After Bruising ’12 Election, Fiscal Fears Hover Over U.S. Outlook

Now that the 2012 race for the White House is in the books, the spotlight on Wall Street is shifting from a major political question mark to a more monumental fiscal one that threatens to cripple the stock market, send unemployment above 10% and drive the U.S. into a double-dip recession.

Greeted with essentially the exact same political landscape they went to bed with, investors sent the Dow plummeting more than 300 points on Wednesday amid concerns renewed political gridlock will force the  U.S. off the looming fiscal cliff.

The gloomy mood on Wall Street underscores the fact that President Obama isn’t in store for a honeymoon to kick off his second term and highlights the near-term challenges facing both the domestic economy and equity markets.

“The economy will be on hold until the fiscal cliff is addressed,” David Joy, chief market strategist at Ameriprise Financial (NYSE:AMP), wrote in a note. “Longer-term, the economy will limp along until whatever budget deficit deal we're going to get, if any, is done. If no deal is made, the economy will struggle.”

Staring at the Fiscal Cliff

While average Americans and hardcore traders alike are relieved the long election battle has ended without a repeat of the 2000 recount, the removal of the electoral uncertainty alone is clearly not enough to keep stocks and the economy afloat.

Much more important is a speedy resolution to the fiscal cliff, the $600 billion batch of spending cuts and tax increases to take effect if unless Congress acts before January 1.

“Failure to reach even a temporary deal on [the] fiscal cliff would mean that the general election had not resolved the political gridlock in Washington and likely result in a sovereign rating downgrade by Fitch,” David Riley, managing director at Fitch Ratings, wrote in a statement.

Fitch further warned that falling over the fiscal cliff will “tip the U.S. economy into an unnecessary and avoidable recession” that sends the unemployment rate soaring from the current 7.9% level to 10% in 2013.

Russell Price, senior economist at Ameriprise, predicted a compromise on the fiscal cliff could emerge “rather quickly” now that the political rhetoric can recede, providing a “strong economic stimulus.”

Status Quo Jitters

Yet the market reaction to the election results suggests investors worry the status quo -- Democrats keeping control of the White House and the Senate and Republicans holding onto the House of Representatives -- raises the chances that political gridlock will persist and send the U.S. over the cliff.

“That’s what is spooking the market. If it’s business as usual -- if the Republicans are saying they are standing pat and not willing to discuss a single tax hike and Democrats say they won’t accept anything less than a tax hike -- we’re just back to where we were,” said Sam Stovall, chief investment strategist at McGraw-Hill’s (NYSE:MHP) S&P Capital IQ.

Jim Rickards, a partner at hedge fund JAC Capital Advisors, predicted the U.S. will be taken over the fiscal cliff, but “with some smoke and mirrors.” He said before reaching a compromise in 2013, both sides may promise to retroactively apply changes in the tax law to January 1.

“Only in Washington is that viewed as a solution. Back in the real world people are not very trusting,” said Rickards. “I think they’re going to fudge it and I don’t think they’re going to fix it and the markets are going to react badly.”

1948 All Over Again?

Wall Street’s knee-jerk reaction to the election results is reminiscent of the response to the well-signaled 2008 race for the White House: the blue chips plummeted 486 points, or 5.05%, -- their worst post-election drubbing on record -- after similarly rallying on Election Day itself.

Stovall said the gyrations in the markets are similar to when the S&P 500 plummeted more than 10% in November 1948 after Democratic President Harry Truman’s surprise re-election against Thomas Dewey.

“I’m calling it the Truman Dewey Redo,” said Stovall, who said the same thing could happen now.

The S&P 500 had been up 8% on the year heading into the ‘48 election and the index managed to recover a bit in December before rallying more than 10% in 1949, Stovall said.

While a 10% selloff from Tuesday’s close wouldn’t bring the S&P 500 into bear-market territory, it would leave the benchmark gauge down to 1285.55 -- a level not seen since early June.

Easy-Money Party Carries On

Others are more optimistic about the outlook for stocks even after the election.

Pointing to historical trends showing the year after presidential elections as even more favorable for equities than the election year, Brian Belski, chief investment strategist at BMO Capital Markets, (NYSE:BMO) said he is “exceedingly comfortable” with his S&P 500 targets of 1425 and 1575 for 2012 and 2013, respectively.

“While earnings growth has become more stable and consistent and cash and efficiency levels are at or near all-time highs, valuations remain below historical averages,” Belski wrote in a note to clients.

Market bulls are also breathing a sigh of relief that Obama’s victory means Mitt Romney can’t take away Wall Street’s easy-money punch bowl with a hawkish new chairman of the Federal Reserve.

Obama is now free to either persuade highly accommodative Fed chief Ben Bernanke to stay on board when his term expires in 2014 or at least choose a dove in his mold such as Janet Yellen, the Fed vice chair.

“You will see new faces but you’re not going to see new policies,” said Rickards.

Banks, Dividend Plays Dive

There are individual areas of the market likely to benefit from Obama’s re-election, including hospital stocks like HCA Holdings (NYSE:HCA), which should benefit from the fact that Obamacare is virtually certain to be fully implemented.

On the other hand, fears of higher taxes on dividends are already weighing on high dividend paying stocks like Altria (NYSE:MO) and Exelon (NYSE:EXC), which tumbled more than 5% a piece on Wednesday.

The re-election of Obama and ability of Democrats to pick up seats in the Senate also removes the chances of repealing parts of the Dodd-Frank financial reform overhaul.

Some on the left, including consumer crusader Elizabeth Warren who won election in Massachusetts on Tuesday, could also reignite efforts to break up the big banks. Shares of financial heavyweights Bank of America (NYSE:BAC) and Morgan Stanley (NYSE:MS) plummeted about 6% and 7%, respectively, on Wednesday.