Via Michael Naso of FBN Securities,
After the first Presidential debate, I argued that Governor Romney’s solid victory over President Obama was the worst outcome for U.S. stocks, for it gave false hope to a Republican sweeping into the White House despite the Electoral College landscape projecting otherwise. I suggested that a more gradual acceptance of the November result would give the market a better chance to absorb the news with minimal impact.
We are presented with a similar scenario with Washington’s addressing the fiscal cliff. Optimistic comments about resolving the crisis has spawned gains in equities that are sustainable while losses resulting from downbeat remarks have offered profitable short term buying opportunities. While much of this price action the past few days has benefitted from typical calendar money flows that will disappear in the middle of next week, some of the positive sentiment arises from the overwhelming belief that both sides can consummate a deal on the budget ahead of the December 31 deadline.
The longer investors anticipate such a compromise, the more violently shares will tumble upon recognition that assuaging the crisis with a comprehensive solution will take extra innings. Complicating matters is the presence of year end, for the band of negative convexity will narrow as New Year’s approaches such that a downward exogenous shock would precipitate waves of panic selling to protect 2012 gains.
Speaker Boehner pounced on the Administration’s negotiating misstep documented in Tuesday’s online Wall Street Journal by aggressively moving to the attack. Unlike more sanguine remarks that have permeated the airwaves by others, he indicated that the talks between the two parties have stalled. Democratic leaders quickly downplayed the House leader’s comments as mere bargaining tactics. However, one has to have concerns about the viability of an agreement given his tone and Senator Reid’s observations from Monday, for the two represent two of the primary actors of this fiscal drama. This fact cannot be underestimated as any statements given by peripheral players such as GS CEO Lloyd Blankfein have minimal importance in comparison.
Much of the initial sparring has centered upon revenue, however, the two sides are even further apart on the spending side of the equation based on President Obama’s proposed $50B in new stimulus as part of his opening bid to the process. A comprehensive solution seems near impossible given the ideological divide and differences in each faction’s risk profile unless stocks dislocate to a point that forces bargaining in good faith. If institutions remain optimistic for a compromise, then similar to the Election, the acceptance of reality might come too late to preclude a sharp selloff.
Even cobbling together a piece of temporary legislation to avoid falling over the cliff would be problematic, for I suspect the Democrats will have tremendous difficulty maintaining current marginal rates for all income levels while the Republicans almost assuredly will cry foul if high earners are excluded during this supposed transitory period. Consequently, the headline chasing tape should build throughout December which will steadily increase volatility and ultimately weigh on shares.
In the interim, additional divergences across the economy and market will continue to surface to foreshadow longer term issues for equities. I have spoken at length all week about the Shanghai Composite’s troubles, yet other warning signs have reared their heads as well. Despite the S&P 500’s recent lift off the bottom, the yield of the long end of the treasury curve sits near four month lows as the price action in bonds hints at more macro headwinds. Moreover, while most of the housing figures point to sector expansion, manufacturing has taken a step backwards with 5 out of the 6 regional Fed surveys this month pointing to a contraction. Most notably, Thursday’s Kansas City reading reached a three year low which puts additional pressure on this morning’s Chicago PMI.
Moreover, recent Core PCE data projects an extension of a disinflationary environment. Although the bulls view these statistics as a green light for the FOMC to maintain their current QE program, I view the softening of pricing pressures as a sign that economic growth has started to stub its toe again. Finally, open interest in the futures has decreased consistently during sessions when equities have risen since the November bottom. Therefore, short covering has sourced the fuel for this bounce which makes these gains quite susceptible to a reversal especially if and when the tone surrounding the fiscal cliff unravels.