Like the sequel of blockbuster horror movie, the debt ceiling may strike again.
In an echo from early August, a gridlocked bipartisan Congressional committee must find a way to agree on a deficit reduction plan by Nov. 23rd. Congress itself must then pass the bill, without changes, by Dec. 23rd.
If it doesn't, $1.2 trillion in spending cuts will automatically take effect beginning in 2013. Analysts worry that the looming cutbacks, which are scheduled at time when the economy is expanding at an annual rate of just 2.5 percent, could knock the U.S. back into another recession.
That's because the cutbacks wouldn't be the only drag on the economy. If Congress isn't able to agree on the deficit framework, there's little hope they will extend stimulus measures like unemployment benefits, a payroll tax cut and Bush-era income tax cuts that have helped bolster consumer spending, said David Kelly, chief market strategist at JP Morgan Funds. That combination may halt the economy in its tracks, leading to more layoffs and weaker business confidence right when the unemployment rate is still stuck at 9 percent.
"Everyone's attention has been focused on Europe lately, but this is a real issue that's being ignored," Kelly said.
For investors, that means that it could be another good time to get defensive. Analysts suggest raising cash, buying highly-rated corporate bonds, and increasing the holdings of health care, utilities and consumer staples companies that aren't as dependent on a growing economy for profits.
This potential stumbling block comes as investors have otherwise been feeling pretty optimistic. The S&P 500 index has jumped 15 percent since Oct. 3, when it hit a low for the year, after Greece finally got a new financial rescue package in place and on encouraging signs of strength in the U.S. economy. The S&P 500 jumped another 1.9 percent Friday after Italy passed an economic reform that may help it avert a financial crisis.
"We've had two of the three big concerns in the market largely resolved over the last month," said Mark Lamkin, head of Lamkin Wealth Management. "But the third is Washington, and there's no telling what will happen."
Some of those concerns are already playing out in the stock market. So-called defensive sectors have done better than the rest of the field, a sign that investors are still cautious. Healthcare companies in the S&P 500 are up 7 percent since the debt panel was announced in August. Utilities, meanwhile, have jumped 10.5 percent. The S&P 500 itself is up 5.4 percent over the same time. That's a sign investors are putting a premium on reliable earnings.
The looming government cutbacks might be holding back the most defensive group of stocks around: weapons manufacturers. More than $500 billion of the automatic cuts would come from the military, and the rest from other areas of the federal budget. Defense companies Lockheed Martin and Northrop Grumman haven't received the boost investors would normally expect after each company reported surprisingly strong quarterly results Oct. 26. Each company is up roughly 6.5 percent since the deficit panel was announced, only about a percentage point above the broad S&P 500 index.
Northrop Grumman CEO Wes Bush told analysts during a conference call that the company is readying itself for the possibility of broad cuts in government spending. "It's certainly going to be a more challenging environment," over the next year, he said.
Despite its 2.5 percent growth rate last quarter, the economy remains fragile. The Federal Reserve recently lowered its economic outlook for 2012. The central bank predicted that the economy will grow at a rate of about 2.7 percent next year. That is a full percentage point below a forecast from June, and below the 3 to 5 percent annual growth rate that is considered healthy. Economists at JP Morgan have a far gloomier forecast: 1.7 percent.
Few investors have much faith that Washington will pass the next deficit-cutting bill in time. Congress was barely able to reach an agreement to raise the government's debt ceiling ahead of the Aug. 2 deadline. The possibility that the U.S. government could default on its debt and a subsequent downgrade by Standard and Poor's that cut the nation's credit rating for the first time sent financial markets in a tailspin.
The Dow Jones industrial average plunged 11 percent over the first six trading days of August. Yields on Treasurys, which move in the opposite direction of their price, fell to the lowest since the 1950s.
Lamkin, the wealth manager, said he is already preparing for the deficit panel to stall. He's recently moved more of his client's money to cash. He's staying away from U.S. Treasury debt because a massive rally has already pushed the yield on the 10-year note down to a puny 2.06 percent. Instead, he's buying intermediate corporate bonds from blue chip companies like International Business Machines Corp. and Microsoft Corp. that yield more than 3 percent.
"We're hoping that it's not going to come to this, but this past summer showed that we have to be ready for the worst," he said.