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Market Thoughts: Post-Election Update 11.7.12

November 7, 2012

Last night’s election results across the U.S. have pulled forward many important questions about the economy, events heading into the calendar year-end, and other considerations linked with political changes. We see the pending “fiscal cliff” as an important focal point for plan sponsors and your plan participants. While we do not want to draw unnecessary attention or create angst about the uncertain outcome, we do want to take a moment to define the fiscal cliff and communicate our views about what we could see in coming weeks as Washington works toward a potential compromise. We expect capital market volatility based on recent precedents but do not see the fiscal cliff as a reason for plan sponsors or participants to diverge from their long-term retirement savings objectives.

The U.S. election season highlighted several issues central to Americans across the political spectrum: healthcare, government spending, taxes, economic growth plans, foreign policy, and energy represented some of the most critical election flashpoints. Based on Tuesday’s election results across the presidential, congressional, and gubernatorial races, no party received a clear mandate to affect their views across these major issues. The House of Representatives remains under Republican control, Democrats retained the Senate, and President Obama was reelected by a decent Electoral College margin—but it was a relatively close popular vote in several key states. 
 
With Tuesday’s election behind us, a natural question is what impact yesterday’s developments may have on financial markets. The most important issue from the perspective of both magnitude and timeliness is what will happen with the fiscal cliff, which represents roughly $500 billion of budget cuts and tax increases slated to occur as of December 31, 2012. These measures are intended to help offset accumulated government debt and address the government’s borrowing trend which is reaching levels that could potentially thwart long-term economic growth. 
 
Specifically, unless Congress negotiates a partial or full compromise, a number of tax-related events, including rollback of the Bush-era tax cuts, will occur:
  • The maximum tax rate on ordinary income would increase from 35% to 39.6%.
  • The maximum tax rate on qualified dividends would increase from 15% to 39.6%.
  • The maximum rate on long-term capital gains would increase from 15% to 20%.
  • The estate tax would increase from 35% to 55%.
  • Estate tax exemptions would fall from around $5 million to around $1 million.
  • The 2% payroll tax cut will end.
  • A 0.9% Medicare payroll tax increase for upper-income households will kick in.
  • The Medicare tax base for the same households’ investment income will also take effect.
  • Extended unemployment benefits will cease.
Government spending will also be impacted should no compromise emerge:
  • The first round of discretionary spending cuts (established in August 2011) kick in, focused on discretionary spending caps over the next 10 years.
  • The second round of discretionary spending cuts triggered by the bipartisan Supercommittee’s failure to reach a compromise in November 2011 would also be implemented.
Historically, tax increases and government spending decreases have had a negative impact on economic growth—due to their adverse impact on consumers and, in turn, businesses who anticipate weaker consumer activity. Should the U.S. economy endure the “full” fiscal cliff—or if all of the tax increases and budget cuts highlighted earlier are triggered simultaneously—the International Monetary Fund and other economic agents project the U.S. will fall into recession. 
 
With the U.S. economy currently growing at a 1.3% annualized rate in the second quarter and a 2.0% rate in the third quarter, economists predict that a worst-case outcome could see the U.S. economy slip to a -4.0% growth rate (or lower) as early as the first quarter 2013. This would likely have a negative impact on riskier asset classes such as global equities and parts of the commodity and bond markets. The impact’s intensity would be a function of how long it takes consumers and businesses to adapt to higher taxes and lower government spending. While many predict an ephemeral or temporary slowdown, as more fiscal cliff components become economic realities, the more intense the economic slowdown, the worse riskier asset classes may fare.
 
With the Obama victory, the fiscal cliff resolution timetable is likely shorter than what markets may have granted Mitt Romney. The 112th Congress is in session until December 14, leaving only five weeks for compromise unless Congress stays in special session. We anticipate that global capital markets will be volatile until more clarity on compromise emerges, but given the resultant political landscape (a divided legislature and Democratic executive branch), a Congressional “deal” will require both sides to migrate away from pre-election dogma that polarized both parties. 
 
Financial markets do not respond well to uncertainty, especially uncertainties of the fiscal cliff’s potential magnitude. While the election may provide leadership clarity—and no one wants to lead the economy into recession—the debt crisis behind the fiscal cliff must be addressed. 2011’s debt ceiling debates and failed Supercommittee negotiations provide recent examples of periods when markets did not respond favorably to intransigence. And if fresh election wounds remain unhealed, the fiscal cliff could prove a headwind for financial markets.
 
Given the potential for short-term volatility, CAPTRUST has developed a communication piece for your defined contribution plan participants to arm you with some answers to likely questions. We do not want to be alarmist with respect to the fiscal cliff and its uncertain implications, but we are very conscious that participants may seek guidance. Our message is that investors need to be mindful of current news flow—yet they should remain focused on their long-term objectives. This is unlikely to be the last significant event to impact their savings (positively or negatively) and we offer tips to navigate through this and future challenging investment climates. 
 
With respect to the election’s investment implications outside of the fiscal cliff, it is too soon to offer definitive conclusions at this point but we will continue to assess potential outcomes—and we’ll keep you posted as details emerge. We are constantly assessing how adequate your retirement plans’ design—including your defined benefit, defined contribution, and nonqualified plan, as applicable—and investment options are relative to the global opportunity set. We value your trust as we work towards our shared goals. If we can help with any outstanding questions or concerns, please do not hesitate to let us know.  
 
For more on the fiscal cliff and its potential implications for the U.S. economy, please read Just a Spoonful of Sugar in CAPTRUST’s recently published third quarter Strategic Research Report.
 
The information provided in this article is for educational purposes and should not be construed as individualized investment advice. This is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. CAPTRUST Financial 
 
Advisors does not render legal, accounting, or tax advice. Clients should consult their tax professional or legal counsel for such advice. 
 
 
© 2012 CAPTRUST Financial Advisors  
 

 

 

© 2012 CAPTRUST Financial Advisors  

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