Fiscal cliff deadlock weighs on company profits

• If fiscal cliff deal doesn't happen, continued uncertainty could hurt corporate profits
• Analysts have slashed earnings estimates for the next four quarters
• Resolution is needed to reduce uncertainty and give CEOs more clarity

NEW YORK — The uncertainty caused by the political squabbling over how to fix the nation's fiscal problems has already taken a bite out of corporate profits. If negotiations drag on and Congress can't seal a deal to avoid automatic tax hikes and spending cuts by Dec. 31 or early next year, profit growth for U.S. companies in future quarters could also be squeezed, creating a fresh risk for stocks.

Over the past eight weeks stocks have been driven by Wall Street's perception of how the "fiscal cliff" talks are progressing. Hints of a deal have proved bullish and fueled risk-taking, while signs that talks are breaking down have put downward pressure on stocks as investors flee risk. The Dow Jones industrial average has fallen 1.3% in the past two sessions, including a 52-point drop to 13,139 in a holiday-shortened session Monday.

Earnings growth posted by companies in the Standard & Poor's 500-stock index, which is a huge driver of stock prices, has been decelerating. One culprit has been the political dysfunction that has increased the odds that the U.S. economy will fall off the fiscal cliff, an outcome economists say is likely to cause a recession.

The inability of Washington lawmakers to reach a compromise that will clarify policy related to taxes, regulations and deficits, has resulted in a chilling effect on U.S. companies. Many CEOs are reluctant to invest in their businesses, build new plants or hire new workers because they don't know what the rules of the game will be.

And that cautiousness is dragging down earnings.

Earnings growth for the third quarter of 2012 was non-existent, with Standard & Poor's 500 companies growth of 0.1%. Similarly, analyst estimates for S&P 500 profit growth in the final three months of 2012 have been cut to 3%, down from 10% on Oct. 1. In a further sign of CEO caution, there have been 3.6 profit warnings for every one company issuing a positive profit pre-announcement for the current quarter, vs. a long-term average of 2.3 to 1, according to Thomson Reuters.

"It is likely that earnings estimates for many companies are at risk due to fiscal cliff implications, as evidenced by the continuing decline in those estimates," says Eric Schoenstein, co-portfolio manager of the Jensen Quality Growth Fund. Despite ongoing risks, he says investors can limit risk by focusing on quality businesses that have proved successful and been able to churn out solid profits no matter what the headwinds.

Congress broke for its Christmas break with deal negotiations deadlocked, which boosted the odds of going over the cliff. If the lawmakers can't hammer out a deal in the final six days of 2012, it is likely to result in a short-term loss of investor confidence and a further drag on business and consumer spending, which is expected to act as a drag on profits.

"The approaching U.S. fiscal cliff remains a formidable headwind to growth," says Bill Stone, chief investment strategist at PNC. "Progress needs to be made ... to support global equity markets and assure the global economic recovery continues uninterrupted."

The fiscal cliff is actually more of a slope, with the spending cuts and tax increases taking effect incrementally over time, adds Rod Smyth, chief investment strategist at RiverFront Investment Group. "If the fiscal cliff is resolved in the first few weeks of 2013, its economic impact should be minimal," he said.

Stone remains hopeful that a deal will get done in time to avoid the majority of the fiscal drag. But he won't rule out the Dec. 31 deadline passing before a deal gets done early in 2013. He expects markets to be volatile during the ongoing negotiations. An eleventh-hour deal will likely be bullish for stocks, as it will provide clarity and limit the damage to the economy.