NEW YORK, Oct 18 (IFR) - US investors, like their political leaders, appear to be shrugging off the pending fiscal tightening threat with the markets currently close to multi-year highs.
The S&P 500 remains less than a percent away from its five-year high, Treasury yields are near their lows for the year thanks to Federal Reserve easing, and credit spreads remain at or near their tights.
Yet if Congress fails to strike a deal, 2013 will usher in the end of stimulus measures, the expiration of the Bush tax cuts and the automatic imposition of spending cuts all at the same time, an event dubbed the "fiscal cliff," which some economists say will tip the US back into recession.
"The markets may have taken their eye off the fiscal cliff to a certain extent, and may be underestimating the probability that an agreement won't be reached before January 1," said Peter Newland, senior US economist at Barclays.
"There is a very short window between the presidential election and the end of the year, and the chance of an agreement is getting smaller with each passing day."
A failure to hammer out a deal to stave off the cuts would shave $607 billion, or 3.7%, off GDP between fiscal 2012 and 2013, according to the Congressional Budget Office.
Others are even more gloomy.
Bank of America economists expect the hit to the economy could be as high as $720 billion, or a whopping 4.6% of GDP. Morgan Stanley puts the figure at 5%.
And then there's Moody's which has indicated it stands ready to downgrade the US sovereign rating if Congress fail to implement a plan that would stabilize the national debt relative to GDP.
For markets, the impact would be dramatic as investors who are currently embracing risk with open arms will be forced into a swift retreat.
The lack of global defensive instruments and shortage of risk-free assets will lead them to the very instrument that may suffer its second downgrade -- Treasuries, one of the most liquid instruments available and a safe haven given the reserve currency status of the dollar.
KBW is expecting the 10-year Treasury yield to push below 1%, compared with its recent low of 1.39% hit on eurozone sovereign concerns.
That in turn will send corporate bond spreads wider with corporate yields unlikely to keep pace with Treasury yields.
And that will have an impact on corporate bond portfolios, which have steadily built this year as investors went on the hunt for yield.
Companies have issued record levels of debt this year to take advantage of low borrowing costs and investors have eagerly snapped it up, moving down the credit spectrum as returns have shrunk.
The Barclays Investment Grade Index closed on Tuesday at a 2.67% yield-to-worst, a new all-time low. High-yield credit remains near its record low yields as well, offering investors 6.30%.
As quickly as investors have piled into the market, fears of rising default risk in a contracting economy could cause a dramatic exodus, driving up yields on higher-risk corporate bonds.
If this is exacerbated by massive mutual fund outflows and redemptions from ETFs, investors may be overwhelmed.
To be sure, some investors have taken measures to hedge their risk.
Federated Investment Management, for example, has already allocated capital out of high-yield credit and taken refuge in the mortgage market, according to fixed income strategist Jospeh Balestrino.
The Fed's commitment to continue purchasing mortgage-backed securities has made that an attractive strategy, he said.
Some market players are expecting the central bank to do even more to combat an economic downturn.
Carl Lantz, head of interest rate strategy at Credit Suisse, is expecting the central bank to increase its asset purchases of Treasuries in 2013 to $60 billion a month with an unsterilized Treasury purchase program.
Still, the market turmoil may slam the window shut on new debt issuance, particularly for lower-rated securities.
For smaller high-yield companies, the cost of refinancing may become prohibitive and also cause defaults.
Earnings will also be affected.
If the full fiscal cliff were to occur, the contraction in the government deficit from 2012 to 2013 would cause a 31% decline in 2013 corporate profits, according to Jordan Alexiev of Pyramis Global Advisors.
Cyclical and consumer-driven sectors that rely on economic activity are likely to underperform if spending is cut. That could mean a weak holiday shopping season, which would hurt sales at mid- to higher-end retailers that are highly dependent on optimistic consumer sentiment.
Market-oriented financials should also be expected to sell off, after recent buying pushed bank spreads to the tightest levels in 18 months.
Global investment banks like Goldman Sachs and Morgan Stanley would face serious challenges, which would have an impact on liquidity, according to KBW.
"A recessionary period would freeze up the markets, shutting down trading volumes and investment banking activity at a level worse than four-quarter 2010 and the first half of 2011," KBW analysts said.
Finally, the market response to any downgrade would likely be fiercer than the reaction during last year's debt-ceiling debacle, when Standard & Poor's stripped the US of its triple-A rating.
In the week after the downgrade, the 10-year yield fell 32bps, and the S&P 500 index fell 6.7% on the following Monday.
Corporate spreads spiked as the asset class underperformed, with the Barclays High Grade Index widening by more than 34bps and the High Yield Index spiking 80bps.
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