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Goldman Sachs Can Fall Off the Fiscal Cliff

NEW YORK ( TheStreet) - Since Goldman Sachs (GS - Get Report) chief executive Lloyd Blankfein is openly talking about why U.S. lawmakers need to get their act together and avoid the so-called 'fiscal cliff,' investors might do well to consider the impact on the bank's shares if the U.S. falls into an abyss of budget austerity.

Blankfein and Jamie Dimon of JPMorgan Chase (JPM - Get Report) have recently taken to the public to sound the alarm bell on the cliff and investors should listen.

"We sure know what the consequence will be and it will be awful," said Blankfein in a CNBC interview Thursday. It's "one of the major ways in which the slow recovery that we have could be completely derailed," he added.

In the case of Dimon, the JPMorgan CEO made two pressing points after the bank's third-quarter earnings on Friday. First, he's ready to call a housing rebound. Second, Dimon is quietly noting the fiscal cliff's impact on banking sector earnings.

"If the fiscal cliff actually happens, you have to be prepared for various scenarios, including the worst possible one even if you don't predict it," said Dimon on the JPMorgan's earnings call. While the CEO was confident a cliff wouldn't impact the positive momentum at JPMorgan's commercial bank, he noted risks for its investment bank.

It's the latter that should concern bank stock investors -- and especially Goldman Sachs shareholders -- who benefited from a near 20% surge in the company's stock during the third quarter and are bracing for what's likely to be a strong earnings report due on Tuesday morning.

Heading into earnings, Goldman Sachs has faced a steady drumbeat of optimism on the company's profitability and its industry position as competitors like Morgan Stanley (MS - Get Report) scale back in some trading, underwriting and private equity activities where competition was fierce prior to the crisis. Meanwhile a rising stock market tide is expected to lift Goldman's boat.

"Despite a sluggish seasonal quarter, we expect Goldman to put up pretty solid results given the improvement in market values, relatively stable volatility and market share gains in its merger and acquisition business," writes KBW bank analyst David Konrad, in a preview of earnings. KBW identifies Goldman, Morgan Stanley and Citigroup as sector out performers through year-end, as traditional lenders like Wells Fargo face a profit margin squeeze from the Federal Reserve.

Still, in spite of an improving earnings outlook and signs in recent M&A and trading activity that augur well for investors headed into 2013, a do nothing Congress can still hurl the U.S. economy over a cliff of sharp budget cuts and wreck a financial sector rally.

Consider that the last time Congress posed a risk to the U.S. economy - namely in a last minute negotiation of an increase to the U.S. debt ceiling that staved off default and was punctuated by a downgrade of the U.S. government's debt rating by Standard & Poor's in August 2011 - the deal sharply cut at overall confidence and economic growth. The summer 2011 debt ceiling standoff also destroyed bank earnings.

As lawmakers wrangled over budget cuts, tax increases and fiscal ideology in the third quarter of last year, businesses pulled back from merger activity and the financing of risk taking through stock and bond issuance. The ensuing slowdown in underwriting, in addition to a sharp drop off in M&A fees hit the earnings of pure play investment banks like Goldman and Morgan Stanley, in addition to the earnings of securities units tucked within larger conglomerates JPMorgan (JPM - Get Report) and Bank of America (BAC - Get Report).

When the dust settled, Goldman posted its first quarterly loss in over a decade and Wall Street as a whole had its worst quarter since the depths of the financial crisis. Were the U.S. to go over the fiscal cliff - a scenario Goldman Sachs' top stock strategist doesn't take lightly - who's not to say earnings couldn't return to such a dire state, in spite of general optimism headed into the bank's release on Tuesday morning?

Analysts expect Goldman will earn $7.3 billion in revenue and $2.12 in earnings per share, according to ThomsonReuters data, a turn from a 84 cent loss that the bank posted in the third quarter of 2011. Earnings expectations are also buoyed by the generally strong reports from competitors Citigroup (C - Get Report), JPMorgan and Wells Fargo (WFC) in October.

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