The fiscal cliff isn't gradual, and it will matter(Read article summary)
Some financial bloggers argue that the fiscal cliff won't have much effect on the economy at all. But the actual impact of the fiscal cliff doesn't matter. What matters is the perception.
Let's not make this more complicated than it already is - this is a Fiscal Cliff at the current moment. It is not a Fiscal Slope or anything gradual.I actually wish they'd call it a Fiscal Brick Wall because that's what it will actually act as upon investable assets.
If there is no compromise the US economy absolutely will slam into a wall. The smart money, however, would not be placed on that scenario. It is unlikely that anyone on either side wants a repeat of last year and the more obstinate wing of the GOP that started the whole episode has just been neutered.
But let's get back to the Cliff's impact, should we go over it...
Now there is a new meme going around that some of the more prominent bloggers have repeated, wherein we hear about how "the changes don't all take effect at once" and "this whole thing is just like Y2K" and "actually, it will probably have very little effect on the economy at all."
The bloggers who are repeating this are technically correct. But they tend to be either journalists or economists, and not market people necessarily.
And so I think that here's what they miss:
1. What the fiscal cliff's actual impact on the economy will ultimately be is not the point, it is the perception.
2. In the short-term, stocks trade on psychology and sentiment. This happens en masse and things change quickly. Fear over increased taxes, lower government spending and a further contraction of economic growth will not lead to a gradual adjustment of risk asset prices. Rather, it will mean a fear-driven race to the exits all at once. I don't care what your surveys say, deep down everyone who is in the stock market right now is operating under the assumption that a compromise will occur, on time, and one that kicks the can on all of the big issues. Any hint that we're deviating from this script will show up in the tape.
3. Economists and journalists who do fact-based empirical work sometimes forget that most people, including investors, do not behave rationality or react to the data in proportion with its actual meaning. Many people in this world, even some successful ones, can turn from reasonable human beings into hysterical monkeys when their fight-or-flight instinct is triggered. And nothing triggers it like a whiff of panic in the air and the threat of the unknown, in this case the question of how the economy will weather the effects of the Cliff.
So while Fiscal Slope may turn out to be the reality, intelligent people who have figured this out ought not to assume that that's how "the market" will react to it in the short-term. Especially if the calendar turns and we've gone "over it." Expect hysterical monkeys to rule the markets in that scenario rather than human beings at that point, even if their fear turns out to be unfounded.