Washington’s last-minute solution to a portion of the “fiscal cliff” provided some much-needed clarity to the direction of tax rates. Yet, the portion of the cliff concerned with spending cuts remains, and its brief delay puts it on a collision course with the upcoming debate about another increase in the federal debt ceiling.

The likelihood for further drama in Washington explains why fiscal policy remains the biggest concern among financial advisors in 2013, according to a survey of more than 500 advisors conducted during a recent Lord Abbett web conference. Despite the lingering concerns about fiscal policy, about half of those advisors surveyed believed that domestic equity represents the best investment opportunity over the next six months. With international equity coming in second, more than 85% of the respondents believed the best investment opportunities are in the equity markets. (For the full survey results, see Charts 1–2.)

For further perspective on the developing fiscal landscape, Milton Ezrati, Lord Abbett Partner, Senior Economist and Market Strategist, and Zane Brown, Lord Abbett Partner and Fixed Income Strategist, weigh the investment implications of the recent tax package and the prospects for Washington’s upcoming fiscal debates.  

Milton Ezrati: The approval of the tax package [the American Taxpayer Relief Act of 2012] could be viewed as the easy part of resolving the fiscal cliff because it did nothing to address the federal budget deficit. Actually, the deal is expected to add another $4 trillion to the budget deficit over the next 10 years, according to the Congressional Budget Office. The combination of not addressing the budget deficit and delaying the decisions on spending cuts for two months represents a classic case of Washington continuing to kick the can down the road.

But the can was not kicked very far. After all, the debt ceiling will need to be addressed in mid-February to early March, the new sequester deadline is March 1, and the decision on how to deal with the postponed spending cuts will need to be made in late March.   

In terms of the economic impact of the tax package, there is a list of positive and negative factors to choose from. (See Table 1 for details.)

Zane Brown: The certainty around the direction of future tax rates is a significant positive aspect of the recent deal. But it is important to recognize that taxes are still going up for the majority of taxpayers. This is because of the expiration of the payroll-tax holiday, which will lift that rate from 4.2% to 6.2%, and this increase could have immediate consequences, considering that more than one-third of American households live paycheck to paycheck.

In addition, households making more than $250,000 will also be subject to the 3.8% Affordable Care tax on investment income, as well as the 0.9% increase in the Medicare tax on income over $250,000.

The onset of these taxes on individuals could result in a sluggish pace of economic growth in the first half of 2013 before a moderate acceleration in the second half of the year.

Milton: In addition to the certainty on federal income taxes, there were other aspects of the tax package that could be considered positive compared to what might have occurred in a different scenario. Indeed, the items pertaining to the alternative minimum tax [AMT], Medicare payments to doctors, and capital expenditures, could be positive for many households and businesses. There are also items in the package that could benefit very specific industries. For some, the inclusion of these items in the bill could be considered “pork” and another sign that Washington has yet to change its ways. 

Overall, the fiscal impact of the tax package represents a fiscal drag of nearly 2%. This probably is not enough to cause another recession, nor will it encourage a great acceleration in economic growth. And if the $120 billion of spending cuts proceed as scheduled in March, this would add another 0.6% of GDP [gross domestic product] to the fiscal drag. With these prospects, a reasonable GDP expectation in 2013 will be consistent with the recent trend of about 1.5–2.0%.

The credit rating agencies could also come into play in 2013 because they have previously acknowledged Washington’s divisiveness and its procrastination in dealing with the deficit. And after the tax deal, Moody’s Investors Service said that further measures to address the deficit would be needed to support its ‘Aaa’ rating on the United States. Although another ratings downgrade is possible, it is unlikely that it would cause a similar level of volatility as Standard & Poor’s ratings downgrade in 2011. With conditions in Europe having moderated and little concern about an actual Treasury default, another downgrade could merely be a confirmation that U.S. politicians have not been governing well.   

Zane: As far as the tax implications for the capital markets, the recent tax deal could be considered fairly positive. Even after the increases in capital gains and dividend taxes, the tax treatment on equities could still be considered preferential when compared to the most draconian proposals that would have aligned these rates with those on income taxes. 

The changes to personal exemptions and itemized deductions also underscore the municipal bond market as one of the few tax havens available to investors. Indeed, for the tax-exempt market, there did not appear to be anything negative within the tax deal.

For households making more than $450,000, the increase in income tax rates, from 35% to 39.6%, will also increase the tax-equivalent yields¹ on municipal bonds for those investors. Municipal bond income would also be exempt from Medicare, affordable care, and dividend taxes. In addition, the permanent patch to the AMT should benefit bonds that provide income that is subject to that tax.

Although there were some prior comments about potentially capping the exemption on municipal interest at 28%, that topic was not addressed in the tax legislation, and it is unclear if it will be addressed as part of the upcoming discussions on spending cuts. The delay in the spending cuts was a positive development for municipal budgets, but any of these upcoming decisions will need to be monitored for its potential impact on state and local governments.  

Milton: A broader look at the equity market might also provide some context to the stock market’s recent resiliency in the face of the fiscal cliff. Based on even conservative valuation metrics, equities have been priced for disaster. This perception is evident throughout much of the large cap market, where the yields on dividend-paying equities are higher than the yields on corporate bonds from the same company. This suggests that investors remain concerned about the market retreating significantly or dividends being cut. And in an environment that is conditioned for disaster, a degree of relief from these concerns can be enough to provide further support for equity prices.   

Zane: A broader look at the fixed-income universe highlights the potential need for investors to move out along the risk spectrum with carefully selected credit exposure. This is because the current environment of low short-term yields on high-quality investments could continue, especially considering the recent expiration of the Treasury Account Guarantee program that insured about $1.6 trillion in non-interest-bearing accounts. This movement in this money could keep rates on Treasury bills and short-term notes near their recent historical low levels.

With the lingering uncertainty about fiscal policy and economic growth, investors may be wary of increasing their exposure to credit risk, and the daily headlines about these issues could certainly spark some volatility within the markets. But in 2012, equities² and high-yield bonds³ posted total returns in the double-digit percentages, even as the uncertainty around the fiscal cliff, the eurozone, China’s economy, and geopolitical situations remained.

While that performance may not be repeated this year, 2013 should also continue the trend of strengthening economic fundamentals in the energy, manufacturing, and housing industries that could continue to support gains in the equity and credit markets.