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Dollars & Sense: Political Risks Remain Acute Print E-mail
Long Term Forecasts | Written by TD Bank Financial Group | Nov 08 12 15:43 GMT

Dollars & Sense: Political Risks Remain Acute

Highlights

  • With the U.S. election in the rear-view mirror, markets are focused on a resolution of the fiscal cliff. A compromise on adjusting America's fiscal path should be reached, but fiscal restraint will constrain economic growth.
  • Other political risks abound, such as the leadership transition in China and the ever-lasting European fiscal crisis. Concern over Iran's nuclear program is also a political wild card.
  • Most likely scenario is that global financial markets will navigate through the risks. Accordingly, the lower-for-longer interest rate environment will likely persist, and moderate economic growth should be supportive to commodities and equities. In other words, recent developments have not materially altered our financial forecasts for foreign exchange rates, fixed income yields or commodity prices.

Financial markets are navigating their way through a myriad of political risks. The U.S. election produced a status quo result, President Obama was returned to office and Congress remains divided. The knee-jerk market reaction was a rally in fixed-income markets and a sell-off in equities. Although an Obama victory had been largely priced into markets before the voting results were known, the response shows an immediate and renewed focus on the approaching fiscal cliff - the legislated expiration of tax cuts and slated spending cuts that threaten to push the U.S. economy back into recession. The main concern is that the unchanged outcome of the election raises the possibility of continued gridlock.

In our opinion, the fears about the fiscal cliff are overblown. Both the Democrats and Republicans are fully aware of the legislated measures and the risks they pose to the economy. The most likely scenario is that some compromise will be reached to adjust the path of future fiscal rebalancing. The main uncertainty is how messy and protracted the process will be, and this could affect financial markets. It should also be stressed that there is no question that fiscal policy will become a headwind on economic growth; but, rather than the 3-4 percentage point hit to real GDP growth posed by the fiscal cliff, the actual negotiated settlement of higher tax revenues and spending cuts is likely to lower economic growth by about 1.5 percentage points.

The good news is that the private sector side of the economy is showing signs of greater health. On a national basis, real estate prices have stabilized and the pace of home building has doubled from its recessionary trough. Credit is flowing again, raising the possibility that hyper-stimulative monetary policy could have a greater affect in terms of boosting economic growth. Meanwhile, job creation is showing some tentative signs of improving. Some have speculated that the Obama victory gives the Fed more scope to continue with its unconventional quantitative easing, as the Democrats are more supportive of this policy approach. The election outcome opens the possibility that Fed Chairman Bernanke might consider another term. At a minimum, his successor in early 2014 is likely to maintain the prevailing Federal Reserve monetary strategy. While all of these trends are positive, the stronger prospects for private sector demand growth will be largely offset by fiscal drag, keeping U.S. economic growth in the 2% to 3% range next year.

The financial market implication is that while uncertainty over how the fiscal cliff will be navigated around is likely to add to volatility in the near term, the ultimate resolution and the continued moderate economic growth environment implies a continuation of the lower-for-longer interest rate environment and renewed gains in equities.

But, political risks abound elsewhere as well. China is going through a generational leadership transfer. At the time of writing, financial markets are struggling to assess what changes this could mean for macroeconomic and financial policy. It is possible that the incoming leadership might be comfortable with economic growth of 7%, or slightly higher, implying that financial markets could be disappointed by how much stimulus the new government entertains. Nevertheless, we still feel that a soft landing in the Chinese economy is playing out, as signaled by recent improved industrial activity. Even if China's economic growth does not accelerate materially in 2013, the outcome would still be constructive for commodity prices- although it would limit their upside, which is incorporated in our commodity price forecast.

Another on-going political risk is the European fiscal crisis. While many could be disappointed with the speed of progress, Europe is headed in the right direction. A particular positive is the acknowledgement that the banking crisis needs to be separated from the sovereign debt crisis. There have been measures taken to shore up the balance sheets of the banks. There has been an agreement that the funds in the European Stabilization Mechanism (ESM) can be used to recapitalize banks - although it is enormously disappointing that Germany, a few other nations, are calling for the funds to be used only for future bank problems, and not address the banks currently in trouble. Progress is also being made in improving oversight of the banking system. And, the use of ESM funds for bank recapitalization is unlikely to occur until the new oversight is operational.

Europe is gradually addressing the need for a fiscal union and the necessary fiscal rebalancing as well. A core challenge is the on-going economic contraction in the countries experiencing fiscal distress. With respect to Greece, there is growing awareness that the terms of the financial aid program needs to be adjusted. So, it is likely that Greece will continue to receive the required financial support in the near-term. However, the Spanish government is caught in a bind. It needs ESM funds to recapitalize its banks, but the terms of such a financial support package would require the government to take on the financial liabilities of the banks. Spain is already striving hard to rebalance its finances while its economy contracts and unemployment is over 25%. Adding banking system liabilities to the government's books would push their public finances to unacceptable levels, creating its own risks.

From a financial market point of view, the greatest risks come from the socio-economic strains that are building in Europe from high and rising unemployment. The central issue is whether the governments can maintain their fiscal rebalancing in the face of these social pressures. The sad reality is that the financial crisis must continue because it is the catalyst that forces the political system to make progress towards a resolution. However, the financial pressures cannot be allowed to go beyond a breaking point, but that line in the sand is not readily visible. Since this crisis started in early 2010, Europe has always taken action before going over the precipice, and there is every reason to believe that they will continue to do so. And, unlike 2010 and 2011, progress does seem to be occurring. So, odds are that Europe will continue to muddle through.

The main message for investors is that much has happened, and yet much remains the same. Global financial markets are navigating a risk-filled environment, which is dominated by political risks. All-in-all, the risks are being managed relatively well, but there are periods when investors lose confidence or become fretful, causing gyrations in markets. Given this backdrop, the most likely path is a continuation of the low interest rate environment and relatively modest-to-moderate economic growth, which should ultimately support continued advances in earnings.

 

About the Author

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.

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