News that U.S. lawmakers reached a last-minute deal to avert the so-called fiscal cliff rallied Asia and European stock markets on Wednesday, sending oil and gold higher and the dollar lower, as investors got into a risk-on mood for the first trading day of the year. Wall Street futures were responding as well, pointing to a strong open Wednesday.
Investor relief is understandable, given weeks of uncertainty and what appeared to be some heated debate at times between lawmakers. But that relief will be temporary, say strategists who harp on the U.S. borrowing limit and longer-term budget cuts that still must be tackled.
“No doubt the market will use early month, New Year and the fact we avoided ‘an even worse’ event to take the market higher, but I doubt it will last more than 24/48 hours. The market is long and too long, we look for correction as debt ceiling talks gets going,” says Saxo Bank’s chief economist, Steen Jakobsen, in emailed comments.
It’s a deal that just buys lawmakers some time, he and others say. “Politicians failed again to do any reform…it increases debt by $4 trillion over 10 years and it only includes higher taxes, no real spending cuts. Stopping the tax hike is almost negated by payroll tax — we see this as a net drag on the U.S. economy to the tune of 1.7% net and increased uncertainty,” says Jakobsen. The deal raised taxes on higher-earner households, but also let a 2% payroll-tax cut expire, meaning everyone’s taxes will go up.
Calling it a “bare bones agreement,” analysts at Citigroup say while it removes the threat of “immediate, severe fiscal tightening,” it also leaves both short-term and long-term spending decisions in the hands of the new Congress within the space of two months.
Joe Rundle, head of trading at ETX Capital, notes that as markets retreated going into the year end on worries a deal wouldn’t be reached, bargain hunting is to be expected. However, he says it’s “only a matter of time before market participants lose their buzz as U.S. lawmakers will have to reconvene to address the remainder of unresolved issues…The likelihood that we will see a series of setbacks in talks, continued political posturing and finger pointing is again set to unnerve investors, prompting huge bouts of volatility in markets.”
Jakobsen notes that investors are ushering in 2013 with some of the highest expectations for the stock market since 1999, with not a single Wall Street house expecting the S&P 500 SPX +1.69% to take a hit this year. And that’s despite a number of factors that could get markets upset, including tax hikes, austerity and a general slowdown in world growth.
“This means the main return needs to come from multiple expansion, which we find hard to imagine considering the tail-risks,” such as the debt ceiling, and Italian and German elections, says Jakobsen. He suggests investors cut back on their equities exposure and go heavier on Treasury Inflation Protected Securities and commodities.
Here is Saxo Bank’s game plan for now:
Current allocation (normal allocation)
Stocks 10% (18.75%)
Emerging market bonds 15% (14.5%)
Commodities 25% (14.5%)
Corporate bonds 0% (6.25%)
Treasurys 20% (25%)
TIPS 30% (21%)