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John Manley

A fate worse than debt?

AdvantageVoice® Blog—1-7-13
John Manley, CFA, Chief Equity Strategist

If it were done when 'tis done, then 'twere well it were done quickly…” Macbeth

Well, it’s not done and it certainly wasn’t done quickly, but then, Macbeth never was a good role model for politicians. Congress and the president did not meet the deadline, did not address spending cuts, and certainly did not craft a grand plan to systemically address our yawning deficits going forward. Still, I believe that what they did was a real accomplishment that deserved the applause it was given by the financial markets.

Our government was designed to be inefficient but, ultimately, effective. That is a fairly good description of what happened in Washington over the New Year’s Day holiday. The legislation was incomplete, but it was not entirely ineffective. Tax rates will rise but not in the French manner (i.e., 75% marginal rates). Also, they will rise for those most likely to cut savings more than spending to pay them. (For a more complete exposition of the new law, I would recommend the piece on the legislation recently written by my colleague Dr. Brian Jacobsen, “Fiscal cliff: A 13th–hour deal”.)

While battles on spending issues and the debt ceiling will most likely roil the markets from time to time in the weeks ahead, corporate managers and investors do have a somewhat clearer picture of the road ahead. They also have at least one example that our divided government can achieve something if the pressure on it is strong enough and the apparent result of inaction is worse than the compromise. Remember, the debate started with one side saying that income redistribution was a prerequisite for any discussion and the other saying that higher tax rates could never be put into effect.

I choose to view what happened as the first movement in a long process that, eventually, will resolve our debt issues. I suspect that the process will resemble the action of plate tectonics, with pressure building slowly but inexorably until it is released in a rapid, stuttering movement. If this scenario develops and the Federal Reserve continues to encourage growth and corporate earnings do not sag dramatically, then, in my opinion, an excellent environment for equity market appreciation should be in place this year. Our target for the S&P Composite remains 1,600 for the end of this year.

I believe that one particular part of the new tax law deserves special attention. The tax on dividend income (for “high” income individuals and families) goes from 15% to 20% (23.8% if the surcharge for health care is included). In my opinion, this is important for several reasons:

  1. It is not confiscatory. Higher taxes always discourage the activities that are taxed. However, the impact of that tax is somewhat muted if the majority or super-majority of the benefit is allowed to pass through to the person who earned it. Investors probably will not shun dividends because they get to keep only 75%, not 85%, of it.
  2. The tax rate remains below that of ordinary income. Whether this is an acknowledgement by our legislators of the benefits of stimulating capital formation or just a nod to the duplicative nature of the corporate structure, it is at least a psychological boost for entrepreneurs and investors.
  3. The dividend tax rate remains equal to the capital gains rate. No distortion is created and individuals should not shift their preference away from the pursuit of income to the pursuit of appreciation. I believe that this reinforces our view that dividend-paying stocks (with the perceived ability to raise payouts and grow over the long run) should become increasingly attractive to those facing the realities of retiring in an era of very low interest rates on high-quality bonds.

The views expressed are as of 1-7-13 and are those of Chief Equity Strategist John Manley, CFA, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

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