Investors fear the fallout from election

Investors are looking at what the election has done to Washington — and they are worried about what they see.

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Tuesday’s election brought back for a second act one of the more dysfunctional political alignments in recent memory — a Democrat-controlled Senate, a GOP-led House, and President Obama. 

Markets responded Wednesday with the worst trading day of the year, as concerns over striking a deal on the fiscal cliff returned to the spotlight. The Dow Jones Industrial Average dropped 313 points Wednesday, followed with another 121 point decline Thursday.

“When we got a status quo election … there was an immediate reaction to sell off because, basically, the voters sent the same team who had not agreed on anything for the last two years back to Washington,” said Brian Gardner, senior vice president of Washington research at Keefe, Bruyette & Woods. “It was, in some respects, a gridlock selloff.”

Part of the sell-off can be attributed to a sell-off by investors who had been optimistic about a Romney win, and who surged into financial markets before votes were cast. They anticipated potential tax or regulatory relief that would come from a GOP administration, and stocks ran to solid gains in the two days before polls closed.

Obama's victory spoiled the mood. 

Another factor driving down stocks could have been investors positioning for potentially higher taxes on capital gains and dividends that could come from a second Obama term. Continued concern about slowing economic growth in Europe and China also remains factors.

But the broader concern gripping markets is whether the same teams that fought to the brink on the debt ceiling and flirted with a government shutdown can now find a way to avert the automatic spending cuts and expiring tax breaks set to take effect in the new year. Experts agree they would push the economy back into a recession.

“The nightmare scenario is really upon us,” said Andrew Busch of BMO Capital Markets, who also was an economic advisor to Sen. John McCain (R-Ariz.). “They don’t see a way forward on this. That’s disturbing, and I think that’s reflected in the markets.”

Market anxiety over a Washington standoff is nothing new. Wall Street was captivated by the high-stakes debt limit standoff last August, which ultimately led to market turmoil following the first-ever downgrade of the nation’s credit rating.

But Gardner contends that a protracted fight over the fiscal cliff could do even more harm. For one, the timing is significantly worse.

The debt limit fight occurred over July and into early August, and the dog days of summer tend to be a slower time for the economy. The same cannot be said for the end of the year, which is a key financial and economic time for the country.

Continued uncertainty about the course of the nation’s tax and fiscal policy could put a damper on the holiday shopping season, and the end of the year typically is accompanied by a selloff that could be even worse with the cliff looming, according to Gardner.

“People are really trying to lock in those gains now because of the looming uncertainty, so this really becomes a self-fulling cycle,” he said.

Furthermore, the impact of the fiscal cliff could be exacerbated by underlying weaknesses in the economy and other factors. David Stockton, formerly chief economist to the Federal Reserve, warned Thursday that the cliff’s impact would be worse than many are expecting. Stockton is now a senior fellow at the Peterson Institute for International Economics.

He warned that the Federal Reserve is already overextended in terms of policy and would have few options to dampen the cliff’s impact. 

Fed Chairman Ben Bernanke has repeatedly warned Congress the central bank would be unable to protect the economy from the impact of the cliff.

“There isn’t going to be any cushioning there,” Stockton warned. “It’s one heck of a big risk to take.”

While the first parts of the cliff are not set to take effect for over a month, Wall Street is already ebbing and flowing with every new statement out of Washington. 

On Friday, stocks steadily climbed throughout the morning, even as House Speaker John Boehner (R-Ohio) spoke with reporters, laying out his commitment to lower taxes but increased revenue as part of a fiscal cliff deal. 

But stocks slid sharply back into negative territory as the day progressed, as President Obama reiterated his demands that higher taxes must be part of any fiscal cliff deal. Stocks ended the day effectively flat.

Expect more market turmoil as the Washington work unfolds, according to Gardner.

“We are on a rollercoaster,” he said. “Every time there is an event coming out of Washington for the next six weeks, Wall Street will be riding that rollercoaster.”

And perhaps most frustrating to investors is that concern over the cliff is overshadowing what seems to be steady improvement in the U.S. economy.

“It’s really unfortunate. There’s positive things going on in the U.S. economy,” said Busch. “We’ve got to get this done. It’s got to get taken care of.”