Market Overview

David Malpass' Fiscal Cliff Playbook and Likely Outcome

Both political parties in Washington have provided plenty of posturing but little of real substance publicly in terms of what might happen in the negotiations over the impending fiscal cliff. Do you get the sense that we are facing a train wreck precipitating a real economic recession under  the watchful eyes of incompetent political engineers?

What are the real issues on the table and the potential likely scenarios that may play out? Forget the noise provided by the political pundits. Let's review the “fiscal cliff playbook” and likely outcome as outlined by Encima Global's David Malpass,

Rather than one cliff, the U.S. is facing a continual set of fiscal problems on both the spending and tax side. They won't be resolved in the December lame duck session and will weigh heavily on business investment and jobs into 2013.

We expect a limited year-end deal which leaves many large tax increases, tax uncertainty and complexity, and another divisive debt limit battle early in 2013.

House Republicans want to have time to read the lame duck bill and the scoring of its deficit impact before voting (unlike the 2010 lame duck.) This becomes a key variable in the lame duck deal-making – if the actual legislative language is going to be available prior to the vote, the deal will have to be quite limited and market unfriendly.

The Administration will want to label the Republicans as obstructionists and finalize a bigger deal at the last minute. The vote could then be backed up against the Christmas or New Year's holidays, leaving no time for most members or the public to read the legislative language.

In December 2010, President Obama agreed to a two-year extension of all the Bush tax rates. This added to the equity rally which had started in September due to strong earnings, no double dip and QE2 excitement. Key to the 2010 deal was that the legislative language and the deficit scoring (roughly $400 billion per year not counting the “doc fix” passed separately) weren't available until after the House and Senate votes.

We disagree with the press theme that a big compromise is in the works. The differences are getting wider, not narrower, and we think both sides may prefer the cliff (a limited deal) to major concessions. For now, however, almost everyone in Washington benefits from deal-talk and meetings at the White House – the press, lobbyists, politicians through campaign contributions, congressional staff disseminating information, and non-profit budget organizations using deal-talk for their massive fundraising. The reality is that the two sides are far apart, but no one wants blame for being obstructionist.

Why a Meaningful Year-End Deal Is So Hard

More tax rates are scheduled to go up than in the past, so the problem is harder to fix. The budgeting and scoring system has been forcing short-term deals to avoid paying for the whole 10-year budget window. This leaves the tax code and spending horizon worse each year, culminating in this year's high cliff including AMT patch, doc fix, tax credit extenders, payroll tax, and Bush rates(including cap gains, dividends and estate tax.)

The national debt is bigger and House membership more conservative, making it harder to sweeten a deal with extra spending and tax credits as was done in 2010.

Obamacare taxes are kicking in at the same time including the Medicare surtax of 0.9% and the Medicare tax applied to passive income. This makes a compromise on tax increases on the rich that much harder.

A limitation on schedule A deductions isn't attractive. It breaks the Republican tax pledge. It hurts tax reform by using up one of the base broadeners. It faces massive opposition from charities, homeowners, the housing industry, realtors, and state and local governments and their unions (since state and local taxes are deductible.)

Simpson-Bowles has been touted by both parties as a framework, yet probably wouldn't pass either House. It proposed raising taxes a lot and cutting entitlements and was vague in terms of details (no clear provisions or legislative language.) The reality is that there is no current path to a bigger solution nor a Treasury Secretary to set the tone, so the lame duck deal has to stand on its own. We think this argues for a limited deal.

We think it will be harder to use smoke and mirrors due to opposition in the House. In the past, current spending was often “paid for” by assuming cuts in future spending that wouldn't actually occur — on food stamps or Medicare payments to doctors, for example. To win votes, earmarks including special tax and spending provisions were buried in the fine print. These won't work if the bill is made public before the House vote.

Deal Scenarios
The President wants an increase in the top marginal income tax rates for fairness, many tax rate extensions (AMT, most income tax brackets, R&D credit, large solar and wind credits, etc) and more spending (i.e. doc fix, no sequester, disaster relief, etc.) In combination, this adds a lot to the deficit though the cost can be held down by making the deal short term.

Republicans want to extend all the Bush rates and offset any new spending with cuts elsewhere. They are otherwise committed to spending and tax restraint. Over 200 of the 241 sitting House Republicans are constrained by their signed pledge to “oppose any and all efforts to increase the marginal income tax rates for individuals and/or businesses; and oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates.

Limited Deal
We expect a limited deal that won't resolve any of the longer-term issues but will still run to hundreds of pages and hundreds of billions of dollars. Compared to current law, it would include:

>>the “doc fix” ($245 billion, all numbers are 10-year, though its more likely that Congress will just make temporary patches);

>>reducing the defense and Medicare sequester ($1.1 trillion) along with some spending reductions elsewhere as offsets;

>>extending the AMT patch ($864 billion)

>>none of the Bush rates extended, leaving the problem for 2013

>>some of the 80 tax extenders (all 80 including the R&D credit, solar credits, ethanol and others cost $890 billion for 10 years)

>>emergency appropriations for the hurricane (perhaps $150 billion)

>>a new farm bill and/or flood insurance recapitalization.

We think the market will welcome the deal talk but will end up dissatisfied with the deal, buying the rumor but selling the news. The deal will probably set up another cliff and won't improve the tax code, restrain excess spending or resolve the debt limit increase. We think this type of deal points to a recession in 2013. There will be talk of lowering taxes back down in the new Congress, but that will be hard and take time. The making of the deal will put a spotlight on the U.S. political divide over ways to restrain spending, limit the national debt and improve the tax code. We expect Moody's to downgrade the U.S. debt rating (as S&P did in August 2011.) That won't be a market negative by itself, but reflects the rapid U.S. fiscal dissipation that is blocking business investment.

Smaller Deal
Given the obstacles, it's possible Washington will end up with an even smaller deal including only the “doc fix”, emergency appropriations for the hurricane and very limited tax repairs meant to last until bigger repairs can be done in 2013.

We don't think the market will make much distinction between a small deal and the limited deal outlined above. The advantage of the small deal is it might force more action in 2013 including rearrangement of spending as the sequester begins to bite. It will cause a recession, worsen the already chaotic tax environment, and confirm to the ratings agencies and the markets the severity of the U.S. fiscal impasse.

Larger Deal on Democratic Terms
There will be an effort at a larger deal including the extension of the Bush rates. For example, the Administration might agree to a compromise raising the top rate to 37%, not Clinton's 39.6%, on incomes over $1 million, not $250,000, along with a limit on some of the schedule A tax deductions for upper incomes or a phase-out of the lower tax rates that are currently applied to the first portion of higher incomes.

It's conceivable there would be 60 votes for this in the Senate (possible to get some votes from departing Republican Senators and ones not up for election in 2014.) To get it through the House would require mostly Democratic votes and the acquiescence of Republican leaders wanting to avoid the obstructionist label and the blame for a recession. We think it is unlikely.

Larger Deal on Republican Terms
Republicans want no tax rate increases. The Administration might go along if it got changes that caused a higher average tax rate on higher incomes (e.g. by limiting schedule A deductions or taking away the benefit of lower tax rates on the first portion of income.) The details and bargaining style become important at this point. It violates the tax pledge. It doesn't resolve the House desire for spending cuts to offset the sequester. If the President wanted a deal like this, he could probably get it. However, it would be at most one year, setting up another fiscal cliff and holding down the market impact.

There would be more market upside if the lame duck kicks the can more than a year or introduces a new rule or dynamic.

The best case scenario is a big multi-year deal that also extends the debt limit and most tax cuts and gets around the sequester problem using targeted spending cuts or even some gimmicks. This type of deal would also add big-time to the deficit and national debt but the market tends to like can kicking.

Of most value would be a year-end agreement that increases the odds of future structural reforms like tax reform, a usable budget, constructive 2013 spending restraint or a meaningful debt ceiling. (We think a proper debt limit law would restrain spending when the limit is exceeded, whereas the current law puts fiscal conservatives in a bind because it lets the executive branch warn of a debt default and a government shutdown rather than cutting spending.)

All of this to deal with by year end and here we sit on November 26th.

What a mess.

Navigate accordingly.

Larry Doyle




Posted-In: Economics Markets Trading Ideas


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