Markets rallied strongly on Wednesday in reaction to the last minute deal to avert the worst of the so-called fiscal cliff. The Nasdaq rose 3% and the S&P 500 rose 2.5%. As you can see on the chart below, the move takes the S&P 500 back near the September highs, which of course was before the election and the fiscal cliff negotiations. The expected economic impact of the deal, around -1% to -1.5% of GDP, is close to consensus expectations, so it is little surprise that the markets have traded back to pre-election levels. With New Year re-investment demand, stocks could continue to rally for a while before debt ceiling negotiations take center stage.
I see two major positives in the deal: 1) the Bush tax cuts have been made permanent on incomes up to $400,000/$450,000 (single/joint filers), averting the largest component of fiscal drag; and 2) the top tax rates on capital gains and dividend income rose to only 20%, which should alleviate pressure on dividend paying stocks.
Of course, the agreement fell far short of hopes for a “grand bargain” in that it fails to address the fiscal deficit and debt ceiling. In fact, the Congressional Budget Office projects an additional $4 trillion in deficits over ten years due to the extension of the majority of the Bush tax cuts. The debt ceiling has already been reached, and the Treasury will run out of flexibility to manage around that by the end of the first quarter. The President has stated that he won’t negotiate on the debt ceiling, and Republicans feel they have leverage now that taxes have been raised. Expect a nasty fight over the debt ceiling.