Fiscal Cliff Is Higher Than You Think: BofA-Merrill

Washington lawmakers’ infighting could throw U.S. taxpayers off the fiscal cliff as Bush tax cuts expire and debt ceiling looms

Bank of America headquarters, Charlotte, N.C. (Photo: AP) Bank of America headquarters, Charlotte, N.C. (Photo: AP)

As the presidential elections draw near, the nation’s debt woes are coming into clearer focus—and Bank of America-Merrill Lynch Global Research warns that the “fiscal cliff” is bigger than most market observers imagine.

The fiscal cliff, off which U.S. taxpayers may have to leap on Jan. 1, 2013, if the Bush tax cuts expire, is seen as being the inevitable consequence of Washington lawmakers’ infighting unless President Obama and Congress honestly confront this deadline in an election year.

Further, according to BofA-Merrill’s analyst team at a midyear press conference on Wednesday in New York, any positive budgetary effect of the tax increases would be overshadowed by the growing burden of the U.S. debt ceiling as spending and hiring decisions are put on hold and the election heightens partisanship.

U.S. GDP Could See 4.5% Shock

But if lawmakers don’t act, U.S. GDP could see a 4.5% shock, warned Senior U.S. Economist Michelle Meyer.

“In the second half of 2012, the headlines will really be focused on the debt ceiling and the Bush tax cuts,” Meyer said. “We think the economy is slowing faster than most forecasts on the Street.”

BofA-Merrill’s view is for real GDP growth of 1.9% in 2012 versus consensus expectations for 2.1%, and for only 1.4% real GDP growth in 2013 versus the consensus of 2.4%.

In particular, Meyer pointed to battleground areas of contention including $180 billion in Bush tax cuts, a $120 billion payroll tax cut, debt ceiling deadlines of $110 billion and $40 billion, another $40 billion in extended unemployment insurance and $20 billion in taxes for the Patient Protection and Affordable Care Act that the Supreme Court upheld Thursday.

However, Meyer acknowledged signs of a slow recovery in the housing market, which should add 0.2% to GDP this year, while her colleague Priya Misra, head of U.S. rates strategy, said inflation is not a concern because the U.S. Treasury market is on a continued flattening trend. Misra, too, warned that the fiscal cliff at year-end could precipitate a yield curve steepener if all measures are postponed.

Another positive view came from Global Credit Strategist Hans Mikkelsen, who said that he has seen “significant and impressive” improvement in all the U.S. banks, which have been able to withstand harsh stress-test scenarios and are now decoupling from problematic European banks. “We’ve seen a decrease in the big systemic risks from the European into U.S. markets and a significant decline in credit risk,” Mikkelsen said.

Investors’ Best Bet: High-Yield Bonds, Dividend Stocks

So what’s an investor to do? Invest in high-yield bonds and dividend-yielding stocks, says the BofA-Merrill team, which is overweight high-grade and high-yield corporate bonds, including financial sector names that are especially sensitive to the housing market.

As for stocks, BofA-Merrill’s year-end target for the S&P 500 index is 1450, compared with its open on Friday at 1330. The target is principally based on the BofA-Merrill research team’s earnings forecast, but it also has incorporated technicals and sentiment.

“Our target for the S&P 500 sounds pretty high at this point,” conceded Savita Subramanian, head of U.S. equity and quantitative strategy, “but what the last few years have taught us is that fundamentals sometimes take a back seat to other factors such as sentiment and technicals.”

Read Reports of ‘Death of Equities’ Greatly Exaggerated: DFA at AdvisorOne.

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