Why 'Fiscal Cliff' May Be Bigger Threat Than Europe

Many investors have been focusing on the current financial crisis going on in the euro zone that many of them fail to notice the problems going on right here in the United States. Trillions of dollars in automatic tax increases and spending cuts are on the horizon towards the year-end that many investors are overlooking.

By: Jeff Cox
Published: Friday, 8 Jun 2012
CNBC

Investors have been so worried over what to do about the rapidly moving European debt crisis that many of them probably have overlooked the political mess in Washington and looming "fiscal cliff" at year-end.

While troubles in Greece and throughout the euro zone have dominated headlines and driven market behavior, the idea that trillions of dollars in automatic tax increases and spending cuts are on the horizon has generated comparatively little chatter.

That's a dangerous position to be in for a market that has been so volatile and grasping for direction.

"It is unlikely that the cliff is fully priced into the markets," said Ethan S. Harris, North American economist for Bank of America Merrill Lynch. "The economic consensus and markets have recognized the fiscal cliff for some time, but are only beginning to understand the size and timing of the shock to the economy."

Harris recently prepared a lengthy analysis of the effects from the fiscal cliff — a term coined by Federal Reserve Chairman Ben Bernanke to describe the automatic financial triggers that will go into place if Congress does not come to a deficit-reduction agreement before the end of the year.

The picture is decidedly unpretty, with the Harris analysis amping up on earlier economist projections over how much damage the fiscal cliff triggers would impose on an already languishing U.S. economy.

Whereas the consensus has been for a drag of about $500 billion or 3.8 percent of gross domestic product, Harris said the actual total is closer to $720 billion, or 4.6 percent of GDP.

The areas of the economy likely to suffer the most damage are the most vulnerable — capital spending, home and auto sales and employment, which has slowed considerably over the past three months after strong wintertime gains.

"The cliff is likely to hurt growth this year as much as next year," Harris said. "By risking a recession-sized fiscal contraction and then offering no guidance to how it will be resolved, politicians are creating a major uncertainty shock."

In remarks to a Senate panel Thursday, Bernanke was sure to mention the dangers of inaction by Washington both on the fiscal cliff and policy in general, which he said risked both neglecting deficit reduction as well as promoting growth.

"Uncertainty about the resolution of these fiscal issues could itself undermine business and household confidence.," the central bank chair said. "Fortunately, avoiding the fiscal cliff and achieving long-term fiscal sustainability are fully compatible and mutually reinforcing objectives."

Ratings service Fitch also jumped in, repeating its warning that it would cut the U.S. debt rating if Congress doesn't resolve its various budgetary problems. Fitch analyst Ed Parker said the U.S. is the only one of four AAA-rated countries that "does not have a credible fiscal consolidation plan."

Yet investment pros have talked little about the danger the fiscal cliff poses to the stock market, with most research focusing on the economic reports of the day, bond and commodity prices and, of course, the damage that a breakdown of the euro zone will bring to the global economy.

"The market is reacting to whatever the market presents itself with on any given day," said Quincy Krosby, chief market strategist at Prudential Annuities in Newark, N.J. "Bernanke cares (about the cliff), serious economists care, but they are not the ones who rule the market."

Those who do care about the predicament in Washington seem unwilling to confront a future where Congress, which remains divided on party lines, seems unwilling to agree on even the smallest measures, much less on charting the fiscal future of a slow-growth economy.

Politically, the stakes couldn't be higher.

President Obama and his Republican challenger, former Massachusetts Gov. Mitt Romney, are battling over who has the better economic vision.

Obama, though, is faced with an economy growing at only 1.9 percent and the reality that there are just 100,000 more Americans working than when he took office in January 2009, while there are nearly 700,000 more counted as unemployed. (The statistical discrepancy comes from the surge in those who have left the labor force as well as population changes.)

For the Republicans, though, it will be a dicey gamble that Americans won't blame them as well for letting the George W. Bush-era tax cuts expire, and allowing a menu of other growth-stunting mandatory measures to be implemented unless an agreement is reached.

"When push comes to shove they probably can (work out a deal), but there will be more pushing and shoving to get them to do it," Krosby said. "Maybe this is hope springs eternal, but I don't think any of them wants to be blamed for the consequences of the fiscal cliff."

For investors, meanwhile, attention could turn more acutely to the fiscal cliff after Greek elections later this month and when Germany indicates what concessions it is willing to make to keep the euro zone together.

"The next words out of everyone's mouth will be, 'What about the fiscal cliff?'" said Art Hogan, managing director at Lazard Capital Markets in New York. "Right now, it's running a close second in terms of market participants' concerns. It will take the lead as soon as we get some resolution or some near-term answers from Europe."

From Hogan's view, there is actually a bright side: If the market's overriding view is that Congress won't be able to get anything done, agreement on at least some of the key issues could provide a positive surprise. He said record low yields on the 10-year Treasury and a recent surge in gold buying have shown investors' pessimism regarding the mess in Washington.

Agreement will come, he said, in the form of an extension of the tax cuts before the election, with the most difficult decisions made after voters make their choice for president.

"I have a sense that we're going to address this, that we're not going to drive off a cliff at 100 mph into a double-dip recession," Hogan said. "The market's not prepared for that. That's where the upside risk is in the marketplace."

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