As predicted both parties have dragged out the "fiscal cliff" drama to the VERY end of the year. The news around this will swirl mightily tomorrow and is likely to whipsaw the markets (more on that later), but first a review.
It's important to remember that the premise behind the "fiscal cliff" is merely some of the same type austerity measures imposed in Europe over the past couple of years. A combination of two things - spending cuts and eliminating temporary tax cuts - was designed to get our fiscal house in order.
These changes would ultimately lower our ratio of debt to GDP back to around 50% by 2035 and we could, at least in theory, begin running a primary budget surplus by 2015.
I can hear you asking yourself this -- "Wait, those sound like good things?? What's the drama about?". Well, you see those are good things for the country as a whole, but if you are Congressman elected from a district that has been carved to keep you in power, your base is not going to like much of this "cliff" business. Either your constituents are dependent on the government spending that will be cut (think defense contractors, doctors accepting Medicare, or even Ft. Drum for example) or your constituents have grown used to those temporary tax cuts and they don't like the idea of paying higher rates.
So, because Congress is beholden to their constituents and they can't work together for the greater good, we've seen this fiscal cliff become the bogeyman of 2012.
Ultimately, we have to have this conversation like adults. To get our fiscal house in order tax receipts need to increase and spending needs to decline. However, no one wants to have that conversation, so what we will be left with is some type of lame "Cliff Avoidance" plan that does raises taxes on a few, patches the AMT, extends unemployment benefits and ultimately doesn't do very much to help our economy.
The current sticking points seem to be CPI indexing of some benefits, how to tax high income earners (as I originally predicted $400-$500k is likely to be the new threshold for high income), and how to handle estate taxes. These are big issues that are unlikely to get hammered out in the next 24 hours so I'll stick with a prediction that a "deal" will be announced but it will be very limited in its scope. My concern is that this is some sort of mock run for the real showdown coming in January over the debt ceiling. If you talk to global business leaders they have very little concern about the future of the US economy but what does concern them is the lack of our leaders to lead. The true cliff we are up against is our position as a leader of the global economy and if we can't demonstrate an ability to make hard, smart choices that position our country for growth 10-20-30 years down the road, then we might as well yell "Cowabunga" and jump today.
So what will this mean for the markets? This is tricky mainly because of the date. On a normal date, I would expect the announcement of a deal to ramp stocks 2-3% and that may very well be the initial reaction. However, as details emerge I expect people will be less than impressed and we may sell-off. However, there is the matter of 12/31 to be dealt with. Many equity managers have to beat an index from 1/1 to 12/31 which means if the index is 100 on 1/1 and goes to 110 on 12/31 then they should return 10% or more to earn their keep. Well, imagine if your a mutual fund manager and you've locked in all of your 2012 gains and you're sitting on the sidelines until this fiscal cliff is cleared up. Well, what if the market you were supposed to beat jumps from 100 to 103 on 12/31. Now in 2013 you have go from your assumed 100 to 113 or more because the base number on 1/1 will be higher. As I type this I know it's not making sense, but let's just say it is in the money manager's best interest for a big bonus in 2013 to have lower starting point at the end of 2012. For that reason stocks might end flat or down after a deal is announced. It should be entertaining either way.
Happy New Year!