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MarksJarvis: Cliffhanger has stocks on edge

Investors leery as Fed chief Ben Bernanke warns of the 'fiscal cliff'

Gail MarksJarvis

November 21, 2012

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It's a cliffhanger — one that no one will find entertaining if the final episode leads to the economy plunging into a recession next year.

Investors can't decide if they should use the threat of the potential tax shock of the "fiscal cliff" as an opportunity to buy stocks, as they did Monday, or sell, as they did during the past couple of weeks.

Some Wall Street firms have hired political advisers to help them handicap the likelihood of Congress letting the economy fall off the cliff.

"There is something to be concerned about because there are so many moving parts, but I don't think it will be the worst-case scenario," said Tom Block, a former JPMorgan Chase lobbyist who is advising the bank's analysts and clients.

The worst-case scenario being anticipated is the economy going into recession and putting 2 million more people out of work. The Congressional Budget Office said that would happen if Congress and the president can't compromise on more than $600 billion in tax increases and government spending cuts. They are set to happen automatically if there's no action from Capitol Hill by Dec. 31.

Erskine Bowles, who engineered deficit-cutting in the Clinton administration, said there's about a 1-in-3 chance that political fighting will send the nation over the cliff at the end of this year. There's also about a 1-in-3 chance Congress will patch something together by Dec. 31.

And then there's the 1-in-3 chance Congress does take action — in early 2013 — to avert a recession before spending slows dramatically.

Federal Reserve Chairman Ben Bernanke saw enough of a threat to the economy to warn in a speech at the Economic Club of New York on Tuesday that Congress needs to "protect the economy from the full brunt of the severe fiscal tightening at the beginning of next year that is built into current law — the so-called fiscal cliff."

If political leaders don't step up, he said, the country could face a fiscal shock so huge it could "send the economy toppling back into a recession." According to government estimates, unemployment could rise to more than 9 percent in a recession from the already weak 7.9 percent.

Bernanke isn't pleased with the progress of the economy. He said it's taken too long to produce limited improvement in employment. Although the unemployment rate is better than the 10 percent from fall 2009, Bernanke said 7.9 percent is too high, and "a large number of people are working part time" because they can't get jobs.

He noted that the recovery remains constrained by a reluctance of lenders to provide loans and a "prominent risk" from Europe's recession.

Bernanke said the government needs to address the nation's debt problems for the long term but not with the immediate shock that would come with the full force of more than $600 billion in new taxes and government spending cuts on Jan. 1.

To avoid a recession-inducing shock next year, many economists advocate that Congress put into place a debt-cutting plan but phase in tax increases and government spending cuts over many years.

The economy is considered too fragile for sudden shocks to household paychecks, especially since the tax increases would hit low-, middle- and high-income taxpayers as well as unemployment checks.

Although economists are encouraged by a recent upturn in the housing market, they have been troubled by the recession in Europe and slowing growth in emerging markets.

U.S. manufacturing output dipped 0.6 percent on an annual basis in the third quarter, and industrial capacity and utilization declined, said Moody's Analytics economist John Lonski. He called that an "ominous" sign that points to slowing profit growth. "The evidence is clear: Equities now face significant head winds," Lonski said.

With the third-quarter earnings reporting season coming to an end, the final tally is discouraging for investors. Executives talked repeatedly about challenges selling abroad, and although the U.S. economy has strengthened, corporate spending decisions have been put on hold pending more clarity on the potential fiscal cliff.

The blended earnings growth rate for the Standard & Poor's 500 is a negative 0.2 percent, said analyst John Butters of FactSet. If that becomes the final figure for earnings season, it will end 11 straight quarters of earnings growth.

In addition, corporate sales in the third quarter were disappointing. About 59 percent of companies reported revenue below analyst expectations — the weakest since the first quarter of 2009. Sales last quarter averaged a 1.2 percent decline, largely from the energy and basic materials sectors that have been affected by slowing overseas economies. Butters noted weakness in Europe and a slowdown in growth in emerging markets.

Companies such as DuPont, Dow Chemical and AMD are coping with declines with massive layoffs. Lonski said that as the labor market weakens, 10-year Treasury yields may fall to 1.5 percent. Treasurys on Tuesday were yielding 1.67 percent after Bernanke spoke. Typically, investors put money in Treasurys when they are seeking a haven from the stock market and a weak economy.

Although the Standard & Poor's 500 index has climbed more than 10 percent for the year, it has declined about 3 percent since the election. Some analysts think the decline has been driven less by concern about the economy and more by investors locking in capital gains at 15 percent this year, rather than risking an increase to 20 percent next year.

Investors began buying stock Friday after Democrats and Republicans signaled a willingness to work together to avert the fiscal cliff. Some strategists expect stocks to rally if politicians are seen coalescing around a plan, but Block said there may not be clarity until New Year's Eve.

gmarksjarvis@tribune.com

Twitter @gailmarksjarvis