By Ryan
Vlastelica and Edward Krudy and Doris Frankel
Dec 30 (Reuters) -
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 New York.
U.S. Treasury
Secretary Timothy Geithner said the United States will technically reach its
debt limit at the end of the year.?
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 market participants.
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 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.??
PLAYING
DEFENSE
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 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, 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 Investments.
"Things will be resolved, just
maybe not on a good timetable. All else being equal, we see any further decline
as a buying opportunity."?
(Wall St Week Ahead runs every Sunday.
Questions or comments on this column can be emailed to:
david.gaffen(at)thomsonreuters.com)?
(Reporting by Edward Krudy and
Ryan Vlastelica in New York and Doris Frankel in Chicago; Writing by David
Gaffen; Editing by Martin Howell, Steve Orlofsky, Jan Paschal and Maureen
Bavdek)
? 2011 Reuters
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