The standard view on Wall Street is that we will somehow avoid going over the “Fiscal Cliff.” That may ultimately prove to be true, but investors should proceed on the assumption we could well go over the cliff and will at least come perilously close — close enough to damage the confidence of investors, businesses, and consumers.
Frankly, the main reason for Wall Street’s complacency about the cliff is that it (like a decline in housing prices in 2008!) is “too awful to contemplate” – a U.S. recession while the rest of the world is already in a slump. But if one considers how Washington actually handles these issues, there is little reason for optimism. This is demonstrated by The Price of Politics, Bob Woodward’s excruciatingly detailed, meeting-by-meeting, phone call-by-phone call account of the 2011 fiscal negotiations between Congress and the White House. Salient highlights:
- Both sides are “dug in” on defining issues – no tax hikes for the Republicans, and no cuts in Medicare or Medicaid benefits for Democrats. “Giving in” on them damages the political “brand.” For example, Democrats feel that agreeing to Medicare benefit cuts would put them in the same boat with Paul Ryan. One reason for this: the issues are so complex that it is hard to make concessions and then communicate to constituents that they are fairly minor.
- For Republicans, the only acceptable way to get “more revenue” is tax reform lowering rates and broadening the base. (Boehner’s comments today appear consistent with this position.) Obama has shown little interest in doing this; he considers higher rates on the affluent a moral issue.
- Woodward, a liberal icon, portrays Obama as a clumsy negotiator who attends way too many meetings and tends to lecture people.
- In the negotiations nothing was really settled until the very end. Bargaining positions on complex issues kept changing. Boehner likened it to “nailing jell-o to the wall.”
- One reason for the extreme fluidity of negotiations is that there was a veritable four-ring circus: the Simpson Bowles Committee, Republican Majority Leader Eric Cantor’s negotiations with Vice President Joe Biden, John Boehner’s secret negotiations with Obama, and the Senate’s “Gang of Six.” The Gang of Six derailed Boenher-Obama by recommending $1.2 trillion in new revenue, more than the $800 billion Obama was asking for. This prompted Obama to raise his revenue demand by $400 billion, which Boehner rejected, killing the deal.
- Negotiations dragged on and on until the “last minute.” Negotiators did not care much about developments on Wall Street or in the real economy. In my experience investors exaggerate how much Washington worries about the stock market.
- Keep in mind that these fevered negotiations that dominated Washington for well over a month did not actually solve any substantive issues – they merely handed fiscal problems over to a “supercommittee” which also could not resolve them, leading in turn to January’s fiscal cliff.
When it comes to cliff-avoidance, this dreary record shows, there is no reason for optimism. And even if we do avoid the cliff, another debt ceiling limit fight looms in January or February. Obama will be very angry about having to deal with this again; in 2011 he claimed it was effectively unconstitutional because it undermined his authority as President. And Obama can now afford to be an even tougher negotiator because, unlike in 2011, he does not need a strong economy to help him win reelection. Some Democrats are willing to go over the cliff and blame the resulting economic damage on Republicans. In July Senator Patty Murray said, “If we can’t get a good deal – a balanced deal that calls on the wealthy to pay their fair share – then I will absolutely continue this debate into 2013, rather than lock in a long-term deal this year that throws middle-class families under the bus.”
Keep in mind that, on top of all this “uncertainty,” fiscal policy very likely will tighten early next year at a time when Europe is in recession and emerging markets are sluggish. The payroll tax cut will probably end and Obamacare taxes on high earners will kick in. So profits, which slightly declined year/year in Q3, are not likely to rise much in 2013; S&P EPS of $106, representing a gain of 4-5% is a reasonable number. But if we really go over the cliff and have a recession $95-100 is likely. This risk will create extreme market volatility over the next few months.
