By Ryan Vlastelica and Edward Krudy and Doris Frankel
Dec 30 Investors fearing a stock market plunge -
if the United States tumbles off the "fiscal cliff" this week -
may want to relax.
But they should be scared if a few weeks later, Washington
fails to reach a deal to increase the nation's debt ceiling
because that raises the threat of a default, another credit
downgrade and a panic in the financial markets.
Market strategists say that while falling off the cliff for
any lengthy period - which would lead to automatic tax increases
and stiff cuts in government spending - would badly hurt 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 become 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
2-1/2 percent, the risk is that you lose 10-1/2," said Jonathan
Golub, chief U.S. equity strategist at UBS Equity Research, in
U.S. Treasury Secretary Timothy Geithner said the United
States will technically reach its debt limit at the end of the
INVESTORS WARY OF JANUARY
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.
Stock 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 had passed, stocks plunged in what
was seen as a vote of "no confidence" in Washington's ability to
function, considering how close lawmakers came to a default.
Credit rating agency Standard & Poor's lowered the U.S.
sovereign rating to "AA-plus," citing Washington's legislative
problems as one reason for the downgrade from "AAA" status. The
benchmark S&P 500 dropped 16 percent in a four-week period
ending Aug. 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, or the VIX, the market's preferred
indicator of anxiety, has remained at relatively low levels
throughout this process, although 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 is a sign of increasing near-term worry among
The CBOE Volatility Index closed on Friday at 22.72, gaining
nearly 17 percent to end at its highest level since June as
details emerged of a meeting on Friday afternoon of President
Barack Obama with Senate and House leaders from both parties
where the president offered proposals similar to those already
rejected by Republicans. Stocks slid in late trading and equity
futures continued that slide after cash markets closed.
"I was stunned Obama didn't have another plan, and that's
absolutely why we sold off," said Mike Shea, a managing partner
and trader at Direct Access Partners LLC, in New York.
Obama offered hope for a last-minute agreement to avoid the
fiscal cliff after a meeting with congressional leaders,
although he scolded Congress for leaving the problem unresolved
until the 11th hour.
"The hour for immediate action is here," he told reporters
at a White House briefing. "I'm modestly optimistic that an
agreement can be achieved."
The U.S. House of Representatives is set to convene on
Sunday and continue working through the New Year's Day holiday.
Obama has proposed maintaining current tax rates for all but
the highest earners.
Consumers do not appear at all traumatized by the fiscal
cliff talks - yet. Helping to bolster consumer confidence has
been a steady recovery in the housing market and growth in the
labor market, albeit slow.
The latest take on employment will be out on Friday, when
the U.S. Labor Department's nonfarm payrolls report is expected
to show jobs growth of 145,000 for December, in line with recent
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.
Options strategists have noted an increase in positions to
guard against weakness in defense stocks such as General
Dynamics because those stocks would be affected by
spending cuts set for that sector. Notably, though, the PHLX
Defense Index is less than 1 percent away from an
all-time high reached on Dec. 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
"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, in New York.
"You're not going to see the markets react to anything with more
than a 5 (percent) to 7 percent correction."
Save for a brief 3.6 percent drop in equity futures late on
the evening of Dec. 20, after House Speaker John Boehner had to
cancel a scheduled vote on a tax-increase 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 keep taking 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
"Things will be resolved, just maybe not on a good
timetable. All else being equal, we see any further decline as a
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