After two years of an expensive and divisive presidential election we have emerged with a “Status Quo” government. With President Obama remaining as president, the Congress is split with a Democratic‐controlled Senate and a Republican‐controlled House of Representatives. So what does this mean for the economy and the markets going forward?

The first issue on everyone’s agenda is the Fiscal Cliff. With a divided political landscape in Washington, politicians may use a brinkmanship negotiating style to leverage their position. This will likely create some angst and volatility in the short‐term, especially as the United States is facing an almost perfect storm of tax increases including:

• The sunset of the Bush Tax Cuts;
• The implementation of the Patient Protection and Affordable Care
• Act (PPACA) often referred to as Obamacare;
• The reversion of the Estate tax to year 2000 levels;
• The expiration of the 2009 payroll tax holiday; and
• The expiration of the Alternative Minimum Tax patch.

Many have aptly dubbed what the U.S. is facing “Taxmageddon.” One would hope that despite the divide, that Washington will be able to come up with some compromise in order to prevent our country from going over the fiscal cliff. Regardless, it is likely that our clients will see some level of tax increase to their bottom line. This is just a small list of tax consequences should Washington not work together to avoid the cliff.

• The lowest income tax bracket of 10% would expire, reverting to15%
• The top four income tax brackets would see rate increases.
  • The 25% bracket increases to the 28% bracket
  • The 28% bracket increases to the 31% bracket
  • The 31% bracket increases to the 33% bracket
  • The 35% bracket increases to the 39.6% bracket
• Long‐term capital gains tax would rise from a maximum of 15% to a maximum of 20%.  Additionally, a 3.8% capital gains tax on high‐income individuals (income of $200,000 for an individual or $250,000 for a couple) is added to help pay for PPACA. The top capital gains rate would thus be23.8%.
• Tax on qualified dividends would rise from 15% to ordinary wage tax rates. Again, a 3.8% dividend tax on high‐income individuals would be added per PPACA. The top dividend tax rate would thus be 43.4% (39.6% plus 3.8%).
• The child tax credit would fall from $1,000 to $500 and no longer be refundable.
• The estate tax at the federal level would increase from 35% on anything above $5.12 Million to 55% on anything above $1 Million greatly impacting farmers and family businesses.
• The payroll tax holiday expiration will cause employees to see a reduction in take home pay with a tax increase from 5.65% to 7.65%.
• Employee Medicare payroll tax will increase by 0.9% for high‐income earners (those earning $200,000 as a single filer or $250,000 for couples) to help pay for PPACA.
• There will be a higher threshold for medical expense deductions. Currently, taxpayers may deduct for medical expenses that exceed 7.5% of their income. In 2013, that threshold changes to medical expenses that exceed 10% of income.

As U.S. taxpayers feel the “bite” of a higher tax environment, it is likely to reduce their appetite for consumption.

Further complicating matters is the debt ceiling and sequestration negotiations. With federal borrowing levels at an average of $2.7 Billion per day, the government should hit the debt ceiling sometime between the end of the year and February, 2013. During the last debt ceiling negotiations, a law enacted in August 2011 implemented $900 Billion in initial budget reductions but set up a joint select committee to develop a further $1.5 Trillion in deficit reduction for congressional consideration. In November 2011, this “supercommittee” announced that it would not be able to produce a recommendation. The August, 2011 law provided a “stick” if Congress failed to implement the required deficit reduction: $1.2 Trillion in forced automatic cuts (sequestration) would take place over the 10 years, divided equally between defense and non‐defense discretionary programs. For 2013, the portion of the across‐the‐board reductions total $109.33 Bil‐ lion, again divided equally between defense ($54.67 Billion) and non‐defense ($54.67 Billion).  Obviously, this reduction in government spending will have an impact on the economy.

As we discussed in our June 2012 Riggs’ Report,  the Fiscal Cliff is a series of mandatory changes that… including tax hikes, reduction in transfer payments and mandatory spending cuts all of which are scheduled to take effect on January 1st, 2013. If left unaddressed, current estimates show we could see a reduction in GDP (Gross Domestic Production) by as much as 4.4%. … thus driving the U.S. economy into recession.

Our best guess is that the political process will be ugly but eventually Washington will come to some type of agreement. This agreement will likely set the framework for the heavy lifting in budgeting, spending cuts and tax reform that the Administration and Congress will need to address next year. In the meantime, the economy will likely remain sluggish as Washington works its way through this process. Businesses are un‐ likely to make large bets on capital spending until they have more clarity on the new tax landscape. Further, the markets will likely react to each headline as politicians posture and push for advantage so we are likely to see the market’s remain volatile until a deal is reached.

With that as the backdrop, there are some longer term trends that will continue to advance despite the political wrangling in Washington.

FIXED INCOME MARKETS

On the fixed income side, we are likely to continue to see an activist Federal Reserve. As economic growth will likely remain sub par and jobs growth remain anemic, it would not surprise us to see the current round of quantitative easing expanded in 2013.  Currently, the Federal Reserve is purchasing $40 Billion
worth of mortgage‐backed securities each month. If the current trend remains in place, we would likely see a dramatic increase in the current round of bond purchases. The intent here would be to provide liquidity for the economy, keep interest rates low to support the fledgling recovery in housing and stimulate commercial loans while boosting asset prices.

For fixed income investors, this policy should continue to support the bond market. However, there is a limit to how much juice one can squeeze from this lemon. So while we view these policies as supportive to the bond market we see little upside and an incipient increase in risk. Therefore, we believe it is important that fixed income investors hedge against policy miscalculations.

As you know, your bond portfolios are well positioned for this environment. Over the last few years, we have augmented some of the traditional holdings to enhance returns and reduce risk. We have been holding gold in your portfolios for over a decade now. We have added corporate and international bond funds to enhance yield and we have purchased government bonds of resource‐rich nations with conservative fiscal policies and stable political systems. All of these positions are benefiting from actions of activist Central Banks.

EQUITY MARKETS

Global growth will continue to be driven by the U.S. and the developing world. The expanding affluence of populations in Asia and Latin America will remain the key to global growth and success here in the U.S.  In the U.S., we are uniquely positioned to benefit from growth in the developing world. With port access to both the Pacific and Atlantic trade routes, the U.S. is a natural trading partner with both the developed
and developing economies. Those companies that provide products and services that meet the needs of
these populations should continue to do well. We believe the housing market is in the early stages of a multi-year recovery, which should help to boost the U.S. economy.

So longer term, we see many positives. However, on a shorter term basis we have seen some deteri‐ oration in our indicators. For example, as we discussed in our last newsletter, while the broader markets were hitting highs the Dow Jones Transport Index (DJTI) was not. In fact, (DJTI) peaked in July of 2011 and since that time it has been in a gradual downtrend. This index is made up of companies in the airlines and air freight, trucking, railroads and shipping industries. Essentially, these are the folks that move stuff. The DJTI has historically led the markets and the economy both to the up side and the down side.

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It would be nice to see the DJTI break above it’s downtrend line and see some of our other indicators improve. Until then, we will remain cautious. An agreement in Washington would certainly help businesses‐‐ both large and small‐‐so they could plan and spend. While we all want to be rid of the “uncertainty,” a deal that is certainly bad may not be an improvement. We will have to see what the Status Quo government can come up with.

As you may have noted, we have taken some profits in your accounts and increased your cash positions.  This will buffer your portfolios from some of the market volatility likely to occur as a result of the negotiations in Washington, D.C. We remain vigilant in protecting your portfolios from market downtrends and in identifying market opportunities.