12/06/2012 05:20 EST | Updated 02/05/2013 05:12 EST

Why Fiscal Cliff Panic Is Overblown

Parkinson's Law, in its original form, states that "work expands so as to fill the time available for its completion." This was a humorous attempt at mathematically describing the rate at which bureaucracies expand over time -- the consequence of which is something that Washington is now dealing with.

Hence the mania over the so-called "fiscal cliff" as the clock is ticking towards the January 1st and 2nd deadlines for automatic spending cuts (sequestrations) and tax hikes which form most of the penalty for failing to come up with a plan to reduce the US federal deficit by $1.2 trillion (by the so-called "super committee" which was created out of the Budget Control Act of 2011).

Of the seven laws that cover the above-mentioned fiscal tightening, four are expirations (including the Bush tax cuts, payroll tax reductions and extended federal unemployment benefits) and to combined $600 billion or more in fiscal tightening that will take place in 2013, legislation has come down the pipe that either repeals the existing laws or extends the original legislation.

Despite the apparent enormity of the situation, Republicans and Democrats seem intent on dragging negotiations down to the wire, just as they did in the summer of 2011 (debt ceiling crisis) and the autumn of 2008 (TARP). Indeed, a corollary (Stock-Sanford) to Parkinson's Law states "If you wait until the last minute, it only takes a minute to do."

Compared to the stretch of days taken since the Presidential election to come up with a compromise deal, the amount of time it will take to announce whatever deal emerges will seem like a minute. The problem is that global capital markets have lost patience, especially after seeing the game of 11th hour brinkmanship being played out during the autumn of 2008 (TARP) and summer of 2011 (debt-ceiling crisis).

There are just 14 trading days left before the end of the year and it is unlikely that market participants will wait until the last minute themselves before passing judgment on the perceived success of negotiations on averting the fiscal cliff.

Even though this hasn't been a great quarter for stocks, all major indices are still up smartly on the year and it is too tempting for money managers and retail investors alike to cash in some chips now rather than risk losing most if not all these gains in a frenzied bout of selling. This sets up a very interesting set of dynamics for the markets as we head into January since even resolution of the fiscal cliff issue could still come amidst a heavy downdraft in equities, which in turn could influence consumer confidence and behavior and potentially business sentiment.

Any decline in that scenario, however, would most probably be limited to about 10-15 per cent; followed by a sharp rebound on the assumption that economic fallout from the delayed resolution would be minor. But let's say that lawmakers fail to deliver a plan and we go over the "cliff." What will this do to our portfolios?

First, let's recognize that markets will again shoot first and ask questions later, meaning that there will be a greater potential for a 20-30% slide in stock indices. I don't think we'll generate enough selling pressure to carve out a 50% bear market (like 2008-09), unless investors believe the economic shock to the US will last longer than 6-9 months. It shouldn't.

Unlike the tidal wave that hit the US four years ago (which was a balance sheet implosion), the impact of the fiscal cliff will be more a cyclical contraction in output -- something which will likely see a faster pace recovery than what we have experienced since 2009. Considering that such an outcome should send bond yields (and therefore mortgage rates) lower, the recent recovery in the US housing sector would not evaporate and most likely provide a buffer against weakness in government, business and consumer spending. Keep in mind that once the clouds begin to clear towards the end of 2013, we will be looking at a sharply reduced US federal deficit (the intended outcome) which will also be key in providing a ceiling for rates.

To be sure, there are some important unknowns in this cursory glance at the fiscal cliff scenario. For one, we don't know how heavy the rating agencies will hit Washington for its inaction, though there would again be a limit to how much the US credit rating could be reduced if in fact the deficit was going to be sliced in half. There will be a knock-on effect of weaker economic activity in the US on other parts of the world (like fragile Europe), but it is probably not going to be as intense as the wave created by the 2008-09 recession. Having said that Canada's economy is highly sensitive to a downturn in US activity, especially with the massive debt load being carried by households currently, so the impact here might be disproportionately high.

The bottom line, however, is that doomsday predictions of the fiscal cliff are overblown. We should not take the developments over the coming weeks lightly and be prepared to act in a tactical manner if a worse-case scenario unfolds; but this could turn out to be a bear trap for retail investors. In other words, aggressive selling by professional money managers could spark a capitulation trade by individual investors (stocks and equity fund redemptions), leading to much cheaper entry points for said pros in a month or so.