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Investors prepare for Obama victory, more expensive gridlock

NEW YORK -- As President Barack Obama widened his lead over Mitt Romney in polls this month, traders at hedge funds and investment firms began shooting e-mails to clients with a similar theme: It's time to start preparing for an Obama victory. 

What many in the market worry about isn't that high earners may pay more in taxes if Obama wins. It's gridlock in Washington come January, when more than $600 billion in spending cuts and tax hikes could kick in just as the country smacks into its borrowing limit again. 

In a second term, Obama would likely be pitted against a Republican-controlled House of Representatives. Investors say that's likely to set up a budget battle similar to August of last year, which ended with the country losing its top credit rating and panicked investors fleeing the stock market.

"If you have any kind of gridlock, you run the risk of inaction," says Tom Simons, a market economist at the investment bank Jefferies. "This is a situation where inaction is the worst outcome."

The next fight could get just as messy, but most on Wall Street think Congress and Obama would eventually manage to postpone some of the $600-billion-plus "fiscal cliff" and avoid tipping the economy into a recession.

The Congressional Budget Office recently laid out the grim consequences of dropping off the fiscal cliff. The economy would shrink at an annual rate of nearly 3 percent in the first half of next year and push unemployment up to 9.1 percent by the fall. Recent surveys of businesses suggest the threat is already weighing on the minds of executives when they're making hiring and spending plans.

For the world's biggest money managers, the fiscal cliff now ranks as the greatest hazard to the global economy, according to Bank of America's most recent fund manager survey. It topped the European debt crisis, a collapse in Chinese real estate and even a war between Israel and Iran.

The danger looms so large to most investors that they believe Washington will find a way to escape it.

"Ultimately, I think a deal gets done, but it's just a question of how long it takes to get there," says Jeff Kleintop, chief market strategist at LPL Financial. "By no means is it going to be an easy process. Gridlock means there's a greater chance that this drags on into next year."

Analysts at investment firms have kept a close eye on polling numbers and especially on the prediction market Intrade. National polls show voters leaning toward Obama. On Intrade, the odds have swung strongly in Obama's direction, jumping to a 76 percent chance of re-election, up from 51 percent at the start of September.

Democrats are far less likely to take the House from Republicans, who hold a 50-seat majority. Intrade markets put the chance that Republicans will control the House at 74 percent.

If these forecasts prove right, the balance of power in Washington would remain the same. Democrats keep the White House and a slim majority in the Senate, and Republicans keep the House.

What troubles investors is that the same cast of characters who fought over raising the debt ceiling last year could be taking up the same task again while debating how best to maneuver around the fiscal cliff.

Expect to see a replay of the debt-ceiling fight, says Ian Lyngen, a senior government bond strategist at CRT Capital. Except that this time the stakes are even higher.

"I'm sure it's going to go just like it did last time — very messy," Lyngen says. "It will probably be a repeat of what we saw in the summer of 2011."

In one dizzying stretch that August, the Dow Jones industrial average dropped 2,000 points in three weeks.

The widespread belief on Wall Street is that Congress and Obama will start negotiations over raising the debt limit and pushing back the fiscal cliff when they return in late November — the so-called lame-duck session, because newly elected members of Congress will not have taken their seats.

Twists in the talks will likely rattle markets as the new year approaches.

"Ugly negotiations in the lame-duck session could really throw the market for a loop," says Kleintop. "It could be a painful process for investors."

In a report out this week, analysts at Goldman Sachs tried to estimate just how painful the process will be. Goldman expects the stock market will start sinking after the elections as people realize the fiscal cliff "will not be solved in a smooth fashion."

That's the reason Goldman forecasts that one broad measure of the stock market, the Standard & Poor's 500 index, will end this year at 1,250 — a 13 percent drop from where it closed Thursday.

But all of that mayhem sounds better than the alternative: another recession caused by letting the $600 billion in tax increases and spending cuts through. It's also why many take solace in the idea that, whatever their political party, nobody wants the economy to shrink.

Dan Greenhaus, chief global strategist at the brokerage BTIG, wonders if that's placing too much faith in Washington. "Republicans aren't losing the House," Greenhaus said. "So as the odds of Obama winning reelection go up, what you have to ask is: How are these two parties going to find middle ground in just a few months? I have no idea."

Below, James Poterba, National Bureau of Economic Research president, explains to CNBC how current fiscal policy could lead the nation into a recession if the economy falls off the fiscal cliff.