Investors Play Chicken With Washington

From The Wall Street Journal:

Washington's can-kickers are lacing up their boots, increasingly confident they will be playing a familiar sport come November. It may turn out to be a dangerous game of chicken instead.

The federal budget is headed in less than eight months for what Federal Reserve Chairman Ben Bernanke calls "a massive fiscal cliff." Yet stock markets seem to be operating under the assumption that a postelection, lame-duck Congress will take the sting out of expiring tax cuts and spending restrictions.

It might even seem that economic data are raising the odds of that happening. Following two months of disappointing jobs data, the release Thursday of April budget data from the Treasury Department is expected to see the first monthly surplus in 3½ years. The Congressional Budget Office forecasts it will come in at some $58 billion. Meanwhile, the rolling, 12-month deficit, while still massive at $1.15 trillion, would be the lowest since May 2009.

But a positive budget number would be an island in a sea of red ink caused by the timing of receipts and payments. Another $450 billion or so in deficits are projected for the remaining five months of fiscal 2012, ending in September.

In other words, no improvement is seen between now and then. This will make it difficult to postpone most of the looming budget changes, barring the unlikely event comprehensive reforms of entitlements and popular middle-class tax breaks are agreed upon.

Equity and debt markets seem diametrically opposed in handicapping the situation. Treasury yields are negative after inflation—hardly a sign of robust growth ahead funded by yet-more government spending.

But equity investors seem unfazed by the economic hit posed by the combined expiring measures, equal to about 4% of gross domestic product. That would result in recession, upending equity analysts' forecasts, which currently predict corporate revenue rising slightly faster in 2013 than this year. That depends on decent economic growth, less likely with austerity.

Of course, much hinges on politics. Citigroup Inc. C -2.78%executive and former Obama budget chief Peter Orszag lamented recently that the most likely option is that no compromise is reached, allowing all the measures to expire.

Equity investors must hope he is wrong or, come January, they'll be kicking themselves.