Tackling US fiscal cliff key for equities, says Citi

Obama's re-election as the president of the United States was a likely outcome and therefore, the nature of politics is not expected to change, said Geoffrey Dennis, MD & Global EM Strategist at Citi Investments. According to him, it is now important to watch how both parties tackle the problem of the fiscal cliff.

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A robust reaction from the equity markets can now be expected only when the fiscal cliff is effectively dealt with, added Dennis. He is positive about equities next year and believes the fiscal cliff might be sorted out by the end of calendar year 2012. Here is the edited transcript of the interview on CNBC-TV18. Q: Citi has called it right. In the last one-and-half year Citi has been calling for an Obama return and he has returned to the White House. What do you think about equities and bond markets from here?
A: We have been seeing Obama’s victory as the most likely outcome. It was a base case and we think that this is a complete status quo election in the sense that President Obama has been reelected, the Democrats have won the senate and the Republicans have won the house. We need to get back to business on the basis of the same structure of politics in the US as before.
I do not expect that to be much of a market reaction to the election itself. What will matter now is how quickly and how successfully the politicians on both sides of the political spectrum come to an agreement about its massive fiscal cliff. About 4-5 percent of GDP in terms of fiscal tightening is scheduled to come into effect on January 1. Q: What is the base case you are working with? I saw an instant reaction from your European desk which suggests that you all are watching for a possible last minute compromise, do you think that is possible?
A: Certainly, our view is very positive for equities next year. It is because our base case is that they will fix the fiscal cliff by tightening the scale from 4-5 percent of GDP, like it is now to around 1 percent of GDP. They will probably get the deal done before the end of calendar year 2012.
That is our base case assumption but, we need to let the viewers know that this is far from guaranteed. In fact, it is quite possible that this debate goes into the New Year. All I am trying to say is that, this is the most likely outcome and it will be fixed before the end of the year. I don't believe that you will see a robust reaction by equity markets until we see how they are going to deal with its fiscal cliff. And this is why the election was important of course but, what happens with the fiscal cliff now is going to be very important in the weeks ahead.
_PAGEBREAK_ Q: What is your view on emerging market equities for 2013? Indian markets are up close to about one odd percent. Do you expect the rally to continue or do you think on account of fiscal cliff the returns are likely to be tapered?
A: In fact markets have lost some ground and have fallen into a trading range in the last six weeks. We had a nice rally from early June until the middle of September. We do expect the markets to regain some momentum eventually and that to happen in 2013.
It will be based on a resolution of the fiscal cliff with respect to the US. It is also based on some eventual signs that global economy will strengthen somewhat next year. The earnings story will improve in emerging markets and all that will get some 15 percent return between now and the end of next year. But the outlook for the next few weeks is very unclear in the short-term. Q: How are you positioned on India in particular, post the recent rally and the reforms that we have seen?
A: We are currently neutral on India. We did raise India from underweight to neutral on the back of the very important structural reforms that were introduced in the middle of September. Markets had a very good run, it has flattened off since. India now needs to be an outperformer, see potentially some more structural reforms coming through.
We need to see some clarity on monetary policy. We had expected the RBI to reduce interest rates and will probably need to see the growth in the economy beginning to bottom out and perhaps come back which will happen next year. So, you had your bounce on the back of the structural reforms. But it doesn’t prove the outlook for the market, it probably warrants some increased valuations. You need some other developments to push the markets higher from here. Q: There seems to be a consensus view that we had a rally and need incremental steps. But within sectors, sector rotation could still play out. Do you think cyclicals, the high beta rally that we are currently seeing after the Obama election is here to stay? Do you see anything in terms of sector strategies?
A: We are generally overweight of the cyclical stocks around emerging markets including India. We like the financials. We also have an overweight in the material sector and with the Chinese economies leveling out, that would help the sector overall. It has been an underperformer.
We also like consumer discretionary which are of course generally placed on low interest rates. That is also a good sector to be in. We are underweight on the defensive sectors, consumer staples which are extremely expensive and telecom utilities which have done fairly well this year.
Now if the market is volatile in the short-term until we get the resolution for fiscal cliff, we may expect the defensive sectors to still do relatively well. But, investors should be positioning themselves for a much better 2013. We are not just saying that the global economy looks better, the fiscal cliff broadly gets resolved. But we still have a lot of liquidity in the global financial markets, which should push equity markets up next year and in that environment investors should look to position themselves more aggressively.