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Cash In on Washington Dysfunction, Friedman Urges Investors

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While Congress reached a last-minute deal Wednesday to allow the government to keep borrowing until Feb. 7 and keep the government funded until Jan. 15, the next fiscal battle will come as the bicameral conference committee that was set up under the deal tries to hammer out a budget for 2014 — specifically, replacing the next round of sequestration cuts.

So says analyst Andy Friedman of The Washington Update in his Monday commentary. The sequestration spending cuts, which are set to take effect on Jan. 15 — when yet another government shutdown looms — were implemented as part of the compromise that raised the debt ceiling in August 2011. They reduce spending for defense and other government functions, but as Friedman notes, the cuts do not impact Social Security, Medicare and Medicaid benefits.

As yet another twin deadline looms, the markets will likely “get nervous” and suffer another downturn, he says.

However, “because Congress will not allow the nation to default, that downturn should be temporary, with the markets rebounding once an agreement is in sight. Thus, investors should view the downturn as a buying opportunity.”

Noting that the cuts “are not popular with either party,” Friedman says that Republicans will seek to replace the defense cuts with “deeper cuts to social programs and cuts to entitlements,” — namely, slowing the growth of Social Security cost-of-living increases through the use of the “chained” consumer price index and requiring affluent recipients to pay more for Medicare coverage.

Democrats, on the other hand, “will resist entitlement changes and will seek to offset the sequestration cuts at least in part with new taxes,” Friedman says. To that end, President Barack Obama has proposed a number of tax changes, including taxing municipal bond interest, limiting the amount individuals may accumulate in tax-preferred retirement accounts, and reversing recent expansions of the estate and gift tax exemptions. But, says Friedman: “I can say with virtually certainty that none of these proposals will get through the conference committee.”

Indeed, Senate Minority Leader Mitch McConnell, R-Ky., said Sunday on CBS’ Face the Nation that when Congress “re-engages” early next year, he will not allow lawmakers to “raise spending” by raising taxes, as the Democrats have suggested. “Our Democratic friends want to bust the caps — in other words, spend more — and they want to raise taxes. For me, the bottom line, when we re-engage early next year, is I don’t want to bust the caps, and I don’t want to raise spending because we are, in fact, reducing government spending, not as much as we need to,” but the bipartisan Budget Control Act of 2011 “is a success.”

Freidman predicts the following proposals from the president are “more viable” options: to close “loopholes,” including (1) eliminating the ability of someone who inherits an IRA or 401(k) to “stretch” the payments over his or her lifetime; and (2) curtailing the availability of sophisticated wealth transfer techniques such as grantor retained annuity trusts (“GRATs”), intentionally defective grantor trusts and dynasty trusts. If the budget committee fails to reach an agreement, Freidman warns, Congress faces yet another choice on Jan. 15: Either fund the government for the remainder of 2014 “at the lower spending levels reflected in the sequester,” or not pass a funding bill at all, resulting in yet another government shutdown.

McConnell noted on Face the Nation that there would not be another government shutdown. “Shutting down the government, in my view, is not conservative policy,” McConnell said. “I don’t think a two-week paid vacation for federal employees is conservative policy. A number of us were saying in July that this strategy could not and would not work, and of course it didn’t. So there will not be another government shutdown. You can count on that.”

But Friedman says the “bigger issue” will come after Feb. 7, when Congress will need to raise the debt ceiling to avoid default. “In Washington, past really is prologue,” he said. “Stay tuned.”

Friedman notes the market drop that occurred between Sept. 8, when the market first took notice of the brewing conflict over funding the government, and Oct. 8, when the Republican House leadership acknowledged that it would not permit the nation to default. During this time period, the Dow lost 5.7% and the S&P index lost 4.1%.

But the from Oct. 8 through Oct. 17, when Congress passed the compromise legislation, the Dow gained 4% and the S&P gained 4.7% to reach an all-time high and “investors who purchased equities on the downturn were rewarded,” he says.

Investors, he says, can still find comfort in knowing that “plenty more opportunities for Washington dysfunction are upcoming.”

While Friedman says that he continues to believe that Congress will not allow the nation to default on its debt, “any market downturn in anticipation of a debt ceiling deadline can provide a buying opportunity.”

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