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What to Expect as Fiscal Cliff Talks Resume

Thomas Essaye

Fiscal Cliff negotiations resume today as the major principals have returned to Washington. How those negotiations progress will be the determining factor in the short term direction of all risk assets, so it's vitally important to understand where the negotiations currently stand, and more importantly what the markets expectations are, and the opportunities and risks should those expectations be exceeded or missed. Put simply, the only thing that matters to markets right now is the fiscal cliff, so it's essential you have the need to know information. 

Because of that, I've included an excerpt from Wednesday's issue of The 7:00's Report which contains analysis of the scenarios regarding a resolution of the fiscal cliff, as well as the expected probability for each scenario.

Fiscal Cliff Update (From 12/26/12 The 7:00's Report)

House Speaker John Boehner made a huge political miscalculation last week that puts the negotiations basically at a standstill less than 10 days before a deal "needs" to be done. At this point, the prospects for a "grand bargain" are very low, and the most likely scenario is some sort of a smaller deal to reduce the effect of the cliff (the tax hikes) and then negotiations for a bigger deal centered around significant entitlement and tax reform later in 2013. 

Currently there are four potential scenarios on the cliff between now and the end of the year: 1) Do nothing, and the country goes over the cliff.  Probability: Very Low. 2) A deal that extends the Bush tax rates for everyone under the $200k/$250k threshold but doesn't have any spending reductions, doesn't extend the debt ceiling, or address the mandatory spending cuts (known as the sequester).  Probability: Likely . 3) A bigger deal that is close to what the principals were working toward before the Plan B debacle. So, something like tax rates staying the same for everyone making under 500k, one-for-one spending cuts, a "chained CPI" shift for increases in entitlement benefits, and a one- year extension on the debt ceiling and removal of the sequester.  Probability: Most likely.  4) A bigger deal that sees Bush rates extended for incomes under 750k, one-for-one spending cuts, elimination of the sequester and a two-year extension of the debt ceiling.  Probability: Unlikely but possible.


Bottom line is that the most likely outcome is option 3, followed by option 2. The "positive" outcomes from a market standpoint are 3 and 4, however, because they settle the debt ceiling increase issue and ensure that we won't all have to get dragged through these negotiations in another two or three months. Expect over the next week for the Treasury department to formally announce it has run out of borrowing capacity, and it's employing emergency measures that give it two more months of room (this announcement isn't a surprise, but it highlights the importance of the debt ceiling--ratings agencies could downgrade the outlook for U.S. debt to negative on the news.)

If option 2 is the outcome, it will further support the long international trade, as the U.S. will be held back by further uncertainty in the first quarter of 2013.

Finally, the key here appears to be the issue of the "majority of the majority." It's clear from Thursday the only way a deal gets done is if the Democrats in the House support it--as some Republicans are going to vote against any tax increases, period. So, that's why options 2 and 3 are the most likely outcomes, as they'll bring Democratic support in the House.

The question then turns to whether or not Boehner will bring those options to a vote. It is policy that a Speaker wouldn't bring a bill to the floor unless he has a "majority of the majority," meaning the majority of Republicans would vote "yes" on the measure. Given Thursday's vote, it's not 100% certain the "majority of the majority" will support any tax increases, so the question remains whether Boehner will bring the legislation to a vote at all.

By what I'm reading, it appears he will, regardless of the support (and I think most Republicans in the House acknowledge there needs to be tax increases to get a deal done) so this shouldn't be an issue, but in Washington you never know. Negotiations should resume today.

Going "over" the cliff on Jan. 1 isn't catastrophic, but the longer this goes unresolved, the more concern will creep into investors' psyches and it will begin to affect consumer and business behavior.

Portfolio managers main fear remains missing a fiscal cliff rally, so I think stocks will remain easier to rally than sell off in the short term. But concern is rising that a lack of a solution will start to become a negative for the economy in January, not because it will cause a market crash, but instead because the uncertainty will negatively affect consumer spending and business investment, which will result in lower business activity and lower share prices.

The long international/short U.S. trade remains the best idea out there as the prospects for no deal or a "mini" deal that sets up another fight over the debt ceiling in Feb/March will be a headwind for U.S. Stocks.