MAY 2012 Muni Market Update: Please proceed to the fiscal cliffMay 23rd, 2012 by David Waring
As the year progresses and election debates heat up, consider this: Washington will be forced to make some tough decisions in 2013. Are legislators looking out for investor interests?
How will their actions affect munis?
According to Ben Bernanke, unless legislators step in to change current laws, “On January 1, 2013, there’s going to be a massive fiscal cliff of large spending cuts and tax increases.” 1
The Bush tax cuts are set to expire, automatic government-spending cuts will kick in and investment surcharges will be levied to help pay for the Patient Protection and Affordable Care Act (ObamaCare). The threat of these developments has inspired the term “taxmageddon.”
How large will the drag on the economy be? What will be the impact on the financial markets in general and the muni market in particular? What is the likelihood that legislators will fail to act?
1.1 POTENTIAL DRAG ON THE ECONOMY
It’s no stretch to say the federal budget deficit is unsustainable at current levels and, sooner or later, legislators must agree upon measures to pay it down.
Source: Strategas Research Partners as of 4/16/12
By some estimates, the cost of the “massive fiscal cliff” will be approximately $534.8 billion in 2013.2 The largest sources of the deficit will be expiring tax provisions ($303.3 billion), changes in the payroll tax ($92.7 billion) and cuts to the defense budget as dictated by the Budget Control Act ($55.0 billion). Assuming the U.S. economy will be $16.015 trillion—which is the official estimate of the Congressional Budget Office (CBO) for calendar year 2013—the total fiscal drag will be somewhere between 3%-3.5% of gross domestic product (GDP). 2 ,3
CBO estimates that if current laws remain in place, GDP growth will drop from 3.6% this calendar year to 2.4% in 2013.4 The CBO’s baseline budget is useful because it provides a benchmark, based on current laws, against which potential policy changes can be measured. By contrast, those economic projections are significantly lower than the 4.2% and 3.9% for 2010 and 2011, respectively. The projected lower economic growth rates will obviously have significant implications for housing, unemployment, corporate profits, consumer sentiment, etc. If you believe the U.S. economy is on course for slower growth, the Congressional Budget Office agrees.
1.2 IMPACT TO INVESTORS
Under current law, after January 1, 2013 individuals will be subject to increased capital gains, dividend and ordinary income tax rates; long-term capital gains will go from 15% to 20%; the top tax rate for ordinary income will rise from 35% to 39.6%; and dividend income, which is currently taxed at the 15% capital gain rate, will be taxed as ordinary income. Additionally, a new 3.8% tax to pay for the Patient Protection and Obamacare will be applied to unearned income, including interest, dividends and capital gains, but will exclude muni income.
So, if you are in the top federal tax bracket, dividends you receive from your taxable investment accounts could go from a rate of 15% to a rate of 43.4% (39.6% plus 3.8%).
The challenge of trying to handicap policy outcomes during an election year stems from the difficulty of knowing the outcome of the presidential election and the composition of Congress next year.
We can say with reasonable certainty that major fiscal reform will not take place between now and the November 6th elections. Any major reform, if it comes at all, could possibly take place at the end of this year, but would probably not happen until 2013 or 2014. In the meantime, the uncertainty of the fiscal cliff will weigh on the minds of investors.
So, as we approach the fourth quarter, we could see investors favoring more conservative strategies that may seek to preserve principal, as opposed to more aggressive strategies that aim for capital appreciation. We believe high-quality munis have the potential to perform well in that environment.
1.3 AVERTING THE FISCAL CLIFF?
In the run-up to the elections both parties will want to appeal to voters. They will want to avoid introducing large tax increases or cuts to programs that voters hold dear. But policy makers will be forced to balance out the popular choices on the one hand with the unmanageable deficit on the other. Washington may be confronted by another debt-ceiling crisis if it reaches its debt limit earlier than expected, and current projections suggest this may happen before year end.
If we do arrive at 2013 with no major fiscal reform having taken place, legislators may seek measures that buy them time. They could temporarily extend the tax cuts yet again, or they could delay the introduction of defense-spending cuts, etc.
The CBO’s baseline budget assumes there will be no legislative intervention before tax cuts expire and mandatory spending cuts take off. The CBO Office also published an alternative fiscal scenario which shows the budgetary consequences of maintaining certain tax and spending policies that have recently been in effect. The alternative scenario assumes:
- The Bush tax cuts will be extended
- The Alternative Minimum Tax (AMT) will be indexed for inflation
- Medicare’s payment rates for physicians’ services will be held constant at their current level, and
- The automatic spending reductions required by the Budget Control Act will not take effect.
CBO summarizes: “Under that alternative fiscal scenario, far larger deficits and much greater debt would result than are shown in CBO’s baseline. Deficits would average 5.4 percent of GDP over the 2013–2022 period, rather than the 1.5 percent reflected in CBO’s baseline projections. Debt held by the public would climb to 94 percent of GDP in 2022, the highest figure since just after World War II.” 4
Knowing this, elected officials may find the CBO’s alternative scenario more palatable than the tough and unpopular decisions of the baseline scenario. On this topic we make two observations:
1) A deficit of this magnitude will not be eliminated by budget cuts and/or economic growth alone. Significant reduction of the deficit will come from a combination of GDP growth, government-spending cuts and tax reform. Therefore, sooner or later Washington will be forced to reform the tax laws in order to reduce the federal budget deficit.
2) Washington will be neither willing nor able to craft and pass sweeping changes to the tax code that affect muni income between now and the end of the year, we believe. If proposals to tax muni income do gain momentum in 2013, changes are unlikely to be introduced overnight. Such changes typically take time to craft, debate, revise and approve, all the while receiving the attention of the news media and the investment markets.
Most professional muni investors and analysts—ourselves included—expect the tax-exemption of muni income will persist. (For more information on this topic, including the link between tax exemption and support for infrastructure projects, see the October 2011 Muni Opinion “Is Taxing Munis a Smart Idea?”)
Yes, there is a risk that a new law could eventually get passed that limits the tax exemption of munis, and certainly such a law would undermine some of their attractiveness. Typically, these sorts of policy changes apply going forward, not retroactively. Obviously, we are monitoring this closely.
By contrast, if tax rates go up, expect munis to become even more attractive.
Keep in mind that muni yields continue to be elevated relative to U.S. Treasuries and other high-quality fixed income. At the time of writing (4/30/12), yields of triple-A rated munis in most maturities are equal to, or higher than, yields of U.S. Treasury bonds, whose income, of course, is subject to federal income tax.5
In the meantime, investors should do their best to make themselves as comfortable as possible occupying an environment of uncertainty. Policy issues will eventually have a major impact on the investment markets and on the performance of investor portfolios, but we will likely have to wait until next year for clarity to emerge.
We expect that as we approach the 2013 fiscal cliff, investors will increasingly look to munis as a means of hedging some of their tax uncertainty.
The opinions and forecasts expressed herein by the fund managers and product specialist do not necessarily reflect those of DWS Investments, are as of 4/30/12 and may not come to pass.
2 Strategas Research Partners, Policy Outlook as of 4/16/12
3 Gross domestic product (GDP) is the value of all goods and services produced by a country’s economy.
5 Credit quality measures a bond issuer’s ability to repay interest and principal in a timely manner. Rating agencies assign letter designations such as AAA, AA and so forth. The lower the rating, the higher the probability of default. Credit quality does not remove market risk and is subject to change.
IMPORTANT RISK INFORMATION
Bond investments are subject to interest-rate and credit risks. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Investments in lower-quality and non-rated securities present greater risk of loss than investments in higher-quality securities. The fund invests in inverse floaters, which are derivatives that involve leverage and could magnify the fund’s gains or losses. Although the fund seeks income that is federally tax-free, a portion of the fund’s distributions may be subject to federal, state and local taxes, including the alternative minimum tax. See the prospectus for details.
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