The Ultimate, Worst-Case, Fiscal Cliff Nightmare Scenario

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The battle over the fiscal cliff began last week when President Obama asked for a one-year extension of the Bush tax cuts for those making under $250,000. Experts continue to be worried about the the $607 billion – $750 billion drag the could occur in the event of the expiration of tax and spending provisions at the end of the year that will hit the economy in 2013.

Some warn that the uncertainty surrounding the event will likely start impacting the economy as early as this year.

We drew on reports from Wall Street’s top analysts to see what the worst case scenario means for the U.S. economy, stocks, and commodities.

A quick re-cap: What is the fiscal cliff?

The fiscal cliff refers to a number of different policies that are set to change around the same time, most on January 1, 2013.

  1. The 2001 and 2003 tax cuts that are set to expire.
  2. The Alternative Minimum Tax (AMT) will hit more people.
  3. Payroll taxes will increase by about $120 billion in 2013 if the tax cuts expire.
  4. The sequester will slash defence spending.
  5. Unemployment benefits are set to run out which could cut payments by about $34 billion in CY2013 (calendar year).
  6. The debt limit will also be reached again around the same time.
  7. And there are other miscellaneous issues like 'doc fix' and 'tax enders' that need to be resolved.

Source: Goldman Sachs

The CBO's baseline projection calls for a $607 billion drag on the economy, or around 3.7% of GDP

The projections in the Congressional Budget Office's most recent budget projections serve as a useful baseline against which to compare other predictions.

  • The total of all spending reductions and tax increases would amount to a $607 billion.
  • They expect, if there's no fiscal restraint, a 1.3 per cent decline in GDP in the first half of 2013, followed by a 2.3 per cent rebound in the second half.
  • The CBO also provides an alternative fiscal scenario, where tax cuts are extended, there's another doc fix, sequestration is avoided, and the AMT is indexed for inflation.
  • In that case, GDP is projected to expand by 1.7 per cent in the first half of 2013 and by 2.5 per cent in the second half.

Source: CBO

BofA economists think the potential drag from the fiscal cliff could be as high as $720 billion or around 4.6% of GDP

Current consensus is that GDP growth will accelerate this year and dip slightly in 2013. But Bank of America analysts believe the uncertainty surrounding the fiscal cliff will hurt growth in 2012 and 2013.

  • BofA's baseline forecast expects a 2 percentage point hit to economic activity over the 12 months surrounding the fiscal deadlines.
  • But the potential fiscal drag from all the measures is 'unprecedented in size' -- $720 billion, or roughly 4.6% of GDP.'
  • BofA's forecast of 1.4 per cent growth in 2013, is well below the average of 2.5 per cent growth.

Source: Bank of America

Morgan Stanley goes even higher, saying that the impact could be as high as 5% of GDP

Morgan Stanley projects that the actual impact of the fiscal cliff could reach 5 per cent of GDP, as opposed to the CBO's figure of 3.7 per cent.

  • Morgan Stanley's figure differs because the CBO fails to account for the full impact of the payroll tax extension
  • Further, using a fiscal year comparison (October to September) as the CBO does underestimates the impact, as most of the cliff would occur on January 1st, 2013.
  • The last equivalent fiscal event occurred in 1968/1969 under LBJ. It was a fiscal tightening of approximately 3.75 per cent. The country went from 5 per cent GDP growth in most of 1968 and early 2009 to a recession by the end of 1969.

Source: Morgan Stanley

UBS sees less than a 5% chance of the worst-case-scenario, but in the following slides they explain what the worst-case-scenario means for the financial markets

UBS sees a very small chance of the fiscal cliff having its full theoretical impact, less than 5 per cent in fact. If it did happen, GDP would contract by an estimated 4.7 per cent.

  • Their most likely scenario at 50 per cent is a 'fiscal pothole' in which Congress kicks the fiscal can down the road.
  • This would include the expiration of a few provisions, including the payroll tax holiday and emergency unemployment measures.
  • However, most provisions would be extended in this case, leaving the impact at only around 0.7 per cent of GDP.
  • What happens depends mostly on November's elections.

Source: UBS

The S&P could fall to 1,000

In UBS' worst case fiscal cliff scenario, in which a majority of fiscal provisions expire next year with no change during the first quarter, they expect US equities to suffer 'severe double digit losses'.

Here's how it would happen:

  • In this worst case scenario, UBS projects that the US would fall into a recession.
  • Average recessions cause a 15 to 20 per cent decline in earnings.
  • Valuation multiples tend to decline with earnings possibly to 11-12x.
  • Should all of this come to pass, the S&P would be expected to trade at 1,000-1,100.

Source: UBS

Then of course there's the ultra-nightmare risk of the debt ceiling not being raised, and the US going into technical default.


In the event of a recession or severe US economic contraction, we would likely see a pronounced flight to quality, particularly to US Treasuries. This would push those rates down, and widen credit spreads, pressuring corporate bonds and EM Debt.

It's possible that the recession would provoke further Fed easing, contributing to both of the above trends.

UBS has an ultra bear case in which Congress fails to avert the fiscal cliff and fails to extend the debt ceiling. In this case, the United States would be in technical default, and a resulting sell off could cause rates to rise.

Societe Generale

Treasury issuance could shrink dramatically from $1.2 trillion in the current fiscal year, to about $700 billion in FY2013, and $370 billion by FY2015.

Source: UBS / Societe Generale

Demand for the U.S. dollar will spike

If the fiscal cliff hits with its full impact, the dollar would likely appreciate significantly due to:

  • Increased demand from a 'flight to quality' associated with recessions
  • A decrease in the private savings rate
  • Decreased demand for foreign goods, particularly oil.

Source: UBS

A full blown fiscal cliff could see Brent oil tumble to $67/bbl

A full blown fiscal cliff would be particularly disastrous for commodities. UBS predicts that:

  • Diversified commodities indices could drop by 25 per cent.
  • Energy would be particularly hard hit. FY 2013 US oil demand would contract by .35 million barrels per day as opposed to growing by 0.15 mbpd in the base case.
  • This would send WTI down to $55/bbl and Brent to $67/bbl.
  • Natural gas, coal, and base metals would see significant decline as well.

Source: UBS

However, Citigroup thinks that the consequence of a full-blown fiscal cliff are so dark that markets assume some sort of resolution

Citigroup believes that a fiscal cliff with full sequestration and sunset (tax cut expiration) would result in a GDP contraction of around 4 per cent on a fiscal year basis. The calendar year impact would be closer to 5 per cent.

  • They aren't that concerned about the economy suffering the full impact, it is so large that markets seem to be assuming at least a partial resolution.
  • Only 20 per cent of institutional investors expect the Bush tax cuts to expire at years end.
  • They see the real risk as a scenario where adjustments come only after another partisan showdown, similar to what happened with the debt ceiling in 2011. That would impact both confidence readings and some activity measures.
  • Those looking to the Fed should look elsewhere, the Fed would not be able to buffer the impact of a current law fiscal cliff.

Source: Citigroup

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