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Over The Cliff
Raymond James
By Scott Brown
December 26, 2012

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Leaders in Washington failed to reach an agreement on the fiscal cliff. What does that mean for the 2013 outlook?

Stock market participants were encouraged by progress in fiscal cliff negotiations last week. For months Democrats and Republicans have been digging in, refusing to budge. However, in the early part of last week, the two sides took some steps toward the middle. Their positions remained far apart, but it seemed like progress. By Tuesday, negotiations were stalled again and House Speaker Boehner proposed a plan B. Plan B would raise taxes on those making $1 million or more per year. However, it faced opposition from Senate Democrats, President Obama, and some of the more conservative members of the House. Largely a symbolic gesture, plan B had no chance of passing in the Senate and the President threatened to veto it if it did. Lacking enough support from House Republicans, Boehner was forced to pull the plug on Thursday evening. Unfortunately, there was no plan C.

The lack of progress and ultimate failure of the fiscal cliff negotiations has puzzled veteran Washington observers. In recent weeks, leaders were besieged by business executives and others warning of the economic consequences should the cliff hit. The pressure to reach a deal has been enormous. The Democrats had the upper hand (taxes would rise even more if there wasn’t an agreement), but the Republicans may not have realized it. A large part of the failure was the fact that many Republicans were never going to vote for higher taxes. This was the same failure in the debt ceiling negotiations of 2011. Any agreement made by Speaker Boehner that included tax increases could not be approved by his own party. Ironically, taxes will go up more than if the Republicans had agreed to a budget deal in the first place. It boggles the mind.

There is still a strong expectation that a deal will be reached in January or early February. Post-cliff, with tax rates higher, Republicans would then be voting to lower taxes. One possible strategy for the Republicans would be to delay and then use the debt ceiling as leverage to cut taxes. However, that would be a dangerous game. Republicans would be arguing to raise the debt ceiling in orders to lower taxes. In the 2010 mid-term elections, Democrats failed to use the political grassroots that had helped Obama get elected. Republicans retook the House (a colossal failure for the Democrats in that the Republicans were then able to redraw districts after the 2010 census, solidifying their control). The Democrats are not going to make such a mistake again. Word has it that they will make a strong push to take back the House in 2014, leaving Obama with a chance to set a legislative legacy in the final two years of his term. Indeed, there is a lot at stake here for the Republicans.

Of course, one could just as easily blame the Democrats for failure to reach a fiscal cliff agreement. However, the political calculus will change. The starting point is now from a position of higher tax rates. We’ll have a new Congress and perhaps a change in leadership in the House. Speaker Boehner may be replaced by someone who is even less likely to negotiate.

For those worried about large budget deficits, the fiscal cliff is not completely bad news. A recent survey showed that more than half of the public believes that the failure to reach an agreement would add to the budget deficit. That’s wrong. The fiscal cliff would substantially lower the budget deficit over the next two years. The concern about the fiscal cliff is not that it reduces the deficit; it’s that it reduces the deficit too rapidly and the negative impact that would have on the economy.

If not for the fiscal cliff, the economic outlook for 2013 would be promising. Many of the headwinds of the last couple of years have faded. Homebuilding will add to GDP growth. Replacement needs will continue to support vehicle sales. State and local government will no longer be a drag on growth. Federal Reserve policy remains very accommodative.

If some of the fiscal cliff hits, growth will be slower in the first half of 2013 – and if the full fiscal cliff hits, the economy is likely to experience a mild recession (“mild” means short and relatively shallow). This would not be a repeat of the 2008-2009 recession. Growth should pick up again in the second half of the year. However, there will be some loss of jobs in the short term. The unemployment rate would likely rise by more than a full percentage point in 2013.

For investors, uncertainty is likely to remain elevated. The market still expects a deal to be reached, but it could be some time into 2013 before we get much clarity.

Best Wishes for a Prosperous New Year!


(c) Raymond James



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