Wall St clings to hopes for budget deal, but market risks rising

NEW YORK Fri Dec 21, 2012 3:20pm EST

NEW YORK (Reuters) - If the United States sails over the fiscal cliff in less than two weeks, it probably will not mean disaster for the stock market, investors said on Friday, but the margin for error is getting dangerously thin.

At heart are fears over how long the U.S. economy, the world's largest, can hold up under the brunt of higher taxes and big spending cuts that would be triggered by the fiscal cliff.

If Washington's inability to reach a deficit-reduction deal persists into late January or provokes a second credit ratings agency to strip the United States of its top triple-A rating, all bets may be off.

"Clearly, if this thing drags on with no deal, eventually markets are going to start to take it on the chin," said Sandy Lincoln, chief market strategist at BMO Asset Management in Chicago, which oversees $38 billion.

Stock markets fell on Friday after a Republican proposal that would have prevented tax increases on all but those earning more than $1 million unraveled amid a conservative backlash.

Though President Barack Obama had vowed to veto the bill, opposition from Republicans stoked doubt about the ability of House of Representatives Speaker John Boehner to win support within his party. That suggested the two sides were too far apart to reach a deal to forestall the $600 billion in automatic tax hikes and spending cuts before they are set to begin to take effect in January.

"The fact they couldn't even get the Republicans in Congress to sign on for that is disturbing. If we get into late January, early February and we are still in the soup, then the odds of going into a recession go up, and I just can't believe anybody wants that," said Jeffrey Saut, chief investment strategist at Raymond Jones Financial.

HEATING UP

If the new year dawns without a deal, Jack Ablin, chief investment officer at BMO Private Bank, said he would view "any incremental market sell-off as a buying opportunity."

But if things remain in limbo in February, "that is going to leave a mark on the economy," he said. "The way I'd characterize it is that we're sitting in this pot of water and on January 1, Congress turns on the flame underneath. It's comfortable at first, but eventually it's going to start to hurt."

Americans would start to feel the effects in their wallets. As of 2013, payroll taxes would revert to 6.2 percent of Americans' paychecks, up from the 4.2 percent level put in place during the economic downturn.

Higher income tax rates would also start to hit, though that could be delayed by officials in Washington. Still, Americans would start to feel a pinch on their paychecks, which could hurt spending next year. Some investors believe holiday sales are already being affected.

Another risk, said BNY Mellon currency strategist Michael Woolfolk, would be if a second ratings agency cuts the United States' AAA rating, a move that Standard & Poor's made after a similar budget standoff in 2011.

Fitch Ratings said this week it would be more likely to downgrade the United States if the economy goes over the cliff.

"Markets would take that very badly," Woolfolk said. "Stocks sold off by 10 percent after the S&P downgrade in 2011, and I'd expect something at least as severe" if Fitch were to act.

LAST-MINUTE DEAL STILL POSSIBLE

Of course, lawmakers still have 10 days left in 2012 to strike a deal, and some are confident they will return to Capitol Hill after Christmas and do just that.

"So far, the market has been handling setbacks in talks very well, and with a bit of time left on the clock, this time will be no different," said Jim Barnes, senior fixed income manager at National Penn Investors Trust Co.

For some, the political disarray among Congressional Republicans that sent Boehner's "Plan B" to defeat late on Thursday only increased those hopes.

"Given that Reid called Plan B 'dead on arrival' and Obama said he would veto it, the non-passage of this bill due to lack of Republican support makes it more likely, not less likely, that compromise will be reached," said Jeffrey Gundlach, chief executive officer and chief investment officer of DoubleLine Capital, which oversees more than $50 billion.

Harry Reid is the Democratic Senate leader.

The "continued positioning and posturing" isn't a huge concern to investors, Woolfolk said. "Neither side has incentive to compromise too much, too soon. They can extract concessions by delaying. So I would not be surprised if it takes until minutes before midnight on December 31."

All the back-and-forth, however, may keep the stock market a bit more volatile than it would normally be so late in the year.

The benchmark S&P 500 .SPX has gained or lost more than 1 percent in three of the past five trading sessions, while the CBOE Volatility Index .VIX has climbed more than 20 percent over the past three days.

In a sign of the type of volatility investors may be confronted with, S&P 500 E-Mini futures fell as much as 3.6 percent in after-hours trading Thursday evening, with a 15-point drop in less than one second that resulted in a brief halt in futures trading.

"While last night's mini-crash is a rare event, I do expect bigger moves than we've seen in the past year," said Enis Taner, global macro editor at RiskReversal.com, an options trading firm based in New York.

(Additional reporting by Chuck Mikolajczak, David Gaffen, Richard Leong and Jennifer Ablan; editing by Leslie Adler)

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