Both the election results and current polls suggest Republicans are more likely to be blamed if no deal is reached. At the same time, it is clearly in President Obama’s interests to reach a resolution. As such, most politicians appear motivated to find some sort of middle ground.
The two sides still appear to be quite far apart on some important issues (particularly regarding a potential tax increase for higher-income Americans), but the parties are at least attempting to avoid brinksmanship.
Our best guess as to the outcome is that, at the 11th (or 12th) hour, President Obama and Congress will agree to some type of compromise deal that includes a short extension of at least most of the Bush-era tax cuts, some sort of tax increase on upper-income households and a delay of most of the scheduled spending cuts.
Any such deal also is likely to include provisions that launch the process of more comprehensive deficit reduction and tax and entitlement reform. Should this come to pass, our assessment is that the size of the tax increases and spending cuts would be reduced to the point that they would cause about a 1.5% hit on US economic growth, less than the currently forecasted more-than-4% impact, but still significant.
It is important to remember that the risks are still heavily skewed to the downside, and until we see some sort of fiscal cliff resolution, equity markets are likely to remain choppy.
Investors are understandably focused on the near-term risks of the fiscal cliff, weakness in the global economy and escalating geopolitical conflict, all of which are driving volatility higher. However, we continue to believe that, from a fundamental perspective, stocks remain attractive.
The combination of decent valuations, easy monetary policy, low inflation and still-positive economic growth suggests stocks will continue to outperform bonds over the next 12 months.
