Ever More Pessimistic on a Budget Deal

 | May 18, 2013 | 1:30 PM EDT
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As stocks continue meandering upward, Wall Street strategists are beginning to fear a melt-up. As Dr. Ed Yardeni – one of my favorite strategists -- reminds us, melt-ups are typically followed by meltdowns.

To look at it from a Washington perspective: Might the instinct to sell off finally coincide with the inevitable face-off over the federal debt ceiling?

Top budget veterans say: "Maybe." The recent forecast by the Congressional Budget Office has lowered this year's deficit estimates by $200 billion. That, in turn, has boosted expecations that Congress will now approach budget cuts and tax hikes with the attitude, "Let's not and say we did."

Improvement in the ongoing fiscal 2013 budget has been driven largely by one-time factors, including unexpectedly high tax revenue from late-2012 corporate payouts -- designed to get ahead of 2013 tax increases -- and certain remittances from Fannie Mac and Freddie Mae. It will likely push back the day of reckoning over extension of the debt ceiling, or "x-date," to mid-November.

Separately, the House and Senate are marking up discretionary spending totals for fiscal 2014 that are as much as $91 billion (or 10%) apart. This could necessitate passage of a split-the-difference "continuing resolution" by late September in order to fund the government for three months or longer. Defense stocks, suffering under sequester-triggered budget presures at the Defense Department, thus may need to wait longer for any relief. Discretionary spending on technology and other priorities could also be hit.

Meanwhile, Republicans may be boxing themselves into a corner this summer. Per signals from House Speaker John Boehner (R-OH), the party may refuse to consider a debt-limit extension that excludes Republicns' "asks" for a tax-reform trigger and major entitlement cuts, or one that would otherwise pass with only Democrats providing the majority of votes.

For investors, this means Washington might blow a modest ill wind during the fourth quarter. As we wait, we will watch anxiously for White House guidance on the "X Date" and whether the two parties will attempt to synchronize initial fiscal 2014 funding measures and a debt limit extension.

Under the best scenario, the desire to end the sequester, extend the debt ceiling and trigger tax reform -- a notable new focus of House Republicans -- could beget a budget deal in January or February of 2014. Democrats might want to declare short-term victory over the austerity imperative created by the Simpson-Bowles Commission's late 2010 debt reduction report -- and to change the subject from the Obama Administration's Internal Revenue Service and other scandals.

Republicans, for their part, might resolve not to play small ball over funding levels, continuing resolutions and debt limits, but instead go into the 2014 elections as the party of economic growth. Indeed, bipartisan interest in growth-oriented tax reform has noticeably risen, albeit amid lingering questions of how much in net new revenues might have to be sought in tandem.

Meanwhile, Congress is being credited for already having slashed 10-year deficits by $2.5 trillion, largely due to discretionary spending cuts in the 2011 Budget Control Act and tax hikes in the January fiscal cliff fix. So, as I've long noted, a deal to cut $1.5 trillion more -- to meet the Simpson-Bowles minimum of $4 trillion -- just might have a chance.

As a result of the backloaded budget face-off hat's now anticipated, my partners and I have sharply reduced our odds of a deal late this year -- perhaps to 20% down from the prior estimate of just under a toss-up . Nevertheless, due to still-mounting sequester pressures, new focus on growth, and the wildcard of scandal-driven politics, we remain contrarian optimists and have reinstated our 45% odds for a potential deal in 2014.

For investors, the message in all of this might be: Do not go too far or for too long when the spit hits the fan this Thanksgiving or beyond. After all, an unexpected positive catalyst could come from Washington by winter. Never mind that this perceived plus could seem a mixed bag by next summer. That is when tax reform could potentially put in play the mortgage-interest deduction and other sacred individual and corporate tax breaks. The bulls may get fresh oxygen around Valentine's Day with the initial prospect of lower corporate rates, territoriality and a growthier bent to the tax code.

Much Ado About Foreign IT Outsourcers

I continue to expect passage of immigration legislation, although it is nowhere near the "done deal" that many have assumed. It is unclear how much the bill might be modified once the Senate finishes its deliberations over the Gang of Eight's draft proposal, likely in late May or early June.

That proposal, with its restrictive language regarding H1-B visas and employees, is perceived as a potential disaster for information-technology-outsourcing companies like Cognizant (CTSH), Infosys Technologies (INFY), Wipro (WIT) and Tata Communications (TCL). My colleague Loren Smith predicts that the bill's union-drafted provisions will mostly survive on the Senate floor, but that the overall measure will be "improved" as it moves on to the House -- and then to a House-Senate conference committee, if it gets that far -- late this year or early next.

Workarounds will emerge to mitigate the impact of whatever new rules result. As a result, we guess that Washington is in the process of creating a painfully slow-in-developing investment opportunity within the IT space. I promise to write more about this topic in future posts.

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