Dancing on the edge of a (fiscal) cliff

May 2, 2012

With hundreds of billions worth of stimulus measures set to expire on Jan. 1, investors are all too aware that the United States is hurtling toward what economists are calling “a fiscal cliff.” It’s just that most seem to think Congress will execute one of its typical last-minute, hairpin turns to avoid plunging the economy over the edge.

As Russ Koesterich, global chief investment strategist at iShares told Reuters recently, “people are worried but they feel some sort of fix will get done.” Certainly the equity and bond markets back him up: the S&P 500 is up a healthy 12.7 percent this year while benchmark 10-year Treasury yields remain pinned beneath 2 percent.

Ethan Harris at Bank of America-Merrill Lynch isn’t so sure. After all, we’re talking about the same group of politicians who nearly forced the United States to default last year and earned it a credit downgrade from S&P in the process. This time, Republicans and Democrats will have just seven weeks to stitch up a deal, and they’ll have to do it while the wounds inflicted by a brutally negative a presidential election campaign are still fresh.

At stake are about $240 billion in income, capital gains, dividend and estate tax cuts – the Bush tax cuts – that are scheduled to expire on Jan. 1, along with Obama’s $90 billion payroll tax cut. Also set to start next year will be the first round of a 10-year diet of automatic spending cuts totaling $1.2 trillion. These were triggered when a Congressional committee failed last year to agree on a long-term deficit reduction plan.

Harris is warning clients to prepare for the worst:

Absent new legislation, fiscal policy will tighten by more than 4 percent of GDP. Even if just half of the threatened tightening occurs, it would be a major shock to growth.

Financial markets may not even have to wait until 2013 to feel the sting. As Harris puts it:

Faced with the risk of a recession-sized fiscal tightening, we expect the markets, businesses and households to pull back as we approach year end. Many “lumpy” big commitments such as car and house purchases and business expansion plans are likely to be delayed until the outcome is clear. The ‘fiscal fog’ will likely hurt growth well before the ‘fiscal cliff.’


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