Waddell & Reed

Market Perspectives

Post-election 2012: Questions of clarity and the looming cliff ahead

Story Highlights

  • Political parties may be able to compromise on some parts of the fiscal cliff.
  • Debate expected to form over definition of “wealthy."
  • Businesses seek regulatory clarity.
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Despite the months of intense rhetoric, presidential campaigns that combined to spend more than $2 billion and some hotly contested Congressional races, the 2012 election left Washington, D.C. nearly unchanged with the re-election of President Barack Obama, the Republicans retaining control of the House and Democrats in control of the Senate. That means the same key players in the same roles, trying to tackle the same problems that could not be resolved before voters headed to the polls.

For those hoping that the election was going to remove a substantial portion of the uncertainty that has been hanging over the U.S. economy and the markets, the election results fell short.

“The market hates uncertainty,” said Hank Herrmann, chairman and CEO of Waddell & Reed Financial, Inc., and CEO of Ivy Investment Management Company. “The election part of the uncertainty has been put to bed, but there are still a lot of issues in front of us in terms of the management of the economy.”

Fiscal cliff

The most pressing issue, of course, is the combined $600 billion of automatic tax increases and government spending cuts that has become known as the fiscal cliff. This is in addition to the need to raise the current government debt ceiling from $16.4 trillion, which it is expected to hit near the end of this year or early next year.

The cliff was an issue for months ahead of the election and now becomes the top priority for a lame duck Congress and the White House. If policymakers are unable to come up with some kind of budget deal that includes an extension or resolution of its various components, the U.S. will hit the cliff on Jan. 1, 2013 – a development that forecasters expect could shave anywhere from 1 to 3 percent off of U.S. Gross Domestic Product, depending on how events unfold, enough to thrust the U.S. back into recession while subjecting U.S. government debt to potential further downgrades.

“I believe many parts of the fiscal cliff can be resolved in December,” said Greg Valliere, chief political strategist at the Potomac Research Group. “And I also think they can avoid a nasty fight over the debt ceiling.”

There is initial thought that the election results may encourage a move toward some kind of compromise on the cliff. Valliere said the Republicans, for example, may be more willing to yield on some positions rather than risk being viewed as obstructionist.

If so, some fiscal cliff issues could be addressed before year end: for example, there could be some headway on the alternative minimum tax (AMT) exemptions or budget cuts for defense may be avoided.

That said, there is virtually no question that taxes are going to increase.

“Somebody is going to pay higher taxes next year. That is the consequence of the Obama victory,” Valliere said.

Events currently point to a focus on a couple fronts: the elimination of some tax breaks and an increase in taxes on the wealthy. Obama has made clear he wants the Bush tax cuts to expire for high-income Americans. That means debate will likely unfold about what specific income level is defined as wealthy – the White House has argued it is couples earning more than $250,000 while others see the number at $500,000 or $1 million. Regardless, House Republicans are expected to prevent a dramatic increase, although taxes on capital gains and dividends may rise. As a result, Herrmann noted, municipal bonds may become increasingly attractive to investors because of their tax benefits.

“In the end, I think the final deal on the fiscal cliff will be fairly benign,” Valliere said. “We are not going to go dramatically higher on taxes (because) the House will not allow it.”

The need for clarity

Beyond budget issues and taxes, there is the continuing need for clarity related to the Dodd-Frank Act and its proposed reform of the oversight of financial institutions, and the Affordable Care Act, known as Obamacare, and the mandates on business.

“Business is confused about what’s next,” Herrmann said. “This, ‘What game am I playing and what are the ground rules?’ environment is very important to get addressed.”

Herrmann said that uncertainty – namely the debt ceiling debate earlier in 2012 – injected a new round of uncertainty into the economy at a time when the recovery appeared to be gaining momentum. As a result, investor risk aversion continued to appear in the bond markets, although equities did perform fairly well. On election day, the Standard & Poor’s 500 Index was up nearly 12 percent from June 1, signaling that the domestic equity market held up despite the uncertainty.

For investors, diversification remains an important element within investor portfolios, according to Herrmann. The election did nothing to alter views about the Federal Reserve’s promise to hold interest rates at exceptionally low levels well into any economic recovery. Ben Bernanke’s term as Fed chairman expires in January 2014 and with Obama appointing the successor, it is likely whoever he picks will have a bias toward easy monetary policy, potentially extending low rates beyond the Fed’s current vow of mid-2015.

“Monetary policy is crafted toward doing whatever is possible to try to get the economy going and trying to establish some price stability – a.k.a. inflation,” Herrmann said. “In that environment, ultimately, equities will benefit and I think at some point in time you have to assume investors are going to start thinking about equities a lot more than they have recently.”

However, given the search for yield that has been so critical in the low-rate environment, investors may well continue to flock toward fixed income in the near term. Nonetheless, Herrmann pointed out, domestic equities continue to remain attractive relative to other alternatives at current levels.

The Standard & Poor’s 500 Index is an unmanaged index of common stocks. It is not possible to invest directly in an index.

Past performance is not a guarantee of future results. The opinions expressed in this article are those of Mr. Herrmann and are current through Nov. 7, 2012. Mr. Herrmann’s views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. Waddell & Reed Financial, Inc. is the ultimate parent company of Ivy Funds Distributor, Inc.

Consider all factors. Investment return and principal value will fluctuate, and it is possible to lose money by investing. Fixed-income securities are subject to interest-rate risk and, as such, the net asset value of a fund may fall as interest rates rise. Ivy Funds Distributor, Inc. is not related to or affiliated with Greg Valliere or the Potomac Research Group.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for any of the Ivy Funds, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.

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