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Analysis: Washington, Wall Street misreading each other again as cliff nears

by
A security guard is seen at the New York Stock Exchange in downtown Manhattan as Hurricane Sandy makes its approach in New York October 29,
A security guard is seen at the New York Stock Exchange in downtown Manhattan as Hurricane Sandy makes its approach in New York October 29,

By Edward Krudy and David Lawder

(Reuters) - Exit presidential elections. Enter looming budget crisis. And once again, a disconnect between how Washington and Wall Street see the world could cause pain for investors if the two get their signals crossed.

At the beginning of next year, $600 billion in tax increases and spending cuts - known as the fiscal cliff - will automatically become law unless Congress acts. Such dramatic moves could hammer consumer and business spending, push the U.S. economy back into recession and send markets reeling.

However, there is a sense that neither the financiers and investors in New York nor the lawmakers in Congress are taking each other seriously enough. Many in Washington believe Congress could do nothing, and the market reaction would be relatively sanguine. Plenty on Wall Street say the fiscal cliff, one way or another, will be dealt with. It raises the possibility that Congress will sail over the cliff, and markets will freak.

"The markets have been way too sanguine on the fiscal cliff," said Greg Valliere, chief political strategist for Potomac Research Group, which tracks Washington for institutional investors.

The fiscal cliff's automatic triggers were built into law as a way to force lawmakers to tackle huge U.S. budget deficits.

Wall Street banks, investors, and financial industry lobbyists have coalesced around the view that after the elections Congress will reach a short-term deal to avert the worst of the cliff. In short, they believe Congress will kick the can down the road for several more months.

"They'll have to do some sort of short-term extension to buy some time to develop the larger component of addressing the fiscal cliff, which is a large-scale fiscal plan," said Ken Bentsen, head of the Washington office for financial industry group SIFMA, who sees that happening.

As SIFMA's chief lobbyist, Bentsen is essentially Wall Street's eyes and ears in the nation's capital. He was a congressman himself - a Texas Democrat who served in the House of Representatives from 1995 to 2003.

But Wall Street and Washington have misread each other in the past, and it has not been pretty for markets. One of the ugliest examples of that was in September 2008, not two weeks after Lehman Brothers collapsed, when the House rejected a $700 billion financial bailout plan. Markets plunged; that shock was enough to galvanize lawmakers to pass a revised plan a few days later.

There is some concern that poor assumptions are being made about each side. In Washington, there are Tea Party-backed Republicans who anticipate a market shock but believe the pain is worth it if it changes what they see as a culture of spending in Washington.

While none of them are saying this publicly in the pre-election environment, lobbyists in close contact with Capitol Hill say there are enough members with such an outlook to create headaches for leaders like House Speaker John Boehner just as they did during debt ceiling negotiations in 2011.

In addition, there is a growing group of Democrats and center-left policy wonks who say that going over the cliff may be a viable tactical option to force revenue increases on Republicans, who have resisted them.

The theory is simple: no one has to cast a potentially career-ending vote to raise tax rates, and lawmakers can easily blame the other party for the impasse.

The tax rates snap back to pre-2001 levels, to the levels prevailing before the tax cuts brought in by President George W. Bush, and $109 billion in automatic spending cuts start to bite - half military and half domestic programs.

Senator Patty Murray, the second-ranking Democrat on the Senate Budget Committee and a top player in last year's debt limit and deficit reduction negotiations, was among the first lawmakers to voice willingness to pursue a previously unthinkable tactic.

"If we can't get a good deal - a balanced deal that calls on the wealthy to pay their fair share - then I will absolutely continue this debate into 2013 rather than lock in a long-term deal this year that throws middle-class families under the bus," Murray said in a speech at the Brookings Institution in July.

A spokesman for Murray said her views on the topic have not changed since then.

Other Democrats also say that going over the cliff, while painful, would be better than simply extending all tax rates and delaying the spending cuts for six months or a year. They argue this will incur another debt downgrade from ratings agencies.

"We have the leverage, we should use it," said Vermont Democratic Representative Peter Welch. "In the past, when we had leverage, we've blinked."

Welch said Democrats did not use their leverage in 2010 when Obama agreed to a two-year extension of Bush-era tax cuts, and did not push hard enough for revenue increases in the debt limit deal in August 2011.

Welch also voiced a belief among many Democrats and liberal-leaning policy analysts that there will be some wiggle room to go over the cliff in January but still reach a deal early enough in the new year to spare the economy serious damage.

According to this line of thinking, not all of the $600 billion in gross fiscal tightening happens immediately - the drag on the economy builds up over time, prompting comparisons to a steep slope, rather than a deadly drop.

"It's not a Wile E. Coyote moment for the economy," said Chad Stone, chief economist for the liberal-leaning Center on Budget and Policy Priorities, referring to the devastating plunges suffered by the hapless cartoon canine.

MISREADING THE TEA LEAVES?

But if lawmakers think they will get an easy ride from markets should they choose the cliff, they are in for a surprise.

"If that's the sense in Washington I think they're sorely mistaken," said David Joy, chief investment strategist at Ameriprise Financial in Boston, where he helps oversee $655 billion in assets.

Joy is optimistic. He expects a short-term deal by the end of the year. He said he has increased his contact with the firm's Washington's representatives and is now talking to them at least once a week and sometimes several times.

"The sense that I'm getting from some of the readings that we get on the ground from Washington is that they're starting to wake up to the idea that it is serious and that it would unnecessarily harm the economy starting in January," said Joy.

Indeed, Boehner on Sunday told CNN that he expected a temporary deal that would push resolution to 2013.

"Lame-duck Congresses aren't known for doing big things and probably shouldn't do big things, so I think the best you can hope for is a bridge," he said.

There are influential voices on each side of the political divide that abhor the idea of going over the cliff.

Bentsen said he has been speaking to many lawmakers during the recess, including Democratic Senator Mark Warner and Republican Senator Saxby Chambliss, both part of the bipartisan so-called Gang of Six senators dedicated to budget issues. They told SIFMA's annual conference in New York in October that Congress would get this done, Bentsen said.

For now, investors are buying it.

Billionaire investor Ken Fisher is so convinced a deal will be done he says any market trepidation - or short-term selloffs later in the year - should be used as a buying opportunity. Fisher was in Washington in June and has talked to three legislative aides since then. He believes the fiscal cliff will be punted far into the future, perhaps after the next midterm elections in 2014. In his read, it is a non-issue.

"I don't think the fiscal cliff is anymore of a reality than the concern once was about swine flu and Y2K," said Fisher. "My view is that this issue is a cause for bullishness, because fear of a false factor is always a bullish factor," he said.

Still, as well as the 2008 debacle, many investors are all too familiar with the lengthy, drawn-out negotiations involved in raising the debt ceiling in August 2011. That resulted in a selloff on Wall Street and the battle over what for years had been a procedural move was partly responsible for the downgrade of the pristine U.S. credit rating by Standard & Poor's.

Until there is more clarity, Joy recommends paring back riskier investments such as stocks and says low-quality, high-yielding bonds, popular with investors seeking higher returns, could get badly hurt if the fiscal cliff is triggered.

Valliere notes that this Congress is the same one that stumbled its way through the debt limit mess, triggering a credit downgrade, and could barely agree on a short-term extension of payroll tax cuts before Christmas last year. Investors should be cautious in believing that things are different this time around.

"I think the markets are not focusing on the possibility that talks could totally break down in December," Valliere said.

(Editing by David Gaffen and Mohammad Zargham)

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