US fiscal cliff deal is a stopgap not a solution, says BlackRock’s Russ Koesterich

Russ Koesterich, BlackRock’s chief investment strategist, has listed 18 implications of the limited deal agreed by branches of the US government to avoid the fiscal cliff.

Highlights:

• The 11th-hour deal is better than nothing … but its limited scope and the need for additional negotiations will likely translate into increased volatility for financial markets. Expect more late-night drama from Washington in the coming months.

• Higher payroll taxes will likely depress US consumer spending in the short term. This could result in a drag on the US economy early in the year. We expect a rebound later this year, but believe gross domestic product (GDP) growth is unlikely to exceed the 2% annual clip we have seen in recent years.

• For equities, we prefer US mega-cap companies and non-US stocks (especially emerging markets, but also exporters on Europe’s periphery). Dividend stocks look attractive, especially those companies that are cash-flow rich and have a track record of increasing payouts.

• Within fixed income, we like to focus on credit sectors – including high yield and emerging market debt. Municipal bonds remain a good source of tax-exempt income for US investors but we expect little price appreciation. US Treasuries look dangerous with yields low and duration risk high.

What does the fiscal cliff agreement include?

1. Here’s a quick summary of what the fiscal cliff agreement reached late on January 1 covers:

• Permanent extension of the Bush-era tax rates for individuals with income up to $400,000 and couples with income up to $450,000.

• Permanent maximum 15% tax rate on dividend income and long-term capital gains for individuals and couples up to those same income levels, with a 20% rate for those with higher incomes.

• Permanent lower estate tax rates for estates worth up to $5 million.

• Permanent fix for the Alternative Minimum Tax.

• Two-month delay of scheduled spending cuts (known as the “sequester”).

• One-year extension of unemployment benefits.

• One-year freeze on scheduled cuts in doctors’ Medicare payments (the “Doc Fix”).

• Five-year extension of stimulus-related spending cuts.

2. Significantly, the deal did not include an extension of the payroll tax holiday, any entitlement reform, any restructuring of personal or corporate tax codes or any increase in the debt ceiling.

3. The bottom line: The agreement mitigates the full impact of the scheduled tax hikes and spending cuts but is incomplete in many ways. The compromise will still produce a modest fiscal drag, fails to address the longer-term fiscal challenges facing the United States, and leaves the debt ceiling as an unresolved, near-term issue.

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