How Wall Street Hopes to Profit From the 'Fiscal Cliff'

US News

If you're not paying much attention to the approaching "fiscal cliff," you probably will before long -- like when Congress is poised to cause a fresh recession virtually overnight.

There's a widespread expectation that Republicans and Democrats will somehow strike a deal to avert the huge set of spending cuts and tax hikes scheduled to go into effect at the beginning of 2013. Once this year's elections are over, such thinking goes, Washington politicians will actually do their jobs and begin to deal with the $16 trillion national debt, while also nursing along the sickly economy. But that might be naïve. "Washington insiders are sure political dysfunction will push the nation off the fiscal cliff," investing firm BlackRock explained in a recent report. There's method to the madness, at least in the convoluted logic of American politics. A deal to get Uncle Sam's finances back on track will require compromise from both Democrats and Republicans. And neither side is likely to give up cherished priorities unless a crisis forces them. So Congress must threaten to wreck the economy in order to save it.

Many investors remain blasé about the possible turmoil. Most economists, for instance, predict moderate economic growth in 2013, even though the coming spending cuts and tax hikes would lop about 5 percent off of GDP if they fully go into effect. And the stock market has been rising steadily this year, with some analysts predicting it will hit new highs over the next 12 months.

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Yet Wall Street firms are now beginning to game out the consequences if Washington torpedoes the economy. Current expectations that everything will work out could set the stage for an ugly stock-market rout if there's no deal by the end of the year, which would mean a sharp hike in taxes for most Americans along with steep cuts in government spending. But that in itself might be a chance to buy stocks at fire-sale prices. "Any market weakness late in the year would present a buying opportunity," BlackRock advises. That's because a stock-market plunge could be the very thing that forces legislators back to the table to hammer out a deal.

There's precedent for that sort of volatile dance between Wall Street and Washington. After the collapse of Lehman Brothers in the fall of 2008, Congress rejected the first round of bank-bailout legislation. Stocks promptly fell by 9 percent, changing a lot of minds on Capitol Hill. Congress signed a slightly revised version of the bailout bill a few days later.

The fiscal cliff will probably take longer to play out. If there is a bipartisan deal on revamping tax and spending policy, it won't happen until the next Congress is seated in January, and even then it would probably take months, if not years, to negotiate the details. A wobbly stock market could test investor fortitude for the better part of 2013. But those willing to hold on and ride out the dips could enjoy handsome gains if Washington finally sets a stable, predictable course for the government's finances -- something many CEOs and economists say is necessary for the U.S. economy to truly flourish.

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There are other wild cards likely to represent both risks and opportunities. If Washington simply puts off the tax and spending decisions coming due, it might mean a temporary respite for the economy -- but it could also trigger another downgrade in the U.S. credit rating, which rating agencies such as Moody's have basically promised. When the first downgrade occurred in 2011 -- following the brinksmanship over raising the U.S. borrowing limit--stocks fell by 7 percent in one day and took nearly five months to regain prior levels. Some analysts think the consequences of another downgrade would be less severe (been there, done that) while others think recurring downgrades could eventually raise Washington's borrowing costs, which would be a much uglier scenario.

Another pucker moment could occur in early 2013 when it's time to raise the government's borrowing limit yet again. Without a long-term plan to trim spending, there's no way around the need to borrow more. Yet it could be just as contentious as last time, especially if both sides view the debt limit as a bargaining chip in broader negotiations over tax and spending policy. Again, stocks could wobble or plunge, unnerving skittish investors.

Trying to exploit political developments for financial gain over the next year or so will require more than steely nerves. Investors, first of all, need to decide whether they think Washington will sink or save the economy in the end. Even if there's an ultimate deal that cuts spending to more reasonable levels and brings down the national debt, it could still harm the economy enough in the short term to make the overall problem worse instead of better.

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The Federal Reserve is another factor, since it could implement new types of monetary stimulus meant to offset the pain of fiscal austerity. Yet the Fed is already relying on unconventional tools and may be out of tricks.

Then there are other things that could flare up, exacerbating any economic problems originating in Washington. Europe is a continual worry and could still endure some sort of financial contagion. Tensions over Iran's nuclear program could culminate in a military confrontation, causing an oil spike. Or China could succumb to a severe slowdown. Washington politics may dominate the markets in 2013, but there will be plenty of competition for turmoil.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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