Despite daily warnings about the effects of the fiscal cliff -- tax increases and budget cuts that could cripple the economy -- the markets seem supremely convinced that all will be fixed before the Dec. 31 deadline.
"The markets are assuming that a deal is still likely to save the day," says Alec Young, international analyst for Standard & Poor's. "If they thought nothing would be done, the markets would sell off badly."
But if you look closely enough, you start to see the markets' calm facade starting to crumble. While most analysts say they're convinced Congress will avert causing another recession, every day brings growing uncertainty. Just how long Congress can drag out the talks before a big sell-off in stocks and commodities is the big unknown.
At first glance, the financial markets seem exceptionally calm, given the potentially calamitous fallout from the so-called fiscal cliff. Since the Nov. 6 elections, the Standard & Poor's 500 has fallen 1 percent. Treasury yields have barely budged. Even gold is up less than $10 an ounce.
The markets seem to have, at least at the moment, a deep and abiding faith that Congress will work things out. "People believe that there's already a secret deal that will be put through at the 11th hour," says Jeffrey Gundlach, portfolio manager and CEO at DoubleLine, a Los Angeles bond management firm. The current buzz is that Republicans and Democrats will agree to raising taxes by half the amount the president has proposed.
Exactly why the markets believe this is puzzling. House Speaker John Boehner, R-Ohio, at a press conference Friday, said, "This isn't a progress report because there's no progress to report."
One reason markets remain confident: Investors don't want to miss a potentially huge rally if Congress and the president come to an agreement and avoid falling off the cliff. Absent the fiscal cliff, the stock market looks reasonably good: Corporate profits are high, company balance sheets are solid and consumers have an enormous amount of pent-up demand.
Another reason: "For now, the markets aren't that worried about the fiscal cliff debate, because they have had bigger fish to fry," says Rob Haworth, senior investment strategist for U.S. Bank Wealth Management. One example is the November employment report, which showed the unemployment rate falling to 7.7 percent from 7.9 percent in October. And signs of a turnaround in China, for example, have kept the stock market's spirits relatively high.
A Wile E. Coyote moment?
Should the financial markets have a Wile E. Coyote moment -- the point when the hapless predator realizes he has walked off a cliff -- they, too, could plummet. Consider what happened when Congress balked at raising the debt limit in 2011. The S&P 500 plunged 16 percent in 11 trading days, culminating in a 6.7 percent decline after Standard & Poor's downgraded the nation's credit rating for the first time on Aug. 5, 2011.
And there are a few signs of cracks appearing. "We're starting to see a more volatile trading pattern indicative of investor nervousness," says Jim Russell, senior equity strategist for U.S. Bank Wealth Management. For example:
The VIX, the so-called fear index of volatility, tends to rise when politicians make announcements about the fiscal cliff, Russell says. The VIX soared during the debt-limit debate in 2011.
Utilities stocks have lagged. Investors prize electric utilities stocks because they pay higher dividends than most other members of the S&P 500. But those dividends will be taxed at ordinary income tax rates if Congress doesn't renew the George W. Bush-era tax cuts. The Dow Jones utility average has fallen nearly 5.5 percent since Oct. 31, while the S&P 500 has been virtually flat .
International stocks have started to outperform U.S. stocks. "For the past two and a half years, the U.S. has been the safe port in the storm," says Russ Koesterich, global chief investment strategist for asset manager BlackRock. "Now the source of risk is the United States."
But stocks aren't the only market starting to tremble. In the commodity markets, oil prices have started to weaken, in part because of fears of weakened demand if the U.S. falls into a recession. The spot price of a barrel of West Texas Intermediate crude oil has fallen from $99 a barrel on Sept. 14 to about $86 now. Although some of that fall stems from increased supply -- the U.S. is now the fastest-growing non-OPEC oil producer -- some also stems from fears of an economic slowdown.
Other commodities are starting to show strain, too. Among the worst-performing S&P 500 sectors, for example: steel producers, down 4.5 percent the past three months. The S&P 500 diversified metals and mining index has plunged 17.5 percent.
Gold has rallied modestly in recent weeks but still remains well below its October highs. Gold's vacillation is partly because you can argue that gold will either rise or fall if the U.S. steps off the fiscal cliff. A recession tends to be deflationary -- bad news for the ultimate inflation hedge. But the Fed will have to step up its efforts to keep the economy going, and that could be inflationary in the long run.
Only the bond market shows little sign of wavering, and that, in part, is because Treasury bonds would benefit from a sharp contraction in the economy. In a big downturn, Treasuries are the ultimate haven in troubled times. Investors push Treasury prices up -- and yields down.
If Congress doesn't sort out the fiscal cliff by Dec. 31, investors will have precious few havens. Even Treasury securities are suspect, because a fiscal cliff debacle could result in the nation's credit rating getting downgraded again. Although the Treasury market shrugged off the last downgrade, it may not do so for the next.
'It's not like dodge ball'
S&P's Young offers two areas that might not get hit as badly as the rest of the market, although he cautions that all areas are vulnerable: "It's not like dodge ball," he says.
Health care. Everyone needs health care. S&P is predicting 10.1 percent earnings growth for the S&P 500 in 2013, assuming Congress doesn't push the market over the cliff. Young says the health care industry should weigh in at about 5.9 percent earnings growth. But the sector is cheap and predictable, and it might not get hurt as badly as others in a downturn.
Consumer discretionary. If you've been lusting after a new car, new clothes, or a few dinners out, you know that there's lots of pent-up consumer demand. Companies that cater to those whims should grow earnings about 15 percent next year, Young estimates. He likes the sector, even though it's pricey: "It's not cheap, but it's got the growth to justify it."
Koesterich thinks high-quality tax-free municipal bonds could also be a haven: Their interest is generally free from federal income taxes. A 10-year muni yields about 1.4 percent.
As the Dec. 31 deadline approaches, you can expect the market to get more skittish. While the markets represent the collective wisdom of its participants, it can also be dead wrong. After all, analysts widely attributed the stock market's run-up in October to the growing belief that Mitt Romney would win the presidential election.
And the fiscal cliff is not a single piece of crafted legislation that can simply be passed by a voice vote. Fixing the cliff would require amendments to five major bills, including the Affordable Care Act and the Budget Control Act of 2010.
Gundlach, for one, is skeptical that the U.S. will avoid the cliff. "I don't know if they can make a deal or not -- the story hasn't changed a tick from day to day," Gundlach says.
Perhaps the best to be hoped for is a few quick patches for the worst parts of the fiscal cliff -- the Alternative Minimum Tax, for example -- and an agreement for a more thoughtful discussion after the first of the year. "We can hope that cooler heads get locked in a room with no smoke, no mirrors, and that they find a way to credibly put the country on a path to lower debt over time," says U.S. Bank's Russell.
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