Cliff may be a fear, but debt ceiling is much scarier

Sat Dec 29, 2012 2:47am IST

An elderly man walks past The National Debt Clock, which displays the current United States gross national debt and each American family's share, on a wall in midtown Manhattan, in New York July 13, 2011. REUTERS/Brendan McDermid/Files

An elderly man walks past The National Debt Clock, which displays the current United States gross national debt and each American family's share, on a wall in midtown Manhattan, in New York July 13, 2011.

Credit: Reuters/Brendan McDermid/Files

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REUTERS - Investors fearing a stock market plunge if the U.S. tumbles off the "fiscal cliff" next week may want to relax.

But they should be scared if a few weeks later Washington fails to reach a deal to raise the nation's debt ceiling as that threatens a default, another credit downgrade and a financial markets panic.

Market strategists say that while falling off the cliff for any lengthy period - which would lead to automatic tax hikes and stiff cuts in government spending - would badly dent both consumer and business confidence, it would take some time for the U.S. economy to slide into recession. In the meantime, there would be plenty of chances for lawmakers to make amends by reversing some of the effects.

That has been reflected in a U.S. stock market that has still not shown signs of melting down. Instead, it has drifted lower and gotten more volatile.

In some ways, that has let Washington off the hook. In the past a plunge in stock prices forced the hand of Congress, such as in the middle of the financial crisis in 2008.

"If this thing continues for a bit longer and the result is you get a U.S. debt downgrade ... the risk is not that you lose two and half percent, the risk is that you lose ten and a half," said Jonathan Golub, chief U.S. equity strategist at UBS Equity Research in New York.

U.S. Treasury Secretary Tim Geithner said this week that the United States will technically reach its debt limit at the end of the year.

The White House has said it will not negotiate the debt ceiling as in 2011, when the fight over what was once a procedural matter preceded the first-ever downgrade of the U.S. credit rating, but it may be forced into such a battle again. A repeat of that war is most worrisome for markets.

Markets posted several days of sharp losses in the period surrounding the debt ceiling fight in 2011. Even after a bill to increase the ceiling passed, stocks plunged in what was seen as a vote of no confidence in Washington's ability to function, given how close lawmakers came to a default.

Credit ratings agency Standard & Poor's lowered the U.S. sovereign rating to double-A-plus, citing Washington's legislative problems as one reason for the downgrade. The benchmark S&P 500 dropped 16 percent in a four-week period ending August 21, 2011.

"I think there will be a tremendous fight between Democrats and Republicans about the debt ceiling," said Jon Najarian, a co-founder of online brokerage TradeMonster.com in Chicago.

"I think that is the biggest risk to the downside in January for the market and the U.S. economy."

There are some signs in the options market that investors are starting to eye the January period with more wariness. The CBOE Volatility Index .VIX, or the VIX, the market's favored anxiety indicator, has remained at relatively low levels throughout this process, though on Thursday it edged above 20 for the first time since July.

More notable is the action in VIX futures markets, which shows a sharper increase in expected volatility in January than in later-dated contracts. January VIX futures are up nearly 23 percent in the last seven trading days, compared with a 13 percent increase in March futures and an 8 percent increase in May futures. That's a sign of increasing near-term worry among market participants.

Consumers don't appear at all traumatized by the fiscal cliff talks, as yet. Helping to bolster consumer confidence has been a continued recovery in the housing market and growth in the labor market, albeit slow.

The latest employment take will be out next Friday, and the Labor Department is expected to show jobs growth of 145,000 for December, in line with recent growth.

Consumers will see their paychecks affected if lawmakers cannot broker a deal and tax rates rise, but the effect on spending is likely to be gradual.

President Barack Obama was this afternoon meeting congressional leaders from both parties for discussions about the fiscal cliff, and the House of Representatives is set to convene Sunday and continue working through the New Year. Obama has proposed maintaining current tax rates for all but the highest earners.

PLAYING DEFENSE

Options strategists have noted an increase in positions to guard against weakness in defense stocks such as General Dynamics (GD.N), as those stocks would be affected by spending cuts set for that sector. Notably, though, the PHLX Defense Index .DFX is less than 1 percent away from an all-time high reached December 20.

This underscores the view taken by most investors and strategists: One way or another, Washington will come to an agreement to offset some effects of the cliff. The result will not be entirely satisfying, but it will be enough to satisfy investors.

"Expectations are pretty low at this point and yet the equity market hasn't reacted," said Carmine Grigoli, chief U.S. investment strategist at Mizuho Securities USA. "You're not going to see the markets react to anything with more than a 5 to 7 percent correction."

Save for a brief 3.6 percent drop in equity futures late on Thursday evening last week after House Speaker John Boehner had to cancel a scheduled vote on a tax-hike bill due to lack of Republican support, markets have not shown the same kind of volatility as in 2008 or 2011.

A gradual decline remains possible, Golub said, if business and consumer confidence continues to take a hit on the back of fiscal cliff worries. The Conference Board's measure of consumer confidence fell sharply in December, a drop blamed in part on the fiscal issues.

"If Congress came out and said that everything is off the table, yeah, that would be a short-term shock to the market, but that's not likely," said Richard Weiss, a Mountain View, California-based senior money manager at American Century Investments.

"Things will be resolved, just maybe not on a good time table. All else being equal, we see any further decline as a buying opportunity." (Reporting By Edward Krudy and Ryan Vlastelica in New York and Doris Frankel in Chicago; Writing by David Gaffen; Editing by Martin Howell and Steve Orlofsky)

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