Despite looming 'fiscal cliff,' world markets calm

Markets appeared Monday to be taking in stride the prospect that U.S. politicians will fail to agree a budget deal in time to avoid automatic tax increases and spending cuts that many economists think could tilt the world's largest economy back into recession.

With just hours to go before the U.S. falls off the so-called "fiscal cliff," Republicans and Democrats remained divided over tax and spend, raising the prospect that markets will start 2013 without a clear idea of America's budget policy. The main sticking point appears to be what level of taxes are imposed on higher incomes.

Discussions in the Senate broke off Sunday night without an agreement. The Senators will return to their offices Monday to try and hammer out a deal before the deadline.

"With the gulf between both parties still wide and the desire to protect their supporters' key interests so ingrained, it is difficult to see how both sides can compromise enough to agree a deal at this point," said Rebecca O'Keeffe, head of investment at Interactive Investor.

However, it's not the first time that budget discussions in the U.S. have gone down to the wire, and investors remain confident that some sort of deal will be reached, if not Monday then in the coming days or weeks. As a result, they think that the potential damage wrought by higher taxes and spending cuts will be limited.

In addition, a backup proposal that would address only a few issues is expected to be presented by Senate Majority Leader Harry Reid, a Democrat, if a bipartisan deal is not reached.

The prospect of counter-measures to offset the "fiscal cliff" impact helps explain why markets were fairly calm in Europe and Asia, and Wall Street was poised to open higher.

In Europe, the FTSE 100 index of leading British shares was down 0.4 percent at 5,901 but the CAC-40 in France was 0.4 percent higher at 3,633. Most European indexes are only trading for half of the day ahead of the New Year break, while others including Germany's DAX were closed.

U.S. stocks were poised for gains at the open, with Dow futures up 0.2 percent and the broader S&P 500 futures 0.4 percent higher, even though in theory, the U.S. faces around $671 billion of tax increases and spending cuts over the coming months, equivalent to the sort of fiscal tightening taking place in highly indebted Europe.

Clearly, their full imposition would hobble an economy that has shown some signs of late of a more sustainable economic recovery.

Some economists predict the tax-and-spending effects of the "fiscal cliff" could eventually throw the U.S. economy back into recession — although if the deadline passes, politicians still have a few weeks to keep the tax hikes and spending cuts at bay by repealing them retroactively once a deal is reached.

"It is likely that many of the fiscal cliff measures allow a certain amount of room within which the government can introduce measures to refrain from any tax increases," said Joshua Mahony, an analyst at Alpari.

Still, the failure to adhere to the deadline following weeks of squabbling and procrastination could be view negatively by the major credit rating agencies and weigh on investor confidence going into 2013.

"I think the market reaction to that will be very negative. This means the U.S. will never be able to bring its house in order. And the deficit will continue to accumulate," said Francis Lun, managing director of Lyncean Holdings in Hong Kong. "No meaningful reform and no solution in sight. You can throw confidence out of the window."

Earlier in Asia, the picture was fairly subdued in those markets that were open — among others, markets in Japan and South Korea were closed for the New Year's holidays.

Hong Kong's Hang Seng, trading for a half-day, closed marginally lower at 22,656.92, while mainland Chinese stocks rose after a private survey showed the country's manufacturing growth at its strongest level in 18 months in December. Australia's S&P/ASX 200 fell 0.5 percent to close at 4,648.90.

There was also a fairly calm atmosphere in other financial markets, with the euro down just 0.2 percent at $1.3191 and the price of benchmark New York crude down 11 cents at $90.69 a barrel.