The Fiscal Cliff And The Fed: Investors' Election Fears

Investors around the world are preparing for the global market reaction to what could be one of the most economically significant elections in decades, as Americans go to the polls to choose their next President.

Both Barack Obama and Mitt Romney could have an enormous impact on monetary and fiscal policy through the appointment of a new Federal Reserve Chairman and the steerage of budget plans that are likely to slow growth in the world's largest economy.

However, with several hundred billion dollars of spending cuts and tax increases - known as the "fiscal cliff" - poised to kick in next year, regardless of who wins the White House, many investors are more focused on the 33 Senate seats in play alongside the full 435 Congressional constituencies to be chosen in Tuesday's vote.

"Failure to avert this fiscal cliff would likely plunge America back into recession and destroy 2 million jobs," warned BlackRock, the world's biggest assetmanager in an open letter printed in the Wall Street Journal, New York Times and Washington Post and co-signed by several major global investment firms. "Not only would it arrest the current momentum in our economy, it also would damage our nation's ability to finance our debt, attract job-creating investment and generate growth for years to come."

Off the Cliff

Last year's debt-ceiling debates gave way to an 11^th hour agreement between feuding Democratic and Republican lawmakers that resulted - despite months of extended negotiations - in partisan political gridlock. The brokered compromise at the time, now known as the "fiscal cliff", represents an automatic series of fiscal measures that will activate (with the aim of reducing the nation's over $16tn debt load) on 1 January 2013.

The $620bn programme could, according to various analysts, slow U.S.'s fragile economic recovery by at least 1.3 percentage points to as much as 2 percentage points. In the most aggressive case, it could also return the economy to recession. The figures are significant given the fact that American job growth has been disappointingly slow (President Barack Obama's four-year term has seen the net creation of only 194,000 new jobs, the lowest total in four decades) and the economic recovery is beginning to wobble (the last two quarters of GDP growth have been the slowest since 2009).

U.S. lawmakers, in theory, have the power to stop the Cliff from kicking in, through a compromise by which Democrats could agree to extend Bush-era tax cuts while wringing concessions on government spending from their Republican rivals. Neither prospect seems likely, however, from a "Lame Duck" Congress that may feel it has lost its electoral mandate, even though its term doesn't technically expire until January.

Republicans currently hold 241 Congressional seats to the Democrats' 194 and are widely predicted to hold onto a House majority regardless of the Presidential outcome. Chastened GOP lawmakers - be they returning to Washington or heading home for two years in the private sector - will be in little mood for conciliatory politics if their party leader, Governor Mitt Romney, suffers a substantial defeat at the hands of the incumbent.

The same is likely true for Senate Republicans, who will be fighting to defend 11 of the 33 seats up for grabs (Senate seats carry terms of six years compared to the two-year Congressional stint). With 22 Democratic seats in play, the GOP may feel it has a statistical advantage towards gaining enough seats to win control of both Houses of Congress, giving it perhaps even more power than a re-elected incumbent President.

"The November-December period will therefore be one of intense focus on Washington and Congressional deliberations," wrote Societe Generale's Aneta Markowska. The anticipated outcome for the House of Representatives "could spell more gridlock ahead and does not bode well for a long-term fiscal solution."

New Fed Chief

Investors are also having to worry about the longer-term implications of either a new Romney Presidency or the return of President Obama, as both men are very likely to be tasked with the appointment of a new Fed Chairman when Ben Bernanke's second term expires in January 2014.

"The Fed nomination could very well be the most important one the next president makes due to the controversial nature of current Fed policy and the extraordinary influence it is having on financial markets," wrote Josh Thimons of PIMCO, the world's biggest bond fund manager. "Under normal circumstances, the Federal Reserve acts like a pit crew - incrementally adjusting the federal funds rate higher or lower to provide more or less speed to the race car that is the U.S. economy, ensuring that it neither stalls nor overheats. In the current environment, though, the Federal Reserve is more like a tow truck, with the economy tethered to its back, trying to haul the race car across the finish line. "

President Obama is said to favour current Fed vice-chairwoman Janet Yellen to replace Bernanke, a choice most investors consider relatively seamless in terms of Fed policy and one that would likely maintain its current programme of quantitative easing and near-zero interest rates.

Governor Romney, however, has been highly critical of the Fed's so-called accommodative monetary policy and hinted during Republican primaries that he was actively preparing to show Bernanke the exit. Insiders suggest his two preferred choices - Glenn Hubbard, Dean of the Columbia Business School and Harvard economics professor Greg Mankiw - may tweak the Fed non-conventional strategies but are unlikely to upend them completely given the huge impact such a drastic change could have on US and global financial markets.

"In our view, if Governor Romney wins, the chances of avoiding the fiscal cliff (for at least six months or longer) are higher than if President Obama is re-elected," wrote Barclays analyst Rajiv Setia in a client note. "In addition, given Romney's comments that he would not reappoint the current Fed Chairman, the knee-jerk market response will entail re-pricing Fed expectations and the outlook for easy monetary policy."