The election is over, but in some ways the landscape of the last few months is no different. In other words, the status quo and potential for gridlock over key economic issues remain.
The election essentially played to script: a narrow victory (the electoral college obscures how close the popular vote was) for the President and the Republicans holding the line in the House. They only surprise was the Republicans lost a couple of seats in the Senate — arguably due to idiosyncratic occurrences in Missouri and Indiana — rather than any real change in the political climate.
Obviously, the near-term issue for investors now is the fiscal cliff, although longer-term issues of tax and entitlement reform still loom. We still believe that the market is unprepared for a trip over the fiscal cliff with economic and analyst estimates still suggesting that most investors believe it will be avoided. Further evidence of that is the fact that up until Wednesday’s trading action, volatility remained puzzlingly low given the risk of a 2013 recession.
What now? We would watch for comments out of House Speaker John Boehner and the White House for any softening of entrenched positions, particularly on taxes. This will be the main sticking point. There is some consensus on extending the alternative minimum tax and avoiding at least part of the sequester, which would trigger automatic spending cuts. On the other hand, the payroll tax holiday and extended unemployment benefits are almost certain to expire, which suggests at least some fiscal drag, around 1 percent in 2013.
Bottom line for investors is we would remain cautious and expect the market to remain what traders like to call “range bound.” In other words, expect markets to move based on news particularly related to clues on how the two parties are likely to behave, as we saw Wednesday, rather than longer-term trends.
In the meantime, we continue to think mega cap equities, municipal bonds, and international stocks are good places to be. On the latter, it is worth noting that non-US stocks dramatically outperformed in October.
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.