Fiscal Cliff? Why Markets Haven't Priced In Disaster—Yet

The stock market hasn’t priced in the end of the world this December, and it’s not pricing in the “fiscal cliff.”

That’s because most investors don’t believe either will happen.

Fiscal Cliff
Steve McAlister | Photodisc | Getty Images
Fiscal Cliff

While economists say the fiscal cliff (Learn More) has already created a drag on the economy, the impact on the stock market is less certain, and the outcome is about as predictable as the behavior of Congress.

“Most people have a relatively benign view of the risks involving the fiscal cliff, and the idea that it’s going to be addressed in the lame duck session of Congress,” says Goldman Sachs U.S. equity strategist David Kostin. “Some people have that view, and that’s a pretty optimistic view. Experience might suggest that politicians are not in the mood to coming to resolutions necessarily.”

The Mayan calendar predicts an end to the world on Dec. 21, and the U.S. reaches the so-called fiscal cliff on Jan. 1. That's when Bush-era tax cuts expire and automatic spending cuts go into effect if Congress does not act to stop them.

The severe spending cuts, agreed as part of the debt ceiling (Learn More) compromise, slice across federal agencies but disproportionately bite into the defense budget.

Kostin, speaking on “Squawk on the Street” this week, said there’s justified concern that Congress might act much like it did during the debt ceiling debate last year. (Watch the video)

“You saw the experience last year. Ten days, market fell 10 percent around the whole issue of the debt ceiling and negotiations,” he said. (Read More: Goldman Says Dump Stocks Before Fiscal Cliff)

But other analysts say investors expect more from Congress this time and they doubt it will let $500 billion in tax increases and spending cuts barrel into an already weak economy.

“I think the consensus is we don’t hit the whole fiscal cliff, and in that respect it is priced in,” said Bill Stone, chief investment strategist with PNC Wealth Management. “I think you can find enough places where there is enough agreement, and once the election goes by, whoever is in charge can get it done. The danger is people are worrying that there’s a chance the market does get more nervous about it. This leaves all of us with a little shudder (after) last year’s debacle with the debt ceiling.”

The fate of the fiscal cliff is unlikely to be resolved in any way prior to the election.

“The fiscal cliff is something that will affect us in fewer than six months, could have a devastating impact. A lot of people believe cooler minds will prevail but the fiscal cliff could have a swifter and more devastating impact. You pretty much will have an idea as to whether this will happen right after the election,” said Sam Stovall, chief equity analyst with S&P Capital IQ.

There is as much speculation about the fiscal cliff as there is about the outcome of the election.

If President Obama were to be re-elected but the Republicans win a majority in the Senate, his post-election behavior might be very different than if Democrats remain in control. There is also a view it will be much easier for compromise to be reached on taxes than on spending cuts.

Mesirow Financial chief economist Diane Swonk said the impact on the economy may have already been felt in the second quarter, as companies slowed down investment and became more cautious.

“I’ve talked to several CEOs in the Midwest who just assume we’re going off the cliff regardless of who wins,” she said.

Stovall said there are scenarios where the uncertainty could remain into the new year, which would be negative for markets.

“Technically, you could say even if Romney were to get in, and both houses of Congress were to be Republican, they’re not going to be in charge until January of next year. The current make up of Congress could say we’re going to let you worry about that next year and we’re going to fall off the cliff anyway,” he said.

There’s been some speculation that if Republican presidential candidate Mitt Romney wins, he could push extension of the Bush tax cuts for everyone post Jan. 1, and make any changes retroactively. (Read More: How Much Will It Cost You If Bush Tax Cuts End? A Lot)

The Obama administration, meanwhile, is adamant about reinstating higher tax rates for wealthy Americans. If there is a compromise on taxes, and Bush tax cuts are extended before the end of the year, it would stop the biggest immediate hit to the economy. But that would leave the thorny budget issues for the new year.

"It's not going to save the stock market, but it could save the economy,” Stovall said.

“There’s one scenario people are talking about. The Republicans win, and they don’t want to compromise. There’s no way that’s going to happen,” said Daniel Clifton, head of policy research at Strategas. He said both parties will recognize the political gravity of not acting.

Another scenario may be that should the Republicans sweep, taking the White House and Senate, they could make clear to rating agencies that they have a mandate, but they need more time to make major changes.

The Congressional Budget Office this week warned that the U.S. could fall back into recessionduring the first half of 2013, if Congress fails to act on the tax increases and spending cuts.

The “fiscal cliff” would drive unemployment back up to 9.1 by the end of the year and economic progress would stop, it said. The CBO previously forecast that inaction by Congress would trigger a mild recession for the first half of 2013, but now it sees contraction of 2.9 percent in GDP.

“Our base case is we’re probably going to get a fiscal drag of 1 percent of GDP but that’s telling you not all the provisions are going to make it through,” said Clifton.

Clifton said interest in the cliff among investors is high but the uncertainty makes it difficult to invest around it.

“The election is going to have an outsized impact on what provisions do make it through or not. There’s a very high interest, but there’s very little interest to act on it. You have more immediate things. You have QE. You have Europe,” he said. “You’re not going to be able to fully handicap the fiscal cliff until you get through the election. If Obama wins, there’s a higher probability that Bush tax cuts are reinstated for upper income.”

Clifton said the stock market could also feel the impact if investors believe capital gains taxes will go up. There is already an increase of 3.8 percent increase for high income individuals, which goes into effect on capital gains and certain other type of income Jan. 1, as part of the new health care law. The Obama Administration would like the capital gains rate to rise to 20 percent from 15 percent.

“It’s a 63 percent increase in the capital gains tax rate. On a real financial equity market impact, you’re lowering the after-tax rate of return on equities and that means, all else being equal, the stock market goes lower,” he said. Clifton said when the capital gains tax rate was raised to 28 percent from 20 percent in the late 1980s, there was “a rush out the door.” In the last three months of 1986, investors realized capital gains at 8 percent of GDP, a number that is more normally 2 percent, he said.

Clifton does not anticipate knowing which way it will go until the beginning of December, and then Congress has three weeks to get it done.

“Once you get into the lame duck session, it gets very serious,” Clifton said. For instance, Congress will need to act or the Alternative Minimum Tax(AMT) (Learn More) will impact many millions more tax payers. Internal Revenue Service Oversight Board chairman Paul Cherecwich warned in an interview last week that if Congress misses the Dec. 31 deadline to extend expired tax provisions there will be a domino effect including delays in the start of the tax filing season and a delay in sending refund checks.

“They only act when the gun is at their head,” he said. If Obama wins, he may want to deal with the existing Congress on the debt ceiling extension, which comes back for a vote March 1. Because of that, he may fold on some of his opposition to tax extensions for the wealthy, Clifton said.

The toughest task for Congress will be making changes in the budget to stop the automatic, or “sequestered” cuts. “ “Defense is 20 percent of total federal spending. They are 50 percent of all the sequestered cuts,” Clifton said.

“Fifty percent of cuts are non-defense. They will hit the Department of Agriculture, the Department of Education, all across the government. We are going to have to fire federal employees. Nobody wants the sequester to go into effect.”

If Congress waits until after the election, it will have just several weeks to get the cuts done, but each party already has a framework. Odds of a resolution of the sequester before year end are about 55 percent, says Clifton. “It’s really a reflection of what Congress looks like,” he said.

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