Cliff Notes: The Investment Environment Beyond the Fiscal CliffPrepared: January 15, 2013

The American Taxpayer Relief Act of 2012 (ATRA), signed into law on January 3, 2013, provided at least a partial resolution to the fiscal cliff crisis that hung over lawmakers in Washington. The cliff was the name applied to a combination of tax increases and spending cuts scheduled to take effect at the start of 2013. While efforts to reduce the government’s deficit are desirable, there was a growing concern that the combination of these policies had the potential, in and of itself, to push the U.S. economy into a recession.

The ATRA limited the potential economic impact, although some tax increases did result. However, it also delayed serious action on the nation’s deficit challenges. In particular, Congress put off any tough decisions on ways to more effectively manage federal spending in order to pare down the deficit. The measure did succeed in lifting some uncertainty, and stock markets reacted positively immediately after passage of the legislation. Important fiscal issues still remain and will quickly surface again in the first months of the year.

Investors need to prepare for the possibility that the next fiscal crisis, likely to occur by mid-February, could lead to a significant short-term market reaction. It may be particularly negative for stocks and other risk segments of the market and positive for assets perceived as safe havens, such as U.S. Treasury securities. However, as the year progresses, we believe the environment for stocks will prove to be favorable and investors will shift their focus to risk-oriented assets.

Important disclosures provided on page 6.

A summary of the Tax ActThe Act raises tax revenue as a way to reduce the nation’s deficit, and most important for individuals, it provides long-term certainty on tax rates as most key provisions do not have sunset clauses. This was a major issue with the Bush-era tax cuts which all had a set expiration date. Of course, future changes to the tax code are inevitable. Various provisions of the newly approved ATRA affect taxes in a variety of ways:

• Incometaxratesthathaveappliedsince2001are “permanently” locked in (meaning no expiration date was included) for individuals with incomes up to $400,000 and married couples with incomes up to $450,000.

− For taxpayers over these amounts, the top income tax bracket increases to 39.6%

− For trusts and estates, the threshold is projected to be $12,000

• TheAlternativeMinimumTax(AMT)hasbeenpermanently “patched” and will be adjusted for inflation going forward.

• EstateandGiftTaxexemptionamountsremainunified and are set at an inflation-adjusted $5 million per person (estimated to be $5.25 million in 2013).

• WhilenottechnicallypartoftheAct,thepayrolltax holiday ended and the Social Security wage withholding returned to 6.2%. This represents an increase of 2% over 2012 for virtually every wage earner.

Situation Analysis

How the fiscal situation was affectedWith policymakers in Washington spending considerable time debating issues surrounding the federal debt and deficit, a big question being asked is whether the tax plan just passed and other policies being discussed will make a significant dent.

A good starting point is to look at a breakdown of tax revenues and federal spending compared to historical levels. A common measure is to compare today’s rates of taxes and spending as a percentage ofthenation’seconomy(quantifiedbyGrossDomesticProduct,orGDP)tohistoricallevels.Thefollowing table demonstrates that tax revenue as

apercentageofGDPisabitbelowhistoricallevels,whilespendinglevelsasapercentageofGDParewellabove historical averages. The net result is a deficit that is significantly greater than the historical average when compared to the nation’s overall economy.

% of GDP

Historical Current Difference

Revenue 17.7% 15.8% -1.9%

Spending 19.8% 24.3% 4.5%

Surplus (Deficit) -2.1% -8.5% -6.4%

Source: Bloomberg Historical Average: Since World War II Current: Represents 2012 figures

The table below summarizes a number of the tax changes that took effect due to the American Taxpayer Relief Act of 2012, as well as a number of other provisions that will have an impact on taxes in 2013.

Changes As A Result of the American Taxpayer Relief Act of 2012

Provision 2012 2013

Top Ordinary Income Tax Rate 35% 39.6%

Top Capital Gains Tax Rate 15% 20%

Top Qualified Dividends Tax Rate 15% 20%

Phaseout of Personal Exemptions Repeal of Phaseout in PlaceLimitations restored for taxpayers with income

in excess of $250,000 and $300,000 (single and joint filers respectively)

Limitation of Itemized Deductions Repeal of Itemized Deductions in PlacePhaseout restored for taxpayers with income

in excess of $250,000 and $300,000 (single and joint filers respectively)

Alternative Minimum Tax Exemption$33,750 and $45,000

(single and joint filers respectively)$50,600 and $78,750

(single and joint filers respectively)

Estate, Gift and Generation-Skipping Transfer Taxes $5 million exemption amount and a top rate of 35% $5 million exemption amount and a top rate of 40%

Expiration of the Payroll Tax Holiday

Provision 2012 2013

Social Security Wage Withholding Rate (Employee Portion Only)

4.2% on wages up to $110,000 6.2% on wages up to $113,700

Changes As A Result of the Patient Protection and Affordable Care Act of 2010

Provision 2012 2013

Additional Medicare Withholding Tax Not Applicable0.9% on wages in excess of $200,000 and

$250,000 (single and joint filers respectively)

Net Investment Income Surtax Not Applicable

3.8% of net investment income of certain individuals, estates and trusts above the threshold

amounts ($200,000 - single, $250,000 - joint, and approximately $12,000 for estates and trusts)

Situation Analysis

Cliff Notes: The Investment Environment Beyond the Fiscal Cliff

Important disclosures provided on page 6.

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These numbers indicate that policymakers need to come to grips with an unsustainable budget situation. The lines in the adjacent chart show that the discrepancy between revenue and spending widenedconsiderablyduringtheGreatRecessionandthis imbalance persists well into the future. Without serious action, federal debt will continue to represent a significant portion of the nation’s overall economy.

Federal Government Budget: Unsustainable

Source: The Economist (December 15, 2012); Office of Management and Budget, Congressional Budget

The combination of revenue increases enacted in early January with the projected sequester spending cutsduetotakeeffectonMarch1,2013willmakea modest dent over the long run, but only represent a start. In reality, we anticipate that some of the cutsscheduledforMarch1stwillnotbeenforced.The nation’s debt problem still requires a long-term solution that will likely involve a combination of spending cuts and additional revenue increases.

Economic impact in 2013With higher taxes now in place, particularly the return to a 6.2% Social Security wage withholding that results in higher taxes for most wage earners, the economy is likely to be negatively affected in the first half of 2013. The modest revenue increases included in the ATRA (compared to the large deficit) should not, in and of itself, have enough impact on the economy to cause a recession. However, it may constrain growth in the first half of the year to around 1%.

Consumers will likely face the brunt of the adjustment. Higher payroll taxes (reducing take-home pay by $20 for every $1,000 earned for most individuals) may be a drag on consumer spending. The impact will be most notable early in the year as wage earners adjust to the change in their paychecks. As we move into the second quarter and beyond, consumer spending should normalize as both job creation and wage growth improve. This is assuming that no other major tax changes occur.

While the impact of higher taxes and reduced government spending may take a toll on the nation’s economy in the early part of 2013, we expect that in the second half of the year, strong fundamentals of the private economy will take precedence and drive faster overall growth in the economy. We anticipate growth to be above the 2% level in the second half of 2013. Drivers of this increased economic strength could include an improved housing market and the fact that many corporations are holding high cash reserves ready to be invested in new capital expenditures and labor.

Market impact in 2013 and beyond

Equity Markets

The outlook for equities remains generally favorable. The fact that lawmakers appear to be coming to terms with deficit and debt issues should be seen as a positive development for market sentiment. Our expectation is that equities will continue to trend higher in 2013. We estimate the benchmark S&P 500 Index (a broad measure of U.S. stock market performance) will gain in the range of 7%-10% in 2013. Three primary factors that are likely to have a big affect on how the market performs this year are:

• Ongoing fiscal issues: Uncertainty remains, with many key issues, including the debt ceiling, spending cuts and entitlement reforms, yet to beaddressed.Expectmoresharprhetoricandincreased volatility by mid-February as these discussions continue. If the debt ceiling crisis of 2011 is a guide (see adjoining chart), stocks could be in for some short-term challenges early in the year.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Debt (gross)Publicly held debt

Debt as % of GDP

100%

80%

60%

40%

20%

0%

BUSH TAX CUTS OBAMA STIMULUS PLAN FORECAST

RevenueSpending

35%

30%

25%

20%

15%

Reve

nue

& Sp

endi

ng a

s %

of G

DPSituation Analysis

Cliff Notes: The Investment Environment Beyond the Fiscal Cliff

Important disclosures provided on page 6.

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Stocks Fell After a Close Encounter With the Ceiling Last Time

Source: ISI Group

• Relative valuation:Equitiesappeartobeattractively valued relative to other asset classes, and are trading modestly below historical averages. The market is poised to have a positive year even if earnings growth is muted and valuations only advance modestly from current levels. This seems like a reasonable expectation in a year when taxes are going up and consensus expectations from Wall Street about 2013 earnings are trending lower. A catalyst for stronger corporate earnings could be reaccelerated growth in emerging markets. This would potentially benefit U.S. companies with emerging market exposure.

• Sentiment:Marketsentimentremainsfavorable.ExpectationsthatpolicymakersinWashingtonwill come to terms with the nation’s key fiscal issues is one factor. The wealth effect associated with the stock market’s positive performance in 2012 and signs of improvement in the housing market also serves as a contributing factor.

Fixed Income Markets

Fixed income investors breathed a sigh of relief with newsofthefiscalcliffagreement.Generally,intheimmediate aftermath, risk-oriented sectors of the market, including high-yield bonds and emerging market bonds, showed significant price appreciation. Municipalbondsheldtheirground.Corporatebonds were a mixed bag, with shorter-term securities posting modest returns, while those with longer maturities lost ground. U.S. Treasury bonds also retreated.

Looking forward, we anticipate that the environment for fixed income investments will evolve this year:

• Inthefirstquarter,continuedwranglingoverthedebt ceiling, budget, and status of the sequester spending cuts may lead to a re-emergence of a flight to safety. If so, a Treasury bond rally is likely to follow, reversing a setback for Treasuries that occurred in the immediate aftermath of thenewtaxlegislation.Municipalbondsmayalso appear attractive to risk-averse investors as state and local governments maintain balanced budgets. High quality corporate bonds would likely benefit as well. By contrast, high yield bonds may struggle if negative risk sentiment develops.Emergingmarketdebtmayalsoloseground as the dollar could regain strength, limiting attractive opportunities.

• Inthesecondquarterandbeyond,municipalbonds may show additional strength as higher tax rates on upper income earners will enhance theappealoftax-freeincome.Municipalbonddefaults in 2012 were well below the levels of previous years, and the volume of new issues in this market has declined. This could create a more favorable supply/demand environment that may boost bond values.

• Corporatecreditshouldalsoseecontinuedsupport. With tax rates clearly defined going forward, investors may be more comfortable taking on additional risk. Yields on corporate bonds remain attractive in today’s low interest rate environment, which should draw more investment flows. We anticipate a drop in new issuance of corporate debt this year compared to last, again contributing to a favorable supply/demand situation.

A policy outlook – what to expect nowThe ATRA signed into law in early January was justastartingpoint.Muchmoreliesaheadinthecoming months in terms of debate and potential action out of policymakers in Washington:

S&P Downgrades U.S. Debt Outlook

to Negative

S&P Downgrades U.S. Debt Rating

Jan2011

1400

1350

1300

1250

1200

1150

1100

1050Apr2011

S&P

500

Inde

x Le

vel

Jul2011

Oct2011

Dec2011

8%Gain

20%Decline

Situation Analysis

Cliff Notes: The Investment Environment Beyond the Fiscal Cliff

Important disclosures provided on page 6.

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• Adecisionmustbemadeabouthowtoproceedwith the mandated sequester cuts that were delayed by two months and now are scheduled totakeeffectonMarch1,2013.

• Congressmustdealwitharequirementtoincrease the nation’s debt ceiling. In the past, this has been primarily a procedural move, but the situation has become more controversial in recent years. However, the risk of not doing so on a timely basis is that the United States would default on some of its obligations.

• Pressuresurroundingthesecriticalfiscalissuesislikely to build quickly and will become a focus for the markets again at least by mid-February.

As political posturing mounts, we anticipate that the stock market may retreat and investors will, as they have during recent crises, flee to the perceived safety of assets such as U.S. Treasuries. The scenario that could develop as the debate builds is:

• Marketpressureshelpaccelerateapoliticalagreement, just as it did to end the debt ceiling crisis (and threat of default) in 2011.

• Theagreementconsistsofacompromisesetofactions that again delays the severity of spending cuts in the near term, with limited revenue increases. As a result, fiscal deficits persist at high levels for the foreseeable future, but the near-term economic impact is muted.

In this scenario, which we believe is a realistic expectation, the major credit rating agencies (Moody’sandStandard&Poor’s)maydowngradethe U.S. credit rating by mid year. The first downgrade took place in the midst of the 2011 crisis. If another downgrade occurs, the immediate market reaction would likely be a flight to safety and a downturn for risk assets.

While the actual outcome is far from known, it is important for investors to be prepared for continued market volatility as policy confrontations in Washington again take center stage.

Current investment guidance Although the issues on the table in Washington at the start of 2013 are significant, our investment guidance today is much the same as it was at the end of 2012:

Equities:Giventhefundamentallystrongfinancialposition of corporations and the fact that capital expenditures have been inhibited in recent times, we believe there is a strong case for an overweight position in equities.

• Equitiesremainrelativelycheapcomparedtobonds as actions by the Federal Reserve and other central banks worldwide have helped drive bond yields to historically low levels.

• Weseesignsofanascentrecoveryinemergingmarkets, with China (the world’s second-largest economy) showing particular promise for renewed growth.

• Theneartermiscloudedbythecontinuedpartisan gridlock in Washington, and that may temporarily sidetrack equities. Over time, we anticipate that other fundamental factors will again come to the forefront and move markets higher.

Fixed Income: The extremely low interest rate environment continues to make us cautious about the outlook for fixed income investments. We currently prefer an underweight position.

• Whilewemaynotyetbeonthecuspofasustained rebound in interest rates, today’s very low yields in investment grade debt give us little choice but to underweight that category. We are especially cautious about U.S. Treasury securities.

• Werecommend,whenappropriate,hedgedapproaches to fixed income investing. This allows the flexibility to focus on attractive currencies, credits and debt markets, and can help counteract the impact of central bank monetary policies on higher-grade debt.

Real Estate and Commodities: We maintain our standard allocations to both the real estate and commodity sectors.

Situation Analysis

Cliff Notes: The Investment Environment Beyond the Fiscal Cliff

Important disclosures provided on page 6.

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ConclusionThe American Taxpayer Relief Act of 2012 is, at best, a partial solution to the need to attain fiscal balance at the federal level. In the months ahead, more contentious debate is likely to occur that could addtouncertaintyforthemarkets.Mostnotablewill be decisions surrounding the planned sequester spending cuts and the battle surrounding legislation to increase federal debt ceiling limits.

While today’s federal budget battles and long-term debt forecasts are a concern for investors, we anticipate that fundamental economic factors and business conditions will take center stage after the first quarter of 2013. This, along with attractive valuations, should help create favorable opportunities for equity investors. Fixed income markets may face more headwinds given that interest rates remain near historical lows.

Our current investment guidance includes a modest overweight in equities, with a slight underweight position in fixed income. Investors need to be careful not to let short-term headline events overly influence their long-term investment strategies.

IMPORTANT DISCLOSURES

This commentary was prepared on January 15, 2013 and is subject to change at any time based on market or other conditions. This information represents the opinion of U.S. Bank Wealth Management. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or the forecasts will come to pass. It is not intended to be a forecast of future events or guarantee of future results and is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this publication are not affiliates or associated with U.S. Bank in any way.

U.S. Bank and its representatives do not provide tax or legal advice. Each individual’s tax and financial situation is unique. Individuals should consult their tax and/or legal advisor for advice and information concerning their particular situation.

Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes mentioned are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer term debt securities. Investments in lower rated and non rated securities present a greater risk of loss to principal and interest than higher rated securities. Investments in high-yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risks related to renting properties (such as rental defaults). Hedge funds are speculative and involve a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage, and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem units in a hedge fund.

© 2013 U.S. Bancorp (1/13)

Contributed by: Timothy J. LeachChief Investment Officer, U.S. Bank Wealth Management

Situation Analysis

Cliff Notes: The Investment Environment Beyond the Fiscal Cliff Page 6

Situation Analysis

Cliff Notes: The Investment Environment Beyond the Fiscal Cliff Page 6

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