Gauging the fiscal cliff ahead

Washington averted an imminent fiscal crisis, but the result could be a steep fiscal cliff in December or early 2018.

We see heightened political uncertainty toward year-end as the U.S. Congress must revisit lifting the federal borrowing limit and funding the government. We could see this delaying and reducing the scope of any tax reform.

Last week’s deal raises the statutory debt ceiling and funds the government through Dec. 15, taking the risk of a technical default off the table for now. We see short-term U.S. Treasury debt as a key barometer of this risk, as the chart shows. Yields on Treasury bills maturing soon after the original late-September deadline fell as these T-bills were no longer seen as most vulnerable to default, while rates on T-bills maturing after the new December deadline rose.

Crisis averted, for now
It was a natural disaster that spurred politicians into action last week. The debt ceiling and funding plan is packaged with provisionsto provide hurricane relief as authorities in Texas and Louisiana assess the devastation and tragic toll caused by Hurricane Harvey. This came just as Florida was bracing for the impact of Hurricane Irma. A government shutdown, the likely outcome of failure to pass a 2018 budget, would have been detrimental at a time when states are looking to the federal government for much-needed assistance.

The upshot is a likely fiscal cliff toward year-end as lawmakers again confront the debt limit and government funding –without the face-saving element of disaster relief. They also face a range of other thorny issues, including addressing residency rights for children who entered the country illegally and the controversial funding of a wall on the border with Mexico. Adding to the political storm: President Donald Trump sided with Democrats last week on the deal, despite Republican calls for a much longer extension of the debt ceiling and budget. This could make the fiscal debate harder the next time around. It could also complicate and delay tax cuts or reform,already a casualty of a busy legislative calendar.

Political risk has quieted for the moment, but we expect higher uncertainty as Dec. 15 approaches. We see T-bills as a useful gauge for potential market anxiety. We favor equity and fixed income segments tied to the sustained global economic expansion, and advocate some allocation to long-dated government bonds as a buffer against equity market sell-offs.

Richard Turnill – Global Chief Investment Strategist – BlackRock