Goldman Sachs Can Fall Off the Fiscal Cliff

NEW YORK ( TheStreet) - Since Goldman Sachs ( GS) 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) 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) 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) and Bank of America ( BAC).

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), JPMorgan and Wells Fargo ( WFC) in October.

Goldman Sachs may operate cautiously as the fiscal cliff hangs over fourth quarter earnings, notes Michael Wong, an equity analyst with Morningstar.

"With the potential for a 'fiscal cliff,' Goldman Sachs and other banks will stay to the high ground in terms of liquidity and their capital structure," says Wong, in an interview earlier in October. Caution may not be great news for investors given that new regulations and declining leverage at Goldman are depressing some of the firm's key stock drivers.

Meanwhile, although a rising tide of analyst forecasts bodes well for Goldman's earnings, bank stock investors generally haven't been good at identifying risks to earnings a quarter or two out. After Goldman's shares touched levels above $120 for a sustained period following the bank's strong fourth quarter 2011 results in January, investors bid up shares only to see them fall sharply amid fears of the impact of ratings downgrades by Moody's.

On Monday, Goldman's chief equity strategist David Kostin put out a decidedly bearish stance on stocks headed into year-end, as the cliff wrecks what's been a strong year for equities. Kostin sees the S&P 500 falling over 10% through year-end, as Congress walks slowly toward the fiscal cliff, derailing C-Suite and consumer confidence.

"We assign a low probability that Congress addresses the 'fiscal cliff' in a benign fashion prior to year-end 2012," Kostin wrote, in a note that gave one-in-three odds the U.S. will go over the cliff in January. Such a scenario would have a notably similar impact to the drain a budget ceiling standoff caused last summer.

All spring and early summer market participants assumed Congress would raise the borrowing limit before the ceiling was reached," writes Kostin, who notes a 17% plunge in the S&P as talks came down to the final hour. " The dynamics are actually similar because both debates involve date-specific deadlines that encourage brinksmanship," adds Kostin of the similarities between the 'fiscal cliff' and the 'debt ceiling.'

A forward-looking stance on the risks to bank stock earnings may put investors in good stead as the U.S. hurtles toward a fiscal cliff in the wake of Presidential elections in November. That may especially be the case if Goldman Sachs reports blowout earnings on Tuesday, as some expect.

For more on Goldman Sachs, see why the firm is readying for a bayou battle on its M&A advisory work and why the bank is cutting its PE future by half. For more on Goldman's shares, see why the bank may grow by shrinking.

-- Written by Antoine Gara in New York

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