By Terry Flanagan

Peering Over the Fiscal Cliff

The looming ‘fiscal cliff’ is causing reverberations throughout the capital markets as investors seek safe havens in the event of a recession.

The fiscal cliff—a combination of mandatory tax cuts and decreases in government spending that is due to take effect on December 31—is likely to precipitate a recession unless resolved, most economists agree.

In Washington, where financial reform has been on the agenda since the credit crisis of 2008, actions such as tweaks to the Dodd-Frank Act will take a back seat to the fiscal cliff during the lame duck session of Congress that began after election day.

“All discussions on financial reform will be utterly subsumed by the fiscal cliff,” said Jim Himes, a U.S. Democrat Representative from Connecticut and member of the House Committee on Financial Services, at the Sefcon III conference in Manhattan on Tuesday—a gathering devoted to swap execution facilities. “Little else will be done in the lame duck session that isn’t directly related to averting the fiscal cliff.”

The post-election political climate favors a resolution of the situation.

“A re-elected President Barack Obama, who is no longer constrained by the need to win a second term, and Speaker [John] Boehner will reach an agreement,” said Himes. “The president will need to sell the deal aggressively to defenders of the status quo on Medicare, and Speaker Boehner will have to get Republicans to agree on new revenues.”

While it’s difficult to gauge the impact a resolution of the fiscal cliff will have on markets, the potential implications are too great to ignore.

“Traders and investors alike are sensing that there has been a qualitative change in the character of our equity markets,” said Steven Carhart, president of Trust & Fiduciary Management Services, an investment manager. “Whatever backdrop may have existed of long-term fundamentals trends, positive or negative, seems to have been replaced with trendless volatility punctuated by unpredictable government or central bank interventions.”

Unlike in 2008, when the markets were rocked by the sub-prime mortgage crisis and the ensuing financial meltdown, the current environment is closer to that of 2001.

“The credit crisis was monetary in nature, because of the mountains of debt that couldn’t be repaid,” said Carhart. “Back in 2001, the economy was just beginning to recover from the tech bubble when September 11 occurred, which set the recovery back significantly.”

In the meantime, investors need to reshape their thinking to adjust to current economic realities.

“The first premise to change must be the notion of buy and hold investing for capital gains in equities,” said Carhart. “The inescapable conclusion is that if we are seeking capital gains in this market, then we’re all traders. This is supported by the profusion of hedge funds, high-frequency traders and other actors in the markets.”

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