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Fiscal Cliff: What It Really Is And Why Will It Affect Us

FYI | Sep 27 2012

By Jonathan Barratt
It all seems as if the market sentiment is becoming more pessimistic about a recovery. The glaring problem being what the central banks will try next in order to stimulate growth. 

As we have mentioned before, Bernanke’s "tool box" is empty and we continue to question what "real" benefits we have or will receive from QE1, 2 and 3. Unemployment in the US remains high and economic numbers around the world remain mixed if not soft. The only real result we can see is that Bernanke has succeeded in lining the pockets of Wall Street. How can it be that the Dow is trading at pre-GFC levels?

In Europe, the entire fanfare has dried up with Merkel, Draghi and Lagarde now facing the task of trying to resurrect some confidence. It actually feels as if this “muddling” through process is of a grand design: just keep propping up confidence with a plan that placates traders; over time maybe it will go away. If sovereign bond yields can be kept at manageable levels then ok. However, as confidence wanes and debt levels grow issues will emerge.

At the moment we see Spain and Italy holding out on relief and they will continue to do so, given that if relief is sought they are giving up some of their sovereignty. The market is on tenterhooks waiting for Rajoy to flick the switch, however he is resisting. This is a crucial issue, as it becomes a battle that could place EU back in the danger zone.

In Asia, we continue to battle on with Chinese data which are again showing that China is hurting. Next week's HSBC PMI for manufacturing will be a focus, the market is feeling that this number will be soft (47.6). This will become a problem for Australia, already the iron ore price is back under pressure and as the commodity rally starts to fizzle out then Australia will feel the pain.

Although we can see developing concerns in Europe and Asia we feel the crux of the issue lies in the US. Regular readers are no stranger to the fact that like Ben we see “formidable headwinds”: the US General Elections, Congress passing the Budget and the “fiscal cliff” merging. What is the fiscal cliff?

The “fiscal cliff” is a name given to a series of events that will occur in the US at the end of 2012 and it appears that little is being done about it. And as time progresses and less is done about it the severity of the problem emerges. As of 31st December 2011 the terms of the “Budget Control Act of 2011” come into play. This means that on midnight 31st December the following will occur:

1) the end of last year's temporary payroll tax cuts, which will result in a 2% tax increase for workers;

2) the end of tax breaks for businesses and shifts in alternative minimum taxes, which means people pay more taxes;

3) the end of tax cuts from 2001-2003 and the beginning of taxes related to Obama's health care law;

4) spending cuts agreed on as part of “debt ceiling deal “ of 2011 come into effect.

Overall it is anticipated that over 1000 government programs are in line for automatic cuts. It is anticipated that as the changes stand they will cut 4% off of GDP in 2013 and lift the US Unemployment rate by 1%. It is further estimated that the changes will cost close to US$500 billion and when you consider the 40 billion worth of stimulus per month from the Fed, the magnitude of the problems become apparent. What can they do?

They could cancel all of the scheduled tax increases and spending cuts, then risk an EU-style of crisis, or adopt the middle road. The problem either way is in pushing this into law and as it stands we already have issues with the current round of Budgetary talks which look to be compromised. We do expect that an eleventh hour decision will be made however the problem is that as time moves on investors see no solution forthcoming they will take it out on the market, hence the growing pessimism.

There is ground swell of protagonists aligning their thoughts with ours, which is good, as sometimes we feel we are alone with our ideas. The fiscal cliff is a worry.  However, we actually see it as an opportunity for the US Government to realign the economy with good value. If they do nothing, markets will come under pressure or perhaps trade to more realistic levels, we will see US$560 billion wiped off the deficit or as percentage of GDP it would be halved.

Strategically, Bernanke has already lined the banks with money and soaked up their toxic debt. The banks are sitting on US$1.4 trillion in excess capacity, which they can ease up once Ben gives them the nod. Remember at the moment, nobody in the US can get a loan. The only side affect we feel is that unemployment will go up which is a concern, however for the first time in a while we feel the economy would be in a position to organically grow.

Apart from this, on the radar for the week we see Europe taking the limelight as the EU waits for Spain to put its hand up and ask for more assistance. Up until an announcement is made in Europe the market will be nervous as such we expect to see a little fallout in this respect. In the US the market will focus on the elections, US budget and fiscal cliff, closer to home we see more evidence that the RBA will cut rates when next they meet and this should keep markets soft.

 Chart Point Dow Jones

The Dow looks to be stalling at current levels. 13450 remains important support and if we trade through this level and have a daily close below it then the market will test the downside. Momentum indicators are at the top end of the range as well, so it would not take too much to see the market decline. As we have failed to sustain the break we are now short the market with a stop above the previous high.

Edited by Jonathan Barratt, Barratt's Bulletin is a weekly subscription newsletter that provides expert analysis of commodity markets, global indices and foreign exchange movements. Click here to take a no obligation 21-day trial to Barratt's or to learn more visit Content included in this article is not by association necessarily the view of FNArena (see our disclaimer).

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