Why ‘Fiscal Cliff’ May Be Bigger Threat Than You Think

As the deadline for fiscal peril in the U.S. nears, Wall Street is worried that the impact could be much worse than anyone thought—while investors remain nearly oblivious to the danger.

Looming tax increases and spending cuts — which Federal Reserve Chairman Ben Bernanke has labeled the “fiscal cliff” — would send the economy into a deeper recession than many have predicted, according to economists at Bank of America Merrill Lynch.

At the same time, fund managers the firm surveyed believe investors are far too optimistic that warring Washington factions can get together to take the steps necessary to prevent the economy from going over the cliff—at least temporarily.

Some 72 percent of respondents believe investors have yet to price in the ramifications—a view that is spreading across Wall Street as time winds down for a solution.

“The fiscal cliff impacts the economy both by creating uncertainty and by imposing austerity,” Ethan Harris, BofA’s North American economist, said in a report. “If we go over the cliff for an extended period of time, a recession is likely.”

He later added, “One reason we remain cautious on equities for the next few months is the likelihood for heightened volatility and the potential for a near-term correction amid the risks posed by the US presidential election and the fiscal cliff.”

The election between President Barack Obama and Republican challenger Mitt Romney is frequently cited as a market risk, but the fiscal cliff has been less emphasized. (Read More: Pension Envy: Who Has More—Obama or Romney?)

The cliff entails spending on unemployment benefits, a payroll tax and the Bush-era tax cuts that, if left to expire, would slice already-weak U.S. growth even further.

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