No budget deal won't push stocks off a cliff

Despite the hype and hysteria over the fiscal cliff, it's unlikely the stock market will suffer a hair-raising correction, at least in the short term, if politicians can't agree on a deal.

If lawmakers don't avoid automatic tax hikes and government spending cuts by Dec. 31, the stock market may suffer a drop of just 2% to 3%, some Wall Street analysts say.

The reason investment strategists don't expect a massive selloff is because they believe some sort of deal will come early in the new year, limiting damage to the economy from any short-term fiscal drag.

"I think the market comes under some pressure if nothing is done by Dec. 31," says Mark Luschini, chief investment strategist at Janney Montgomery Scott. "It may not be more than a 3% correction ... The longer it drags out, however, the greater the likelihood its impact will start to show in economic data, which will then be counterproductive to stocks as corporate profits are threatened."

To a certain degree, fiscal-cliff fears have been "overblown in the sense that it sounds so terminal," Luschini says.

Indeed, the full force of any government spending cuts or tax hikes won't have a major impact right away. The economy won't go into recession Jan. 1 barring an eleventh-hour deal. Automatic spending cuts of $1.2 trillion will occur over a decade.

There's a consensus that if lawmakers can agree on a deal by year-end or early in 2013, even one that simply extends tax cuts for the middle-class, stocks will probably enjoy a relief rally as some uncertainty fades.

The market's big test, however, will come in the first quarter of 2013, when lawmakers are forced to tackle the nation's mushrooming deficit.

That requires tough decisions on tax policy and entitlement reform to put the nation's finances on a more healthy, sustainable path, says Michael Pento, president of Pento Portfolio Strategies. Pento also believes stocks would suffer an initial drop of 2% to 3% if the U.S. goes over the cliff.

The next big obstacle for markets is likely to be a renewed debate on the debt ceiling, which needs to be raised again early in 2013, Pento says. The Treasury Department said Wednesday that the U.S. will hit the $16.4 trillion borrowing limit Dec. 31 but it can take "extraordinary measures" to extend the government's borrowing ability for another two months or so.

"The real fight will be over spending cuts and raising the debt ceiling," says Pento. "If there is no agreement to raise the borrowing limit of the U.S., we will see a panic move lower (in stocks) in the area of 15% unless action is taken quickly."

The upside, of course, is if politicians can agree on a mix of tax hikes and spending cuts that limit the amount of fiscal drag and are perceived as market friendly, says Luschini.

"The economy will overcome it," he says. "I think the stability that will be brought from a fiscal cliff resolution would lift business spending, and allow job growth and spending to occur. Add the improving housing market and we could well see growth accelerate as the year unfolds."

USA Today