Uncertainty over U.S. fiscal policy will hang over the economy for at least another two months. How will financial markets behave as the debt-ceiling deadline approaches?
T he U.S. equity market cheered last week because a major part of the cliff – middle-class taxes – has been averted. The fiscal drag in 2013 will be about 1.5% of GDP. This is good news in terms of growth, but the bad news is that investors still face a replay of the summer of 2011 when an acrimonious fight over the debt ceiling contributed to a rout in risk assets. The S&P 500 fell by about 16% in the summer of 2011, although there were other factors weighing on risk tolerance besides the debt ceiling (Europe, China and questions regarding the strength of the U.S. economy).
Investors have learned from that episode and may be more reluctant to sell risk assets in fear of missing the rally once a deal is struck. The fact that the stock market correction in the closing weeks of the fiscal cliff debate in 2012 was not particularly severe suggests that investors have become more tolerant of Washington infighting. Nonetheless, this is far from assured.
Stocks and high-yield bonds will deliver solid, if not outstanding, returns over the next 6-12 months. (tweet this!)
Our medium-term bullish view remains in place, in part because China’s economic growth is bottoming and the risk of another European financial crisis has moderated. Stocks and high-yield bonds will deliver solid, if not outstanding, returns over the next 6-12 months. Investors that cannot move in and out of the market quickly should remain overweight equities and high-yield bonds and ride out the near-term market volatility.