Wall St Week Ahead-Cliff may be a fear, but debt ceiling much scarier

Ryan Vlastelica and Edward Krudy and Doris Frankel
Reuters Middle East

(Updates column with White House meeting details and quotes,

fall in futures)

Dec 28 (Reuters) - Investors fearing a stock market plunge -

if the United States tumbles off the "fiscal cliff" next week -

may want to relax.

But they should be scared if a few weeks later, Washington

fails to reach a deal to increase the nation's debt ceiling

because that raises the threat of a default, another credit

downgrade and a panic in the financial markets.

Market strategists say that while falling off the cliff for

any lengthy period - which would lead to automatic tax hikes and

stiff cuts in government spending - would badly hurt both

consumer and business confidence, it would take some time for

the U.S. economy to slide into recession. In the meantime, there

would be plenty of chances for lawmakers to make amends by

reversing some of the effects.

That has been reflected in a U.S. stock market that has

still not shown signs of melting down. Instead, it has drifted

lower and become more volatile.

In some ways, that has let Washington off the hook. In the

past, a plunge in stock prices forced the hand of Congress, such

as in the middle of the financial crisis in 2008.

"If this thing continues for a bit longer and the result is

you get a U.S. debt downgrade ... the risk is not that you lose

two-and-a-half percent, the risk is that you lose ten and a

half," said Jonathan Golub, chief U.S. equity strategist at UBS

Equity Research, in New York.

U.S. Treasury Secretary Tim Geithner said this week that the

United States will technically reach its debt limit at the end

of the year.


The White House has said it will not negotiate the debt

ceiling as in 2011, when the fight over what was once a

procedural matter preceded the first-ever downgrade of the U.S.

credit rating. But it may be forced into such a battle again. A

repeat of that war is most worrisome for markets.

Markets posted several days of sharp losses in the period

surrounding the debt ceiling fight in 2011. Even after a bill to

increase the ceiling passed, stocks plunged in what was seen as

a vote of "no confidence" in Washington's ability to function,

considering how close lawmakers came to a default.

Credit ratings agency Standard & Poor's lowered the U.S.

sovereign rating to double-A-plus, citing Washington's

legislative problems as one reason for the downgrade from

triple-A status. The benchmark S&P 500 dropped 16 percent in a

four-week period ending Aug. 21, 2011.

"I think there will be a tremendous fight between Democrats

and Republicans about the debt ceiling," said Jon Najarian, a

co-founder of online brokerage TradeMonster.com, in Chicago.

"I think that is the biggest risk to the downside in January

for the market and the U.S. economy."

There are some signs in the options market that investors

are starting to eye the January period with more wariness. The

CBOE Volatility Index, or the VIX, the market's preferred

indicator of anxiety, has remained at relatively low levels

throughout this process, though on Thursday it edged above 20

for the first time since July.

More notable is the action in VIX futures markets, which

shows a sharper increase in expected volatility in January than

in later-dated contracts. January VIX futures are up nearly 23

percent in the last seven trading days, compared with a 13

percent increase in March futures and an 8 percent increase in

May futures. That's a sign of increasing near-term worry among

market participants.

The CBOE Volatility Index closed on Friday at 22.72, gaining

nearly 17 percent to end at its highest level since June as

details emerged of a meeting on Friday afternoon of President

Barack Obama with Senate and House leaders from both parties

where the president offered proposals similar to those already

rejected by Republicans. Stocks slid in late trading and equity

futures continued that slide after cash markets closed.

"I was stunned Obama didn't have another plan, and that's

absolutely why we sold off," said Mike Shea, a managing partner

and trader at Direct Access Partners LLC, in New York.

Obama offered hope for a last-minute agreement to avoid the

fiscal cliff after a meeting with congressional leaders,

although he scolded Congress for leaving the problem unresolved

until the 11th hour.

"The hour for immediate action is here," he told reporters

at a White House briefing. "I'm modestly optimistic that an

agreement can be achieved."

The U.S. House of Representatives is set to convene on

Sunday and continue working through the New Year's Day holiday.

Obama has proposed maintaining current tax rates for all but the

highest earners.

Consumers don't appear at all traumatized by the fiscal

cliff talks, as yet. Helping to bolster consumer confidence has

been a continued recovery in the housing market and growth in

the labor market, albeit slow.

The latest take on employment will be out next Friday, when

the U.S. Labor Department's non-farm payrolls report is expected

to show jobs growth of 145,000 for December, in line with recent


Consumers will see their paychecks affected if lawmakers

cannot broker a deal and tax rates rise, but the effect on

spending is likely to be gradual.


Options strategists have noted an increase in positions to

guard against weakness in defense stocks such as General

Dynamics because those stocks would be affected by

spending cuts set for that sector. Notably, though, the PHLX

Defense Index is less than 1 percent away from an

all-time high reached on Dec. 20.

This underscores the view taken by most investors and

strategists: One way or another, Washington will come to an

agreement to offset some effects of the cliff. The result will

not be entirely satisfying, but it will be enough to satisfy


"Expectations are pretty low at this point, and yet the

equity market hasn't reacted," said Carmine Grigoli, chief U.S.

investment strategist at Mizuho Securities USA, in New York.

"You're not going to see the markets react to anything with more

than a 5 (percent) to 7 percent correction."

Save for a brief 3.6 percent drop in equity futures late on

Thursday evening last week after House Speaker John Boehner had

to cancel a scheduled vote on a tax-hike bill due to lack of

Republican support, markets have not shown the same kind of

volatility as in 2008 or 2011.

A gradual decline remains possible, Golub said, if business

and consumer confidence continues to take a hit on the back of

fiscal cliff worries. The Conference Board's measure of consumer

confidence fell sharply in December, a drop blamed in part on

the fiscal issues.

"If Congress came out and said that everything is off the

table, yeah, that would be a short-term shock to the market, but

that's not likely," said Richard Weiss, a Mountain View,

California-based senior money manager at American Century


"Things will be resolved, just maybe not on a good time

table. All else being equal, we see any further decline as a

buying opportunity."

(Wall St Week Ahead runs every Friday. Questions or comments

on this column can be emailed to:


(Reporting by Edward Krudy and Ryan Vlastelica in New York and

Doris Frankel in Chicago; Writing by David Gaffen; Editing by

Martin Howell, Steve Orlofsky and Jan Paschal)

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