared to a year ago, new home sales are 15.3% higher; the November number represents the highest level since April 2010.

Holiday sales stood in contrast to this good news. According to MasterCard’s SpendingPulse unit, holiday sales rose a smaller-than-expected 0.7% from October 28 through December 24, compared with a 2% increase for the comparable period last year. The 2012 rate represents the slowest growth rate since the recession of 2008 and could potentially be due to fiscal cliff concerns.

Finally, The Conference Board’s Consumer Confidence index dropped to 65.1 in December, from a downwardly revised 71.5 in November. This represents the lowest level in four months, which is likely due to fiscal cliff concerns. Most notably, the “expectations” figure dropped to 66.5 in December from 80.9 in November. The December figure represents the lowest level since November 2011. While The Conference Board’s index fell in December, consumer confidence measured by Rasmussen, a survey of public opinion data, rose. This may reflect the beneficial effect of higher home prices and lower jobless claims, partly offset by lower-than-expected holiday sales and the stalemate in Washington.

New leadership in Japan and China spurs momentum

News flow remained quiet out of Europe during the holiday week, with many larger markets closed. U.S. headlines continued to be of greater interest than ongoing eurozone sovereign debt concerns.

Asian markets continued their upward momentum this week. China, Japan and other key Asian economies have proven resilient in the face of the negative news flow from Washington.

Chinese equity markets continued their rise, and have nearly wiped out yearly losses of as much as 11%. The Shanghai “A” Share market index has broken through its 200-day moving average. Chinese economic data has also been improving, with steel prices moving higher and Shanghai property prices spiking. The general sentiment is that much of the credit for this improvement is due to the new leadership’s reform efforts to boost growth.

In Japan, markets have been reacting positively to the election of Prime Minister Shinzo Abe, who is expected to do more to spur growth and reverse deflation. His party reached an agreement with coalition ally Natsuo Yamaguchi this week on a policy that includes "bold monetary easing" to reach an inflation target of 2%. The weakening yen is also propelling optimism in the country, as this helps boost prospects for Japanese exports.

Outlook: All eyes on Washington

As we move into 2013, we continue to await progress on the fiscal cliff. Markets are expected to move lower if no agreement is reached by December 31, with the first test of market reaction likely to be a drop below November’s S&P low of 1350.

However, while the prospect of the cliff remains daunting, we have seen the market discount similar events in the past, resulting in less impact than the consensus would have us believe. This is particularly true given the relative health of U.S. industry balance sheets and equities’ current cheap valuations compared to fixed income, coupled with the preparations many companies have already made to deal with a “worst case” cliff scenario.

In addition to the showdown in Washington, investors will continue to focus their attention on Europe’s ability to address its debt crisis in 2013. In emerging markets, the focus in 2013 will be on countries’ ability to keep inflation benign and companies’ ability to continue their positive earnings trends.

We will continue to monitor fiscal cliff developments closely. The next Weekly Market Update is scheduled to be published on January 4, 2013.