Deal Or No Deal? Assessing A Bare Bones Fiscal Plan

by: Russ Koesterich, CFA

In a recent blog post we suggested that the potential for a grand bargain in fiscal cliff negotiations was fading and that a bare bones deal was the best that could be hoped for. While a resolution still remains elusive as of this morning, it looks like the Senate will settle on some type of small deal, although the odds are rising that it may not happen by January 1st. Assuming the outcome is a bare bones deal, this is better than a full-blown trip over the fiscal cliff. However, it would still be modestly negative for markets, at least in the near-term. Here’s why:

1.A limited deal still means significant tax hikes and spending cuts, which suggests that the drag on the economy is likely to be greater than expected.

2.The delay in reaching an agreement implies that tax refunds will also be held up, which will further depress personal consumption in the first quarter of 2013.

3.While still possible, a bigger budget deal now looks unlikely in the coming year.

4.We would not expect a bare bones deal to address the debt ceiling, which means lingering uncertainty for investors and probably more volatility in Q1.

5.If by some chance Washington is unable to agree to even a bare bones deal, there is considerable downside for financial markets as, even at this late date, investors expect some deal to be reached in the next few days.

No doubt about it – the failure to reach a more comprehensive fiscal bargain is a negative. However, barring a complete failure in Washington, the US is still likely to expand in 2013 thanks to low rates, somewhat cleaner consumer balance sheets and an improving housing market. In this environment, we favor an overweight to equities and a focus on credit sectors and municipals within fixed income.

The year ahead will certainly bring with it its share of challenges, but we believe that opportunities exist as well.

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