Economy

Why 'Fiscal Cliff' May Be Bigger Threat Than You Think

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As the deadline for fiscal peril in the U.S. nears, Wall Street is worried that the impact could be much worse than anyone thought—while investors remain nearly oblivious to the danger.

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Looming tax increases and spending cuts — which Federal Reserve Chairman Ben Bernanke has labeled the "fiscal cliff" — would send the economy into a deeper recession than many have predicted, according to economists at Bank of America Merrill Lynch.

At the same time, fund managers the firm surveyed believe investors are far too optimistic that warring Washington factions can get together to take the steps necessary to prevent the economy from going over the cliff—at least temporarily.

Some 72 percent of respondents believe investors have yet to price in the ramifications—a view that is spreading across Wall Street as time winds down for a solution.

"The fiscal cliff impacts the economy both by creating uncertainty and by imposing austerity," Ethan Harris, BofA's North American economist, said in a report. "If we go over the cliff for an extended period of time, a recession is likely."

He later added, "One reason we remain cautious on equities for the next few months is the likelihood for heightened volatility and the potential for a near-term correction amid the risks posed by the US presidential election and the fiscal cliff."

The election between President Barack Obama and Republican challenger Mitt Romney is frequently cited as a market risk, but the fiscal cliff has been less emphasized. (Read More: Pension Envy: Who Has More—Obama or Romney?)

The cliff entails spending on unemployment benefits, a payroll tax and the Bush-era tax cuts that, if left to expire, would slice already-weak U.S. growth even further.

As far as stock market performance BofA is fairly optimistic, with a 1,450 price target on the Standard & Poor's 500 through year's end and a 1,600 target for 2013.

But the firm said that if a political stalemate takes hold, the broad stock market gauge could tumble all the way to 1,000 in the near term and could slide to 1,250 if even a short-term impasse would develop.

The CBO now projects the economy to contract 1.3 percent in the first half before growing 2.3 percent in the second half, after the cliff issues dissipate.

Normally bullish JPMorgan recently cut back its estimates for growth, primarily based on its belief that if nothing else the payroll tax holiday — agreed to in 2010 and frequently touted by Obama as a middle-class tax cut — is unlikely to survive the congressional battles.

The firm now projects gross domestic product to grow just 2.0 percent in the fourth quarter then fall to 1.0, 1.5 and 2.5 percent in the ensuing quarters. Fallout from the cliff impasse will cut 1 percentage point from growth, according to JPMorgan economist Michael Feroli. (Read More: )

"We are no longer of the belief that the payroll tax holiday will be extended," Feroli said. "That change alone is worth over half a percent on GDP growth next year."