Confidence in the condition of the world’s economy is on the rise amid positive economic data, improvements in the Eurozone; and a sense that the worst fears raised by the US “fiscal cliff” crisis at the end of 2012 did not come to pass. However, governments continue to play an abnormally large role in financial systems worldwide, more so than in any time in the past. Furthermore, it is unlikely that this involvement will be scaled back anytime soon, which makes investment decisions more challenging than usual. We are in uncharted territory, which creates a high degree of uncertainty. In this environment, the most prudent investment strategy is to broadly diversify your portfolio, expect dramatic market swings, and keep your focus on long term financial goals and plans.

Government involvement factor is worldwide

In mid-December the Fed announced an open-ended round of quantitative easing, where the Fed will buy Treasuries and mortgage-backed securities in order to keep interest rates low to hopefully stimulate economic activity by reducing the cost of capital. The Fed’s bond asset purchases will now grow to $85 billion per month (its balance sheet will swell to about $4 trillion this year). In January the Bank of Japan doubled its inflation target to 2% and announced an open-ended commitment to buy assets, all in an effort to address deflation. It was the BOJ’s fourth monetary expansion in five months. This "manufactured" liquidity has boosted investors’ willingness to take on risk and, combined with the lagged impact of the past year’s global monetary accommodation, has provided a stimulus to many economies around the world.

As stated above, scaling back this government monetary action will require time and the effects are uncertain. The eventual curtailment could provoke disruption in financial markets, as eventually risky assets will be priced based on fundamentals rather than on their attractiveness relative to ultra-low rate alternatives. But for now, the monetary stimulation is helping to support riskier asset prices.

One major unknown is the direction U.S. monetary policy will take after Ben Bernanke’s current term as Chairman of the Fed expires in January, 2014. If his replacement decides to change the current policy of providing “forward guidance” (communicating the likely path of future Fed policy actions), or makes a change in the announced economic "trigger points" where Fed policy will change, or announces a different policy all-together, we may very well see some disruption in the markets. Even if Bernanke continues as Chairman, it is unclear what action will be taken when the current economic trigger points (keeping short-term interest rates close to zero until the unemployment rate drops down to 6.5% or inflation rises above 2.5%) thresholds are reached.

Economic impact from new tax law and spending "sequester” is an unknown

The end-of-the-year tax legislation terminated the payroll tax 2% "holiday" for every worker and increased the top incremental tax bracket for high income taxpayers to 39.5% from 35%. This could cause a reduction in consumer spending and slow economic growth in 2013. The resolution of the tax portion of the fiscal cliff temporarily eases a large part of market uncertainty. Congress nevertheless simply “kicked the can down the road” on the spending cuts issues, which may be a significant cloud to the already tepid growth prospects in the U.S. As of the date of this writing, it appears that across-the-board government spending cuts will occur under "sequestration". While this is good for deficit reduction, many argue that it will reduce economic activity, and thus tax receipts. Conversely, a reduction in tax receipts could dampen the effect of deficit reduction.

Some bright spots in the economy

The U.S. labor market, while still weak, has shown very encouraging signs of improvement as private payrolls have increased for the last 35 consecutive months. Consumer confidence has also shown signs of improvement with the housing market stabilizing and auto sales coming back to normal levels. But the limited wage growth (partially due to the increase in payroll taxes) has offset the improving economic backdrop, keeping inflationary pressures in balance.

The opinions expressed herein are those of Stanford Investment Group, Inc. and are subject to change without notice. You should not consider this information as a recommendation to buy or sell any particular security. Past performance is not a guarantee or indicator of future results. Diversification does not eliminate or ensure against loss. All investments are subject to risk and will fluctuate in value. Individual client portfolio holdings will vary due to size of client’s portfolio and liquidity needs, among other reasons. If you have any questions, please contact your Advisor at (650) 941-1717. Do not forward or redistribute this document.