If and when President Obama and Hill Democrats take both delayed eligibility for Medicare and the notion of a "diet COLA" (reduced cost of living adjustments for Social Security and other federal benefit programs) off the table, investors will know that a deal to avert the fiscal cliff has become impossible. Once that happens, there will be no softener to offset Republicans' having to give in on taxes. As a result, the GOP would be confronted with what they will assuredly view as a "bad deal" that they cannot and will not accept.
This scenario would force Republicans into one of two moves:
- They can do nothing and accept most of the blame for going over the cliff.
- They can allow House to pass legislation allowing a one-year extension of the current tax rates for all but the top 2% of wage earners, with about 190 Democrats providing most of the votes.
A growing percentage of Republicans are warming to the idea of such a last-minute gambit. The Senate's bill would also conveniently fix the alternative minimum tax (AMT) for calendar 2012 while extending the child tax credit and the marriage penalty relief; this combination would otherwise raise taxes on millions of middle-class families. It would even set the rate on both capital gains and corporate dividends at what would amount to a top rate of 23.8%.
This would be a substantial increase above the current 15%. But for dividends, it would fall well below the 44.4% that has been expected, prompting recent special distribution announcements from company after company seeking to get under the gun.
The bitter pill, politically, is that such a move would give Obama exactly what he's been campaigning for: It would raise taxes, which Republicans believe in their hearts is a bad idea. It might also look like a cop-out to the party's faithful.
However, here are four political attractions to such a plan:
- It would strengthen the party's hand in negotiating with Obama.
- It would allow 90% or more of Republicans to continue honoring their no-tax pledge without bearing blame for the broad tax hikes that would occur in the event of a nothing done.
- It would leave the party with a credible position from which to force entitlement cuts as a quid pro quo for a debt ceiling increase in February or March.
- It would provide a trigger within one year for action on broader tax reform.
But it would be a mixed bag for investors.
Passage of the Senate bill could force defense layoffs, reduced Pentagon procurement, Medicare provider cuts, and delayed NIH grants affecting health research. Estate tax rates and the R&D tax credit, business expensing, and about $75 billion in so-called "tax extenders" would also be uncertainty. For affected stakeholders, high anxiety may set in as late winter and the 2012 tax filing season approaches.
It would portend a nearly seamless transition to even more high-stakes squabbling over entitlements and the debt ceiling, somewhat reminiscent of the face-off that led to the U.S. debt downgrade in August 2011. In this "Groundhog Day moment" investors will realize the fiscal cliff has been averted but they're facing six weeks or more bad political weather from Washington before reaching a potentially even more ominous fiscal wall.
On the positive side, the unexpected surprise of a reprieve for a lower dividend tax rate should add luster to high dividend-paying stocks -- just when investors may be looking toward defensive options amid fears of a once-again weakening economy.
So, what's an investor to do?
- Remain hedged for market disappointment, since there's a very real possibility that we'll go over the cliff or get a limited and brief reprieve. Even if President Obama and Speaker Boehner come to late agreement on a balanced package disappointing partisans on both sides, it might not have the votes to pass. Any such "TARP moment" would unlikely produce the ferocity of the Dow Jones Industrial Average's 777-point plunge in reaction to the House's initial and unexpected rejection of the controversial bank bailout plan in late 2008.
- Be discerning about dividend-paying stocks. It is not clear that dividend tax rates might not yet triple as we go over the cliff. So consider the risks in buying anything other than the quality high-yielding names you would be comfortable owning in any outcome.
- If the prospect of a Democratic give on one of the two big entitlement requests seems viable, you may want to remain somewhat invested, particularly in consumer and retail stocks. A "grand bargain" might include a near equivalent to the expiring payroll tax cut and at least a year's extension of the debt ceiling. This would all but erase even the 1% of GDP contractionary impact that has been widely expected as a minimum certainty. It could also buy an extended respite before Washington again negatively dominates consumer, business and investor sentiment.
I wouldn't put high odds on a deal. But I wouldn't rule it out -- unless and until all entitlement reform options disappear.
The bottom line? Stay tuned. Stay Ready. And prepare to be nimble between Christmas and New Year's Day.