Romney's selection of Paul Ryan as his veep clarifies the policy debate (forcing typically middle-of-the-road voters to become more polarized to the size of government) into the November election and materially changes the odds of the fiscal cliff's resolution. As Morgan Stanley's Vince Reinhart notes, "by tying one side to an explicit plan for fiscal consolidation, the Ryan selection makes it much more likely that the campaign will focus on the appropriate role of the government. That is, the debate will be about the right level of federal expenditure relative to national income, the progressivity of the tax system, and the extent to which family incomes are protected on the downside by Washington, DC." Although theoretically the Ryan pick raises the chance of a benign, before-the-election resolution to the fiscal cliff 'issue', it also worsens the likely outcome if the legislative stand-off continues into 2013 - which the odds suggest is the case.

Morgan Stanley: Ryan Pick Clarifies the Policy Debate



November election now focused on the role of government. Mitt Romney has now defined his likely economic policies by proxy through his vice presidential pick.



By tying one side to an explicit plan for fiscal consolidation, the Ryan selection makes it much more likely that the campaign will focus on the appropriate role of the government. That is, the debate will be about the right level of federal expenditure relative to national income, the progressivity of the tax system, and the extent to which family incomes are protected on the downside by Washington, DC.

Before Ryan Pick... voters largely indifferent to role of government decision...

After Ryan Pick... more polarized...

The Ryan plan envisions a 14 percentage point lower debt-toGDP ratio by 2022 than the president's budget (see my first exhibit in Appendix). This entails a cumulative $5 trillion cut to expenditures relative to the White House plan. The drama on Medicare is postponed, but when it comes, it is significant. Obamacare would end in favor of a market-related exchange. Fannie and Freddie are to be ended, and Dodd-Frank is to be rolled back. The Fed would be given the single mandate of price stability.



Among the plans in play, Paul Ryan’s would shrink the government the most – if his plan's arithmetic could be trued up. Regarding the fiscal cliff, we think the Ryan pick raises the chance of a benign, before-the-election resolution. But it also probably worsens the likely outcome if the legislative stand-off continues into 2013.

First, the cooperative outcome. A robust debate about fiscal policy will draw voters’ attention to the harm caused by the cloud of uncertainty from the failure of politicians to find a legislative solution. The deadweight loss includes the elevated risk of recession, potential changes in tax rates that make planning more difficult, and potential adverse effects on local communities from deep cuts in the defense budget if sequestration kicks in. The latter issue looms particularly large in important swing states with critical Senate contests, including Florida, Massachusetts, and Virginia. More vigorous voter scrutiny might force politicians to temporarily settle the issue in the run-up to the election.



Contesting the election on big fiscal principles, however, also raises the chance of a punishing 2013 outcome. Individual election victors will view themselves as having a mandate from voters who had been given a clear choice. But what happens if, in the aggregate, voters opt for a divided government? The latest quotes from Intrade (see below) suggest that is the likely outcome. If the control of the White House and the Congress continues to be split, it might be even harder to compromise next year, even compared to this year’s polarized results.

Not much chance of Fed action. We've consistently held that the Fed would prefer to keep on hold in the election season. Since the most recent meeting, financial conditions have eased and data have been a bit more upbeat. Indeed, our tracking estimate of GDP growth has moved up threetenths. In addition, there has been no mention by Fed officials of a lending program. Accordingly, we marked our assessment of action at the September meeting down to 30 percent.





Fiscal Cliff Trades



Under current law, the US federal government will implement severe fiscal tightening at the beginning of 2013. The potential impact of this ‘fiscal cliff’ includes legislative gridlock, falling economic indicators, downward pressure on GDP growth, and declining disposable income. The potential impact to markets could include rising systemic risk, the US Treasury 10-year yield moving past historical lows, flat earnings growth, and rising short-term hedging demand.





So uncertainty reigns. In interest rates we would be long duration in the 10-year sector and suggest a 2s10s curve flattener. In FX we would be short USD/JPY on tighter yield differential. But in my view, now is a great time to put on hedges around the looming uncertainty. In the credit space, for instance, we favor buying MCDX as macro hedge.

Source: Morgan Stanley