We Could Still Skirt the 'Cliff'

 | Dec 21, 2012 | 1:00 PM EST
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Equity markets suffered a tremor early Friday after House Republicans were unable to pass Speaker Boehner's "Plan B" proposal late Tuesday. This may well shape up as a "TARP moment" -- that is, a wake-up call to Congress, much as when the Troubled Asset Relief Program was forged in 2008. I still expect Congress to at least partially avert the "fiscal cliff" before New Year's.

By "partially" I mean legislation that would at least head off automatic tax-rate hikes and an alternative minimum tax (AMT) hit for 98% or more Americans, but perhaps not to avert the scheduled budget sequester. I broadly foresee or 2-in-3 odds on this -- yet I also continue to predict a 75% likelihood that any such result will be of very limited scope, and will thus disappoint the equity markets. To reiterate, this would result in a continued squabbling over spending in the next two months.

For these reasons, my partners and I have reprised our call for investor alert. We also believe we'll see a reprieve in dividend taxes, so this could serve as a life preserver for market players inclined to become defensive once again. After a day of meetings in Washington Thursday, we'd also note more bearishness on defense stocks and other industry groups at risk to the impending budget sequester.

Specifically, we see 40% odds of a negotiated deal. We still place 35% odds on going over the cliff, which we would define as a "nothing done" on taxes before year-end. We also see 25% odds of a modified last-minute fix. This could be fashioned around the earlier Senate-passed legislation that would extend current tax rates on salaries above $250,000, adjust the AMT and put a 23.8% top tax rate on both capital gains and dividends.

R.I.P., Plan B

"Plan B," or Boehner's weekend counter to the Obama offer, would have shielded taxpayers earning less than $1 million, while otherwise making the Bush-era tax cuts permanent. It would have also repealed the AMT and set the "death tax" at a 35% top rate, excluding estates of up to $5 million.

Politically, GOP leaders felt they might be able to regain bargaining advantage by rallying House Republicans to show unity and cornering Senate Democrats and the White House as time runs out. At a minimum, they also to be exonerated from blame should policymakers allow the economy go over the "cliff." It was a risky gambit, and I view it mostly as a reflection of Boehner's calculations about how best to garner a majority vote from his caucus. Senate Minority Whip Jon Kyl (R-AZ) assured his House counterparts that passage of "Plan B" would move the process forward. At that point, Boehner's strategy seemed solid enough.

More on 'Plan C'

Nevertheless, I was surprised that the Speaker also seemed ready to destroy the S. 3142, which had been passed by the Senate -- something that many had viewed as a last option to a cliff-dive. With that plan now jettisoned, I believe one last option could be the House allowing passage of a modified version of S. 3142 (with mostly Democratic votes). In essence, the continued existence of this safety-valve option could work, along with the leverage afforded Republicans by their ability to allow a debt-ceiling hike.

Continued Cautionary Note

We're unlikely to see the kind of fallout that the debt-ceiling debates produced in 2011. Still, investors are now absorbing Thursday's portent of disappointment after the markets have perhaps counterintuitively surged to their mid-September highs. As I noted recently on CNBC, the ultimate investor irony of 2012 could be this: The best strategy may have been buying amid fiscal-cliff nervousness, then selling upon the outcome, regardless of what it is.

At this point, due to Christmas and a late Senator Dan Inouye funeral in Hawaii, barely a week is left for a last-minute partial fix or compromise. Furthermore, thanks to Plan B's demise, Hill Democrats have gained perhaps yet more bargaining leverage.

So why do I still expect movement? Well, we could see a reboot after Congress reconvenes post-Christmas, and differences between the two sides have narrowed significantly. In fact, Politico reports that the White House may accept a tax-hike threshold as high as $700,000 to $800,000, according to the publication's sources. Meanwhile, Boehner has offered to allow a delay on Medicare-related decisions into 2013. This may mean that Obama's apparent acceptance of Social Security "diet COLA" (cost-of-living adjustment) may be enough of an up-front compromise to forge a deal.

Further, as mentioned earlier, the Republicans could deploy the S. 3142 parachute -- which the Senate Democrats have already passed, making it difficult for them to reject now -- and a few "leavening agents" (i.e., some give on extended unemployment benefits and/or estate tax rates) could also work to help Congress avoid the worst of the cliff.

Of course, gone is last weekend's optimism of an inevitable mini-grand bargain, and time is frighteningly short. Liberal Democrats are resisting Obama's give on the Social Security COLAs, and Boehner's Plan B failure has proven that any passage may have to rely on mostly Democratic votes. So, as much as the Speaker has proven that he truly wants a deal, his path toward the magic number of 217 votes seems highly precarious.

In short, failure is still possible.  Indeed, an even more wrenching "TARP moment" could yet unfold. But, for reasons above, I'll remain sanguine regarding at least some late action, pending confirmation that Senate leaders will now indeed become engaged, and that the reported Boehner-Obama dialogue will continue.

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