Analysis: As fiscal cliff nears, markets ponder a rougher ride

NEW YORK Sun Sep 30, 2012 10:53am EDT

The dome of the U.S. Capitol is seen in Washington September 25, 2012. REUTERS/Kevin Lamarque

The dome of the U.S. Capitol is seen in Washington September 25, 2012.

Credit: Reuters/Kevin Lamarque

NEW YORK (Reuters) - When it comes to deficit reduction, many investors would rather Congress "kick the can down the road" again than let 2013 start with a blast of fiscal austerity not seen since the Vietnam War.

While hardly optimal, a temporary deal that prevents a plunge over the "fiscal cliff" would stave off recession and buy time for investors to tweak their portfolios.

That's not to say investing won't be challenging in the meantime, as markets wait to see what action the lame duck Congress takes after the November 6 elections to prevent the automatic trigger of $600 billion of tax hikes and spending cuts in January.

"In our minds, the odds of a volatility spike between now and January 1 are going up," said Joseph Balestrino, fixed income strategist at Federated Investment Management, which oversees assets worth $360 billion. "Risk-off will be in vogue for that period of time."

Even so, investors remain confident Congress will avoid plunging off the cliff, an outcome the Congressional Budget Office has warned would trigger "a significant recession" and the loss of about 2 million jobs.

Chatter in Washington suggests a mini-deal that could include a down payment on deficit reduction while delaying most spending cuts and tax hikes is the most likely scenario.

Mohamed El-Erian, co-chief investment officer at PIMCO, the world's biggest bond fund with $1.8 trillion in assets, expects Congress to strike "a mini-bargain" that shrinks GDP by up to 1.5 percent. "That is something the economy can absorb without going into recession," he said.

FEW EXPECT WORST SCENARIO

That's not to say there aren't risks, especially considering U.S. lawmakers' past inability to compromise on fiscal issues.

Gridlock in 2011, when Democrats and Republicans could not agree on a long-term deficit reduction plan, pushed the economy toward a fiscal cliff in the first place.

It provoked Standard & Poor's to strip the United States of its top AAA credit rating, and pushed the CBOE Volatility Index .VIX, Wall Street's favored gauge of investor anxiety, to levels associated with panic in the markets.

A similar scenario - especially during December, when trading is quieter and moves can be exaggerated - would be worse.

David Joy, who as chief investment strategist at Ameriprise Financial helps oversee $655 billion in assets, said waiting until New Year's Eve to strike a deal would spook investors and probably provoke volatile stock market trade, even if an eleventh hour deal were eventually struck.

He recommends investors maintain neutral positioning, especially in stocks, as the uncertainty could easily trim some of the market's gains in the final months of the year. The S&P 500 index is up 14 percent this year and nearly 10 percent since June, while Treasury yields remain within sight of record lows.

The election, by contrast, looks to be less of a concern for investors. Prediction market Intrade suggests a three-in-four chance the November election results in more divided government, with President Barack Obama winning a second term but Republicans in partial or total control of Congress.

Divided government may make the path to a solution more difficult as both sides dig in their heels.

"I think after the election and before Christmas, when discussions might be most polarized and feverish, is the most likely time you'll see doubts in the markets and an extra risk premium demanded to hold U.S. assets," said Alan Wilde, who helps oversee $50 billion at Baring Asset Management.

As Congress has punted on the hard decisions, the numbers have hardly changed: Federal red ink is expected to total more than $1 trillion in 2012 for the fourth straight year.

If the full $600 billion in taxes and spending cuts were to take effect, economists at Credit Suisse said the hit to the U.S. economy would be sharpest in the first quarter of 2013, with a 5 percent decline in annual gross domestic product, and that the U.S. unemployment rate could rise to 10 percent.

Falling off the cliff would also hurt Europe, posing risks for global growth.

If the entire menu of tax hikes and spending cuts were to take effect at once, it would amount to the most severe fiscal tightening since the 1969 tax increase passed to pay for the Vietnam War. This time, the CBO estimates the economy would shrink by 0.5 percent in 2013, with a crushing first-half contraction of 2.9 percent.

In this worst-case scenario, Credit Suisse said investors should take refuge in defensive sectors such as health care, consumer staples and utilities and avoid homebuilders, machinery and energy stocks.

Of course, few are expecting the worst to occur, which has at least some strategists wondering if Wall Street is being too complacent.

"If you had to access the risk, it's that things get more disruptive, because there's such unanimity that the situation will be handled smoothly," added Jim McDonald, chief investment strategist at Northern Trust, which oversees $704 billion.

Balestrino, for example, said the firm has pulled "quite a bit" of money out of investment grade and high yield credit and taken refuge in the mortgage market, which is more attractive thanks to the Federal Reserve's commitment to make open-ended purchases of such debt to keep mortgage rates low.

McDonald, too, warned of higher-than-usual volatility as the deadline approaches. Yet he still thinks the possibility of no deal is remote. "Disrupting existing portfolios for a such low probability circumstance doesn't make sense to us," he said.

RATINGS AGENCIES, GROWTH RISKS

There are risks tied to a short-term, temporary deal as well. Ron Florance, who helps manage assets worth $169 billion at Wells Fargo Private Bank, said it would forestall disaster but wouldn't encourage people to invest or companies to hire.

"Many investors are sitting on the sidelines because they don't know what the tax rates are. If you don't know the rules of the game, you don't walk on the field to play," he said.

"So if they want to promote continued slow, uninspired economic growth, that would be a good way do it."

Balestrino sees another risk: the ratings agencies.

Earlier this month, Moody's said it too could strip the United States of its top credit rating if Congress does not agree to policies that ensure long-term deficit reduction.

"If you're kicking the can again, you're almost assuring a downgrade, and I don't think that would be met as kindly by the bond market this time as it was a year ago," he said.

Treasury yields fell in 2011 when S&P downgraded the United States, though Balestrino said markets were worried at the time that European monetary union was about to collapse, which helped ensure a bid for dollar-denominated U.S. government bonds.

"The timing of any rating action is not directly related to the fiscal cliff. It's whatever policy actions are taken after the election and over the course of 2013," said Steven Hess, Moody's lead sovereign credit analyst on the United States.

Moody's said earlier this month that if budget talks next year fail to produce a plan that lowers the U.S. debt-to-output ratio over time, it would "expect to lower the rating, probably to Aa1.

Higher long-term interest rates could squeeze some fixed income investors and put pressure on a still fragile economy.

"Once you've had two major ratings agencies opine you're not a triple-A credit," Balestrino said, "I think there has to be a cost in the marketplace."

(Additional reporting by Daniel Bases and Luciana Lopez; editing by David Gaffen, Bernard Orr)

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