Divide over 'fiscal cliff'
Market watchers are split over lawmakers' ability to thrash out a deal, writes Josephine Bond
Trading action on Wall Street is likely to retain its tentative edge over the new year, as uncertainty over the United States' financial future and its economy casts a pall over the market.
Investors are sticking to the sidelines, as political wrangling over the "fiscal cliff", a combination of federal spending cuts and tax increases scheduled to start next year, continues to divide Congress and the White House.
The possibility of a compromise is keeping traders on edge, with the stock market likely to remain volatile until the matter is resolved. Economists have estimated that the fiscal cliff could tip the US back into recession at a cost of US$800 billion and 3 million jobs.
Wall Street is likely to be weighed down further by "market seizure", according to John Woods, Asia-Pacific chief investment strategist at Citi Private Bank. "This is characterised by a lack of investor conviction, directionless price action and weak liquidity," he says.
"It's hardly a surprise that with the year-end fast approaching and, as the latest risks associated with the euro zone and the fiscal cliff intensify, positioning among money managers has become ever lighter as risk assets are unwound, by some accounts to three-year lows."
The re-election of President Barack Obama had the effect of returning a long-deadlocked government, with US stocks factoring in the political stalemate in the wake of the election: the Dow suffered one of its worst weeks of the year.
This looks set to continue as lawmakers thrash out a deal.
Paul Tang, chief economist at the economic research department of the Bank of East Asia, believes a deal will materialise - and is relatively optimistic that market activity will be buoyed as a result.
"We have to make an assumption that it will be OK, they will strike a deal at the last second," he says. "They [US politicians] know what's in the balance, it's important for them to resolve it."
Woods is more cautious, describing a deal as "likely but not guaranteed", as Republicans and Democrats remain deeply divided over the issue.
"In fact there are very much two schools of thought," he says. "Some are now re-labelling this the fiscal 'slope' or 'bump'; others are likening it to the phantom risks associated with Y2K."
Others, including Citi, he notes, see it as a "genuine concern and the main reason why businesses have been so reluctant to invest in recent quarters".
He does, however, think a last-minute resolution will be brokered - as politicians count the cost of failure, estimated by Citi to be anything between 4 per cent and 6 per cent of US GDP.
Another risk is that the market will start pricing in recession unless the fiscal cliff is resolved, he stresses.
Tang notes that there are a few bright spots on the horizon for Wall Street as US employment and housing figures in particular look promising.
Corporate profits in the US have recovered strongly since the 2007-2009 recession, when the prices of blue chips sank sharply. Yet they are still below their 2007 peaks, suggesting that companies that have improved will continue to do so. Continued profit growth suggests a significant upside for the stock market, following this year's 20 per cent price gain.
Other factors likely to weigh on Wall Street include economic risks, such as the situation in Greece, Spain and Italy, and the effect that a slower euro zone would have on China and the US.
In Greece, a new austerity budget has been passed in an attempt to get its finances into order. The country is still seeking US$40 billion in bailout loans from other euro countries.
Many argue that the US stock market has been one of the biggest beneficiaries of the trouble in Europe, as funds flow from the financially-strapped nations into safe havens such as the US.
Risk appetites remain volatile. And in the next few months there are no signs of this dissipating, Woods says. "If investors remain defensive they will almost certainly under-perform in a risk-on environment; being nimble and being willing to take profit quickly is the appropriate strategy."