The View From Beyond the Cliff
by Thomas J. McCarrell, CFA, Vice President, Senior Portfolio Manager
The chatter from the financial media has been alive with assessments of what the impact of the “Fiscal Cliff” will be, but before we jump too quickly into the impact of recent legislation, we should take a look back and pause to celebrate what turned out to be a better than average year for investors.
2012 Revisited: The year was a roller coaster ride of volatility that was pushed along by investors worried about the elections, slow economic growth, the European debt crisis, and the fiscal cliff. But despite all of the concern, stock markets around the world provided above average returns. The Dow Jones 30 Industrials, S&P 500 Index, and the Russell 2000 small company index were up 7.26%, 13.41%, and 14.6%. If you reinvested the dividends, the total return climbed up to 10.24%, 16.00, and 16.35% respectively. International stocks also provided total returns in the mid-teens, in spite of the turmoil in Europe. Investors who maintained a long term focus were well rewarded for the risk of investing in stocks.
In the bond market, interest rates remained low as central banks around the world eased to help prop up weak economies and stimulate growth. While the low rates have been terrific for borrowers, it is a tough environment for those who invest in bonds primarily for the income return. Interest rates on US Treasury issues remain in record low ranges and are expected to stay there until the Federal Reserve senses that the economy is growing at a sustainable rate. The total return on the intermediate term U.S. Treasury bond index was just 1.71% in 2012. The longer term and lower quality bonds were the best performers. The AA rated corporate and municipal bond indices provided total returns of 6.62% and 6.78% respectively.
Now to the Fiscal Cliff... It was no surprise that the legislators allowed us to slip off of the edge before being forced into an agreement. The partisanship that has pervaded Washington continued to influence the process. In simple terms, taxes will go up for most Americans but the upper income wage earners will bear the largest increases.
The changes affect all taxpayers because the temporary 2% reduction in the Social Security payroll tax was allowed to expire and return to 6.2%. The result is an additional tax of $1,000 for every $50,000 of additional household income. The good news is that the lower Bush era income tax rates were preserved at current levels for all except the top bracket payers. For the top bracket wage earners, single taxpayers with greater than $400,000 of income and joint returns with income greater than $450,000, the tax rate will increase from 35% to 39.6%. The current long term capital gain and qualified dividend tax rates were also preserved for lower bracket taxpayers and a new 20% rate was initiated for those in the highest ($400,000/$450,000) bracket. Higher income households will also lose some deductions. Single taxpayers earning greater than $200,000 and joint filers earning more than $250,000 will experience a phase-out of personal exemptions and itemized deductions, along with paying an additional 3.8% Medicare tax that was previously passed and not repealed during Fiscal Cliff negotiations. Those who are subject to the Alternative Minimum Tax (AMT) benefitted from the permanent extension of the AMT patch which will have annual inflation adjustments and, lastly, the Estate tax exemption was established at $5 million with a 40% top tax rate for estates that exceed the exemption allowance. On the spending side of the legislation they extended unemployment insurance for one year, delayed Medicare Reimbursement cuts for one year, and delayed action on mandatory “sequester” spending cuts for two months. Stay tuned for more political drama in February…
Looking forward into 2013: We believe that the U.S. economy will continue to grow slowly, as it did during 2012. The tax legislation that was passed may negatively impact consumer spending slightly, but the resolution of the uncertainty surrounding tax rates should encourage corporations to invest their cash and get off of the sidelines. While the unemployment rate will still be above average, we see continued slow improvement in employment. We have also witnessed improving trends in housing and expect that trend to continue as the prices stabilize. In the near term, the greatest risk of market disruption lies in the political arena and the discussion regarding spending cuts and the need to address the national debt ceiling in February.
We feel that stocks will outperform fixed income investments in 2013, but stock investors will have to accept a higher level of volatility to capture those returns. Investors should keep a long term perspective and ignore the disruptions that affect the market from day to day. Interest rates are expected to be stable as long as the Federal Reserve maintains its simulative posture. Bond investors should expect that interest rates will stay low for the foreseeable future.
2012 provided a good example of how volatile markets can provide excellent returns if you are following a well crafted financial plan. A call to your Wealth Management Group expert can help ensure that you are on the right path to reaching your financial goals!