"The fiscal cliff is worth about $650 billion. It's roughly 4% of GDP, so it's big," Barclays Head of Research Larry Kantor said at a presentation of the firm's latest Global Outlook report, "Don't Fight the Fed," in New York on Tuesday.
Barclays is forecasting that the negotiations for the fiscal cliff, a combination of expirations on current tax cuts and spending cuts, would put approximately $200 billion of the total $650 billion at risk. In that forecast, Barclays expects that the U.S. government will settle to keep the Bush-era tax cuts. Other areas including part of the payroll tax and eventually the Social Security tax will increase, while extended unemployment benefits will be allowed to expire. That projection is just one of many scenarios that might occur, the firm said.
"Judging by the experience of the last couple of years, this can get very messy with a lot of positioning on both sides and can produce a lot of angst in the market," Kantor said. "There [are] almost an infinite number of combinations that could occur."
The most unlikely scenario Barclays foresees would be for both Republicans and Democrats to move towards a massive fiscal policy tightening in an already weak economy. That would almost certainly lead to at least one negative quarter in GDP, Kantor said.
While many cite the upcoming November election as the ticking clock on this issue, Barclays Head of U.S. Equity Portfolio Strategy Barry Knapp said that Thanksgiving is actually the more pressing deadline, with just two weeks after that holiday for lawmakers to get anything done. "In the wake of what's likely to be not particularly robust growth outlook and the markets reacting to that, that they probably would do some sort of extension and then hash it out in the new year," Knapp said. The effect on the markets might be limited if the payroll tax cuts are allowed to expire, according to Knapp, while raising the Bush-era tax cuts could have a much more dramatic effect.
Any effect that policy decisions have on the markets will likely depend on what is done and what else is happening at that time, according to Kantor.
"It's not so clear cut about what the market reaction would be to a fiscal tightening, and the reason is everyone knows it's inevitable," Kantor said. "To get some of it out of the way, like the payroll tax cut expiring, you get a one time hit and that's it. I'm not so sure the market would do something. I think it depends on the context of what else is done."
Barclays' report urges investors to consider more risky investments as new moves by the U.S. Federal Reserve and European Central Bank has provided unprecedented support for the markets. That should result in mildly stronger growth for the rest of the year, Barclays predicts.
To take advantage of that growth, Barclays' report said, investors should favor U.S. equities while looking areas of strength in the emerging markets such as Brazil or South Africa, and also consider more exposure to BBB-rated corporates in the U.S., European credit, cyclically sensitive stocks, lower-rated bonds in investment grade and inflation-linked bonds.