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After the elections, market attention will shift to the Fiscal Cliff– economist shorthand for the double hit of tax increases and spending cuts set to take place at the end of the year. We believe financial markets have severely underestimated the true impact of this looming potential debacle. The fiscal contraction that will occur is around $700 billion, of which only $80 billion is priced in, according to the only study that has attempted to quantify the impact. If Congress does not adequately address the Fiscal Cliff, the likelihood of a recession in the U.S. next year will be substantially increased.
If We Calculate the Risk, Its Concerning
Its not easy to calculate how much of the Fiscal Cliff is, and isnt, priced in. (No investment bank has attempted it). Bank of America (BofA) built a fairvalue model of 10-year Treasury yields based on current economic growth potential, the Feds forward guidance, some assumed risk-averting factors and other measures. It totaled to more than $700 billion in fiscal contraction. Included in their calculations:
- Bush Tax Cuts
- Payroll tax cuts
- Obama Care taxes
- Alternative Minimum Tax (AMT continuing)
|Cuts in spending:|
- Extended unemployment
- Sequestions (entitlements/defense).
- Other spending cuts
Consensus projections from economists show a vast misalignment of expectations, however. The report concluded that only about $80 billion (consensus) of the estimated $700 billion in contraction is priced in. A fiscal contraction of $700bn should have about 4.5% cumulative drag on GDP (likely realized over 1st Half 2013). If Congress doesnt deal with the Fiscal Cliff head-on, all bets are off on how negatively the markets might react. The likelihood of economic recession would be substantially increased.
Qualitative Factors Support the Theory
No one can really be sure if that figure is correct or not, but it is an attempt to at least put some quantitative figures on what is priced in and what isnt, and its concerning. Lets look at some qualitative measures to see if the market is pricing in some Fiscal Cliff risks:
- VIX – below historical average. The VIX index, sometimes called the “fear gauge” of investors, stood at a low 17.81 as of 10/26/12 – very close to recent lows. This stands in sharp contrast to 2011, ahead of the debt ceiling debate, when the VIX was trading at 25. It turned out the debt ceiling debate was a significant tail event as Washingtons failure to raise it sent the VIX surging to over 40 during that period. There is a risk of another repeat performance.
- The market has built short Japanese Yen positions (IMM JPY). Since 2000, the Yen has been the premier safe haven currency. We look at International Monetary Market (IMM) non-commercial futures contracts as a proxy of overall JPY market positioning. Generally, if there is a bout of risk aversion, long JPY positions build, and when there is a period of risk appetite, short JPY positions emerge. Last year during the debt ceiling debate, the market built long JPY positions. This year, investors have built a moderately large USDJPY position. The long USDJPY position indicates that currency investors are not focusing on Fiscal Cliff worries in the near term.
Source: Bloomberg, Pioneer Investments. Last data points 10/26/12.
This analysis reveals that only $80bn of the estimated $700bn of fiscal tightening is priced into asset prices. While no one can be sure if that is the precise figure, it does square with some of the qualitative factors we looked at such as the VIX and the USDJPY positioning that indicate very little priced into the markets. At least from our simplistic exercise, it is fair to say that very little is priced into asset prices and therefore there is a real risk of turbulence in markets if talks over the Fiscal Cliff do not go smoothly.
**For potential investment implications, please read my colleague Michael Temples blog, Fiscal Cliffs Implications for Investments – The Witching Hour.