The Fiscal Cliff Isn't Fully Fixed

 |  Includes: DIA, QQQ, SPY
by: Patrick J. O'Hare

Congress reached a deal to avert the fiscal cliff. The process of getting there wasn't pretty, which was no surprise, and the end result was less than expected, which was also no surprise. The stock market's initial response to the deal was decidedly bullish. Again, that was not a surprise.

We understand why the stock market rallied on Wednesday even if we don't exactly understand what all of the hoopla was about. The deal that got done was another silly, last-minute drama scripted by Congress that dealt with tax rates but essentially kicked the can down the road with respect to needed spending cuts and entitlement reform.

Deal Provisions

The main provision of the deal calls for the income tax rate to go up to 39.6% for individuals making more than $400,000 a year and households with a combined income of more than $450,000. The lower tax rates below those income thresholds will be made permanent. Other provisions include:

  • A bump in the capital gains and dividend tax rates from 15% to 20% for individuals making more than $400,000 a year and households making more than $450,000 a year
  • A one-year extension of unemployment benefits for the long-term unemployed
  • A two-month delay in the $109 bln sequestration, which forced discretionary and non-discretionary spending cuts
  • A permanent fix for the alternative minimum tax
  • An increase in the estate tax from 35% to 40%, with the first $5 mln exempt for individual estates
  • A five-year extension of the child tax credit, the earned income tax credit, and the tax credit up to $2500 for college tuition
  • A one-year extension of the tax credit for R&D costs and the tax credit for renewable energy
  • A one-year provision that allows businesses to write off 50% of new investments immediately
  • A one-year deferral of the 27% cut in Medicare payments to doctors

It is estimated that $600 bln in new revenue will be raised over 10 years. According to the non-partisan Tax Policy Center, $199 bln in new tax revenue will be collected in 2013.

First, the Good News

The good news, economically speaking, is that income tax rates are not going to increase for 99% of taxpayers. That realization was at the heart of the stock market rally. All else equal, it is a compromise component that will prevent the economy from slipping back into a recession.

Things rarely turn out to be equal, though, so we can't categorically rule out the possibility of the US economy slipping into a recession this year.

We digress.

The other good news, relatively speaking, is that the maximum capital gains and dividend tax rates for high-income earners only went from 15% to 20% (it will end up being 23.8% after the surcharge to help pay for the Affordable Care Act). There were concerns the dividend tax rate could be set at the highest tax rate for high-income earners, or 43.4% after the surcharge is included.

There are two benefits, therefore, tied to the capital gains and dividend tax rates: (1) there is the certainty of knowing what the rate will be and (2) the rate is not nearly as high as some participants feared it might be.

The latter consideration in particular should be regarded as a positive for dividend-paying stocks.

The accelerated depreciation and the extension of the tax credit for R&D costs were added bonuses for businesses.

...And Now the Bad News

Even though income tax rates will not be going up for the vast majority of taxpayers, all private-sector workers will see the rate on their Social Security payroll tax revert to 6.2% from 4.2%. For a worker making $50,000, that amounts to $1,000 more coming out of his or her paycheck this year versus last year.

Another negative is that we don't think businesses are necessarily going to feel inspired to start spending liberally and hiring more aggressively.

The tax rate headlines might sound good, but the fact of the matter is that the expiration of the lower Social Security payroll tax and the imposition of higher tax rates for high-income earners will be a drag on the economy by reducing personal consumption. That's one issue.

The other issue is that Congress and the White House are going to be battling again very soon on spending cuts, entitlement reform, and the debt ceiling. They shouldn't be intertwined, yet they will be since the debt ceiling is going to be used as leverage by the GOP for extracting spending cuts.

President Obama has already said he won't negotiate around the debt ceiling, so it is pretty clear that battle lines are being drawn and that the next few months in Washington could be a bloody mess on the legislative front.

That means political uncertainty will continue to act as a deterrent, or simply a convenient excuse, for businesses to defer spending decisions. At the same time, it will pose a real risk of another downgrade to the US credit rating that could roil capital markets.

Bad Is Better than Worse

With the deal that got done, the prospect of a worst-case recession scenario was reduced to a bad scenario of lower economic growth. Accordingly, the equity risk premium has come down in response to the tax rate compromise since bad is better than worse. It's a relative assessment, yet all things are relative for equity market participants.

In that regard, longer-dated US Treasuries got clipped pretty good following news of the deal, but perhaps not as much as one might think if there was a sense that Congress provided market participants with a true solution versus a shotgun compromise on the political chip every voter can relate to -- income tax rates.

The 10-year Treasury note was down 21 ticks as of this writing. It's a notable drop, but it's not a head-for the-safe haven exit kind of move.

There is more work to be done in Washington to reduce our deficit and debt -- a lot more work. That is a daunting thought for a variety of reasons and it is a sobering reminder to keep one's enthusiasm in check over the deal that got done, which was really only a half deal that garnered 167 "No" votes in the House of Representatives.

What It All Means

The equity market has started the new year on a banner note, but the next few months could be fairly turbulent as fourth quarter earnings are reported and as the debate over spending cuts unfolds in public fashion.

The battle over spending cuts is setting up to be even more acrimonious than the battle over tax rates.

With that in mind, we feel compelled to reiterate our view that a blended investment strategy for the equity component of one's portfolio could make sense entering 2013.

That is, don't overweight or underweight cyclical and countercyclical sectors exclusively.

Maintain a balanced mix, as that will allow for participation in upside moves like the one seen Wednesday and help mitigate losses in down markets that might be seen in the near future if partisan politics takes us to the brink again of possibly defaulting on our debt, which is at $16.3 trillion and counting.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.