Why going over the fiscal cliff could be a disaster

After the US presidential elections, Christopher Ferrarone, global equity strategist, UBS, shared his thoughts on the implications of the elections on the global economy and markets.

Edited excerpts:

The US elections

The US election results were in line with expectations and the markets were not surprised.

Importantly, this is considered a strong result for Democrats and expectations of no change in the leadership are looked at positively.

In terms of implications, Christopher said since the leadership doesn't change, significant changes might not be required for the US economy this year and the next.

The US economic recovery and the pick-up, seen through the last several quarters, remains intact.

However, he believes this would be a short honeymoon for Obama and the Democrats, particularly as the negotiation process on the fiscal cliff is set to begin.

On fiscal cliff

Fiscal cliff refers to the effect of a series of enacted legislation or terms of the Budget Control Act of 2011, scheduled to go into effect at the end of this year.

These include tax increases, spending cuts and a corresponding reduction in the budget deficit.

The Fed's approach

Christopher believes there may not be many near-term changes in the Federal Reserve.

As stated earlier, the Fed doesn't wish to renew Ben Bernanke's term, which ends at the end of 2013.

So, against this backdrop, how the Obama administration and the Federal Reserve tackle the fiscal cliff would be important, as that remains the primary concern of global investors.

Implications

This

would have implications on the global economy and markets.

During discussions on the fiscal cliff, there is a possibility of higher taxes.

Various estimates, and our own estimates, on the impact of the fiscal cliff stand at 3.25-3.5 per cent of the US gross domestic product.

We are forecasting US gross domestic product growth of 2.3 per cent next year.

So, that indicates a 1-1.5 per cent drag to GDP, owing to the fiscal cliff.

But If the US Congress doesn't arrive at a negotiated solution and if the US goes over the fiscal cliff, the likelihood of it entering a recession would be extraordinary high.

So, from two per cent GDP growth this year to negative GDP growth next year would certainly be a shock, not only for the US, but also for the global economy.

This would probably come at a time when there are underlying issues in Europe and Asia. So, going over the fiscal cliff could be a disaster for the global economy.

This is why it has become such a key issue for global investors, as we move forward.

So, how spending cuts and tax increases are negotiated would be critical for the markets and investor sentiment in the immediate period.

The upside scenario could be arriving at agreements before the end of the year.

However, we, and most market participants, believe that would not be the scenario.

The consensus is we could see some postponement in the negotiation of the fiscal cliff. But that, too, could lead to a downside risk if the US Congress struggles to arrive at an agreement and keeps on postponing the fiscal cliff issue.

We have already seen lot of uncertainty on this account.