Cliff Notes: The Investment Environment Beyond the Fiscal Cliff

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1 Cliff Notes: The Investment Environment Beyond the Fiscal Cliff Prepared: January 15, 2013 Situation Analysis The American Taxpayer Relief Act of 2012 (ATRA), signed into law on January 3, 2013, provided at least a partial resolution to the fiscal cliff crisis that hung over lawmakers in Washington. The cliff was the name applied to a combination of tax increases and spending cuts scheduled to take effect at the start of While efforts to reduce the government s deficit are desirable, there was a growing concern that the combination of these policies had the potential, in and of itself, to push the U.S. economy into a recession. The ATRA limited the potential economic impact, although some tax increases did result. However, it also delayed serious action on the nation s deficit challenges. In particular, Congress put off any tough decisions on ways to more effectively manage federal spending in order to pare down the deficit. The measure did succeed in lifting some uncertainty, and stock markets reacted positively immediately after passage of the legislation. Important fiscal issues still remain and will quickly surface again in the first months of the year. Investors need to prepare for the possibility that the next fiscal crisis, likely to occur by mid-february, could lead to a significant short-term market reaction. It may be particularly negative for stocks and other risk segments of the market and positive for assets perceived as safe havens, such as U.S. Treasury securities. However, as the year progresses, we believe the environment for stocks will prove to be favorable and investors will shift their focus to risk-oriented assets. A summary of the Tax Act The Act raises tax revenue as a way to reduce the nation s deficit, and most important for individuals, it provides long-term certainty on tax rates as most key provisions do not have sunset clauses. This was a major issue with the Bush-era tax cuts which all had a set expiration date. Of course, future changes to the tax code are inevitable. Various provisions of the newly approved ATRA affect taxes in a variety of ways: Income tax rates that have applied since 2001 are permanently locked in (meaning no expiration date was included) for individuals with incomes up to $400,000 and married couples with incomes up to $450,000. The Alternative Minimum Tax (AMT) has been permanently patched and will be adjusted for inflation going forward. Estate and Gift Tax exemption amounts remain unified and are set at an inflation-adjusted $5 million per person (estimated to be $5.25 million in 2013). While not technically part of the Act, the payroll tax holiday ended and the Social Security wage withholding returned to 6.2%. This represents an increase of 2% over 2012 for virtually every wage earner. For taxpayers over these amounts, the top income tax bracket increases to 39.6% For trusts and estates, the threshold is projected to be $12,000

2 Page 2 The table below summarizes a number of the tax changes that took effect due to the American Taxpayer Relief Act of 2012, as well as a number of other provisions that will have an impact on taxes in Changes As A Result of the American Taxpayer Relief Act of 2012 Provision Top Ordinary Income Tax Rate 35% 39.6% Top Capital Gains Tax Rate 15% 20% Top Qualified Dividends Tax Rate 15% 20% Phaseout of Personal Exemptions Repeal of Phaseout in Place Limitations restored for taxpayers with income in excess of $250,000 and $300,000 Limitation of Itemized Deductions Repeal of Itemized Deductions in Place Phaseout restored for taxpayers with income in excess of $250,000 and $300,000 Alternative Minimum Tax Exemption $33,750 and $45,000 $50,600 and $78,750 Estate, Gift and Generation-Skipping Transfer Taxes $5 million exemption amount and a top rate of 35% $5 million exemption amount and a top rate of 40% Expiration of the Payroll Tax Holiday Provision Social Security Wage Withholding Rate (Employee Portion Only) 4.2% on wages up to $110, % on wages up to $113,700 Changes As A Result of the Patient Protection and Affordable Care Act of 2010 Provision Additional Medicare Withholding Tax Net Investment Income Surtax Not Applicable Not Applicable 0.9% on wages in excess of $200,000 and $250, % of net investment income of certain individuals, estates and trusts above the threshold amounts ($200,000 - single, $250,000 - joint, and approximately $12,000 for estates and trusts) How the fiscal situation was affected With policymakers in Washington spending considerable time debating issues surrounding the federal debt and deficit, a big question being asked is whether the tax plan just passed and other policies being discussed will make a significant dent. A good starting point is to look at a breakdown of tax revenues and federal spending compared to historical levels. A common measure is to compare today s rates of taxes and spending as a percentage of the nation s economy (quantified by Gross Domestic Product, or GDP) to historical levels. The following table demonstrates that tax revenue as a percentage of GDP is a bit below historical levels, while spending levels as a percentage of GDP are well above historical averages. The net result is a deficit that is significantly greater than the historical average when compared to the nation s overall economy. % of GDP Historical Current Difference Revenue 17.7% 15.8% -1.9% Spending 19.8% 24.3% 4.5% Surplus (Deficit) -2.1% -8.5% -6.4% Source: Bloomberg Historical Average: Since World War II Current: Represents 2012 figures

3 Page 3 Revenue & Spending as % of GDP 35% 30% 25% 20% 15% These numbers indicate that policymakers need to come to grips with an unsustainable budget situation. The lines in the adjacent chart show that the discrepancy between revenue and spending widened considerably during the Great Recession and this imbalance persists well into the future. Without serious action, federal debt will continue to represent a significant portion of the nation s overall economy. Federal Government Budget: Unsustainable BUSH TAX CUTS OBAMA STIMULUS PLAN FORECAST 0% Spending Revenue Publicly held debt Debt (gross) Source: The Economist (December 15, 2012); Office of Management and Budget, Congressional Budget 100% The combination of revenue increases enacted in early January with the projected sequester spending cuts due to take effect on March 1, 2013 will make a modest dent over the long run, but only represent a start. In reality, we anticipate that some of the cuts scheduled for March 1st will not be enforced. The nation s debt problem still requires a long-term solution that will likely involve a combination of spending cuts and additional revenue increases. Economic impact in 2013 With higher taxes now in place, particularly the return to a 6.2% Social Security wage withholding that results in higher taxes for most wage earners, the economy is likely to be negatively affected in the first half of The modest revenue increases included in the ATRA (compared to the large deficit) should not, in and of itself, have enough impact on the economy to cause a recession. However, it may constrain growth in the first half of the year to around 1%. 80% 60% 40% 20% Debt as % of GDP Consumers will likely face the brunt of the adjustment. Higher payroll taxes (reducing takehome pay by $20 for every $1,000 earned for most individuals) may be a drag on consumer spending. The impact will be most notable early in the year as wage earners adjust to the change in their paychecks. As we move into the second quarter and beyond, consumer spending should normalize as both job creation and wage growth improve. This is assuming that no other major tax changes occur. While the impact of higher taxes and reduced government spending may take a toll on the nation s economy in the early part of 2013, we expect that in the second half of the year, strong fundamentals of the private economy will take precedence and drive faster overall growth in the economy. We anticipate growth to be above the 2% level in the second half of Drivers of this increased economic strength could include an improved housing market and the fact that many corporations are holding high cash reserves ready to be invested in new capital expenditures and labor. Market impact in 2013 and beyond Equity Markets The outlook for equities remains generally favorable. The fact that lawmakers appear to be coming to terms with deficit and debt issues should be seen as a positive development for market sentiment. Our expectation is that equities will continue to trend higher in We estimate the benchmark S&P 500 Index (a broad measure of U.S. stock market performance) will gain in the range of 7%-10% in Three primary factors that are likely to have a big affect on how the market performs this year are: Ongoing fiscal issues: Uncertainty remains, with many key issues, including the debt ceiling, spending cuts and entitlement reforms, yet to be addressed. Expect more sharp rhetoric and increased volatility by mid-february as these discussions continue. If the debt ceiling crisis of is a guide (see adjoining chart), stocks could be in for some short-term challenges early in the year.

4 Page 4 S&P 500 Index Level Jan Source: ISI Group Stocks Fell After a Close Encounter With the Ceiling Last Time S&P Downgrades U.S. Debt Outlook to Negative Apr 8% Gain 20% Decline S&P Downgrades U.S. Debt Rating Jul Oct Relative valuation: Equities appear to be attractively valued relative to other asset classes, and are trading modestly below historical averages. The market is poised to have a positive year even if earnings growth is muted and valuations only advance modestly from current levels. This seems like a reasonable expectation in a year when taxes are going up and consensus expectations from Wall Street about 2013 earnings are trending lower. A catalyst for stronger corporate earnings could be reaccelerated growth in emerging markets. This would potentially benefit U.S. companies with emerging market exposure. Sentiment: Market sentiment remains favorable. Expectations that policymakers in Washington will come to terms with the nation s key fiscal issues is one factor. The wealth effect associated with the stock market s positive performance in 2012 and signs of improvement in the housing market also serves as a contributing factor. Dec Fixed Income Markets Fixed income investors breathed a sigh of relief with news of the fiscal cliff agreement. Generally, in the immediate aftermath, risk-oriented sectors of the market, including high-yield bonds and emerging market bonds, showed significant price appreciation. Municipal bonds held their ground. Corporate bonds were a mixed bag, with shorter-term securities posting modest returns, while those with longer maturities lost ground. U.S. Treasury bonds also retreated. Looking forward, we anticipate that the environment for fixed income investments will evolve this year: In the first quarter, continued wrangling over the debt ceiling, budget, and status of the sequester spending cuts may lead to a re-emergence of a flight to safety. If so, a Treasury bond rally is likely to follow, reversing a setback for Treasuries that occurred in the immediate aftermath of the new tax legislation. Municipal bonds may also appear attractive to risk-averse investors as state and local governments maintain balanced budgets. High quality corporate bonds would likely benefit as well. By contrast, high yield bonds may struggle if negative risk sentiment develops. Emerging market debt may also lose ground as the dollar could regain strength, limiting attractive opportunities. In the second quarter and beyond, municipal bonds may show additional strength as higher tax rates on upper income earners will enhance the appeal of tax-free income. Municipal bond defaults in 2012 were well below the levels of previous years, and the volume of new issues in this market has declined. This could create a more favorable supply/demand environment that may boost bond values. Corporate credit should also see continued support. With tax rates clearly defined going forward, investors may be more comfortable taking on additional risk. Yields on corporate bonds remain attractive in today s low interest rate environment, which should draw more investment flows. We anticipate a drop in new issuance of corporate debt this year compared to last, again contributing to a favorable supply/ demand situation. A policy outlook what to expect now The ATRA signed into law in early January was just a starting point. Much more lies ahead in the coming months in terms of debate and potential action out of policymakers in Washington:

5 Page 5 A decision must be made about how to proceed with the mandated sequester cuts that were delayed by two months and now are scheduled to take effect on March 1, Congress must deal with a requirement to increase the nation s debt ceiling. In the past, this has been primarily a procedural move, but the situation has become more controversial in recent years. However, the risk of not doing so on a timely basis is that the United States would default on some of its obligations. Pressure surrounding these critical fiscal issues is likely to build quickly and will become a focus for the markets again at least by mid-february. As political posturing mounts, we anticipate that the stock market may retreat and investors will, as they have during recent crises, flee to the perceived safety of assets such as U.S. Treasuries. The scenario that could develop as the debate builds is: Market pressures help accelerate a political agreement, just as it did to end the debt ceiling crisis (and threat of default) in. The agreement consists of a compromise set of actions that again delays the severity of spending cuts in the near term, with limited revenue increases. As a result, fiscal deficits persist at high levels for the foreseeable future, but the near-term economic impact is muted. In this scenario, which we believe is a realistic expectation, the major credit rating agencies (Moody s and Standard & Poor s) may downgrade the U.S. credit rating by mid year. The first downgrade took place in the midst of the crisis. If another downgrade occurs, the immediate market reaction would likely be a flight to safety and a downturn for risk assets. While the actual outcome is far from known, it is important for investors to be prepared for continued market volatility as policy confrontations in Washington again take center stage. Current investment guidance Although the issues on the table in Washington at the start of 2013 are significant, our investment guidance today is much the same as it was at the end of 2012: Equities: Given the fundamentally strong financial position of corporations and the fact that capital expenditures have been inhibited in recent times, we believe there is a strong case for an overweight position in equities. Equities remain relatively cheap compared to bonds as actions by the Federal Reserve and other central banks worldwide have helped drive bond yields to historically low levels. We see signs of a nascent recovery in emerging markets, with China (the world s second-largest economy) showing particular promise for renewed growth. The near term is clouded by the continued partisan gridlock in Washington, and that may temporarily sidetrack equities. Over time, we anticipate that other fundamental factors will again come to the forefront and move markets higher. Fixed Income: The extremely low interest rate environment continues to make us cautious about the outlook for fixed income investments. We currently prefer an underweight position. While we may not yet be on the cusp of a sustained rebound in interest rates, today s very low yields in investment grade debt give us little choice but to underweight that category. We are especially cautious about U.S. Treasury securities. We recommend, when appropriate, hedged approaches to fixed income investing. This allows the flexibility to focus on attractive currencies, credits and debt markets, and can help counteract the impact of central bank monetary policies on higher-grade debt. Real Estate and Commodities: We maintain our standard allocations to both the real estate and commodity sectors.

6 Page 6 Conclusion The American Taxpayer Relief Act of 2012 is, at best, a partial solution to the need to attain fiscal balance at the federal level. In the months ahead, more contentious debate is likely to occur that could add to uncertainty for the markets. Most notable will be decisions surrounding the planned sequester spending cuts and the battle surrounding legislation to increase federal debt ceiling limits. While today s federal budget battles and longterm debt forecasts are a concern for investors, we anticipate that fundamental economic factors and business conditions will take center stage after the first quarter of This, along with attractive valuations, should help create favorable opportunities for equity investors. Fixed income markets may face more headwinds given that interest rates remain near historical lows. Our current investment guidance includes a modest overweight in equities, with a slight underweight position in fixed income. Investors need to be careful not to let short-term headline events overly influence their long-term investment strategies. Contributed by: Timothy J. Leach Chief Investment Officer, U.S. Bank Wealth Management IMPORTANT DISCLOSURES This commentary was prepared on January 15, 2013 and is subject to change at any time based on market or other conditions. This information represents the opinion of U.S. Bank Wealth Management. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or the forecasts will come to pass. It is not intended to be a forecast of future events or guarantee of future results and is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this publication are not affiliates or associated with U.S. Bank in any way. U.S. Bank and its representatives do not provide tax or legal advice. Each individual s tax and financial situation is unique. Individuals should consult their tax and/or legal advisor for advice and information concerning their particular situation. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes mentioned are unmanaged and are not available for investment. 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