While there are other issues investors are grappling with—such as increasing tensions in the Middle East, meager prospects for earnings growth, and the return to recession in Europe after only three short years of growth—the one most heavily weighing on the minds of investors is the U.S.’s fiscal cliff.
The existence of the fiscal cliff is nothing new. We have long expected that a status quo election outcome would result in a deal on the 2013 budget bombshell package of tax increases and spending cuts known as the fiscal cliff in the last weeks of the year.
However, we also expect prospects will darken before a deal finally emerges. The lame duck session began last week (November 11-17), and both sides have offered to negotiate, but we think this duck turns ugly before a deal finally emerges as a swan song.
There is no doubt the fiscal cliff is causing investors grief with the stock market, measured by the S&P 500, having slid by over 7% since the year’s high in mid-September.
That grief is unlikely to end soon. It is generally accepted that the five stages of grief are: Denial, Anger, Bargaining, Depression, and Acceptance.
The Five Stages of Grief
1) Denial. While we have been writing about the fiscal cliff all year, markets have only recently begun to make progress in recognizing the threat.
For example, online searches for "fiscal cliff" on Google have spiked in the last two weeks [Figure 1]. After a long period of denial, markets are now beginning to come to terms with the risks posed by the cliff.
2) Anger. Investors shifted to stage two a few weeks ago and are expressing it by selling, as U.S. stock mutual funds have experienced the largest monthly outflows of the year in the past two months, according to Investment Company Institute. At the same time, the stock market has seen its gain for the year cut in half over the same time period.
3) Bargaining. Stage three is just getting underway. Key meetings took place in Washington last week. Both sides agree that there is a problem and, in particular, House Speaker Boehner's comment after his meeting with President Obama indicated a willingness to negotiate and was viewed positively. But the real discussions will not get underway until after Thanksgiving, which sets the markets up for stage four.
4) Depression. It is likely to be darkest before the dawn as a winding and contentious path to a deal emerges late in December or even early January, taking investors to stage five.
5) Acceptance. No one loves the compromise, but everyone can live with it.
How substantive the deal is will be important to the market reaction. A smaller, short-term deal that merely kicks the can down the road by several months will undermine any confidence that a deal will ultimately be reached. It could lead to ratings agency downgrades of U.S. debt in the first quarter of 2013, along with problems as we reach the federal debt ceiling again in the coming months and with the continuing resolution funding the government that runs out at the end of the first quarter.
However, a large, long-term solution would be bullish for equities and the economy because it would take a substantial first step toward fiscal sustainability. It would greatly reduce the risk of a crisis at some point, which is almost inevitable, given how quickly the U.S. is accumulating debt on an annual basis. It would provide long-term clarity on taxes, spending, and likely eliminate annual fights over the debt ceiling or fiscal cliffs for at least the next few years.
To the extent that these risks and uncertainties are causing businesses and consumers to stay on the sidelines, these headwinds to economic growth would be lifted, more than offsetting any fiscal drag.
In the meantime, a defensive stance may be warranted with some cash in portfolios to sidestep the volatility and enable buying the bargains that may emerge in areas like technology and homebuilders.
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