An inside threat to Wall Street's cheer

A glut of liquidity scared off by fiscal cliff dramas is returning to equities, but the likelihood Republicans will hold future debt talks to ransom means this optimism may be transient.

Boom! That is the reaction of global stock markets to the resolution of the US fiscal cliff negotiations, with gains in the order of 1.5 to 2 per cent across most markets around the world.

A series of compromises, mainly from the Democrats and President Obama as the proposed tax increases were watered down, means that the main fiscal cliff impact on the US economy has been averted. There is still a fiscal tightening in 2013, but it is less than half the size of what was on the cards had the full fiscal cliff been unchecked.

Markets reacted as they should, with the fiscal policy tightening being limited to less than 2 per cent of GDP in 2013 versus the prospective tightening of over 4 per cent of GDP.

The market reaction is according to the textbook. Stocks are strongly higher and government bond yields are sharply higher for the simple reason that, at least in the near term, fiscal policy in the US is not lifting taxes all that much and government spending is not being cut all that much. When viewed from the prism of there also being the easiest monetary policy the US has ever seen, the glut of liquidity is finding a home in the stock market.

There is now nothing in the policy settings, fiscal or monetary, that should spark any fears about a loss of economic momentum in what was admittedly a moderate recovery in the US.

Indeed, helping the mood of markets was news that Institute for Supply Management index of manufacturing rose to 50.7 points in December to suggest a pick-up in activity as 2012 ended. At the same time, spending on home building rose 0.4 per cent in November to provide yet more evidence of a solid pick-up in activity in the previously depressed housing market.

While the fiscal cliff issues have been dealt with for now, fiscal policy, the budget deficit reduction strategy and the stabilisation of the uncomfortably high level of US government debt are key issues that will confront policy makers and financial markets in 2013.

It was illustrative that President Obama, when discussing the passing of legislation to deal with the fiscal cliff, said "the fact is that the [budget] deficit is too high” and that he would continue to pursue a policy agenda that would keep "chipping away at the deficit”.

In other words, Obama will be looking to deliver yet more fiscal tightening in the months ahead. Given the hostile nature of the House of Representative with the Republican majority in place, there will no doubt be political conflict as the fanatical elements of the Republican Party refuse to countenance any tax increases.

This could mean that Obama is fighting the battle to cut the budget deficit and reduce government debt with one arm tied behind his back. The levels of tax in the US are very low, with the housing and banking crisis that started in 2007-2008 undermining tax receipts.

In terms of stabilising the explosion in government debt that has been associated with the deep recession, the next major test could come in February as Congress needs to approve an increase in the $US16.4 trillion debt ceiling if the government is to keep functioning. The debt ceiling increase is also needed if the US government is to issue bonds to pay for its spending plans and avoid defaulting on its current debt obligations.

Until recent years, the debt ceiling issue has never been a concern for Congress given the national interest test that has meant a rubber stamp approach to raising the ceiling as required. But this is no longer the case, with the Republicans again looking to politicise what should be a procedural issue.

The House leader, Republican John Boehner, is sending signs that there may be another manufactured crisis over the debt ceiling when he said, "without meaningful reform of entitlements, real spending controls, and a fairer, cleaner tax code, our debt will continue to grow".

In other words, it is likely that the Republicans will be prepared to hold the debt talks to ransom by demanding Obama cut spending in exchange for a higher debt ceiling.

This approach runs the risk of undermining the current bout of financial market optimism and if there is anything like the re-run of the turmoil of 2011, when the Republicans took the debt ceiling talks to the brink with the risk of the US defaulting on a debt interest repayment, there could be the double whammy of stock market weakness and a credit rating downgrade from one of the credit rating agencies.

The US economy is recovering, but it is not out of the woods. The biggest threat in 2013 to that recovery is not from the eurozone, nor cheap Chinese imports, nor even higher oil prices – it is from within. It is from the economic fanatics in Congress who seem so reluctant to put economic and jobs growth ahead of zealotry over tax increases and spending cuts. Perhaps they will change their minds, but the current signs are not that encouraging.

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