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Look Out Below – Here Comes the Fiscal Cliff

8 November 2012 in Trading Ideas

Investors fearing fallout from President Obama’s re-election only had to wait until Wednesday, when the Dow tumbled 300 points out of the gate, before finishing with a tidy drop of 313 points.

Rather than a repudiation of the presidential contest winner, however, it appeared that many traders were beginning to fret about What’s Next – namely, the scheduled $600 billion in spending cuts and tax increases due to take effect automatically on New Year’s Day unless Congress and the President agree on changes.

Welcome to the walk toward the “Fiscal Cliff.” 

As the Financial Times reported on Wednesday, both the Congressional Budget Office and the Federal Reserve have warned that the US economy risks a return to recession if lawmakers fail to strike a deal.

Similarly, JPMorgan analyst Michael Cembalest said in a Wednesday report that defusing the cliff would help growth in 2013, and perhaps reignite business capital spending, which has stalled. It also would help avoid a “relapse” in personal consumption, which is growing at a 2% real rate before any fiscal belt-tightening, he added.

Credit rating agency Fitch noted that failing to avoid the fiscal cliff and raise the debt ceiling, in addition to “securing agreement on credible deficit reduction,” would likely result in a debt rating downgrade, according to the FT.

All in all, this presents a pretty bleak consensus of the weeks ahead. But let’s take a timeout for a reality check. For starters, as the FT Alphaville blog points out, there may be limited upside to seeing the Cliff in terms of “will we or won’t we fall off?” The $600 billion of cuts and tax hikes is a package of many items, some of which may be more easily agreed upon.

And, as Slate correspondent Matt Yglesias suggests, there’s no immediate catastrophe from having nothing resolved by Jan. 1. If the two sides play chicken and then pass a middle-class tax cut on Jan. 4, the three days of higher taxes just isn’t going to matter.

Is it cynicism or realism that makes that scenario seem like the inevitable one to play out?

Tags: politics