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By Rom Badilla, CFA

The Wall Street Journal reported that Moody’s Analytics puts the probability of a recession borne from the Fiscal Cliff at only 15%. The tax increases and spending cuts as scheduled to come into effect in 2013 would have a huge negative effect on the economy. In turn, this could have a major effect on the capital markets and needs to be taken into consideration in an investor’s strategy.

In the event of a fiscal cliff, real GDP would fall 2.8 percentage points below what it would be if current policies are extended in 2013, Moody’s predicted. A new recession would result, and unemployment would rise to 9.2% by year’s end.

Moody’s said it believes there is a 30% chance that policymakers will avoid the fiscal cliff by extending current policy so that taxes and spending would remain the same in 2013. Under that scenario, the U.S. economy would improve next year, but no progress would be made toward long-term fiscal sustainability.

The firm’s baseline scenario, with a 55% probability, is that policymakers will agree to a middle ground.

In the first scenario where the full Fiscal Cliff would take effect and economic activity collapses, equities would tank, which would result in renewed interest in safe-haven securities like U.S. Treasuries. While U.S. Treasuries would experience price appreciation despite the fact that rates are relatively low, Investment Grade and High Yield Corporate bonds may not fare as well and underperform fueled by fears of rising default risk in a contracting economy. The incremental yield earned or spread on corporate debt would widen and as a result lag their U.S. Treasury counterparts or perhaps even produce negative returns.

In the event that policymakers will avoid the Fiscal Cliff by extending current policy and hence kicking the can down the road, equities could still be at risk to fall while Treasuries could rally. The main driver to this scenario is another possible downgrade by the ratings agencies in response to a lack of an initiative by policymakers to solve the country’s long term debt problem. The response by the markets would be the mirror image of the debt ceiling debacle last summer when one of the credit ratings agencies downgraded the U.S.

On August 8, 2011, Standard & Poor’s stripped the U.S. from its AAA rating and downgraded them one notch to AA+. In response, high yield credit spreads spiked as the sector underperformed. On the day of the downgrade, the spread on the Barclays’ High Yield Index widened by more than 60 basis points. In the prior two weeks, the spread jumped 147 to 670 basis points. The S&P 500 fell 6.7% that day in response and leading up to that day, stocks had fallen by 15% over the previous two weeks.

While the U.S. is not going to involuntarily default given its monopoly on its ability to print its own currency, escalating debt and the subsequent drag on economic productivity would be a concern for the capital markets as evident by last year’s action. This heightened uncertainty and volatility in Wall Street and the flow within the capital markets would ultimately affect Main Street and vice-versa. Bond market deals could be postponed and borrowing costs would increase, which affects a company’s ability to expand and innovate. Furthermore, crippled consumer spending, which makes up over two-thirds of the economy, could hit top line revenue growth for corporations. This drop off in growth, which would lead to a surge in risk aversion, would drive up the demand for safety.

During the final days of summer in 2011, the 10-year benchmark note fell 18 basis points on the day of the downgrade. Comparatively, in the two weeks leading up to the downgrade, the yield had fallen by more than 60 basis points from 3.03% leading to tremendous price gains in a flight to quality bid.

As for the final scenario, the question is the magnitude of concessions and if they will make any headway in dealing with the country’s debt problems. While Moody’s states that a middle ground is the baseline scenario as evident by their 55% probability weighting, the fact is that politicians have little credibility in actually tackling this issue once and for all. Furthermore, the fact is that the markets would not be dealing with this issue in the first place if politicians on both sides were not so incompetent in managing our fiscal balance sheets. Because of this and politicians' propensity to kick the can down the road, risks loom for the markets and the Fiscal Cliff should not dismissed.

Source: Fiscal Cliff Scenarios Lead To Volatility For Stocks And Corporates