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Obama win has investors staring at fiscal cliff

By Rodrigo Campos and Steven C. Johnson

NEW YORK (Reuters) - Investors hit trading floors Wednesday morning with the same president and the same problems in gridlocked Washington, and expected the same solution as always to a looming budget crisis that threatens the economy: punt and deal with it later.

Shares dropped sharply on fears that partisan bickering will prevent compromise. The S&P 500 fell below a key level for the first time in two months. Bank and defense stocks fell on a sell-off by investors who had bought those sectors in hopes Republican Mitt Romney would win.

President Barack Obama beat Romney to win a second term, but he still must contend with a Republican-controlled House of Representatives that could make it hard to forge compromise, especially on the coming "fiscal cliff."

Unless the White House and Congress reach a deal to cut the deficit, a $600 billion package of tax increases and spending cuts are scheduled to take effect automatically at the end of 2012. Investors fear economic damage unless the fiscal cliff is averted.

This is expected to be the top priority of the "lame-duck" Congress that will convene soon, though few hope for anything resembling a permanent solution to the problem.

"The best thing that could have happened is what happened," said Robert Manning, chief executive of MFS Investment Management. "I don't think there will be any grand bargain at all, just small fixes that will kick the can down the road."

Markets reacted negatively, as many feared they might do if the election guaranteed further partisan rancor. The Dow Jones industrial average shed 310 points and the S&P 500 dropped 2.3 percent -- almost three times the average day-after-election decline, according to Bespoke Investment Group.

The S&P 500 had rallied 67 percent since Obama took office - one of Wall Street's most impressive runs ever under a single president. Phil Orlando, chief market strategist for equities at Federated Investors, said the market is asking what happens next.

"We just sent the same folks back to Washington. What did they learn in the last two years that will allow them to act differently in the last two months?"

For now, his peers predict market volatility as investors react to dueling headlines about the likelihood of a solution.

"Positive sentiment will move to worries about the fiscal cliff and the ongoing euro zone debt crisis, resulting in market choppiness over the near term," said Martin Sass, CEO of New York money manager MD Sass.

Steven Englander, Citigroup's head of G10 foreign exchange strategy, agreed markets could panic toward year-end if it looks as though no deal is imminent to avoid the fiscal cliff.

If that happens, investors may think twice about purchasing U.S. government debt at low interest rates. This would strain the economy, widen the deficit, hurt the dollar and raise the possibility that major credit-rating agencies will cut the U.S. debt rating.

Standard & Poor's stripped the U.S. of its pristine triple-A rating in 2011. Moody's said Wednesday it would make a decision after the 2013 budget negotiations, though going over the fiscal cliff would not trigger an immediate downgrade.

DECEMBER SURPRISE?

Market strategist Jonathan Golub at UBS said officials will probably focus on avoiding the cliff, but added that trying to run from the problem will highlight the need for a "grand bargain" to fix the deficit.

Investors have had a tendency to downplay problems emanating from Washington, only to find themselves surprised when lawmakers cannot get together on critical issues.

The market reacted harshly to Washington gridlock after failed legislation to backstop the banks in 2008 and again during protracted talks to raise the U.S. debt ceiling in 2011. Oppenheimer Funds strategist Lori Heinel said daily swings of 100 to 200 points in the Dow will be common through year-end.

A re-elected Obama is expected to look for ways to avoid prolonging that kind of blowback.

"The president entered office with the economy in a recession. I don't think he wants to preside over a recession in his second term," said Jeff Applegate, chief investment officer at Morgan Stanley Wealth Management. "I think you have a president concerned about his legacy, and I don't think he wants to leave his presidency with a sea of red ink."

Hedge fund manager Whitney Tilson, one of the only managers in the $2 trillion industry to publicly endorse Obama's reelection, said he was optimistic a compromise was possible.

"This was a victory for moderates," he said. "I hope both parties recognize this and move toward each other - to the center - to address the pressing problems our country faces."

Like some prominent investors, billionaire restructuring specialist Wilbur Ross told Reuters he hoped for an end to "bitter partisanship" and progress on economic growth. Others were less optimistic, such as Mortimer Zuckerman, CEO of Boston Properties and publisher of the New York Daily News.

"I think you're going to have a very delicate, fragile business community," Zuckerman said. "It is not an inappropriate reaction by the business community to be cautious."

CLARITY ON THE FED, LESS ON THE ECONOMY

The end of the drawn-out campaign will put to rest short-term questions about regulation and monetary policy, but some investors remained on edge about taxes and economic health.

Although markets came into the night expecting Obama to win, most traders and investors supported Romney, who raised more money on Wall Street than the incumbent.

"Wall Street made its bet and lost," said Aaron Gurwitz, chief investment officer of Barclays Wealth, noting that not only did Romney lose, consumer advocate Elizabeth Warren won a Senate seat as well, much to banks' chagrin.

One bit of clarity from Obama's win was the future of Fed policy. Romney had pledged to replace Bernanke, whose dovish monetary policy has helped propel gains in both U.S. bond and stock prices in recent years.

"This was kind of a vote for Ben Bernanke and his policies, since Romney was clear he disagreed with that approach," said Tom Luster, co-director of investment grade fixed income at Eaton Vance. "Clearly there's some public support for what he (Bernanke) is doing."

Benchmark bond yields hit record lows despite a downgrade of the U.S. credit rating last year. Yields fell further on Wednesday after the election results became clear, shedding 11 basis points to 1.64 percent.

Cumulative returns for maturities on all U.S. Treasuries are at 14 percent since Obama took office, according to Barclays.

Under a second Obama presidency, Wall Street will have to forgo trying to repeal Dodd-Frank financial reforms and instead continue to use personal relationships in Washington to keep the law from denting profits, said Karen Shaw Petrou of Federal Financial Analytics, a Washington-based research firm. Bank shares fell sharply Wednesday on fears an Obama re-election meant no respite from the new rules.

But some welcomed the changes.

"I don't think any reasonable observer would want to go back to the risk that we had in the system before the financial crisis," said Evercore Chief Executive Ralph Schlosstein.

(Additional reporting by Tim McLaughlin, Svea Herbst-Bayliss and Ross Kerber in Boston, Atossa Abrahamian, Daniel Bases, David Henry, Rick Rothacker, Jessica Toonkel, John McCrank, Ryan Vlastelica, Sam Forgione, Nadia Damouni, Gregory Roumeliotis, Ilaina Jonas, Ashley Lau and Jennifer Ablan in New York; Writing by Ben Berkowitz; Editing by David Gaffen, Lisa Von Ahn, Prudence Crowther, Andrew Hay, Leslie Gevirtz, Ciro Scotti, Kenneth Barry and David Gregorio)

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