Gradually two of the three main risks in the markets appear to have been moderated, while the third is quickly intensifying. The European Central Bank (ECB) has eliminated the tail-risk when it provided the conditions upon which it would put its balance sheet to help bailout Spain and Italy, if necessary. Economic data in China show stability around a 7% pace of growth, with a potential recovery towards 8%. But the fiscal cliff in the US is what is heating up, each day, as we get closer to the elections, first, and to year-end later. The key question is whether this is short-term noise as the debate on tax reform and fiscal adjustment has developed sufficiently over the last months, and there seems to be broad consensus that something bold needs to be done. On the side of monetary policy, a new risk has emerged, with the prospects of a change in leadership at the Fed towards 2014.

The fiscal cliff is a drastic and sudden fiscal adjustment, which was put into law as a threat that should have led to a better agreement and reform. That agreement never happened, in part because of this being an election year, but also because there are severe differences between the two political parties on how much to get from spending cuts and how much from higher revenue. The debt-ceiling saga of July 2011 showed, though in very unfortunate terms, that there is no reason to believe it would not happen again, especially if the political players are the same. In other words, if Obama wins, Republicans keep a majority in the house but Democrats retain the senate, a similar stalemate is possible, which should not only produce volatility in the markets, but a scenario in which the components of the cliff get actually implemented (tax hikes and sharp spending cuts).

The timing is also unfortunate. Late on November 6 we will know who gets the White House and each house of congress, which will shed light on which path is most likely. But there is still a short set of weeks (plagued with holidays) to have congress implement either a short-term fix or a real solution. Almost nobody expects a real solution between November 6 and January, so the question is whether a short-term solution is quickly attainable, and how that happens should produce a signal about the likelihood, timing and profile of the real solution during the first months of 2013.

Is this a real risk or just short-term noise? There is broad consensus that tax reform is needed and that a clear and strong signal about medium-term solvency needs to be produced. In the last few weeks the business community has joined the debate, with a few high profile events and interviews where they push the political system to compromise and produce a better result than in July of last year. However, the political postures are not conducive, and the fact that the US continues to enjoy extremely low interest rates on its debt is not an incentive for implementing a fiscal adjustment.

We believe that regardless of who wins the elections there will be tax reform (towards a more efficient set of taxes), as well as a plan to show a gradual improvement in the fiscal balance through time. However, we think the process can be noisy and confusing at times. The fiscal cliff, if not averted, means a fiscal adjustment of 4-5% of GDP in a sharp fashion, which many (and most importantly, the markets) believe leads to a recession. We think it might have a negative impact in 1 to 2 quarters, but it is not necessarily the end of the world. However, we think it will be averted around year-end with a quick-fix, to allow for a more substantive debate about tax reform and medium-term fiscal adjustment.

On the monetary side, the fact that Republicans have said in the primary that they would not re-appoint Bernanke, together with rumors that he might not want to stay for another mandate (his ends early 2014), is adding uncertainty about the unfortunate pillar of markets these days: monetary expansion.

Conceptually, it is not difficult to agree that the current monetary policy is a bit excessive, and has produced abnormally low interest rates, as well as spreads. However, markets can over-react to a potential change in policy from a change in leadership at the Fed, and this is a non-trivial risk one needs to keep an eye on. Rates can rise suddenly if a new president seems likely to appoint a monetary hawk. However, it is difficult to imagine that even such a hawk (say, John Taylor) is unlikely to move from the current monetary policy to his ideal policy quickly. But, again, and as we have said in previous notes, markets have grown addicted to monetary policy, and hints of a forceful termination to that addiction can cause excessive volatility.

In sum, we believe 2013 will be better than 2012 in terms of economic growth. However, markets have already priced some of that, but most importantly, there is a set of key uncertainties to resolve in between. We have gradually re-allocated into regions that are showing the first signs of recovering, but because of the above, we are moving slower than usual.