The Markets Don’t Care About the Fiscal Cliff … Should You?

by Daniel Putnam | October 15, 2012 1:10 pm

Rarely has an event with the potential for such an extraordinary negative impact as the “fiscal cliff” been so roundly ignored by the financial markets. Does this present the opportunity for some contrarian thinking, or is the market sending us a message?

First, a brief review. The fiscal cliff is the combination of tax increases and automatic government spending cuts set to go into effect at the end of this year. So far, our leaders in Washington have been unable to come up with a compromise to address the issue, and few experts see one occurring prior to the election or in the lame-duck session that immediately follows. Right now, the consensus prediction is that the two sides won’t come up with a solution until the eleventh hour — an outcome similar to last year’s debt ceiling debacle.

The stakes are high. The Congressional Budget Office has released a series of increasingly dire predictions about the fiscal cliff, the most recent of which called for a 5% hit to GDP growth in 2013 if the full slate of spending cuts and tax increases goes into effect.

Clearly, this would be an event similar to the housing collapse in terms of its economic impact. But so far, the markets are showing no evidence of discounting the possibility that the United States will in fact go over the cliff. The spot CBOE Volatility Index (VIX) closed Friday at 16.17, while the February contract went out at 21.10 — not the type of slope that would indicate traders are looking to hedge the potential for risks around the New Year. Similarly, defense stocks — which would be hit hard if the automatic cuts to defense spending went into effect — have underperformed only slightly of late.

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Is this level of complacency appropriate? This sort of hit to GDP growth would have a catastrophic impact on U.S. stocks and high-yield bonds, and it’s unlikely that international investments would offer a safe haven in the resulting selloff. In addition, dividend-paying stocks would likely lose their safe-haven status[1] since the tax increases would take a bigger bite out investors’ after-tax yields. One of the few asset classes that could be counted on for outperformance would be municipal bonds, which would benefit from rising demand associated with the more oppressive tax structure. U.S. Treasuries also would provide some gains in a flight-to-quality trade.

Reasons for the Complacency

I see three reasons investors have not been reacting to the threat of the fiscal cliff despite its dire implications for the markets:

  1. It’s nearly impossible to handicap the fiscal cliff debate until after the elections, when investors will finally have visibility as to which party has control of Congress, and to what extent. At the time of this writing, odds showed a 92.0% chance that Republicans will control the House but only a 63% chance that Democrats will maintain their current narrow advantage in the Senate. Even then, a lame-duck Congress will be in session until Jan. 3, which further muddies the waters.
  2. The odds that the U.S. will go over the cliff are low. The consensus is that there will be a great deal of blustering, but that the two sides will eventually hammer out an agreement.
  3. Although the imagery of the “cliff” indicates a plunge into the abyss immediately upon the turn of the calendar to 2013, the reality is much less dramatic. The New York Times tackled this issue last week in its article, “Fiscal Cliff May Be Felt Gradually, Analysts Say[2].” The short version: Although the annual impact of the cliff is dramatic, the short-term impact won’t be substantial if Congress fails to act until a few days or weeks after the deadline. In addition, some elements of the cliff are reversible — meaning that Congress could enact solutions retroactively.

Is There a Trade Here?

Now that we’re getting deeper into the fourth quarter, it’s time to question whether the approaching deadline creates the opportunity for a low-probability (but high-reward) trade from the short side. There may be, but it’s probably not as dramatic — or as proximate — as bears would hope.

Keeping in mind that the most likely scenario is a last-minute resolution of the issue, the posturing that will inevitably occur during December could lead to elevated volatility as the year comes to an end. In the five sessions prior to the debt-ceiling deal in July 2011, the S&P 500 fell 3.9% on worries that the two sides wouldn’t come to an agreement. If policymakers again make it that far without an agreement, there may be an opportunity to take advantage of the associated volatility from the short side. Another wrinkle is that the cliff could cause investors to delay their traditional year-end buying, which would set up a huge rally in January once the deal gets done. While it’s still far too early to position for either move, cheap volatility may offer an opportunity to purchase some cheap protection to guard against surprises.

In the meantime, keep an eye on the relative performance of the sectors most likely to be affected, including financials, defense and the iShares Dow Jones Select Dividend Index Fund (NYSE:DVY[3]). If these groups begin to underperform, that’s the strongest sign we’ll have that the fiscal cliff is finally beginning to have an impact on the market.

  1. lose their safe-haven status:
  2. Fiscal Cliff May Be Felt Gradually, Analysts Say:
  3. DVY:

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