Odds of a Cliff Dive Are Rising

My partners and I have reduced our odds of avoiding (before year's end) the spending-cut and tax-hike triggers associated with the "fiscal cliff" from 70% to 60%.

After multiple conversations with House of Representative leadership sources, senators and budget experts in Washington, we still expect a narrow compromise from a so-far-unyielding White House. But large segments on both sides seem increasingly willing to go over the cliff. It wouldn't take much miscalculation from either party to take us there. Nor would it be the end of the world, as most affected funding levels, tax rates and expiring tax and benefit provisions might be fully or partially restored in early 2013 -- albeit amid at least some economic and market displacement. Meanwhile, the "quality" and scope of any last-minute fix might also disappoint.

For these reasons, we're sanguine on the subject, but we urge investors to use caution in the near term. We are looking forward to continued dividends from America's energy renaissance and recoveries in banking, housing and other segments of the economy that are facing uncertainty caused by the Obama administration's healthcare agenda and response to the financial crisis.

President Obama holds the most leverage, to be sure. But he may be miscalculating by pressing Republicans to agree to higher revenues and upper-income tax rates as well as deductions for top wage earners and the ability to self-activate a hike in the debt limit. That would require breaking of the almost-theological "Taxpayer Protection Pledge" that has defined the GOP since the Reagan era. Meanwhile, even though signaling their resignation to net new revenues (if not an eventual nod to a midpoint raise in top marginal rates), a majority of the House Republican caucus will reject tax hikes of any sort without offsetting major reforms to entitlements like Medicare, Medicaid, and Social Security, as well as other, "mandatory" spending programs. President Obama's public campaigning has emboldened Hill Democrats to resist any such cuts, making Democratic votes for a "balanced" package -- should he ultimately endorse one -- likely scarce as well. This portends a potential "TARP moment," after a deal emerges and squeaks by in the Senate only to be initially voted down on the House floor.

To investors, this represents a bit of a nightmare: The odds of the Republicans' caving, perhaps thoroughly, are not zero. The relief from uncertainty accompanying such a move might penalize those who have held back and waited for more clarity or better valuations from which to restart buying programs. Meanwhile, the perhaps-near-equal chance of either going over the cliff or limping past the danger for a brief while might leave the intrepid who have engaged in "willing suspension of disbelief" since fall in a bind of their own.

Bottom line, it could go either way. We've got a lot to accomplish in the next two three weeks and talks between Speaker Boehner's and President Obama's staff are just barely alive. Tellingly, House Republicans have been told to prepare for votes between Christmas and Dec. 31, and to cancel any plans for New Year's.

I now think it's a push as to whether Obama might pull up to offer meaningful spending cuts in order to ease the GOP's caving on revenues. And it's also a push as to whether Hill conservatives might go along with a higher top rate without such concessions. More broadly, however, even if the president manages to get the Republicans to accept a lopsided deal, we would expect the GOP to deny him any lengthy extension in the debt ceiling. This would portend the market's having to eye a potential return to the high-stakes struggle over spending by as early as late winter or spring. And this could spoil hopes of a clean move past the cliff that would allow investors to focus on better prospects for U.S. stocks over the next 12 months.

There is a positive market-moving deal to be made, and I have my own thesis regarding its notional elements. This could start with a one-year extension of all tax rates, but, nevertheless, move toward a $1 trillion upper-income tax raise via a percentage or dollar cap on non-charity-related deductions. Then add a new temporary top rate or surcharge on either millionaires or those earning more than $500,000 to satisfy Obama's lust for a symbolic double-whammy on the "rich." But pair it with long-term entitlement reforms such as an eligibility-age hike or means-testing for Medicare benefits, added state flexibility under Medicaid, and a "diet COLA" (i.e., reduced formula for cost-of-living adjustments) for Social Security to round off an equalizing $1 trillion in spending cuts. Skip the 2013 defense and non-defense budget sequester, but backload a $300 billion or so cut in 10-year discretionary spending totals as part of this number. To all of this, add a one-year extension of the debt ceiling, perhaps along with extension of payroll tax relief and additional emergency unemployment benefits to further buy Democratic votes and business expensing or moderated corporate dividend or estate tax rates to mollify the political right.

How and why would such a compromise work? The need to once again extend the middle-class tax relief within one year would create an imperative and trigger to force the Republicans' objective of comprehensive and base-broadening tax reform next summer or fall -- perhaps within a reconciliation bill also embodying the legislative text effectuating the promised entitlement reforms. Meanwhile, if President Obama finally makes nice, the process and scope of the package could even be stretched to two years, lifting the next debt fight past the mid-term elections.

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