Getting comfortable with living on the edge

Just as you learn to put up with a nagging toothache, this week is expected to provide fresh evidence that the U.S. economy is getting used to life on the edge of the fiscal cliff.

Of course, putting off that trip to the dentist is not necessarily wise. The longer Washington delays, the more painful it will become to narrow its gaping budget deficit.

But surveys of U.S. consumer confidence in January and of house builder sentiment in December are likely to show resilience, buttressing the argument of equity bulls that Wall Street's firm start to the year is more than a relief rally or a desperate search for higher returns on investment.

Bluford Puttnam, chief economist of CME Group, said the U.S. economy had managed to grow almost 2 percent last year and create about 1.8 million jobs despite stagnation in Europe, a slowdown in China and the deadlocked budget talks.

"So I see a lot of momentum going into 2013," Puttnam said. "If we can get past this fiscal cliff, the economy is poised to have a much more confident year."

Despite fiscal tightening, he said growth could reach 2.5 percent to 3.0 percent.

Puttnam said the next rounds in the budget battle later this quarter would again be bitterly fought and the resolution would again satisfy no one. But, as with the showdown at the end of 2012, the economy would quickly move on.

"There is a one-in-ten chance that the government may even shut down for a week. It's just going to be ugly. And then it will be over. There will be some kind of compromise, and by April it will fade quickly into the background," he said.


U.S. retail sales are likely to have increased only 0.2 percent in December, dampened by the budget worries, according to economists polled by Reuters.

But a pair of regional Federal Reserve surveys and the monthly Reuters/University of Michigan consumer poll are projected to improve, while housing starts, new building permits and builders' confidence should all show that the housing recovery stands on firm foundations.

"That's what's really encouraging consumers to feel that the economy is getting better and that the momentum is broadly positive," said Jerry Webman, chief economist at OppenheimerFunds in New York.

While the phrase fiscal cliff used by U.S. Federal Reserve chief Ben Bernanke conjured up an image of an immediate plunge at the start of this year, in truth any austerity was always likely to take effect on the economy gradually.

Bank of America Merrill Lynch describes the challenges the United States faces in coming months rather as three fiscal gorges it must leap over.

The government could hit the debt ceiling approved by Congress as early as mid-February; across-the-board spending cuts are due to kick in on March 1; and the ���continuing resolution' to fund all discretionary government spending expires on March 27.

Ideally, investors would like Democrats and Republicans to resolve all three issues with an overarching agreement to slash the deficit by $4 trillion over the next decade.

Instead, given the dysfunctional state of politics, Webman said the best that could be hoped for was another short-term fix that cuts spending and ends some tax breaks.

"The U.S. doesn't move by grand bargains, by big deals. We move by incremental decisions, and I think we'll make some imperfect but improved decisions over the course of 2013," he said.


Encouraging economic news from China, including stronger-than-expected exports and imports in December, has also supported the start-of-year move by financial market investors out of cash and into riskier assets.

Figures on Friday are expected to show that the world's second-largest economy grew 7.8 percent from a year earlier, rebounding from the 7.4 percent pace of the third quarter and further allaying fears of a hard landing.

"Given some of the bearish commentary on China a few months ago, this should be a relief for markets and it's good for the world economy," said Derry Pickford, macro analyst at investment managers Ashburton in London.

Continuing calm in the euro zone has also helped equities, even though full-year German GDP data on Tuesday will serve as a reminder of the area's economic malaise.

Europe's largest economy contracted last quarter as factories slashed output in response to weak demand from Germany's neighbors, the Economy Ministry said on Friday.

At a news conference a day earlier, European Central Bank President Mario Draghi said he expected a recovery in euro zone growth later this year. But he ruled out an early end to the ECB's crisis policy measures and cautioned that risks were still tilted to the downside. Markets shrugged.

In Europe as in the United States, investors seem to have got used to high levels of policy uncertainty, said Ethan Harris, chief U.S. economist at Bank of America Merrill Lynch.

"It appears that the markets will look past brinkmanship moments unless policy makers break new ground," he said.

In Europe, that might mean not just threatening to eject Greece from the euro zone but actually forcing the exit. In the United States, that might mean not just threatening to violate the debt ceiling but actually doing so, Harris said in a report.

As long as such extreme events do not occur, Harris expects periodic swoons in confidence but no acute crisis.

"This renewed resilience is important because we expect many brinkmanship moments in the months ahead. A now-regular pattern has been established where deals are only struck at the last minute and often under market pressure," he wrote.

(Editing by Patrick Graham)