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Somewhere Over the 'Cliff' ... Skies Are Blue

Washington Monument
Paul J. Richards | AFP | Getty Images
Washington Monument

As investors gaze across the "fiscal cliff," some see a better economy on the far side, making stocks and risk assets more appealing and bonds less so in the year ahead.

But there are many caveats to that scenario and some of them could be decided in the next day as politicians struggle to strike a deal that would avert a fall off the "fiscal cliff." The cliff is the double-barreled blow to the economy from the reversal of dozens of tax breaks and the onset of automatic spending cuts, agreed as a solution to the contentious 2011 debt- ceiling debate.

Congressional leaders worked through the weekend, scrambling to try to avert a New Year's "fiscal cliff." But by Sunday evening, the Senate had put aside its efforts until Monday morning.

(Read more: Senate Leaders Hustle to Try to Avert New Year's 'Fiscal Cliff')

President Obama said the GOP's focus on protecting tax hikes on the rich was standing in the way of a deal.

"They say that their biggest priority is making sure that we deal with the deficit in a serious way, but the way they're behaving is that their only priority is making sure that tax breaks for the wealthiest Americans are protected," Obama said Sunday on NBC's "Meet the Press." "That seems to be their only overriding, unifying theme."

(Read more: Obama: GOP's Focus on Rich Is Standing in Way of a Deal)

Stocks were spooked in the past week by the lack of movement in discussions between Congress and President Barack Obama. As the market closed Friday, the absence of new developments during talks underway at the White House provided a void for selling. The Dow fell 1.2 percent to 12,938, giving it a loss of 1.9 percent loss for the week. The S&P 500 fell 1.1 percent to 1402, for a one week loss of 1.9 percent. The Nasdaq lost 2 percent for the week to 2960.

(Read more: Stocks Tumble 2% for Week, Spooked by 'Cliff' Talks)

Congressional leaders late Friday left the White House without a deal, setting the stage for a weekend of raw nerves. Obama said he was still optimistic Friday that the Senate leadership could come up with a deal that would pass both houses, but he also laid out a second plan for a straight up or down House vote on middle class tax cuts if they can't reach an agreement.

(Read more: Obama: Optimistic We Can Still Reach Deal 'in Time')

Stock futures, sharply lower after the equity market close Friday, were higher Sunday evening but still pointed to a lower opening Monday.

"You could tell a lot of people were very skittish about their trades," said Patrick Kernan of Cardinal Capital. "Everybody is fearful of what exposure they have right now. Right now, we're thinking if they reach a deal we go back to around where we were a week ago, right around 1440" on the S&P 500. If there's no deal, "we think it goes down 30 to 50 points."

Kernan, who trades S&P 500 options, said the market was swarmed by investors seeking portfolio protection Friday. A popular straddle on S&P 500 1390 options that expire next Friday, just to break even, was implying a near 3 percent move in the S&P 500, in either direction. "The way we look at that is it implies a larger move than three percent by next Friday," he said. Kernan added while the mood was largely bearish, one big investor came in at the end of the day making a large bullish bet.

"The other side of this thing from an investment standpoint, is if there's a deal, I don't know what the number is but is it a five-percent rally from here? Is it a three-percent rally?" said James Paulsen, chief investment strategist at Wells Capital Management. "There's risk on both sides of the trade, and I think that's been helping keep this reaction more muted than it otherwise might be."

"The cliff isn't December 31. The real cliff is somewhere down the line when the tax bite and spending cuts start to hurt," he said. "The most optimistic agreement was not that we got this done before the deadline.The most optimistic was we get it done right on deadline, and I think it was fully expected it would get really ugly right before that…the other reality is if it doesn't get done until mid-January it's not going to hurt anything."

Paulsen said the market's anxiety will increase the longer it goes on. "If we go over, the market reaction will start to build…I don't think it will fall apart if we go over. I think if we start to get to the second half of January, I think they'll get way more concerned."

Wait, There's More

Besides the action on Capitol Hill, there is the December employment report Friday and some other key data to look forward to in the week ahead. That includes Thursday's December car sales and chain-store sales and Wednesday's ISM manufacturing data. The minutes of the Fed's last meeting are also expected Wednesday afternoon.

But the outcome of the cliff discussion and Congressional votes will be what drives markets in the week and months ahead, and what will ultimately decide whether the U.S. can be a driver of the global economy or a drag on it in 2013.

"I don't think the story is over yet," said Citigroup economist Steven Wieting. "We all expected agony . It just seems we keep adding to it. As far as the centrists who are out there, which I think is the great bulk of the country, understand is that you can't have the demographics we have and do nothing to adjust to it. There's compromise that's needed and now seemed like a good time, but they already let the window substantially pass. The opportunity to have a really big framework has passed.

Wieting described a another possible scenario. "They're going to completely leave the debt ceiling out of this, and they're going to leave any signs of structural reform out of this. Then we have a deal that includes future cliff dates. That would leave uncertainty in play."

As the weekend wore on, it appeared less likely an agreement would even be reached by New Year's, much less a vote be taken. Yet, analysts and economists also saw a possible outcome, where the cliff is fixed, at least in part, either by New Year's or within several days, and the debt ceiling and remaining dealt issues are dealt with in the first part of the year. If that's the case, it might unleash economic growth, as consumer and business confidence improve.

"I think the global economy is going to surprise on the upside," said Ed Keon, portfolio manager with Quantitative Management Associates. Keon believes Congress will make a deal to avoid the cliff, and he sees gains in the U.S. economy as well as improvement in the European debt crisis and a pickup in the emerging world. "I think in the European situation, time is on our side and everyday things look a little better."

He also sees the U.S. ending the year with stronger growth. "It's hard to believe Washington would want to hurt the economy with malice of foresight," he said. "Doing a small deal will be viewed that they might be able to do a bigger deal."

Kind of a Small Deal

"We'll get a deal," said Steven Stanley, chief economist at Pierpont Securities. "It will be a small deal that will address some of the more onerous aspects of the cliff. Tax rates, they're going to have to address the AMT, and they're going to have to do something with sequestration cuts,either delay them or rejigger them. I think they'll probably do something one state and dividend tax rates, the Medicare doc fix and they'll probably extend the unemployment benefits."

It's the bigger deal, on the debt ceiling, that will be most difficult and most important in terms of the longer term strength of the economy. Treasury secretary Tim Geithner warned this past week that the U.S.will reach the debt ceiling limit Monday, but that the Treasury can make some adjustments to keep the government funded for a couple months while Congress works out a deal. The hope is that Congress would find a way to deal with bigger tax reform and entitlement spending issues as part of that debate.

Avoiding the cliff, even with scaled back tax increases,will not leave the economy unscathed but it should not trigger the recession expected if the cliff were hit. "Basically if we let the payroll tax expire it's going to blunt consumer spending in the beginning of the year, even if we know about it," Stanley said. "The upper income tax increases are not a free lunch either. It's substantially lower than the full cliff." One of the most public points of contention is at what income level, Bush-era tax cuts are reversed. Both Republicans and Democrats agree, tax rates should remain the same for 98 percent of tax payers but the disagreement is over taxing the rich and that's what the Senate leadership will have to tackle this weekend.

The economy could handle that and move on, Wieting said. "If it's a fiscal tightening between 1 and 1.5 percent of GDP, the economy would absorb that in a discrete way and probably move on to stronger growth in the second half of the year. It could be better. It could be clearer. It could be sooner," he said. Wieting said, however, the more unresolved issues and pushed-out deadlines there are, the worse it will be for the economy because business spending would remain constrained.

Wieting expects growth in the beginning of the year of about 1 percent, and assuming a resolution of the cliff and debt ceiling issues,growth could accelerate to 3 percent by the end of the year.

(Read more: When to Re-enter the Market: Najarian)

The economic data this week should continue to show the same slow growth in employment, but possible stronger auto sales and improved manufacturing. Economic data, particularly housing-related data, has been largely surprising to the upside.

Stanley expects the December nonfarm payrolls to be about the same as November's 146,000. "I have 150,000 but that includes a couple of special factors that I think will push the number up a little bit," said Stanley. One of those factors is the addition of couriers, temporarily hired to deliver holiday gifts. Last year, that category gained 40,000 in December, and lost the same amount in January, he said.

"It's hard to get this crisis to have major legs when all the data keeps coming out better-than-expected, not only here but globally,"said Paulsen. "The Shanghai is up 15 percent" this month.

"I think the odds are pretty good we get a twelfth- hour announcement...and this is just horseplay leading up to it. I don't think it's really that surprising we got volatility leading up to the last day," he said.

Monday

Final trading day of 2012

"Fiscal Cliff" deadline

10:30 am: Dallas Fed survey

Tuesday

New Year's Day

Markets closed

Wednesday

8:58 am: Manufacturing PMI

10:00 am: ISM manufacturing

10:00 am: Construction spending

2:00 pm: FOMC minutes

Thursday

Monthly vehicle sales

Monthly chain store sales

8:15 am: ADP employment

8:30 am: Jobless claims

Friday

8:30 am: Employment report

10:00 am: ISM nonmanufacturing report

10:00 am: Factory orders

3:30 pm: Fed Vice Chair Janet Yellen on systemic risk

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC Senior Commodities Correspondent and Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.