While many factors suggest that a short-term deal to avoid the fiscal cliff will emerge, investors should remain cautious until Christmas. It's an unwelcome message, and may seem bogus if you're confident that a lapse of the Bush tax cuts or across-the-board spending cuts will be temporary, perhaps followed by a rally worthy deal.
Meanwhile, what about the Bernanke put? Shouldn't the message be, "Don't stray, the Washington sideshow will be brief"? "Hold your fire," sounds more like it.
There were small, seemingly conciliatory gestures on each side last week, most notably as Speaker John Boehner formally countenanced new revenues as part of a deficit deal and Obama administration officials expressed openness to generating new revenues through base broadening rather than hikes in marginal tax rates. But huge differences are emerging over what a "bridge," or down payment, during the lame-duck session should look like.
Boehner's "give" is offered in the context of comprehensive tax reform, to be matched by entitlement reforms that Obama heard an earful about from fellow partisans Tuesday. Meanwhile, read former Treasury Secretary Robert Rubin's Op-Ed piece in Tuesday's New York Times, or Treasury Secretary Tim Geithner's comments before The Wall Street Journal's CEO Council, if you think that base broadening alone will satisfy this administration or the political left.
President Obama has leverage after a brilliant, if divisive, campaign. His message: Anti-tax Republicans lost nationally. As he said in facing down House Majority Leader Eric Cantor (R-VA) during a leaders' meeting before the budget faceoff of 2011, "Elections have consequences." Were Obama to concede with his iron so hot, his constituency would feel betrayed and angry. And he will arguably have squandered an opportunity to establish a precedent. Thus, he's campaigning to box Republicans in, meeting with labor leaders and liberal groups and CEOs for the past two days.
By the time Republicans visit the White House for a photo-op on Friday, Obama will have shaped the battle lines. He's backed by Democrats urging nothing less than allowing the upper-income Bush tax cuts to lapse, and he will look for double the amount of new revenue Boehner was willing to sell to his caucus during the golf course negotiations last year.
So why be optimistic for a deal in the face of such likely resolve and open campaigning on the part of the newly re-elected president? For one, inflation adjustments to shield 27 million Americans from paying as much as $3,600 more in alternative minimum taxes (renewing a fix that lapsed at year-end 2011) must be passed in calendar 2012 or a roiling result will ensue. At a minimum, trying retroactively to redress such tax burdens locked in by federal law would delay refunds for months, further affecting the economy.
This headache creates both an imperative for Congress to act, and a vehicle for at least a temporary deal.
Meanwhile, Obama and the Democrats must avoid a recession caused by going over the cliff. Republicans are not without leverage here, most notably in their ability to lift the debt-ceiling threat that could hang over the economy after Valentine's Day. Regardless of realignment favoring the Democrats, the party faces a challenging election cycle in 2014, as the party controlling the White House for a second term historically loses seats during mid-term elections. Democrats will have to defend 20 Senate seats to the Republicans' 13. Thus, the GOP's willingness to agree to a deficit reduction outline that sets in motion enough savings to extend the debt ceiling for two years, past the 2014 elections, would be major leverage.
For these reasons, the consensus among lobbyists is that the president will press his case as long and as hard as he can before ultimately consolidating a victory that will harvest at least some GOP concessions. This could range from something as small as closing corporate loopholes to a surtax on millionaires. Nevertheless, the least of these concessions might be hard for departing Republicans in Congress to swallow, given 95% of them have signed the Americans for Tax Reform's Taxpayer Protection Pledge. And if you think it's a cinch that the GOP will concede without a fight, that Obama will give up and take nothing if nothing is offered or that a deal by Christmas is inevitable, I'd say you're too sanguine.
If Congress fails to buy more time, the accompanying drop in the economy could force wholly new calculations of first-half 2013 earnings. Amid uncertainty over 2013 tax rates on capital gains and corporate dividends, all manner of year-end tax selling could be in store. I expect this game of chicken to result in no fatal casualties and give it a 70% chance of resolution by Christmas, but prepare for the next month or so to be noisy and confusing if the 30% scenario prevails.