The Fiscal Cliff
May 7 , 2012

It's beginning to feel an awful lot like a replay of last summer's market mayhem with news out of Europe driving daily swings in North American markets. Incumbents have been falling like dominoes in recession-plagued Europe redefining the political landscape once more. Soaring unemployment in Greece , Ireland and Spain , coupled with a growing chorus of protests, risk a fractious and divisive political climate ahead. The changing of the guard in France will surely break the Franco-German alliance that has insisted on prescribing crushing austerity for Europe 's indebted periphery—a recipe for deep recessions.

Markets finished last week solidly in the red, posting their worst weekly showing since the beginning of the year. The S&P 500 stumbled badly when the ISM Services reading, coupled with a disappointing non-farm payrolls report, suggested that the U.S. economy may be slowing. While consumers may still be spending on goods, they've slowed their outlays on services, such as health care. That sector generates nearly 10% of overall S&P 500 earnings and accounts for one of every four jobs created so far in this recovery.

But the recent sluggishness in the ISM Services reading could be just the beginning, with a fear factor emerging about an approaching fiscal cliff for the U.S. economy. The fiscal cliff is expected to arrive at the beginning of 2013, when the Bush-era tax cuts are set to expire and $1 trillion in spending cuts are set to kick in.

The impact of reduced government spending, coupled with slumping consumption when the Bush-era tax cuts are enacted, will result in a drag on economic activity of somewhere between two and four percent. And with the U.S. economy barely growing at two percent, failure to avert a fiscal cliff could quickly tip the world's largest economy into recession.

Just last week, U.S. Federal Reserve chairman Ben Bernanke warned Congress that the removal of tax cuts, combined with government spending cuts, would create a sudden shock that the U.S. economy would not be able to handle. “The size of the fiscal cliff is such that there is, I think, absolutely no chance that the Federal Reserve could or would have the ability whatsoever to offset that effect on the economy,” Mr. Bernanke said.

But despite the dire warnings, Congress is deeply divided and unlikely to take decisive action before the year end. The situation is creating a panic as economists fret that the same bitterly partisan battles that were fought over the debt ceiling last year may once again be played out over the fiscal cliff. That contentious debate over the U.S. debt ceiling led Standard and Poor's to downgrade the debt of the U.S.—a very real prospect once again as the fiscal cliff looms ever larger.

By the end of this year, the U.S. will once again hit its debt ceiling triggering more acrimonious debate and possibly triggering another downgrade. Bill Gross, the founder and co-chief investment officer of the world's largest bond company PIMCO, recently warned that the U.S. could be headed toward a credit rating downgrade if it does not tackle its deficit.

With Washington deeply divided, an election cycle in full swing and Europe's troubles heating up again, look for consumers and businesses to pull back as the year end approaches. Many big commitments such as house and car purchases are likely to be delayed until the outcome is clear and the fiscal fog is lifted.

With a possible one-two punch in the offing, investors should adopt a more defensive stance over the next few months. Last time there was economic turmoil in the U.S. over the debt ceiling debate, the big beneficiary was gold, which rallied 10%. Gold, a safe haven for centuries, could easily top $2000 per ounce if U.S. lawmakers fail to take decisive action before reaching the fiscal cliff.

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