The New Year began with congress finally agreeing to a partial deal to avoid (or at least delay) the worst of the much-discussed “fiscal cliff” of scheduled tax increases and spending cuts. We provide an overview of the deal and discuss what it means for our clients and financial markets.

Highlights:

• The 11th-hour deal is better than nothing … but its limited scope and the need for additional negotiations will likely translate into increased volatility for financial markets. Expect more late-night drama from Washington in the coming months.
• Higher payroll taxes will likely depress US consumer spending in the short term. This could result in a drag on the US economy early in the year. We expect a rebound later this year, but believe gross domestic product (GDP) growth is unlikely to exceed the 2% annual clip we have seen in recent years.
• For equities, we prefer US mega-cap companies and non-US stocks (especially emerging markets, but also exporters on Europe’s periphery). Dividend stocks look attractive, especially those companies that are cash flow rich and have a track record of increasing payouts.
• Within fixed income, we like to focus on credit sectors — including high yield and emerging market debt. Municipal bonds remain a good source of tax-exempt income for US investors but we expect little price appreciation.
• US Treasuries look dangerous with yields low and duration risk high.

What does the fiscal cliff agreement include?

1.  Here’s a quick summary of what the fiscal cliff agreement reached late on January 1 covers:

• Permanent extension of the Bush-era tax rates for individuals with income up to $400,000 and couples with income up to $450,000.
• Permanent maximum 15% tax rate on dividend income and long-term capital gains for individuals and couples up to those same income levels, with a 20% rate for those with higher incomes.
• Permanent lower estate tax rates for estates worth up to $5 million.
• Permanent fix for the alternative Minimum Tax.
• Two-month delay of scheduled spending cuts (known as the “sequester”).
• One-year extension of unemployment benefits.
• One-year freeze on scheduled cuts in doctors’ Medicare payments (the “Doc Fix”). Five-year extension of stimulus-related spending cuts

2. Significantly, the deal did not include an extension of the payroll tax holiday, any entitlement reform, any restructuring of personal or corporate tax codes or any increase in the debt ceiling.

3. The bottom line: The agreement mitigates the full impact of the scheduled tax hikes and spending cuts but is incomplete in many ways. The compromise will still produce a modest fiscal drag, fails to address the longer-term fiscal challenges facing the United States, and leaves the debt ceiling as an unresolved, near-term issue.

What does the deal mean for the near-term economic outlook.

4. The fiscal drag left in place by the deal, coupled with the lingering uncertainty surrounding the debt ceiling, leads us to expect a weak economic start to      2013. The market consensus currently is for first-quarter growth to be roughly 1.6%, a rate we find to be overly optimistic. We do expect the US economy to rebound later this year, but it is unlikely to accelerate above a 2% annual growth rate.

5. In particular, we expect consumption levels to be weak. Consumers are still struggling with tepid income growth and high debt levels. The fiscal cliff deal adds three additional headwinds for consumers. First, the expiration of the payroll tax holiday will hit workers’ take-home pay to the tune of $30 billion per quarter. Second, upper-income households will face higher taxes on several fronts. Last, the late timing of the deal means tax filing this year will be delayed—as will tax refunds, which totaled more than $200 billion in the first quarter of 2012.

6. The uncertainty over the debt ceiling and the potential for another show down in congress suggests that capital spending will remain constrained.

7. For the near term, the deal does not change our positive view on the US dollar. While it may seem perverse, a protracted debate over the debt ceiling, leading to a debt downgrade and a period of risk aversion could actually strengthen the dollar. However, over the longer term, the dollar is likely to come under renewed pressure if the US fiscal position deteriorates.

8. Given the many issues left unresolved (the debt ceiling, entitlement reform, the sequester, tax code reform, etc.), Washington is likely to remain focused on fiscal issues for the foreseeable future. We, therefore, expect little progress on other pressing matters, including immigration reform, trade agreements or energy policy. In addition, this domestic focus suggests the United States is unlikely to provide much global leadership.

9. A contrarian would see up side potential to all of this. While it seems unlikely, should congress and the White House be able to strike a broader “Grand Bargain,” we would expect to see significant tailwinds for the economy and financial markets.

10. The fiscal cliff deal does very little in terms of altering the long-term US fiscal picture.  It will not significantly reduce the high US debt-to-GDP ratio. Tax revenues are expected to increase by about $600 billion over the next decade, but do not come close to addressing the US fiscal imbalance.

11. Even in the short term, deficits may actually be larger than expected. The White House office of Management and Budget’s latest assessment projected growth levels of 2.7% for fiscal 2013 and assumed average growth of 4% over the next four years. As these growth estimates are unlikely to be reached, revenue levels are likely to disappoint and deficits may be above estimates. Finally, with the debt ceiling soon to be breached, failure to act increases the odds of another US credit rating downgrade.

12. First, we expect to see more volatility. While higher volatility should present buying opportunities for those with longer time horizons, investors should be prepared for a bumpier ride in 2013, at least until Washington produces a more definitive, longer-term agreement.

13. Regarding investment opportunities in equities, we would focus on US large- and mega-cap companies. We believe global growth (including emerging markets growth) will surpass growth levels in the United States, implying that companies with greater exposure to the global economy should outperform. This suggests a higher allocation to large- and mega-cap companies, which are generally less sensitive to domestic growth.

14. At the same time, we would advise investors to reduce any overweight positions they may have in US stocks as a whole. US companies are highly profitable and reasonably priced, but they are somewhat expensive relative to other markets currently. Instead, we believe investors should consider overweighting emerging markets, smaller developed countries and peripheral European exporters. While these areas of the market face their own challenges, valuations are generally more forgiving and growth estimates may be less prone to disappointment.

15. Additionally, we suggest investors remain cautious on US small caps and consumer stocks, which typically fare relatively poorly in slow-growth environments.

16. We believe dividend stocks look attractive. While dividend tax rates will increase for some taxpayers, the deal should not have a significant effect on dividends. The change in tax treatment is quite modest and will only impact a small percentage of taxpayers.  In any case, US companies have a history of making investors whole on an after-tax basis. With current payout ratios near historic lows and balance sheets quite strong, companies have ample room to raise dividend payments to compensate investors for any changes in tax treatment.

17. Regarding fixed income, we believe that slower growth levels imply that Treasury yields will stay low for at least the first half of 2013. Treasuries, however, still look unattractive to us. Real yields are negative and duration risk is high, which means even a modest increase in yields would have a significantly negative impact on Treasury prices. We suggest investor’s focus on credit sectors of the fixed income market, with a particular emphasis on high yield, bank loans, structured credit (including commercial mortgage- backed securities, collateralized loan obligations and non-agency mortgages) and emerging market debt.

18. Finally, we believe municipal bonds remain competitive on a tax-adjusted basis for US investors. Higher marginal rates for at least some investors, along with little prospect of changes to municipal bonds’ tax status, make munis even more attractive on an after-tax basis. While we are unlikely to see significant capital appreciation from municipal bonds, their after-tax yields are attractive and munis remain a solid source of income.

NOTICE:

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 2, 2013, and may change as subsequent conditions vary. Unless otherwise specified, all information contained in this document is sourced by Gustavo A Viera and is current as of the time of writing. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.