The congressional 'super committee' could quickly become a super-sized headache for markets if it doesn't show progress by its Thanksgiving-eve deadline.
Investors are decidedly negative in their view of the bi-partisan committee, as they remember the high level of political rancor surrounding the debt ceiling debate and the subsequent downgrade of the U.S. credit rating last summer.
Fifty percent of the investors polled by Citigroup said they expect the bi-partisan committee to fail in its efforts to find $1.2 trillion in deficit reductions over 10 years.
"It is a clear and present danger for markets," said Deutsche Bankchief U.S. equity strategist Binky Chadha.
"I think the market is still in a very defensively underweighted position. I think if we get a decent deal out of the super committee that would be very positive for the market," he said. "Our baseline view is we will get a deal and it will be modest."
The 12-member super committee, made up of members of the House and Senate, is working in secrecy. With just about a week to go, some of its thinking has become public. It was seen as promising that a tax increase would be considered by Republicans on the committee, a sticking point in the debt ceiling debate this past summer. Democrats however disagree on the size and type of tax increase. The committee is reported by the New York Times to now be considering proposing revenue increases but would leave the difficult job of figuring out how to raise taxes to the tax writing committees.
There are an equal number of Republicans and Democrats on the committee, and the thorniest issues remaining appear to be those at the heart of the divide in the debt ceiling debate— Republican aversion to taxes and Democratic resistance to cutting entitlement programs.
Some 150 members of Congress plan to publicly encourage the committee and show their support for a compromise by standing together on the Capitol steps Tuesday.
The committee has a Nov. 23 deadline, but proposals need to be submitted to the Congressional Budget Office by Nov. 21 so it can calculate the impact on the federal deficit and debt before the members vote. The proposal would then be sent to the Senate and House floor for a vote.
Areas that are likely to see cuts are defense and health care, but if there is no deal then, automatic cuts—or sequestration—will occur starting in 2013.
JPMorgan Chase says if sequestration occurs, the deficit reductions would total $98 billion a year, because they would also reduce the government's interest expenses. The $1.2 trillion in cuts would be split evenly between defense and non-defense discretionary spending. Social Security, Medicaid, and veterans' benefits would be exempt from the automatic cuts.
JPMorgan economist Michael Feroli said in a note that because the economic and political costs of not reaching a deal are large, the greatest odds are that the committee finds some deficit reductions, but then the automatic across-the-board cuts would kick in with sequestration. He puts the odds of the committee finding the $1.2 trillion to $1.5 trillion in cuts desired at just 30 percent, but he gives the idea of a partial deal, where some of the cuts are agreed by the committee, a 50 percent chance.
Some Washington insiders say, at this point, it seems this partial deal scenario is most likely, where the two parties might find cuts around the things they already agree on but not get to the full $1.2 trillion. The balance of the $1.2 trillion would then come in the form of automatic cuts.
Feroli adds that if by Jan. 15, the committee is able to come up with the balance of cuts to make up the $1.2 trillion, then all sequestration at the beginning of 2013 would be avoided.
Some Washington insiders say, at this point, it seems this partial deal scenario is most likely, where the two parties might find cuts around the things they already agree on but not get to the full $1.2 trillion.
The balance of the $1.2 trillion would then come in the form of automatic cuts.
Feroli gives the smallest odds—just 5 percent—to a "big deal" where the 10-year deficit reduction is much greater than expected. If that were to happen, he would expect the credit-rating agencies to reverse their negative watch on the U.S. and return it to stable. Other analysts also give this scenario little chance.
Chadha said Deutsche Bank puts the odds of the committee finding the $1.2 trillion in cuts at 65 percent.
"It's one of those things...if it doesn't pass, many people are going to say 'I told you so.' I think there could be a pretty significant negative reaction. It would be like July and August, but all the indications are we are moving toward our baseline scenario. We get something. We don't get the grand bargain," he said.
Analysts do not expect a return to the environment that surrounded the debt ceiling debate, but they say a failure to find a bi-partisan approach will be seen as a negative to markets, and perhaps by the rating agencies.
"Our big concern is that heading into an election year, there doesn't seem to be a lot of push to cooperate right now," said Gary Thayer, chief macro strategist at Wells Fargo Advisors.
"I think it's probably going to be the minimum that they can do and then we'll have some adjustment through inflation indexing and things like that that wouldn't show a specific target" for cuts to Social Security and other programs, he said. They could also do some inflation adjustment around taxes. "They could affect the tax brackets too, and that would be a way to raise revenue without raising tax rates."
Thayer said there's about a 30 percent chance the committee will find the $1.5 trillion cuts in the committee's mandate, and a more than 50 percent chance it finds the minimum $1.2 trillion required.
But he, like others, says if the committee relies on things that would be removed from the budget anyway, such as the cost of the wars, that could provoke rating agencies to act again. So far just Standard and Poor's has cut the U.S. credit rating by a single notch, while Moody's and Fitch retain their AAA rating for the U.S.
Thayer said Congress has no doubt seen the lessons learned from Europe's failure to control its spending and should act accordingly. He said raising the age for entitlement programs, as has been done in Europe, may be one way to look to for cuts.
"They could cut Medicare payments, or they could raise the Medicare age," said Thayer.
While Citigroup says investors are negative on the committee's work, its own political analysts think changes in the political climate make it likely a deal for deficit cuts of $1.2 trillion gets done.
"That could be seen as positive because markets think they won't even do the $1.2 trillion, and they'll fail. That would be quite a boost to confidence," said Amitabh Arora, head of asset allocation research at Citi.
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