By Abheek Barua
What does President Obama’s re-election imply for the financial markets and currencies? It could bring a sense of relief as the uncertainty regarding which candidate gets to run the US administration for the next four years is finally excised. However, this is likely to be temporary and the markets will soon go back to fretting over how the president will grapple with the key risks that are likely to emerge for the US economy over the next few months.
It might be useful to take stock of the risks that come off the table with the Romney defeat. First, the risk of a change in the monetary policy stance of the US Fed disappears. Romney had expressed misgivings about Fed Chairman Bernanke and his experiment with quantitative easing (QE). So, if Romney had been in the White House, Bernanke’s term would expire in January 2014. Thus, markets would have to factor in the possibility of a successor less accommodative in his policy stance, i.e. an end to QE and perhaps even a rise in policy rates. That risk gets excised with an Obama victory.
The second risk related to Romney’s threat that he would brand China a currency manipulator on the very first day of his presidency. This could have sparked retaliation from China that could have threatened to dump its dollar reserve holdings or start a trade war with the US. A trade war between two of the largest economies in the world could not have been entirely benign for the rest of the global economy and markets would have started to price this in. We needn’t worry about that any longer.
There are essentially two risks of an Obama presidency as far as the financial markets are concerned. Wall Street had been rooting for Romney and, indeed, a large part of his campaign funds appears to have come from financial institutions. The Street’s disaffection with Obama stems both from the belief that he does not have a credible plan for pushing up growth (he could instead stymie it by raising taxes) and the fact that the Street has associated his government with the heavy hand of financial regulation. However, the initial disappointment with an Obama return could translate into a “risk-off” mood in the US equity markets and this could have ripple effects across global financial markets.
The more critical risk and challenge for Obama would be to ensure that the US economy does not go over the much-discussed “fiscal cliff” that is due at the end of the year. This is the combination of the expiry of tax concessions and automatic expenditure reductions that add up to roughly $600 billion or over four per cent of GDP (Gross Domestic Product). If the US economy were to go over the cliff, it is likely to tip into a fairly deep recession. Obama’s task is to reach a consensus between the Democrats, who control the upper house or the Senate, and the Republicans, who control the lower house or the House of Representatives, on postponing some provisions of the cliff for a couple of years when the US economy is in better shape to bear the brunt of aggressive belt tightening
This is easier said than done. Negotiation over the cliff will involve a clash of deeply entrenched positions on fiscal correction. Democrats want to use a combination of tax hikes and expenditure cuts (and, indeed, some new taxes to fund a revamped healthcare programme) and the Republicans want the consolidation to come largely on the back of expenditure and entitlement reductions. A resolution would involve a “grand bargain” between the two parties. However, some compression is inevitable — in the best case in which a “grand bargain” is struck, it is likely to translate into a fiscal squeeze of 1.5 per cent of GDP.
The problem is that Obama, to use the current jargon doesn’t “do bipartisan” well and Romney was seen as more capable of reaching a consensus. Besides, Obama has a deep personal stake in initiatives like health care reform that the Republicans stridently oppose. Thus, there is risk the “grand bargain” might not happen immediately and the US economy might topple over the cliff in the first few months of 2013. Were that to happen all risky assets could be in free fall as investors scurry to the safe haven of US treasuries and gold
The question from a financial market or currency perspective relates to how someone should “trade” this uncertainty. It is likely that markets will remain in “risk-off” mode until some resolution emerges on the fiscal cliff. I am going with the assumption that most American analysts seem to make that a deal between the Democrats and Republicans will be reached by end-December. Until then the rupee could sag under a depreciation bias and perhaps even test the 55.5-56 range. A decision on the cliff will give all risky assets, including the rupee a “risk-on” pop and a brief phase of appreciation is likely. But as 2013 gets underway markets will go back to fretting about the US long-term fiscal strategy, its consequences for growth and, of course, Europe that now seems to have a new set of problems to test the markets yet again. Then it’s risk-off yet again
The author is with HDFC Bank. These views are personal