Equity markets: dragged down by political risk

NYSE trader Concern over the fiscal cliff has all but eclipsed the European debt crisis

The most depressing element of the fiscal cliff is that what was once, briefly, a rather evocative metaphor has become a tedious cliché.

Let's call it the Reichenbach Falls instead - with Obama as Sherlock and Congress as Moriarty (or the other way round, I'm not fussy).

The point we are at now is the one where Conan Doyle left his readers thinking they had both perished at the end of The Final Problem That is, no one's going to agree to anything, and the US (and global) economy will fall into another recession.

The despair has caused the S&P 500 to plummet to levels not seen for three months and taken the Dow and the Nasdaq with it. This concern has all but eclipsed the European debt crisis - a separate and deadly threat hovering in the background we might equate with the Hound of the Baskervilles.

Of course there is one argument, backed by very few, that America should tumble over into the maelstrom. Well, two years ago the G20 countries did agree in Toronto to halve their budget deficits by the end of 2013. Europe is on the way to doing just that and a short step over the cliff would bring US state borrowing from over 7% down to around 4% of GDP.

Post hurricane

But that's not going to happen. The threat of two million more Americans out of work and $600bn sucked out of the economy, whether real or not, is just too much to ask.

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In the Sherlock Holmes analogy, it's like luring the Baskerville Hound with a Doggie-Bix rather than blasting it with Watson's army revolver.”

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So a deal will be reached, or at least it seems that way. As Justin Urquhart Stewart, of Seven Management, says: "It is not in anyone's interest not to do a deal, and neither side is willing to shoot themselves in the foot. They will delay and delay, but in the end come to a deal and set up a programme to get the US going again, encourage housing, and consumer spending and taking advantage of a reasonable wind that's already behind the economy."

Indeed, the US hasn't been doing too badly - some growth in employment, a fairly consistent rise in consumer confidence, a feeling that the housing market has reached the bottom and is starting, slowly, to recover, and the Federal Reserve's commitment to long term quantitative easing. There could be some positive contributions from the post hurricane reconstruction efforts too. None of it is awe-inspiring but surely it deserves better than a 7% fall on the S&P.

The second part of the problem, of course, lies in Europe, one that we have been living with for quite a while. This remains a fairly scary scenario (much like the Hound of the Baskervilles).

However, while the European Central Bank's promise to buy sovereign debt is acting as a backstop to the likes of Spain, the eurozone does have a chance to work its way through its problems. For Europe, though, the key is Angela Merkel.

Mr Urquhart Stewart believes the German election next year will hold the key to more growth oriented policies. "If Merkel has an election she is going to be going for growth, trying to get consumers spending - Germans are notoriously bad at spending money - and getting more investment from business, and that will spin out into the rest of Europe," he said.

'High price'

This matches what appears to be a more accommodative approach to austerity by the European Commission which appears to be giving countries such as Spain and Greece more flexible deficit targets. In the Sherlock Holmes analogy, it's like luring the Baskerville Hound with a Doggie-Bix rather than blasting it with Watson's army revolver.

Finally Asia: the consensus view is the new Chinese administration is likely to carry on the policies of the former one. If it really does take up the exhortations of the outgoing President Hu Jintao the future looks promising. This is what he said: the Chinese economy must be "driven more by domestic demand, especially consumer demand. We should... unleash the potential of individual consumption... and must unswervingly encourage, support and guide the development of the non-public sector."

All this would imply that equities are undervalued, largely because of political risk in the US and in Europe. Assume for a moment they can be overcome and the future immediately looks rosier. Mr Urquhart Stewart is shifting more towards equities "corporate bonds have done very well, but you have to pay too high a price for them now". He puts government bonds in the same category.

Equities at the moment look the best buy. So long as the global economy survives the Reichenbach Falls and the Hound of the Baskervilles, disaster will be avoided, and there are plenty more adventures to come.

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