On the news of the fiscal cliff deal, financial markets are currently rocketing higher. The U.S. markets are up nearly 2% (as of this writing), and everyone seems to want to board this train for fear of being left behind. Before you jump aboard, let's take a deep breath and assess what really happened.
What the deal did:
The good news is that the U.S. didn't go over the "fiscal cliff" (at least not for more than a few hours). Most of the Bush tax cuts were made permanent. They will be permanently extended for all individuals with income up to $400,000 and for married couples up to $450,000. For households above those thresholds, their marginal rate will rise to 39.6%. The capital gains and dividend tax rates for these households will also increase to 20% from 15%.
The U.S. finally created a permanent inflation adjustment to the income exemption levels for the Alternative Minimum Tax. The deal also limited itemized deductions and personal exemptions on individuals over $250,000 in income ($300,000 for married couples), retained some key tax incentives for business, extended the deduction for sales taxes in place of state and local taxes and extended estate tax exemption levels with future inflation adjustments.
What the deal didn't do:
The deal didn't address either the sequestration or the debt ceiling in any meaningful way. The sequestration has now been pushed back for two months, and temporarily replaced by $12 billion in cuts and $12 billion in new revenue. This means that we still have to deal with both of these "cliffs" over the next three months.
The deal also didn't extend the payroll tax cuts, which will raise roughly $126 billion in revenue. Meaning most Americans (not just the wealthy), will actually see higher taxes in 2013.
What does the deal mean for us economically and for markets?
The combination of the expiration in the payroll tax cuts, the partial expiration of the Bush tax cuts and the addition of the Affordable Health Care Act will place a fiscal drag on the economy. The exact amount is debatable, but is generally estimated to be between 1%-1.3%. Considering that the U.S. economy has been growing at just above stall speed, this deal puts us on course for another year of very anemic growth with the high potential for downside.
The total fiscal drag has really not yet been decided. The outcome of the sequestration and debt ceiling discussions will likely create further economic drag. Also, the delay of the sequestration and debt ceiling discussion means that we can expect another few months of market moving headlines and the possible further weakening of consumer and business confidence.
The other potential impact of the deal is to the U.S. credit rating. This fiscal cliff deal did not do anything to address the long-term fiscal health of the nation. This combined with the likely continued vitriolic squabbling over both the debt ceiling and the sequestration may push the rating agencies to take further action. Given the continued and unprecedented scale of the Fed's quantitative easing program, I would not expect to see interest rates spike, but would expect to see a further erosion of confidence that ultimately slows economic growth and more volatility in risk assets.
The fiscal drama is not done and the total drag is yet to be determined. We are only in the opening innings of what will likely be a marathon game. While the market's mammoth rise makes for a wonderful beginning to 2013, I wouldn't chase it too aggressively if you missed the move and would consider purchasing inexpensive protection if you did.