Uncertainty Still Certain

The phrase is often heard that financial markets do not like uncertainty. The uncertainty surrounding the November elections in the U.S. is behind us. However, much uncertainty remains. The main sources of that uncertainty include the fiscal cliff, the need to increase the federal debt ceiling, the absolute level of the federal debt, and the regulatory environment.

There are various scenarios for how these issues could be resolved. However, achieving a quick or easy agreement on any of these issues is unlikely given that the federal level election results will keep in place a divided congress with democrats controlling the Senate and republicans controlling the House of Representatives. The fiscal cliff and related issues in the U.S. are not the only issues investors will be worrying about. The transition of power in China and the slowing economies in Europe also are on the minds of investors. Certain economic data in the U.S. has been showing some improvement, such as the increase in consumer confidence, better housing numbers, and better employment numbers. The question is if these improvements can continue with tax hikes of some form all but certain. Therefore, our expectation is that financial markets will continue to be choppy with frequent and sharp movements to the upside and to the downside based on the latest headlines. In an environment with some encouraging signs of economic improvement and with the Federal Reserve pursuing its QE3 bond buying program, but with no clear path identified to resolve several weighty issues, maintaining a diversified portfolio including both growth strategies and risk reduction strategies is prudent.

The Cliff

The immediate issue in focus for taxpayers, investors, businesses, and government leaders is the fiscal cliff. The fiscal cliff is a combination of tax cut expirations and automatic spending cuts set to go into effect on January 1, 2013. A key element of the fiscal cliff is that the Bush era tax cuts are set to expire, which would mean that tax rates for ordinary income for all but the current 15% bracket will increase.
Also, the rates for investment income will increase, the marriage penalty relief will expire, the child credit will be cut in half, the estate tax exemption will be reduced back to $1 million, and the estate tax rate will increase to 55%. In addition, the temporary social security payroll tax cut and the extended unemployment benefits are set to expire and the alternative minimum tax exemption will be limited.

The second part of the fiscal cliff is the sequestration or the automatic across the broad spending cuts that are set to go into effect on January 1. These tax increases and spending cuts would be a drag on the economy which could reduce gross domestic product by as much as 5% in 2013, according to various analysts’ forecasts. The looming question is whether a lame duck congress that comes back in session for one week before the Thanksgiving recess and then returns in December can come to a resolution on any or all of these issues or if the issue will fall to the new Congress. In addition, what would the agreement look like?

Options

There are any number of ways the fiscal cliff issues could be resolved. Four possible scenarios include:

1) Either the republicans or democrats give in, and the Bush era tax cuts are extended in whole or are extended for everyone except “the rich”
2) A compromise is reached retaining the Bush era tax rates for everyone but “the rich” and the income threshold determining who “the rich” are is raised from President Obama’s definition of $250,000 to something higher, possibly $1 million.
3) Lawmakers raise revenue from different sources, such as limiting deduction
4) Kick the can down the road. In this scenario, the parties agree to a temporary extension of the current tax policy for as little as three months or as long as one year. During the extension period, negotiations continue on longer‐term solutions.

If our elected officials choose option #4, and agree to give themselves more time to hammer out an agreement, uncertainty is prolonged. This scenario is not good for businesses or investors because the uncertainty about tax policy and the economic outlook that has been hampering hiring and capital expenditures will continue. As stated earlier, markets hate uncertainty so a continuation of the uncertainty is not constructive for financial markets.

Near Term and Longer Term

There will likely be a short period of selling by investors looking to take capital gains in 2012 before expected tax hikes are in place. This could put negative pressure on financial asset prices between now and year‐end but the impact of that trading activity is likely to be limited. The back and forth rhetoric as lawmakers wrestle with the fiscal cliff issue is expected to lead to volatile markets which could have a negative trend depending on the length and the tone of the negotiations. Some strategists are suggesting reducing exposure to U.S. equity markets in favor of international markets while the fiscal cliff debate goes on. However, that move has risks of its own as recent news from Europe shows continued economic weakness. Because there are opportunities to make money in every environment, we favor active managers across asset classes that focus on individual opportunities.

The fiscal cliff is not the only topic congress and the president must address quickly. The federal debt ceiling will be reached within weeks, and the last debate on the topic was very unpleasant. The markets reacted negatively and the question today is, will that scenario be repeated? The Obama reelection also creates uncertainty for business on the regulatory front. The consequences of potential new Environmental Protection Agency rules, the implementation of health care reform, and energy policy are just some key areas of uncertainty.

Amidst the strong bear sentiment and the challenges in the market, both politicians and business leaders seem to agree on a solution. All agree that strong economic growth is necessary to deal with the fiscal issues facing the winners of last week’s elections. Creating a cooperative environment and focusing on programs and solutions rather than positions and re‐election will be a challenge for our leaders.

 

DISCLOSURE

To ensure compliance with Treasury Circular 230, we are required to inform you that any advice concerning tax issues contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed by any governmental taxing authority or agency.