Asset Management

Fiscal cliff deal sparks big New Year's rally, but questions remain

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

January 4, 2013

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With Congress and the Obama administration reaching a last-minute agreement to avert a worst-case fiscal cliff scenario, equity markets rang in the new year with big gains. The sharp rise in stock prices underscored the degree to which investors had discounted a negative outcome to the negotiations.

The S&P 500 Index was up 4.1% from New Year’s Eve through January 3, despite the holiday-shortened trading week. Foreign developed- and emerging-market equities gained 1.4% and 2.6%, respectively, during the same period, based on MSCI indexes. Some of the market’s initial euphoria appeared to be cooling later in the week, although returns remained positive at the market close on January 4.

Bond markets were also in a celebratory mood as the year began. Fixed-income spreads—the difference between yields on U.S. Treasuries and higher-yielding, non-Treasury securities—narrowed significantly for investment-grade and high-yield corporate bonds, commercial mortgage-backed securities, emerging-market bonds and other “spread” products, while remaining relatively flat for government agency mortgage-backed securities.

Article Highlights

  • U.S. and global equity markets cheer eleventh-hour fiscal cliff compromise.
  • Select higher-yielding fixed-income sectors also rally.
  • December employment and manufacturing data confirm steady pace of U.S. growth.
  • Federal Reserve sees potential end of quantitative easing in 2013, eventual return to higher interest rates.
  • Despite deal, fiscal uncertainty is far from over, with more political debate on the horizon.

Such narrowing often occurs when investors are confident and willing to take on greater risk: Strong demand for spread products causes their prices to rise and their yields to fall, while weaker demand for safe-haven Treasuries causes Treasury prices to fall and their yields to rise. The closing yield on the bellwether 10-year Treasury, which had dipped below 1.6% in early December, spiked to 1.92% on January 3.

U.S. economy: Current growth path continues

In addition to responding positively to the fiscal cliff news, markets welcomed continued evidence of the U.S. economy’s recovery. Although little data was released during the week, some key indicators supported the case for a steady growth trajectory:

  • The U.S. economy added 155,000 jobs in December, while unemployment remained unchanged from November’s revised 7.8% rate.
  • Monthly indexes published by the Institute for Supply Management (ISM) showed that both manufacturing (50.7) and non-manufacturing (56.1) sectors of the economy grew in December. (Index readings above 50 indicate expansion.)
  • Auto sales totaled 15.3 million units on an annualized basis in December, capping a very strong year. The auto industry represents one of the best-performing sectors of the economy since the end of the recession in 2009.

Other U.S. indicators were somewhat less favorable but do not represent a material change in the basic growth narrative:

  • Construction spending fell by 0.3% in November on a month-over-month basis. Spending on housing construction was strong, but not strong enough to outweigh a dip in non-residential construction spending.
  • Factory orders were flat in November, versus expectations for a slight increase.
  • First-time unemployment claims increased to 372,000 for the week ended December 29, from an upwardly revised 362,000 the week before. We do not read too much into these recent numbers, which remain extremely volatile, due in part to the lingering impact of Hurricane Sandy.

Economic news outside of the U.S. was fairly quiet. Notably, December readings for China’s Purchasing Managers’ Indexes (PMI)—gauges of economic activity similar to the ISM indexes previously cited for the U.S.—held steady at 50.6 for the manufacturing sector and climbed to 56.1 (from 55.6) for the non-manufacturing sector. These above-50 levels offer further evidence that the Chinese economy is stabilizing after a mid-2012 soft patch and will likely continue to grow in 2013. This expectation is further supported by current strength in the Shanghai Stock Exchange “A Share” Index.

Outlook: The “cliff” may be behind us, but fiscal uncertainty is far from over

Although the U.S. managed to avoid going over the fiscal cliff on January 1, the agreement reached was far from comprehensive. Uncertainty over federal spending and a number of specific tax measures will continue in the weeks and months ahead. In particular, while the “cliff” may be past, the “twin peaks” of sequestration (automatic spending cuts that will kick in if no compromise is reached by March 1) and another contentious debate over raising the U.S. debt ceiling still loom.

For some equity investors, these obstacles represent a less daunting “wall of worry” that the market will be able to climb. The base case scenario for these optimists is that a compromise of some sort will be reached by March, as the political pressure to deliver one makes it the most likely outcome. We have already seen some willingness to compromise, in theory and in fact, on key issues such as tax rates and Medicare reform. Moreover, as a vote to raise the debt ceiling draws closer, the actions of officials in Washington will come under intense scrutiny from the ratings agencies, as happened in 2011. It remains to be seen how far parties on either side of the debate would be willing to go before risking a repeat of the credit-rating downgrade that resulted from that year’s tumultuous negotiations.

In the meantime, despite the 4%-plus jump in the S&P 500 during the past week, U.S. stocks remain cheap relative to bonds. The risk premium is still quite wide, underscoring the equity market’s continued sensitivity to a worst-case scenario out of Washington. That said, investors should avoid becoming overly optimistic. On one hand, it is possible to construct a case not only for further stock market gains in this environment, but also for upside surprises in economic growth, if confidence in a deal begins to unleash some of the capital spending and hiring that businesses have put on hold during this period of uncertainty. On the other hand, the market’s strong start to the new year could leave it vulnerable to a correction. With 84% of S&P 500 companies trading above their 50-day moving averages, further gains may be difficult to sustain.

In fixed-income markets, while the new year is generally off to a good start for spread products, there are clouds on the horizon. One wild card is the potential effect, if any, that higher Treasury yields will have on flows into fixed-income funds, particularly those with an investment-grade focus, as total returns for these securities can be low or negative even as spreads tighten. This could cause some retail investors to shift money into equities.

In addition, in the minutes from the December meeting of the Federal Reserve’s Federal Open Market Committee (FOMC), some members advocated ending the Fed’s quantitative easing (QE3) and mortgage-buying programs during 2013, while potentially raising interest rates as early as some time in 2014, based on the economy’s current trajectory. For now, we view this path as a 2+% average GDP growth rate, which reflects a moderate fiscal “drag” (negative effects resulting from the agreed-upon fiscal cliff measures). This forecast is subject to change as we continue to monitor U.S. fiscal policy and debt ceiling negotiations, and their potential economic impact.

The next Weekly Market Update is scheduled to be published on January 11, 2013.