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BofA Merrill Lynch Global Research – A US Economics Report – Monday, 31 December 2012

The clock is ticking

Time is running out. As this note goes to press, the cliff negotiations have devolved into two unpalatable options: (1) extend just the middle income tax cuts and extended unemployment benefits and allow about two-thirds of the cliff to happen, or (2) go over the cliff in the entirety. In our view, given the short time frame and legislative hurdles, the latter appears much more likely.

Here we look at what we believe are likely scenarios and potential impact of each on the economy and markets. We reiterate our key calls as follows:

 Going over the cliff is not a benign “slope” as some suggest. Rather, it accelerates the already-building damage to the economy and markets. The latest evidence is the plunge in consumer confidence. Indeed, this could mark the beginning of the rotation in the uncertainty shock from businesses to consumers.

 Once the cliff deadline has passed, something has to convince politicians that what they are doing is not worth the price. Due to reporting lags, the damage to the economy will only become clear over time. Hence the catalyst for action will likely need to be market weakness and severe public criticism.

 Today the stock market has increasingly become the disciplining force in spurring action in Washington. “Stock market vigilantes” have replaced “bond market vigilantes.”

 Going over the cliff has many secondary, largely ignored, negative impacts, including tax changes that could damage the housing recovery, as well as negatively impact education and alternative energy, among many others.

Over the coming weeks we expect politicians to agree to a series of partial patches, with some parts of the cliff delayed and others allowed to expire. The result would be a series of awkward decision points with attendant pressure on consumer, business and investor confidence. But we continue to believe the cliff will be mostly resolved before the end of the first quarter. In our view, the biggest risk to this expectation is a protracted battle over raising the debt ceiling, which will be reached by late February or early March, after extraordinary measures.

 

 

Read the full report here.