Aftermath of the fiscal cliff

Last week we provided a background on the US fiscal cliff and discussed why it was a source of fear for the markets.

Today we will take our discussion a step further and look at what the fiscal cliff means for the Aussie economy, the stock market and how investors may their position portfolios in response.

Economic impact

We have a clear idea of what it will do to the US economy, but what about the fiscal cliff's impact on the Aussie economy? Before we answer that question, it is useful to revisit the state of the global economy in 2009 during the immediate aftermath of the GFC.

In the chart below, we have included the trend in US exports (yellow line) and imports (white line), global GDP growth (green line), and the US investment grade five-year credit default swap index (purple line).

During the height of the economic crisis there was significant deterioration in US trade activity, represented by the big 'dip' in the white and yellow lines.

The purple line rose as investors became concerned about the credit worthiness of the US corporate sector - not surprising given the major slowdown in business activity during that time.

The 'ultimate' outcome of the crisis was the contraction in world economic growth, represented by the green line.

For the purposes of our argument, we will use the GFC as a reference point in assessing the likely impact of the fiscal cliff.

Whilst it won't be a direct hit, the Aussie economy will suffer collateral damage. The immediate consequence of the US careening off the cliff would be a reduction in that nation's consumer spending and business investment.

Considering the importance of the US to the global economy, that would imply a significant fall in global trade (recall the yellow and white lines on the chart above). And who are two of the biggest trading partners of the US? Europe and China. We can assume those two regions would experience a noticeable downturn in exports to the US.

With China's economy getting whacked from a slowdown in exports, commodity prices would tumble, and this would be bad news for our already beleaguered mining sector.

The bigger mining companies would respond by cutting back capital spending plans, meaning weaker job growth in the mining states of WA and Queensland.

Lower mining profits would mean lower tax revenue for the Australian government, and given Wayne Swan's commitment to returning the budget to surplus next year, that could lead to even deeper cuts in government spending.

Aussie business and consumer confidence would be badly damaged by the global economic uncertainty, leading them to join their US counterparts in cutting back spending and investment. Our banking sector would likely be more worried about the cliff's damage to Europe's economy.

Data released last week showed the eurozone economy entering its second recession in four years during the previous quarter. Imagine how bad the region's economy would be if exports to the US dried up?

This outcome could exacerbate Europe's debt crisis, with the resultant rise in sovereign borrowing costs leading to a credit market squeeze similar to that experienced in 2008 and 2011.

Our banks would be forced to pay more for wholesale funding, and based on recent history, they would likely pass on the higher costs to Aussie borrowers.

We can see a bit of a picture emerging here:

- Mining weakness translating to higher joblessness, lower company profitability and tax revenue, and potentially deeper budget cuts

- Damaged business and consumer confidence translating to reduced spending and investment

- Higher bank funding costs translating to higher mortgage rates, further discouraging consumer spending

This snap projection shows how serious a threat the US fiscal cliff poses to our economy.

Market impact

We don't really need to determine the likely impact of the fiscal cliff on financial markets because we have witnessed it in recent weeks. The S&P500 is down around 9% from the highs reached in September, putting it close to correction territory. Furthermore, our market has fallen around 5% from its October peak.

The key point is that the major global indices have retreated so far in such a short space of time that it makes you wonder how dramatic the losses will be if the US actually drives off the cliff. We need only to look back at what happened in 2008 to get an idea of the potential damage to markets.

For one, the fears of a Chinese economic slowdown will trigger steep falls in commodity markets. Secondly, a freezing of credit markets due to a worsening of Europe's debt crisis would spark a sell-off in global bank stocks. That is not good news for the Aussie market, which is dominated by BHP, Rio Tinto and the big four banks.

Positioning portfolios

Admittedly, we have presented a worse-case scenario in assessing the impact of the fiscal cliff on our economy. Indeed, the damage may be far less than what we have described. The fact is we - and everybody else - cannot know for certain how the fiscal cliff will affect the world economy.

There is no point making a knee-jerk decision liquidating stocks and portfolios in response to the cliff. As mentioned last week, we believe a deal will be struck by US lawmakers to stave off the deadly cocktail of tax hikes and spending cuts that makes up the fiscal cliff.

There might be some market volatility in the short-term, but the only way the fiscal cliff will deal the damage we described is if US lawmakers choose not to do anything about it - not a likely scenario in our opinion. Even if we get some short-term volatility, there is likely to be coordinated central bank action around the world to ease monetary policy.

At home, the RBA has room to cut interest rates further, which should cushion the impact of the cliff on our economy. We have argued that banks and resource stocks would bear the brunt of any fiscal cliff-related market downturn.

Other sectors would also be caught up in the sell-down, with industrials feeling the pinch from a cutback in business investment and retailers weighed down by lower consumer spending.

This could mean investors adopt a more defensive posture rather than engage in panic selling. For example, the low interest rate environment might make high-dividend yield infrastructure and utility funds more attractive relative to the cyclical sectors.

Ultimately, the economic uncertainty may cause investors to batten down the hatches, but we will stress the importance of taking the long view and understanding that for the markets a drop off the fiscal cliff is not fatal.

Aussie Economy And The Fiscal Cliff is a post from: Australian Stock Report Market Pulse Blog