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.