Dec. 30, 2012 at 11:47 AM ET
As investors gaze across the "fiscal cliff," some see a better economy on the far side, making stocks and risk assets more appealing and bonds less so in the year ahead.
But there are many caveats to that scenario and some of them will be decided in the next few days as politicians struggle to strike a deal that would avert a fall off the "fiscal cliff." The cliff is the double-barreled blow to the economy from the reversal of dozens of tax breaks and the onset of automatic spending cuts, agreed as a solution to the contentious 2011 debt- ceiling debate.
Congress meets Sunday evening and may consider the latest proposals.
Stocks were spooked in the past week by the lack of movement in discussions between Congress and President Barack Obama. As the market closed Friday, the absence of new developments during talks underway at the White House provided a void for selling. The Dow fell 1.2 percent to 12,938, giving it a loss of 1.9 percent for the week. The S&P 500 fell 1.1 percent to 1402, for a one week loss of 1.9 percent. The Nasdaq lost 2 percent for the week to 2960.
Congressional leaders late Friday left the White House without a deal, setting the stage for a weekend of raw nerves. Obama said he was still optimistic the Senate leadership could come up with a deal that would pass both houses, but he also laid out a second plan for a straight up-or-down vote on middle class tax cuts if they can't reach an agreement.
The president repeated that strategy in an exclusive interview on NBC's "Meet the Press" Sunday in which he scolded House Republicans for not having come to an agreement sooner.
"They say that their biggest priority is making sure that we deal with the deficit in a serious way, but the way they're behaving is that their only priority is making sure that tax breaks for the wealthiest Americans are protected," Obama said. "That seems to be their only overriding, unifying theme."
Obama said if Congress failed to agree on a deal and if the straight up-or-down vote was blocked, the first bill introduced in the new year would propose a cut in taxes for the middle class.
"Now I think that over the next 48 hours, my hope is that people recognize that, regardless of partisan differences, our top priority has to be to make sure that taxes on middle-class families do not go up. That would hurt our economy badly," Obama said.
He warned that if there was no deal by Jan. 1, it could hurt financial markets.
"What's been holding us back is the dysfunction here in Washington," he said. "And if people start seeing that on January 1st this problem still hasn't been solved, that we haven't seen the kind of deficit reduction that we could have had had the Republicans been willing to take the deal that I gave them, if they say that people's taxes have gone up, which means consumer spending is going to be depressed, then obviously that's going to have an adverse reaction in the markets."
House Speaker John Boehner (R-Ohio) dismissed the president's criticism, and pointed the finger of blame at Obama.
"Republicans made every effort to reach the 'balanced' deficit agreement that the president promised the American people, while the president has continued to insist on a package skewed dramatically in favor of higher taxes that would destroy jobs," Boehner said in a statement reacting to the 'Meet the Press' interview.
"We've been reasonable and responsible. The president is the one who has never been able to get to 'yes,'" Boehner said.
Stock futures fell sharply after the market closed Friday.
"You could tell a lot of people were very skittish about their trades," said Patrick Kernan of Cardinal Capital. "Everybody is fearful of what exposure they have right now. Right now, we're thinking if they reach a deal we go back to around where we were a week ago, right around 1440" on the S&P 500. If there's no deal, "we think it goes down 30 to 50 points."
Kernan, who trades S&P 500 options, said the market was swarmed by investors seeking portfolio protection Friday.
"The other side of this thing from an investment standpoint, is if there's a deal, I don't know what the number is but is it a five-percent rally from here? Is it a three-percent rally?" said said James Paulsen, chief investment strategist at Wells Capital Management. "There's risk on both sides of the trade, and I think that's been helping keep this reaction more muted than it otherwise might be."
"The cliff isn't December 31. The real cliff is somewhere down the line when the tax bite and spending cuts start to hurt," he said. "The most optimistic agreement was not that we got this done before the deadline.The most optimistic was we get it done right on deadline, and I think it was fully expected it would get really ugly right before that…the other reality is if it doesn't get done until mid-January it's not going to hurt anything."
Paulsen said the market's anxiety will increase the longer it goes on. "If we go over, the market reaction will start to build…I don't think it will fall apart if we go over. I think if we start to get to the second half of January, I think they'll get way more concerned."
Wait, There's More
Besides the action on Capitol Hill, there is the December employment report Friday and some other key data to look forward to in the week ahead. That includes Thursday's December car sales and chain-store sales and Wednesday's ISM manufacturing data. The minutes of the Fed's last meeting are also expected Wednesday afternoon.
But the outcome of the cliff discussion and congressional votes will be what drives markets in the week and months ahead, and what will ultimately decide whether the U.S. can be a driver of the global economy or a drag on it in 2013.
"I don't think the story is over yet," said Citigroup economist Steven Wieting. "We all expected agony . It just seems we keep adding to it."
"There's compromise that's needed and now seemed like a good time, but they already let the window substantially pass. The opportunity to have a really big framework has passed," Wieting added.
He described a another possible scenario. "They're going to completely leave the debt ceiling out of this, and they're going to leave any signs of structural reform out of this. Then we have a deal that includes future cliff dates. That would leave uncertainty in play."
Yet, analysts and economists also see a possible optimistic outcome, where the cliff is fixed, at least in part, either by New Year's or several days later, and the debt ceiling and remaining issues are dealt with in the first part of the year. If that's the case, it might unleash economic growth, as consumer and business confidence improve.
"I think the global economy is going to surprise on the upside," said Ed Keon, portfolio manager with Quantitative Management Associates. Keon believes Congress will make a deal to avoid the cliff, and he sees gains in the U.S. economy as well as improvement in the European debt crisis and a pickup in the emerging world. "I think in the European situation, time is on our side and everyday things look a little better."
He also sees the U.S. ending the year with stronger growth. "It's hard to believe Washington would want to hurt the economy with malice of foresight," he said. "Doing a small deal will be viewed that they might be able to do a bigger deal."
Kind of a Small Deal
"We'll get a deal," said Steven Stanley, chief economist at Pierpont Securities. "It will be a small deal that will address some of the more onerous aspects of the cliff. Tax rates, they're going to have to address the AMT, and they're going to have to do something with sequestration cuts, either delay them or rejigger them. I think they'll probably do something on state and dividend tax rates, the Medicare doc fix and they'll probably extend the unemployment benefits."
It's the bigger deal, on the debt ceiling, that will be most difficult and most important in terms of the longer term strength of the economy. Treasury secretary Tim Geithner warned this past week that the U.S. will reach the debt ceiling limit Monday, but that the Treasury can make some adjustments to keep the government funded for a couple months while Congress works out a deal. The hope is that Congress would find a way to deal with bigger tax reform and entitlement spending issues as part of that debate.
Avoiding the cliff, even with scaled back tax increases, will not leave the economy unscathed but it should not trigger the recession expected if the cliff were hit. "Basically if we let the payroll tax expire it's going to blunt consumer spending in the beginning of the year, even if we know about it," Stanley said. "The upper income tax increases are not a free lunch either. It's substantially lower than the full cliff."
One of the most public points of contention is at what income level, Bush-era tax cuts are reversed. Both Republicans and Democrats agree tax rates should remain the same for 98 percent of taxpayers, but the disagreement is over taxing the rich and that's what the Senate leadership will have to tackle this weekend.
Obama did not specify on "Meet the Press" which income level he would accept. He has consistently promoted $250,000 as the dividing line between those who would continue to benefit from Bush-era tax cuts and those who would see their taxes increase. But the figure has been a bargaining chip in the negotiations.
The economy could handle that and move on, Wieting said. "If it's a fiscal tightening between 1 and 1.5 percent of GDP, the economy would absorb that in a discrete way and probably move on to stronger growth in the second half of the year. It could be better. It could be clearer. It could be sooner," he said.
Wieting said, however, the more unresolved issues and pushed-out deadlines there are, the worse it will be for the economy because business spending would remain constrained.
Wieting expects growth in the beginning of the year of about 1 percent, and assuming a resolution of the cliff and debt ceiling issues, growth could accelerate to 3 percent by the end of the year.
The economic data this week should continue to show the same slow growth in employment, but possibly stronger auto sales and improved manufacturing. Economic data, particularly housing-related data, has been largely better than expected.
Stanley expects the December nonfarm payrolls to be about the same as November's 146,000. "I have 150,000 but that includes a couple of special factors that I think will push the number up a little bit," said Stanley. One of those factors is the addition of couriers, temporarily hired to deliver holiday gifts. Last year, that category gained 40,000 in December, and lost the same amount in January, he said.
The week's economic events: