The biggest news during the fourth quarter of 2012 was certainly the November elections, which resulted in no fundamental change in the status quo as President Obama was re-elected, the Democrats retained control of the Senate and the Republicans kept the House.  The partisan gridlock our nation has endured for so long continued right through year-end as Congress failed to act in time to avoid sending the nation over the so-called Fiscal Cliff.   

Missing the 12/31/12 deadline was to result in a return to the pre-Bush era tax rates and draconian, automatic, spending cuts (a process known as sequestration).  In the wee hours of Tuesday, January 1, Congress approved a compromise bill and sent it to the President for his signature.  Bush-era tax rates were reinstated for everyone making under $400,000 ($450k for married couples).  The top income tax rate rose from 35% to 39.6%, the estate tax rate moved up to 40% and the rate on interest, dividends and capital gains increased to 20%.   Additionally, the estate tax exemption was made permanent for individual estates under $5.12 million, will now be indexed for inflation, and will continue to be portable between spouses.  To no one’s surprise, Congress increased taxes but was unable to agree on any significant spending cuts.  The more things change, the more they stay the same. 

Another big result of the election is the implementation of the Affordable Care Act, better known as Obama Care.  One of the features of this bill is the 3.8% surtax on unearned income for couples making over $250,000 ($200k if single).  This surtax, which applies to interest, dividends, capital gains, annuities, and rental income, means that you should pay careful attention to the tax implications of your investment decisions and strategies going forward.   

The economy limped into year-end as rising caution and falling confidence among businesses and consumers slowed spending and investment.  Third quarter GDP came in above estimates at 3.1% due to stronger spending on health care along with increased exports.  It’s too early for 4Q-12 GDP numbers but economists in the latest Wall Street Journal survey predict GDP of just 1.3% in the 4th quarter of 2012 and 1.7% in the first quarter of 2013.  

In December the unemployment rate was flat at 7.8% (after November’s rate was revised up to 7.8%).  Of more concern was the gain in nonfarm payrolls of 155,000 jobs which was in line with the average 2012 monthly gain of 153,000.  This pace will absorb those younger entrants into the workforce but will do little to increase the prospects of the 12 million Americans currently out of work.  Job gains are clearly coming from the private sector which added 1.9 million in 2012, while losses of 63,000 government jobs (mostly state and local governments) over the past 12 months marked the fourth consecutive year of public-sector losses. We need to see consistent monthly job gains of 200k-300k to lower the unemployment rate.   

Housing has been one of the bright spots in our recovery as low interest rates and pent-up demand are creating the long-awaited turn-around.  Home prices gained 4.5% in 2012 and, through November, sales of existing homes are 14.5% higher than a year ago.  Housing starts are expected to rise 24% this year after inventories of new homes fell in 2012 to the lowest level in 50 years.   

Market Commentary 

2012 rewarded stock investors for staying with the program in the face of blistering predictions of catastrophe and $2,000 gold.  Gains were broad based among most sectors during the 4th quarter.  U.S. medium (S&P 400) and small-cap (S&P 600) stocks posted gains of 3.61% and 2.22% respectively, however the largest domestic companies (S&P 500) posted a small loss of -0.38% for the quarter.  International investors saw gains of 6.57% from developed international stocks (MSCI EAFE) and 5.58% from emerging international markets (MSCI EEM). 

For the full year, stocks delivered big-time returns, demonstrating yet again why no one should engage in market timing.  With so many dire predictions, few could have guessed we would have seen the gains we actually experienced.  Equity returns ranged from 16% for the S&P 500 to 18.22% for international emerging markets (MSCI EEM). 

Bond investors saw modest gains of 0.68% for 4Q-12 and 6.17% for the full year (Barclay’s 1-5 Year Corporate Bond Index).   With interest rates at historical lows, the main reasons to include bonds in a portfolio are to temper the volatility of an otherwise all-stock portfolio and to provide a source of liquidity.   We customize each client’s asset allocation to meet their unique need to balance growth, income, risk and liquidity. 

What’s Next? 

Congress will soon hit another debt-ceiling limit and face off again as Republicans view this as an opportunity to enact meaningful spending cuts or at least halt the growth in spending.  If Congress is unable to agree on a deficit reduction plan they may agree to disagree and allow the automatic spending cuts to kick in.  Sequestration was the result of their failure to reach an agreement before the 12/31/12 ”Fiscal Cliff” deadline imposed by the Budget Control Act of 2011.  No one believes this will be good for the country, but we have reached a point where fundamental differences in the role and scope of government are creating an impasse to progress. 

The national debt is currently $16.4 trillion and predicted to hit $20 trillion in four years.  We must get our debt and deficit under control or follow the fate of Greece and other nations, but without Germany to bail us out.  Our economy is stuck in a shallow growth trajectory until structural reforms are enacted.   

On a brighter note, three major imbalances are turning. (1) Housing - the single biggest factor in the financial collapse of 2008-2009, appears to finally be correcting. (2) Energy - thanks to new technologies, the U.S. has gone from the world’s largest importer of natural gas to being essentially self-sufficient. And the International Energy Agency predicts we will be the world’s largest oil producer by 2020.  (3) Household debt – Americans are deleveraging.  Household debt payments, as a percentage of disposal income, are at their lowest level in 20 years. The reversal of these imbalances is now causing an economic tailwind that can continue for years.