Unprecedented

January 2—The process and timing of the avoidance of the “fiscal cliff” in Washington, D.C. was without legislative precedent. The uncertainties created by the fiscal cliff were widely seen as suppressing new investments by business in the last half of 2012, causing the economy to perform below its potential. The cliff was finally avoided, but what remains to be seen is whether a new recession has been averted. Going over the cliff would have caused just a recession, according to the Congressional Budget Office. In the deal that was finally struck, the 2010 reduction in Social Security taxes was allowed to lapse. That’s good news for the Social Security trust fund, but by some estimates the tax increase on workers may reduce gross domestic product in the first half of 2013 by a full percentage point.

Confidence

Perhaps it was the uncertainty of fiscal cliff, perhaps it was Superstorm Sandy, or perhaps there was another reason entirely. But for whatever reason, consumer confidence nose-dived in December, dropping below the average for the year with the largest two-month decline in 15 months. Older Americans showed the greatest concern. The confidence indicator stood at 66.5. For context, the indicator was over 110 before the financial collapse and bottomed out below 30 in early 2009, before the economy began to improve. Although an absolute value of 66.5 may not be terrible, the new trend is unsettling.

Confirming the sour mood, a USA Today/Gallup poll as the year began found that 65% of Americans expect 2013 to be a difficult one for the economy. Some 42% expect unemployment to increase even as the same number believe that inflation will worsen. A tax increase was predicted by 82% of respondents, an event that has now already happened.

Markets

Still, the major stock market indices all showed nice gains in 2012. The Dow Jones Industrial Average rose 7.3%. Including dividend payments, the Dow 30 returned 10.0%. At its peak in 2012, the DJIA was just 555 points short of its all-time high. The S&P 500 did even better, with the index rising 13% for the year.

Inflation was restrained in 2012, and is expected to remain so through 2013. Although economic growth was not robust, it remained in positive territory throughout the year. Interest rates are expected to remain very low throughout 2013, as the Fed announced that the current monetary policy will continue until unemployment falls below 6.5%. That goal could take years to achieve.

In such an ultra-low interest rate environment, investors are expected to return to stocks in 2013. During the past three years nearly $700 billion has been poured into bond funds worldwide, while $300 billion has been pulled from stock funds. But the days of bond price appreciation are largely over. The S&P 500-stock index is trading at a price/earnings ratio of 14, which is well below its historical 10-year average. A p/e of 14 implies an earnings yield of 7%, far higher than can be found in bonds these days.

(January 2013)