A close election, however, that results in either a narrow Democratic or Republican victory, will likely be problematic (for the fiscal cliff and markets), as it will produce a partisan impasse similar to what we have experienced in the past (e.g., during previous budget deliberations). Though it is hard to envision no action being made, even in this circumstance, it will likely hold negative market implications.
Off of my baseline election expectation (Democratic presidency and Senate victories), I am assuming that the fiscal cliff should produce a 1%-1.5% fiscal drag in 2013. (Fortunately, an acceleration in the domestic housing recovery and some pent-up demand in other sectors will likely offset a portion of this drag but will translate into aggregate real GDP growth of only 1%-2% next year.)
Under this scenario, profits will likely be slightly weaker than the consensus forecast of top-down
earnings of $108 a share and much weaker than the consensus forecast of bottom-up S&P 500 earnings of $113 a share, likely falling to about $100 a share from the $103 a share projected in 2012.
If the election results are tighter than I expect and Obama prevails, stocks could drift irregularly lower over the balance of the year, perhaps in the 1350-1400 range for the S&P 500. (Even if the market's drop is contained to 3%-5%, however, many higher-beta stocks will continue to be rocked, as has been the case over the past week.)
If Romney wins in a tight contest (and the Democrats regain control of the Senate), I would expect a brief stock market rally that peters out in the face of the reality that the Democrats will fight tooth and nail and we could fall harder off of the fiscal cliff. As a result, the fiscal drag would be more powerful, and 2013 real GDP growth could fall flat while S&P 500 profits might decline to $95 a share level or lower.
While it is important to recognize that the eventual resolution of our deficits will be importantly influenced by who wins the presidential election, regardless of who wins in November, the uncertainty of how our fiscal imbalance will be resolved will be with us for many months after the election. In all likelihood, this albatross of uncertainty will weigh on the markets throughout the balance of this year and into early 2013.