Q4 2012 Market Commentary
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By Matthew T. Skaves, CFA
Last quarter, we wrote that Congress would pass band-aid legislation at the eleventh hour to avert the full impact of the Fiscal Cliff. Though we were correct in this assumption, it wasn’t due to any great foresight on our part. Congress has made such a habit of delaying decisions and holding the country hostage to politics, that an imperfect, eleventh-hour, backroom deal was almost a certainty. Markets of course rallied when the American Taxpayer Relief Act (ATRA) was announced, because it meant the nation would not be jumping headlong off the Fiscal Cliff. But now, as we look over the edge, the question becomes, will we change direction and move away from the cliff, or will we simply rappel down the mountainside? We’ve started doing the latter.
The Congressional Budget Office (CBO) estimates that, in 2012, the government generated revenues equal to 15.7% of GDP and spent the equivalent of 22.9% of GDP. This is clearly unsustainable. Fortunately, the ATRA manages to increase revenues from historically low levels. Unfortunately, this means taxes will be going up for most U.S. households, creating a drag on an already slow-growing economy.
Wealthier households will be the ones most impacted by tax increases in 2013. There will be a new 39.5% marginal tax-bracket for incomes over $400k ($450k if married filing jointly), and, for those same taxpayers, the tax on qualified dividends and long-term capital gains will rise to 20%. These rate increases are in addition to the new 3.8% tax on investment income and the new 0.9% Medicare tax on wages, both called for in the Affordable Care Act and assessed on taxpayers with incomes over $200k ($250k if married filing jointly).
Middle and lower-income taxpayers, too, will see their paychecks shrink due to the expiration of the 2% Social Security Payroll Tax cut. This means someone earning $50,000 per year will pay an additional $1,000 in taxes, and someone earning just $32,749 will see their taxes rise by $655. These increases are not insignificant to middle and low-income households.
All combined, it’s estimated that tax increases will result in a 1% fiscal drag on GDP growth in 2013. For context, the economy is expected to have grown somewhere between 2-3% of GDP in 2012, meaning the drag on 2013 growth will be material. It will be further compounded by a drag of 0.8% of GDP should the automatic spending cuts spelled out in the Budget Control Act of 2011, commonly known as the sequester, go into effect. The sequester, delayed by the ATRA, is scheduled to reduce spending on defense and other discretionary items.
No one disagrees that the country’s fiscal imbalance is unsustainable and that some combination of tax increases and spending cuts is necessary, but the problem is that both of these cures threaten the immediate health of our economy. We have to take them in such high dosages that they are extremely unpalatable and come with nasty side effects.
For example, we could have gone over the Fiscal Cliff. Doing so would have set us on a better long-term fiscal trajectory, because it called for higher taxes and deeper cuts than what we’ll get with the ATRA and ATRA Part II. However, the Fiscal Cliff would have almost certainly sparked a recession, and it wouldn’t have done enough to eliminate deficits over the next 10 years. According to the CBO, had the full impact of the Fiscal Cliff been allowed to occur, the budget would have come close to balancing in 2018, but then it would have deteriorated due to increased entitlement spending toward the latter half of the decade. Now, with the ATRA in place, Northern Trust estimates that deficits will only improve to around -$600 billion by 2018 before deteriorating again.
The Fiscal Cliff would have been like taking a well-known, powerful drug with a high cure rate, but with serious near-term side effects like blot clots or stroke. The ATRA, by comparison, is like taking a less-potent drug that doesn’t seek to cure the illness as much as provide temporary comfort, and it comes with nagging side effects like nausea. The ATRA, in other words, is like rappelling down the mountainside.
One might imagine it’s none too pleasant rappelling down a mountain while nauseas, but that’s increasingly what it feels like to savers. Being one of the few remaining groups with the ability to pay higher taxes, and having little organized political representation, the average American saver is truly under attack. Zero percent interest rates are delivering negative returns after inflation, which is in fact a shadow tax that reduces the real value of outstanding government debt. And now, savers face higher explicit taxes on dividends and capital gains. With savings rates already dreadfully low in the U.S., this all-out assault on savings and investment doesn’t help improve household balance sheets, and it doesn’t encourage people to save for things like retirement and medical emergencies. What it does is ensure that individuals will spend forward their future earnings in the form of consumer debt, because a dollar today is worth more than a dollar tomorrow. Those individuals who do save will continue to be forced into riskier assets to achieve their return goals and keep up with inflation.
As money managers, we’re always mindful both of an investment’s absolute value and its relative value. The latter informs where we should be invested, but the former informs whether we should be invested. Stocks, relatively speaking, remain attractive compared to many other asset classes, especially investment-grade bonds. But on an absolute basis, stocks seem fairly valued, if not slightly overvalued, considering their increased risks. Going forward, we continue to expect that risk assets will be supported by low interest rates and other accommodative policies. Therefore, stocks remain one of the largest components of client portfolios. However, we’ve kept them slightly underweight relative to typical, long-term allocations. We also expect that interest rates will not rise significantly throughout 2013, as the Fed has now set explicit guidelines (unemployment below 6.5% and inflation above 2.5%) for a rate increase. More so than in 2012, investors will have to work to combat the ill-effects of low interest rates in their portfolios, because stocks are unlikely to post another double-digit return and taxes will take a greater bite.
As we rappel down the Fiscal Cliff, the combined drag from increased taxes and reduced spending may threaten to stall the economic recovery. Still, the elections are behind us, Europe has made progress, and China has so far managed to engineer a soft landing. These are short-term positives that may lead to less volatility this year. Overall, we expect it to be a year where good relative value decisions will trump bad absolute value decisions. As always, we will do what we can to be opportunistic where it makes sense to do so, but we don’t want to lose sight of the very real fiscal problems our country faces. Because these problems have a way of rearing their heads quickly and unexpectedly, we anticipate maintaining a focus on downside protection throughout the year, unless valuations become materially more attractive on an absolute basis.
From everyone here at Deighan Wealth Advisors, thank you for the trust and confidence you’ve placed in us. We hope you and yours have a happy, healthy, and prosperous 2013!