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December 2012 - Mind the Cliff and 'Carry' On

Major financial assets were largely unchanged after a volatile month of November, following a large drop post US elections, which was reversed in the second part of the month. The more optimistic behavior of markets recently could be explained by several factors playing out: signs that some form of Fiscal Cliff compromise is becoming more likely before year end, a stabilization in Chinese growth indicators and yet another Greek debt deal by the EU. But the move is tentative as investors appear unwilling to put on large positions this late into the year.

The US election has settled one source of uncertainty— who will set policy—but another source of uncertainty remains—how will the fiscal cliff be resolved. Unless the President and Congress reach an agreement, almost $600 billion of fiscal tightening is set to hit the economy on January 1, 2013. Out of this $600 billion, about 3⁄4 is higher taxes, and about 1⁄4 is reduced federal spending. Should all of this tightening be realized, the economy would almost certainly sink back into recession.

In principle, avoiding the fiscal cliff is simple; in practice, there are sharp ideological differences that complicate the issue. Among these differences, none is greater than the fate of the upper-income Bush tax cuts. These cuts amount to around $50 billion per year of extra federal revenue.

There are essentially three ways this could be resolved. First, either one side or the other completely concedes the issue. This seems somewhat unlikely given that each side has legislation-blocking power. Second, neither side concedes anything on the issue, and we go over the cliff entirely. This is possible but certainly not appealing. Third, some middle ground is found.

Our view is that the fiscal cliff issue would eventually be resolved towards the end of the year, with a possibility of a deal only taking place in January 2013. Be that as it may, we think the outcome for financial markets will be benign and will not imply a replay of the violent 2011 August sell-off when the US got downgraded.

Last week was a good week regarding political developments in Europe. The Eurogroup reached an agreement on Greece, which ensures the dispersal of Greece’s next tranche of support and reduces the risk of a near-term Greek EMU exit. Similarly, risks around Spain were reduced by an election outcome in Catalonia that was more favorable for Madrid than expected.

Regarding our main ‘carry’ strategy: being long US High Yield bonds: after seeing conditions soften for several weeks, high-yield bonds have benefited from a bounce in stock prices and sense of optimism around progress towards a fiscal compromise in the US. While high-yield bonds could suffer in the interim on any disappointing headlines, we do not see a meaningful sell-off forming unless it is accompanied by tangible deterioration in the US economy.

In the background, investors do seem to be focusing more on some of the positive macro themes such as a quiet European region due in large part to the success of the OMT program, a potential expansion of QE3 by January, a slowly improving Chinese economy, and a US economy benefiting from continued improvement in housing. The other positive development is the return of inflows to US mutual funds last week, and a pick up in the size of European high yield fund inflows.

Hence why we are still comfortable running our long positions in carry strategies such as high yield and high dividend stocks. As our loyal readers probably know by now, next to these two core strategies, we also have a long position in Gold in our portfolio as well as a short volatility position paying high coupons on very low probability scenarios. We will publish our 2013 Outlook for Financial Markets in the coming days.