Asia’s Stock Rally Could Hit a ‘Cliff’ in Early 2013

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Asian stock markets have made hefty gains this year despite global economic uncertainty, but in the weeks ahead, analysts warn against volatility and a possible pull-back in equities if the U.S. is unable to avert the "fiscal cliff" – a series of tax hikes and spending cuts that could tip the world's largest economy into recession.

This year, Japan's Nikkei 225 and Hong Kong's Hang Seng have both jumped nearly 23 percent, and Australia's S&P/ASX 200 has climbed about 15 percent. Gains in Southeast Asia have been equally impressive, with Singapore's Straits Times Index advancing about 21 percent, the Stock Exchange of Thailand Index 36 percent and the Philippine Stock Exchange Index 33 percent.

However, all that could change and there could be a rocky start to 2013 if the U.S. Congress does not reach a deal over the "cliff" by December 31, which would trigger $600 billion in tax hikes and spending cuts on the first day of the new year, analysts said.

"If we go over the 'fiscal cliff' and all these Americans wake up on Wednesday morning and go off to work and their pay packets are lower than they were last week because their taxes have all gone up, that's going to hit the economy pretty hard," said Stephen Halmarick, head of investment market research with Colonial First State Global Asset Management in Sydney.

"If the U.S. economy is going to be flat lining or even worse, in recession, I think you will see quite a pullback in Asian markets, perhaps in the order of 5 percent, maybe even higher," Halmarick told CNBC Asia's "Squawk Box" on Monday.

(Read more: Asia's Booming Equities Starting to Lose Their Shine)

U.S. markets, which fell about 1 percent on Friday because of concerns over the "cliff", would also be hit, he said. The key to markets' performance next year is the economic recovery in the U.S. and he hopes that the 2-2.5 percent pace that the country is on track to grow at remains intact.

However, after a day of talks that were expected to yield some sort of compromise on the so-called "fiscal cliff," Senate leaders called off any further votes until Monday morning, just hours before the deadline. The Senate will meet again on New Year's Eve at 11 am eastern time, the last full day before the "cliff" takes effect.

(Read more: No Fiscal Deal, Senate to Return for Dramatic New Year's Eve)

"The next 28 hours is going to be quite harrowing. There's more than a 50 percent chance that we are going over the 'fiscal cliff'," said PK Basu, managing director and head of Asia research and economics with Maybank Kim Eng in Singapore. "But the U.S. political system has an ability to reach last-minute deals, so 27 hours and 59 minutes from now, we will get something done."

Basu adds that the temporary deal will likely focus on tax rates going up for those earning either $250,000 and above or $400,000 and above a year, which Republicans have been reluctant to agree to.

(Read more: In Obama's Plan to Tax Rich, $250,000 Figure May Mislead)

But we will see some compromise from the Democrats in terms of spending cuts. This will at least buy both sides some time to then negotiate a more comprehensive deal in January and February, he said.

Until a full agreement is reached, markets will remain volatile, as indicated by in the Chicago Board Options Exchange's Volatility Index, or VIX, a widely used measure of market risk.

The so-called fear gauge or VIX jumped to its highest level since mid-June last Friday.

Most investors are not hopeful that a full deal can be reached by December 31, said Ray Attrill, co-head of forex strategy with National Australia Bank in Sydney.

"If you look at that jump that we saw in the VIX on Friday, that's certainly the way some people have chosen to position into year end," Attrill said.

"And if we do get a little bit of euphoria that we at least avoided the "fiscal cliff" with some kind of a deal that's patched together over the next couple of days, any rally is going to be very short-lived," he added.