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Markets brace for a running jump off the fiscal cliff after Obama win

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By Gerard Lyons

Posted  Tuesday, November 13  2012 at  02:00
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The US election results not only see the return of President Obama for four more years, but also Republicans retaining Congress and Democrats the Senate. Despite the uncertainty of the last few weeks, these are the very results the markets were expecting.

The result is a removal of the political uncertainty but markets still have to contend with a continuation of economic and policy uncertainty. Despite the euphoria of the election victory, one should not forget how divided the Republicans and Democrats were during the campaign on some areas and thus one can expect some big policy differences during the next four years. But for now, immediate attention will be on the fiscal cliff.

There is every likelihood of a compromise being reached in this lame-duck session of Congress, before year-end. The uncertainty over fiscal policy has already had a negative impact on the economy as spending plans have not been rolled over in some areas of government, impacting business. The “cliff” itself, with automatic tax increases, or the ending of tax breaks, and spending programmes not being extended, among other things, could knock over 4 per cent off US growth; hence, the concern.

Although the economy is improving, it is too fragile to cope with such a shock. The likelihood is a compromise, extending some combination of the tax and spending programmes. But it would still not be growth constructive but at least not as bad as the worst case, and it would remove the uncertainty, although as we have seen before, from now to year-end will likely see some nervousness as to whether things will be agreed in time.

Although the economy is improving it is too fragile to cope with such a shock. The likelihood is a compromise, extending some combination of the tax and spending programmes. But it would still not be growth constructive but at least not as bad as the worst case, and it would remove the uncertainty, although as we have seen before, from now to year-end will likely see some nervousness as to whether things will be agreed in time.

But the US does not just face a fiscal cliff. As I have said before it has faced “a fiscal cliff, a regulatory mountain and a jobs depression”. In recent months, the economy has shown progress on the jobs issue. Now there is a need for that to continue and for progress on the other two areas as well: the fiscal cliff and the regulatory mountain. The latter has not always received enough attention. The balance sheets of US firms, particularly larger ones, have been improving. But they are reluctant to invest. The weakness of demand has been one reason. So too has been uncertainty over regulatory policy under President Obama.

Demand is improving but needs to withstand any fall-out from the fiscal cliff. Regulatory policy in the second term needs to be addressed; firms seem most concerned about the increasing cost of all the regulatory measures. Trouble is it is hard to quantify fully this effect. It may be that firms have exaggerated this, as a reason not to invest. But as demand recovers - albeit gradually - firms will find more reasons to spend too. And rising wages in China and cheap shale energy may help US competitiveness.

While all this continues, expect a continuation of Fed policy. It remains growth constructive. Monetary policy appears to be working better than before. Smaller firms now appear to find it easier, but still tough, to access funds. The housing market is recovering. And, in recent months, the combination of the Fed’s monetary policy and President Obama’s fiscal policy has helped the economy. The US is recovering but managing expectations is key. There is still an overhang of debt in parts of the economy.

In recent months, the markets have been revising down their US growth forecasts partly because the market was very optimistic before. But this may be the time to revise up US projections. Depending on what happens on policy in coming months, the steady but not spectacular recovery should continue in 2013 as growth edges up.

Although US political uncertainty is now easing, the world economy and financial markets still have to contend with concerns in other regions, namely China and Europe.

Worries about the euro area have eased, but as the riots yesterday in Spain and Greece demonstrate, there are still deep problems as austerity measures continue to be implemented. While one should not underestimate the political commitment in Europe to keeping the euro project alive, one also cannot underestimate the economic and social pain in the Periphery. During a TV discussion with the Former Prime Minister of Ireland in the UK last week, I said that this is not the economic time for the Periphery to be pushing through painful reforms. He said politically this is the only time that reforms can be pushed: when times are bad. Therein lies the problem.

So expect more of the problems we have seen before, with bouts of uncertainty returning. But the good news is that the European Central Bank’s actions have put a floor underneath things, providing liquidity and pulling the euro back from the brink.
While one should never take one’s eyes off Europe - particularly Greece in coming days given the austerity vote - immediate attention will also focus on Chinese politics and in particular on the new Politburo Standing Committee, which is widely expected to revert back from its current nine members to the more traditional seven.
So, the US electoral uncertainty is over.

Now we have to focus on all the other uncertainties. And although vulnerable to shocks, at least the economies in China and the US appear in better shape than a few months ago. Perhaps that was a contributory factor to President Obama’s re-election.

The writer is the Standard Chartered Bank Group Chief Economist. E-mail: editorial@ug.nationmedia.com