tackling the fiscal cliffcdnmedia.endeavorsuite.com/images//organizations/6307fa6f-7b42-… · the...
TRANSCRIPT
Tackling the fiscal cliffCutting through the clutter as the deadline approaches
November 2012
• What exactly is the fiscal cliff?
• What happens if the nation falls off the cliff?
• What impact will the possible outcomes have on my investment portfolio?
Defining the cliff The fiscal cliff comprises two major events scheduled for the beginning of 2013: tax increases and government spending cuts.
The tax increases — technically the expiration of the “Bush-era tax cuts” — are primarily a result of the legislation that created the cuts back in 2001. Many of the legislation’s provisions were originally scheduled to “sunset” at the end of 2010. When that time came, Congress extended the cuts, but only through the end of 2012. Unless some or all are extended again, a number of tax rates will increase as shown in the table on the next page.
In addition to the Bush-era tax cuts, the payroll tax cut enacted under President Obama is also scheduled to expire at year-end.
Federal Reserve Chairman Ben Bernanke is credited with coining the term “fiscal cliff” back in February 2012. Between then and Election Day, you may have heard occasional media references, especially if you follow the financial press closely. But with the elections behind us, the focus has turned to the uncertainty of what could happen as the December 31 deadline approaches. As a result, many investors are looking for answers to three big questions:
November 2012Tackling the fiscal cliff
Page 2 of 8
Qualified dividend taxes
In , qualified dividends (in general, those paid by a U.S. corporation or an internationalcorporation that trades on a U.S. stock exchange) are taxed at today’s more attractivelong-term capital gains tax rates. Those dividends would be taxed at higher ordinaryincome tax rates in if the tax cuts expire.
TAX RATES TAX RATES
& 150 −39.615
Estate taxes
For the tax year, $,, can be excluded from a taxable estate; assets above thatamount are taxed at %. The exemption is scheduled to be decreased to only $ million,potentially exposing more estates to the tax, and the top rate will be %.
EXEMPTION EXEMPTION
$5.12 million
TAX RATE
35
$1 million
TAX RATES
−5541
Child tax credit
Currently, parents of a qualifying child under the age of receive a credit of up to $,on their tax return. Credits reduce a filer’s income tax bill dollar for dollar. For example, in a $, tax bill would be cut to $, for a family with one child claiming the childtax credit. The credit is scheduled to decrease to $ per child in .
PER CHILD PER CHILD
$1,000 $500
Long-term capital gains taxes
Taxpayers in the two lowest ordinary income tax brackets have enjoyed a % capital gainsrate in recent years. Under current law, taxpayers in the % ordinary income tax bracket in (there will be no % bracket) will face a % long-term capital gains rate in . Thosein the higher brackets would see their rate increase from % to %.
TAX RATE TAX RATE
010%−15% tax brackets
1525%−35% tax brackets
1015% tax bracket
2028%−39.6% tax brackets
Payroll taxes
Although not a Bush-era tax cut, the payroll tax cut – worth % of the first $, of aworker’s wages – that started in is also scheduled to expire December . A personmaking $, has enjoyed roughly $ extra a month, while someone making $,has been taking home an extra $. a month.
SALARY ADDITIONAL TAX
$
$
$
$
25,000+50,000+
100,000+110,100+
$
$
$
$
5001,0002,0002,202
If Congress does not act
20132012
Income taxes
Barring further Congressional action, income tax rates will increase after December to what they were prior to . The % bracket will disappear, and the rates for theremaining brackets will increase. The potential expiration of the Bush-era tax cuts hasfar-ranging tax-planning implications.
101525283335
TAX RATE
15283136
39.6
n/a
TAX RATE
For more information ask a Financial Advisor for a copy of our report, “Focusing on UpcomingTax Changes.”
The government spending cuts, which neither party appears to like, were baked into the compromise that allowed the nation’s debt ceiling limit to be raised in 2011. You may recall that the legislation created a Super Committee tasked with finding a solution that both sides could agree on for decreasing the deficit. If the committee failed, and it did, dramatic spending cuts were scheduled to kick in. Now Congress has to figure out what to do about them.
Understanding the riskChairman Bernanke may have exaggerated by referring to what may lie down the road as a fiscal cliff. Economists aren’t foreseeing the end of the world – as the name suggests – if Congress fails to act; some have suggested that “fiscal slope” or “fiscal hill” may have been more appropriate. After all, even if all the tax cuts expire and all the spending cuts take effect, the economy will feel the full impact only after a long period of time.
But no matter what you call it, economists do fear that the combination of the tax increases and spending cuts will curtail the current tepid recovery. Tax increases will remove money from consumers’ hands – money they could spend on goods and services that the economy produces. Likewise, reducing government spending on programs and projects that can help fuel the economy may also have a dampening effect. When put together, the combination eventually could have a negative effect on gross domestic product (GDP)1. According to the Congressional Budget Office (CBO), the U.S. economy could contract 0.5% in 2013 if Congress fails to take action to avoid the fiscal cliff.
On the upside, going over the cliff should help reduce the deficit by increasing taxes and decreasing spending, which might benefit the nation over the long-term. The question is whether the country believes the potential long-term gain is worth experiencing the almost-certain short-term pain.
Page 3 of 8
November 2012Tackling the fiscal cliff
$47MEDICARE
Mandatory spending cuts (in billions)
Mandatory cuts to the federal budget are set to take place from to if Congress does not act.
$455$294$123INFRASTRUCTURE AND SOCIAL SERVICES DEFENSE
MISCELLANEOUS
Data: Congressional Budget O�ce
1 GDP is the total value of the goods and services the U.S. economy produces.
Page 4 of 8
November 2012Tackling the fiscal cliff
Avoiding the cliffWhen it comes to dealing with the cliff, we believe there are three scenarios that could unfold.
Scenario 1: The first and least likely outcome would be for Congress to become deadlocked over negotiations and allow the country to go over the cliff. If this occurs, interest rates would probably test new lows, should the impasse remain unresolved well into next year, as a near-certain recession would push investors into the perceived safety of bonds or out of the market completely, either of which would be a negative for stocks. At the same time, the Fed would likely increase its own bond purchases through its ongoing quantitative easing program. Should the politicians eventually craft a longer-term solution, Treasuries likely could lose some of their appeal, and other assets could increase in value.
Scenario 2: The second and somewhat likely outcome would be for Congress to just postpone the tax hikes and spending cuts for another year. However, this would probably be viewed as irresponsible by credit rating agencies, and the U.S. debt rating could be downgraded again.
Scenario 3: Finally, we believe the third scenario is the most likely. In this case, lawmakers would find acceptable middle ground that would include some tax increases and spending cuts but not the full measure currently scheduled to occur. Finding acceptable tradeoffs for this scenario to play out will take time and difficult negotiations. During the coming
weeks, we are likely to see both parties talk about a willingness to work together. Stating the preconditions for cooperation would be just a first step toward addressing policy differences. The public aspect of the debate may revert to partisan rhetoric as lawmakers position themselves for a likely deal behind closed doors.
Obviously, the process will not be quick or easy. Neither side won a mandate in the election. Therefore, both parties will need to give something in order to get something, and we may not see significant progress until the year-end deadline is near. If some progress has been made but not all the differences resolved, Congress could pass a temporary extension of the cuts and current spending levels, allowing the new Congress to complete the negotiations.
Some strategists are suggesting a fourth scenario in which Congress allows the country to go over the cliff as a way to force a compromise next year. This is possible if negotiations don’t go well. However, the public now seems to prefer that congressional leaders compromise when it comes to dealing with the deficit, which means they probably do not want a prolonged fight like the one that occurred over the debt ceiling limit during the summer of 2011. Investors may not like such a tactic, which could result in added market volatility. In spite of this, this scenario could still occur. If it does, we would expect any compromise reached next year to be retroactive to the start of the year.
We believe the most
likely scenario is that
lawmakers find
acceptable middle
ground that includes
some tax increases
and spending cuts but
not the full measure
currently scheduled
to occur.
Page 5 of 8
November 2012Tackling the fiscal cliff
What a compromise may meanIf Congress reaches a compromise containing modest tax hikes and spending cuts as we expect, it would not severely hurt the economy but could be a potential drag of perhaps 1% on activity next year. Recent data show that the U.S. economy is slowly recovering from the 2008-2009 recession. The housing market has finally turned up after six years of subtracting from growth. We believe any drag a compromise creates will most likely be offset by the housing recovery and continued increases in consumer and business spending.
In addition, the Federal Reserve’s easy money policies may help offset any fiscal drag. The government may borrow and spend a little less next year if a compromise is reached, but net lending in
the private sector has risen, and this increase is likely to support economic growth. The credit markets could also benefit if the Fed continues to provide liquidity to the economy by buying bonds.
It is likely that any compromise will include an increase in the debt ceiling limit. The U.S. Treasury is on track to hit the current limit in mid-January and will then use accounting adjustments for a couple of months before an increase in the limit becomes necessary. However, should the fiscal cliff go unresolved, the outcome of a limit increase will become more uncertain. Should Congress once again piece together a compromise just hours before a technical default, we could see the U.S. debt rating downgraded again. While very unlikely, an actual U.S. Treasury default would rattle fixed income markets – potentially pushing interest rates higher.
Debt ceiling limit
Debt subject to limit
’08
$18 trillion
$14
$12
$10
$8
’10 ’11 ’12
Federal debt approaches debt ceilingThe nation’ s outstanding debt is on track to bumpagainst the current debt ceiling limit.
’09
1Source: U.S. Treasury - as of Nov. 19, 2012.
16.4$
LIMITDEBT-CEILING
TRILLION16.3$
DEBT1OUTSTANDING
TRILLION
$16
Page 6 of 8
November 2012Tackling the fiscal cliff
Many investors have been positioned very defensively during the past year due to the uncertainty of the election and the fiscal cliff. Moreover, lawmakers put off addressing many issues until it was clear which party would come out ahead. Finally, businesses appear to be delaying capital spending and hiring until the direction of government policy becomes clearer. After being in a holding pattern much of this year, next year could potentially be a year of action with businesses resuming capital spending and hiring.
Assuming our third scenario proves accurate, economic improvement should drive better equity prospects in 2013, even with some ongoing political uncertainty. We believe the economy is likely to grow at about a 2.5% annual rate in 2013, and we anticipate a modest gain of 4% or 5% in S&P 500 earnings. Even if confidence does not rebound strongly, and with a modest fiscal drag, we believe our growth expectations are consistent with an S&P 500 index target between 1,525 and 1,575 at year-end 2013. If the fiscal cliff and lingering European issues are resolved more quickly and decisively than we anticipate, the boost to confidence may push equity prices above our target.
We believe investors should use pullbacks to add to equity exposure. If investor sentiment improves as we anticipate, stocks could outperform bonds in 2013 while cyclical sectors of the stock market are likely to perform better than defensive sectors. (Cyclical companies are those
whose performance tends to fluctuate based on where the economy is in the business cycle.) Specifically, our Equity Strategy team recommends an overweight position in information technology, materials, telecommunications and consumer discretionary companies.
With yields at historic lows, we are underweight Treasuries and recommend against longer-maturity fixed income investments. We recommend investors take the opportunity to reduce their exposure to Treasury holdings and rotate into better values in corporate bonds. Considering the potential tax increases, investors may also benefit from municipal bond exposure. We recommend A-rated (or better) large issuers with a particular focus on general obligation and essential service issues.
The current round of uncertainty may support the U.S. dollar against other currencies in general, but that advantage should reverse next year against some currencies. We think the dollar should pull further ahead of the euro, pound and yen in 2013; however, the greenback may slide against the currencies of commodity-producers Australia and Canada and emerging-market currencies broadly. Investors should stay close to their long-term international allocations. The opportunity to add exposure to countries and commodities oriented toward export growth is most likely to arrive once the improving global economy gains more attention than political turmoil.
After being in a
holding pattern much
of this year, next year
could potentially be a
year of action with
businesses resuming
capital spending
and hiring.
Page 7 of 8
November 2012Tackling the fiscal cliff
Looking beyond the cliffWhenever there is uncertainty, investors naturally become concerned about what they should do to help preserve their portfolios. We believe investors should still have a plan and focus on their long-term goals. Having an appropriate asset allocation (investment mix) is critical. Making investment decisions based on short-term market activity can make it more difficult for investors to work toward their long-term goals. To help illustrate the potential risk, the chart below shows what would have happened if you missed the best days in the market during the last couple of decades. As you can see, missing some of the best days would have been very costly.
Furthermore, the stock market’s historical performance trend (chart on page 8) shows that even though there have been some significant periods of uncertainty, the overall long-term trend has been positive. The most likely explanation for this upward trend is that businesses adapt to changing conditions – good or bad – until they learn how to be profitable in the new environment or until the shock passes. Of course, past performance is no guarantee of future results.
7.8%
Investedfor all 5,042trading days
10 bestdays missed
20 bestdays missed
30 bestdays missed
40 bestdays missed
50 bestdays missed
8%Return
6
4
2
0
−2
−4
4.1%
1.7%
-0.4%
−2.3%
−4.0%
The cost of market timingThe risk of missing the best days in the market (-)
Source: ©2012 Morningstar,® Inc. All rights reserved. This hypothetical illustration is based on the Standard & Poor’s 500 Index with dividends reinvested over the 20-year period between 1992–2011. This example does not include fees or commissions. Past performance is no guarantee of future results. This chart is for illustrative purposes only and is not indicative of the performance of any specific investment. An investor cannot invest directly in an index.Returns and principal invested in stocks are not guaranteed. Holding a portfolio of securities for long-term does not ensure a profitable outcome, and investing in securities involves risk of loss.
November 2012Tackling the fiscal cliff
The performance of the Standard & Poor’s 500 composite index — 1965-2011
The fiscal cliff represents uncertainty, and the markets don’t like uncertainty. However, the fiscal cliff will pass, and we believe the economy will continue to grow.
Investors need to focus on their long-term goals and having the proper asset allocation for their objectives and risk tolerance.
1,600
1,200
60
800
200
400
S&P
500
Val
ue
Year Recessions
The Vietnam War Gulf War Iraq War
June 1968 Robert F. Kennedy shot
October 1987Stock market crash
November 1979Iran hostage crisis
April 1968Martin Luther King Jr. shot
August 1974 President Nixon resigns
Stagflation
Federal Reservetightened money
April 1995Oklahoma City bombing
September 2001World Trade Center/
Pentagon attacks
Oct. 2008TARP passed
Feb. 2009$787 billion
stimuluspackage approved
August 2011U.S. debt downgrade
10050095908580757065
About this reportThe opinions expressed in this report are those of Wells Fargo Advisors Advisory Services Group (ASG), which comprises the firm’s top strategists. Their job is to support our Financial Advisors and clients by staying abreast of what’s going on in the economy and the markets, using their expertise to forecast what they see for the future and making recommendations for how they believe investors should position their portfolios.
1112-03458
9041
3-v1
e7542
Additional information is available on request. The material contained herein has been prepared from sources and data we believe to be reliable, but we make no guarantee as to its accuracy or completeness. This material is published solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or investment product. Opinions and estimates are as of a certain date and subject to change without notice.Wells Fargo Advisors is a broker/dealer affiliate of Wells Fargo & Company; other broker/dealer affiliates of Wells Fargo & Company may have differing opinions than those expressed in this report. Contact your Financial Advisor if you would like copies of additional reports.
Investment and Insurance Products: NOT FDIC Insured NO Bank Guarantee MAY Lose Value
Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company. First Clearing, LLC is a registered broker-dealer and non-bank affiliate of Wells Fargo & Company. © 2012 Wells Fargo Advisors, LLC. All rights reserved.
Technology and internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market.Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment. Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.Standard & Poor’s credit rating: Obligations rated A are considered upper-medium grade and are subject to low credit risk.