Wednesday, December 8, 2010

Take That, Fiscal Commission!

   On February 18th, 2010, President Obama signed an executive order creating the bipartisan National Commission on Fiscal Responsibility and Reform. The group of 18 was allotted eight months to derive a plan for reigning in budget deficits and restoring America to a sound fiscal path for the future. Last week, the Commission's final report was published and is well worth reading. With every option on the table, the final report details a number of politically challenging, thoughtful and creative ideas. Although many members were unable to agree on specifics within the plan, the basic conclusion was unanimous and well depicted by the following excerpt from the preamble. "As members of the National Commission on Fiscal Responsibility and Reform, we spent the past eight months studying the same cold, hard facts. Together, we have reached these unavoidable conclusions: The problem is real. The solution will be painful. There is no easy way out. Everything must be on the table. And Washington must lead."

   Only a week after the report's release, President Obama and the rest of Congress are sending a loud and clear message back..."who cares!" This week President Obama announced a compromise with the Republican Party on the extension of tax cuts otherwise ending in a few weeks. Not only does this compromise extend the entirety of Bush and Obama tax cuts for two years, but the plan adds new tax cuts such as reduction of the payroll tax. Social Security was previously expected to deplete all funds in 2037, but new revenue cuts are likely to be pull that end date forward. A few extra tax cuts alone would not have undermined the fiscal commission, but the compromise does not stop there. On top of tax cuts, extended unemployment insurance will be continued for another 13 months. In direct opposition to the fiscal commission's report, the forthcoming tax bill will reduce revenues and raise expenditures without any plan for future deficit reduction. On the whole, the tax compromise is likely to add upwards of $1 trillion to the deficit over the next two years.

   With tax rate questions now practically answered (the bill could fail, inflicting serious negative consequences), the likely economic effects can be analyzed. Looking at the positive aspects, lower taxes should boost short-term GDP growth and extending unemployment insurance will prevent millions of Americans from falling short on bill and mortgage payments. It's also conceivable that increased spending spurs further spending, resulting in rapid economic growth and shrinking unemployment. Although possible, the Bush tax cuts of 2001 and 2003 fail to offer much substantive truth behind this notion. Make no mistake, letting the tax cuts expire for 98 percent of Americans would have likely have had terrible consequences for the economy and equity markets. Despite this view, numerous questions remain regarding the efficacy and effects of the tax compromise.
 
   Let's start with the basics, expectations for GDP growth. Many economists and equity market strategists have been quick to raise 2011 GDP growth expectations in light of lower tax rates. Most have added between 0.5% and 1% to expectations, however a Citigroup report now projects 4.5-5% growth for the coming year. However, the extension of tax cuts should not be mistaken for actual tax cuts. Unless the majority of Americans had truly expected their tax rates to rise at the end of this year (despite Congressional agreement on maintaining tax cuts for the bottom 98%), expectations will not be changed by this bill and therefore action is unlikely to alter greatly either. Further, current tax rates are only guaranteed through 2012 which still leaves businesses with tax uncertainty for large capital projects. Although failing to maintain current rates for most Americans may have thrown the economy back into recession, it remains unclear how much extra growth will be generated by holding them constant.

   Next we'll consider the further extension of unemployment benefits. These benefits will almost certainly be used for consumption and therefore provide added stimulus to the economy. However, quietly ignored by this compromise was any extension of benefits for 99ers, those Americans who already exhausted current weekly maximums for unemployment benefits. A couple million Americans currently hold this designation and the President's Council of Economic Advisors recently calculated another 4 million may stop receiving benefits next year. Having several million people out of work without any benefits is likely to be a drag on the economy.

   Finally, tax rates benefiting the wealthy were seemingly the biggest compromise made by President Obama. The main benefits to highest income groups include holding tax rates at current levels for income, capital gains and dividends, as well as setting the estate tax at 35% with a $5 million individual exemption. In his speech, President Obama made his disapproval of these measures extremely clear. What's been most intriguing in the argument to raise taxes on the wealthy, is how directly its premise opposes Federal Reserve Chairman Ben Bernanke's premise behind QEII. President Obama and Democrats (correctly) argue that providing extra income to the wealthiest few percent of the population leads to a minimal increase in spending and more saving. To the contrary, Chairman Bernanke has suggested that quantitative easing will support asset prices and resulting capital gains will drive increased spending. With nearly 85% of stocks being held by the top 15% of the population, its clear the burden of rising expenditures falls on the wealthy. Extensive research has been done on the wealth effect and much of it supports only a minimal impact on consumption. Unfortunately President Obama has been forced to the opposing side, for which the likely outcome is continuation of widening disparities in the general population.

   So what's the take away from this news with regards to investing? In response to the tax compromise, bonds have sold off sharply reflecting some combination of perceived higher GDP growth, inflation, deficits and debt. Treasury maturities between five and ten years have witnessed yields rise nearly 1% in the past six weeks, breaking significant technical strength. On November 4th, in Fighting the Fed, I recommended shorting Treasuries through use of a couple ETFs, PST and TBT. Since then, each security is up over 11% and further upside seems limited. At this point I'd recommend selling out of those positions and have done so personally, reducing my position by approximately 90%. Rising yields have already impacted other markets as yields now offer a more reasonable alternative to stocks and rising mortgage rates are pressuring an already weak housing market. If Treasury yields rise further, to 5% on 30-year maturities, it may become prudent to reverse course and go long bonds.

   As yields and the dollar rose recently the stock market has managed to hold onto yearly gains. Previous columns have outlined the extreme optimism that currently persists within the market. Several headwinds linger  preventing a sustainable economic recovery from taking hold and limiting corporate earnings growth going forward. Expectations for S&P 500 earnings growth have already come down significantly for next year to about 10%. Based on these views, the stock market remains slightly overvalued at this juncture. My recommendation is therefore to raise some cash and wait for a better opportunity to enter select stocks, ideally with strong dividends.

Disclosure: Long Proshares Ultrashort 7-10 year Treasury (PST) and Proshares Ultrashort 20+ year Treasury (TBT).

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