As I’ve said in the past, the danger posed by the fiscal cliff is not solely whether we go over the side or not – it also matters what shape our economy is in before the plunge.  Last week’s jobs report may have seemed like good news for the latter, but unfortunately a closer look at the numbers revealed a mixed bag.

The headline number in Friday’s non-farm payroll report was well above expectations. The US created 146k jobs in November, versus an estimate of just 85k. In addition, the unemployment rate dropped to 7.7%, its lowest level since December of 2008. That said, there were a few caveats.

First, the number of net new jobs was right in line with the six- month average. The reason it came as a positive surprise was that economists had a relatively low estimate, as they were not sure how much Hurricane Sandy might impact the numbers. Second, the previous month’s estimate was revised down by 33k jobs.

Third, hourly earnings continue to stagnate. Hourly wages are up just 1.7% from a year ago, close to a multi-decade low and below the rate of inflation. In other words, while more people are working, few are getting raises.  Finally, the drop in the unemployment rate can be partly attributed to another drop in the participation rate, which means fewer people are engaged in the work force.

All in, the report confirms the pattern of the past six months: job creation has improved from the summer lows, but remains stuck at around 150k. While this level will slowly bring down the unemployment rate, it is too slow to produce much in the way of wage gains.

Meanwhile, fiscal cliff negotiations continued to trudge along at a snail’s pace.  While it is impossible to know what is going on behind the scenes, on the surface the two parties still seem far apart on three key issues: tax rates for wealthier Americans, cuts to entitlement programs, and whether or not to give the President the power to raise the debt ceiling. Ironically, the one place we may see a compromise is on tax rates. Last week saw some evidence that the Republicans may be forced to capitulate, at least temporarily, on upper income tax rates. But even if that proves to be the case, it is highly unlikely that they will relinquish the authority to raise the debt ceiling. So we’re still in a holding pattern.

Here are some of the conclusions I would draw. First, while a deal is still very possible – particularly if the Republicans give in on upper income tax rates – the odds of going over the fiscal cliff still appear higher than the market is discounting.  Second, even if we get a deal, it is likely to be a small deal.

We will probably see 1 to 2% of what economists call fiscal drag – in other words, higher taxes and lower spending – even if Washington comes to a compromise. Third and final point, given how contentious the debate has become, this may lower the odds of a more substantial deal to address the deficit getting done in 2013.

Russ Koesterich, CFA, is the BlackRock Chief Investment Strategist.

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