How To Know When Markets Are Freaking Out About The Fiscal Cliff

A good note here from Barclays’ Bary Knapp on the “fiscal cliff“, the scene at the end of the year when the tax cuts expire and automatic spending cuts kick in.

Knapp makes two points.

The first is that markets aren’t worried yet. The second is that the odds of a problem are much bigger than people think.

Here’s why he thinks that the market isn’t worried yet.

One way of detecting whether the equity market is pricing the fiscal cliff is to look to the defence sector and estimate the impact of the impending sequestration. With the fiscal cliff approaching on December 31st (including the expiration of the Bush tax cuts, the Obama payroll tax cut and sequestration, along with some additional annual year end tax extensions due to expire), it would stand to reason that defence stocks’ performance and analyst estimates should reflect the probability of a worse case scenario; that is, there is no deal on sequestration and the draconian defence department (DoD) cuts take effect (10% cuts to DoD spending equal to ~$450bn over 10 years).

After discussions with our Aerospace and defence team, we don’t think analysts and investors have fully priced in the sequestration scenario. Looking at a basket of U.S. defence names most levered to DoD spending, we don’t see a downward adjustment in relative valuation to reflect sequestration since the budget control act of 2011 was passed last August.    In fact, even after congress failed to identify cuts in late November, leaving sequestration on the table, relative forward PE multiples for our defence basket drifted higher against the rest of the industrial sector. Furthermore, consensus estimates for this basket call for roughly flat sales growth in 2013 and 2014, far from our Aerospace and defence teams’ revenue declines in a hypothetical sequestration scenario (see Global defence And Aerospace 1/23/12).

This is very useful. Watching defence stocks should be a good “tell.”

As for why there’s a good chance of the fiscal cliff becoming a problem, this table spells out the scenarios.


Photo: Barclays


SEE ALSO: Everything you need to know about the fiscal cliff >

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