Bull Vs. Bear - A Deal For The Fiscal Cliff Won't Be Finalized Before The End Of December

By Stephen D. Simpson, CFA | December 13, 2012 AAA

Question: Is a deal for the fiscal cliff going to happen?

Bear's Response
When considering the question of the upcoming "fiscal cliff" (the expiration of various tax cuts and the simultaneous automatic cuts across a variety of federal budget items), I'm reminded of a famous quote from Winston Churchill, "Americans can always be counted on to do the right thing ... after they have exhausted all other possibilities." While I do believe Congress will have little choice but to find a compromise that undoes the growth-damaging combination of higher taxes and lower spending, it will not come until 2013.

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Politics As Blood Sport
The biggest factor in my skepticism is that politics in the United States has moved from reasoned debate and compromise to winner-takes-all trench warfare. No longer is it acceptable to go to your electorate and point out that you got most of what you wanted; your opponent must be utterly vanquished, and it's frankly better to walk away with nothing than to let the opponent get any benefit from the process.

Consequently, I think both parties in Congress see this as an opportunity to beat their chest in front of their voters and try to cast the other side as unprincipled and inflexible. We in America have seen this before in prior stalemates over budgets and federal borrowing limits, with each party willing to go to (and sometimes over) the brink in the attempt to cast the other party as "the bad guy."

With the GOP smarting from what was generally a very poor national election day, I would expect that they would look to re-energize their base by standing strong and refusing to compromise before year-end, likely secure in the knowledge that compromise can come in January or February of 2013. Likewise, given their successes on election day, I would expect that many Democrats see no reason why they should compromise now given what they perceive as a "mandate" from the voting public for their position.

SEE: GOP Vs. Democrat: Who's Best For America's Economy?

Companies Already Giving Cover
Many companies have already made bets about the likelihood of a year-end compromise, choosing to accelerate dividend payments into December 2012 and/or pay special dividends ahead of the end of the lower 15% dividend tax. Major companies like Walmart (NYSE:WMT), Costco (Nasdaq:COST), Disney (NYSE:DIS), Oracle (Nasdaq:ORCL) and Brown-Forman (NYSE:BF.B) have all either announced a special dividend or an accelerated payment schedule (or both) so as to allow shareholders to avoid the potential of higher taxes for dividends paid in 2013.

Likewise, many companies have been lowering guidance for 2013 and pointing to the problems of the fiscal cliff as a proximate cause. Consequently, investors have come to reevaluate the prospects for economic growth in 2013, and have adjusted their expectations accordingly.

To some extent, this gives Congress cover to do less. Companies have already made their plans, wealthy investors have incorporated the cliff into their outlook and there appears to be less pressure to move quickly to resolve the situation. More importantly, many of the companies that have announced guidance for 2013 in recent weeks have been quite skeptical about the first half of the year, but more optimistic about a growth recovery in the second half - suggesting to me that the companies expect a compromise to be reached in the first quarter of 2013.

SEE: Can Earnings Guidance Accurately Predict The Future?

Does the Cliff Provide Cover for Hard Choices?
Without wanting to go too far into conspiratorial thinking, I could see how both parties may want the automatic tax increases and spending cuts to go into effect on January 1. The Republican party has backed itself into a corner on taxes, even though U.S. tax rates are at very low levels on a historical basis, and most economists agree that more revenue generation (i.e., taxes) is needed. Likewise, the Democrats have put themselves in a difficult place with respect to an unwillingness to shrink entitlement spending and rethink the necessary scale of the government.

If the fiscal cliff happens, the landscape changes, and so too does the starting point for negotiations. Post-January 1, the Republicans will be negotiating on taxes from a higher starting point, allowing them to accept a deal that results in higher taxes relative to December 31 and still claim that they fought for lower taxes. Likewise, Democrats can fight for smaller spending cuts relative to the automatic cuts and claim it as a victory. With that sort of potential win-win for both parties, it almost seems too tempting to not wait for a deal.

SEE: 3 ETFs To Prepare For The Fiscal Cliff

The Bottom Line
Given that some economists have estimated the potential impact to GDP from the fiscal cliff as on the order of a 3 or 4% decline, I have a hard time believing that the tax increases and spending cuts will go on as currently planned. That said, political rhetoric and cable political commentary has made constructive dialog and compromise almost impossible, and both parties likely have more to gain from a post-January 1 deal than they do from a compromise in 2012.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Don't forget to read the Bull side of this debate and weigh in with your opinion below.

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