Fiscal cliff threat to shares

There's an increasing danger of a US recession next year as the economy threatens to fall off the "fiscal cliff", economists warn.

In the new year, several laws which have raised spending and cut taxes will automatically expire. This will cause taxes to rise and spending to be capped, causing a fiscal tightening of $560bn, equivalent to 3.5 per cent of GDP. The Congressional Budget Office - a non-partisan government agency - has warned that this would cause a recession, with GDP falling during 2013.

Economists and investors had hoped that Congress and the President would agree to avert this prospect by agreeing to extend some of the tax breaks and spending rises. But the prospect of continued gridlock after the November elections - with Republicans controlling the House of Representatives and Democrats the White House and Senate - and the failure of presidential candidates to discuss the issue during the election campaign have dampened these hopes. Ethan Harris at Bank of America Merrill Lynch says there's a "growing risk" that the economy will fall over the fiscal cliff. A poll by economic consultants Lombard Street Research found that its clients expect fiscal policy to tighten by 2.6 per cent of GDP next year.

This is an especially worrying prospect because with the US's major export markets such as China, Europe and Japan faltering, and with monetary policy less able to stimulate the economy, fiscal multipliers are probably unusually large now. This means a fiscal tightening would hit the economy hard.

Economists agree that if the US does fall off the fiscal cliff, shares would suffer and bonds would benefit. Lombard Street Research's Dario Perkins warns that stock markets "don't properly discount" the prospect. And Rajiv Setia at Barclays Capital says it could force 10-year Treasury bond yields, which are now 1.76 per cent, below 1.5 per cent. This would be partly because investors would want a safe asset to protect them from recession, but also because Treasuries would become scarce. Aneta Markowska at Societe Generale says the combination of a lower deficit and Federal Reserve buying of Treasuries as part of its quantitative easing policy could see the supply of Treasuries to investors fall from over $1 trillion this year to under $300bn next.

If, however, an agreement is reached to avoid the cliff - and even optimists think it will not come until late December - shares could jump as the risk of recession declines.

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