Moving Past the Election

By Charles Webb

There has been no better evidence around here of the importance of this  year's presidential election than the number of phone calls and emails received after the election from worried clients questioning the economic impact of the results. The post-election thousand point drop in the Dow Industrial Average was another good indicator of the market's uncertainty. The two big questions the election has raised, or maybe not put to rest, are about taxes and the deficit, both of which are encapsulated in the drama surrounding the looming fiscal cliff. We've written extensively this year about all of these issues but we think a recap of those points is in order anyway.

The fiscal cliff is the popular shorthand term used to describe the decisions Congress must make come December 31^st regarding the expiration of the Bush era tax cuts and the scheduled spending cuts set to take effect in January. In 2010, Congress kicked the issues down the road by extending those tax cuts through 2012 and postponing any spending cuts until then as well.

The serious questions about spending and taxes were raised in 2010 because of the massive annual deficits which began in 2008 and have since run well in excess of a trillion dollars per year. The weak condition of our economy two years ago gave cover to the politicians in Washington to postpone any hard choices until now.

Two years later, the economy is in better shape than it was but is far from healthy. The most contentious part of the debate revolves around tax increases. We already knew that taxes on investments were going up with the implementation of the new healthcare legislation. Under that, investment income for those making $200,000 and above is going to be subject to Medicare taxes (3.8%). In addition, the president would like to see the tax rate on dividends and capital gains be subject to the ordinary income tax rate for those same individuals. Furthermore, he'd like to see the top ordinary tax rate raised by several percentage points. The combination of these proposals represents a substantial tax hike on investments and capital formation. For the record, we think this is a terrible idea.

We disagree with these proposals for a number of reasons, some philosophical and some economic. However, the primary reason is that we see big tax hikes as having little impact on fixing the deficit but likely adding substantial risk to the economic recovery. As we've noted before, our annual deficits have averaged roughly $1,300 billion ($1.3 trillion) per year for the past 4 years. A lot of that has been blamed on tax receipt shortfalls from the economic meltdown that began in 2008. While that may have been true in 2009, it certainly isn't now.

Year	Tax Receipts	Outlays	(Deficit)
2007	2,568	2,729	(161)
2008	2,524	2,983	(459)
2009	2,105	3,518	(1,413)
2010	2,163	3,456	(1,294)
2011	2,304	3,603	(1,300)
2012 Est	2,468	3,796	(1,327)

 

 

 

The above table shows tax receipts and expenditures in billions of dollars over the past half dozen years. You can clearly see the fall off in tax revenues from 2007 to 2009. You can also see that this year's estimated revenues are within $100 billion of 2007. It's important to note that in 2007, we had the highest level of tax receipts ever. The expenses are clearly the problem and should be the primary focus of the debate. 2012 expenses are projected to be $1,000 billion ($1 trillion) higher than they were back in 2007. It's hard to see how raising taxes will contribute in a meaningful way to put our country's fiscal house in order. The highest projection we've seen of the proposed tax increases is $120 billion. This, by the way, is if all the proposed tax changes were enacted and those tax payers being hit by them made no changes in response. How likely is that? Not very. A more realistic estimate is about $70 billion. That would bring this year's deficit down from $1,327 billion ($1.3 trillion) to $1,257 billion ($1.3 trillion). That doesn't even affect the rounding.

At the risk of beating a dead horse, this is the third time this year that we've presented these statistics. But we feel it's important to keep pressing this point. This problem won't get fixed until it is honestly addressed. The buzz word constantly thrown around in the fiscal cliff debate is "balanced" - meaning a solution will require both tax increases and spending cuts. In our minds, if the solution were to be truly balanced, we'd have to have 10 dollars in spending cuts for every 1 dollar of tax increases. Rest assured that there haven't been any proposals that resemble those figures.

There's a lot of talk about having to make changes to Social Security and Medicare to balance the budget. This is certainly true long-term, but those programs are not responsible for over $1,000 billion ($1 trillion) of additional spending per year since 2007. The budget would be balanced this year if spending was simply reduced to where it was in 2005. That was also at the height of the Iraq war. You have to ask yourself what in the world has changed in seven years that has necessitated an additional $1,200 billion ($1.2 trillion) of spending? Well, for starters we've had cash for clunkers, cash for caulkers, cash for first time home buyers, cash for high-speed rail, cash for solar, cash for wind energy, cash to help buy electric cars, cash to develop electric cars, cash to build the batteries for electric cars, and on and on and on.

Here's a more specific breakdown by category of where our tax dollars go. Ironically, the smallest percentage increase has occurred in pensions, which is Social Security. The next smallest percentage increase was in healthcare, primarily Medicare. From there, it's a who's who of government agencies and programs. The "Other" group sticks out with $200b in spending. Some of the big items in there are: Freddy and Fannie Mae Bailouts 40b, FDIC Insurance - 27b, Farm Support - 26b, TARP - 19b, NASA - 17b, Land Mgt - 12b, Green Energy - 10b, Pollution Ctrl - 10b.

Outlays By Category in Billions of Dollars
	2007	2012	Chg	% Chg
Pensions	628.3	819.7	191.4	30.5%
Healthcare	641.8	846.1	204.3	31.8%
Education	100.8	153.1	52.3	51.9%
Defense	652.6	902.2	249.6	38.2%
Welfare	262.1	451.9	189.8	72.4%
Protection	42.4	62.0	19.6	46.2%
Transportation	72.9	102.6	29.7	40.7%
Gen Govt	19.8	33.6	13.8	69.7%
Other	71.0	199.6	128.6	181.1%
Interest	237.1	224.8	(12.3)	-5.2%
Total	2,728.8	3,795.6	1,066.8	39.1%

 

 

 

 

 

 

One of the more interesting items here, and we think the most noteworthy, is interest. This gives you a pretty good indicator as to how much of a budget buster interest rates will be in the future. As we've stated before, the outstanding debt has risen roughly $6,000b ($6 trillion) between 2007 and 2012. Yet the interest expense has declined. That shows how far interest rates on Treasury bonds have fallen. If rates were currently where they were in 2007, interest expense would be approximately $380b. That's over $150b higher than it is now and would consume more money than all of the proposed tax increases combined.  

In addition, the government has been financing its deficits with short-term debt in order to take advantage of these super low rates. This is not unlike what subprime borrowers did with their homes a few years ago. Just like those borrowers, the government is going to see its interest cost skyrocket when rates head higher and they have to refinance all of those bonds coming due. Every one percentage point increase in interest rates on $16,000b (16 trillion) of debt would add an additional $160b per year of spending. The current yield on a 10 year treasury is almost 3 percentage points below its normal rate. There's only one reason rates are this low - the economy is in poor health. If you think the economy is going to get better, rest assured rates will return to their normal levels.

Earlier this year, I heard the president field a question about how concerned he is about the nation's debt. He replied that it was a concern longer term but in the short run it's not a big deal because rates have been so low. In my mind, that's a little like having a gun fired at you and thinking that it wasn't a problem because in the short run, the bullet's not here yet. It's ironic that our government is behaving exactly the subprime borrowers that got us in this mess in the first place.

Standing on the Edge of the Fiscal Cliff

By:  Lori Eason, CFP(R) With the election less than two months away, emotions are running high among Americans as the two candidates battle for the Oval Office. The stakes are high as our country has been plagued with an ever increasing deficit, unemployment and a struggling economy for several years now. Our country sat back and watched as the Eurozone debt crisis unraveled with many of us fearing that we were next in line if we continued on our current path. In fact, for the past 18 months, the number one risk that worried money managers has been Europe's debt crisis. Until September, that is. In this month's Bank of America Merrill Lynch Fund Manager survey, the looming fiscal cliff in the U.S. took over the number one mega risk spot.    The fiscal cliff is the popular shorthand term used to describe the decisions Congress must make come December regarding the expiration of the Bush tax cuts and the scheduled spending cuts set to take effect in January. In 2010, Congress kicked the issues down the curb by extending the Bush tax cuts through December 2012 and postponing the spending cuts until then as well.    The Bush tax cuts are a series of temporary income tax relief measures enacted by President George W. Bush in 2001 and 2003. They lowered federal income tax rates for everyone, decreased the marriage penalty and increased the child tax credit. These cuts also lowered capital gains and dividend income rates. The estate tax gradually decreased until it reached zero in 2010. Phase-outs on personal exemptions and itemized deductions were eliminated which allowed millions of households to escape the alternative minimum tax. Another tax break set to expire that is not part of the Bush tax cuts is the 2% reduction of the Social Security payroll tax which President Obama enacted in 2011. Without an extension of these tax cuts, it is estimated that the typical middle class family would face an annual tax increase of over $2,000.    The spending cuts referred to are part of the Budget Control Act of 2011 which requires $1.2 trillion in budget cuts over 10 years. These automatic cuts will be split between security and non-security programs and include $500 billion in cuts to the Department of Defense. There will be no cuts to Medicaid and Social Security. The first $109 billion in cuts are set to take effect in January of 2013.    So Congress clearly has 2 choices: extend the tax cuts and delay the spending again or do nothing and see how things play out. With the impending election, the most likely course of action is to postpone the tax increases and spending cuts and thus kick the issues further down the curb. Let's take a deeper look at these options.    If Congress doesn't avert these tax increases and spending cuts, the Congressional Budget Office predicts that the U.S. economy will face a significant recession in 2013. The CBO estimates that the policies set to go into effect would result in a 1.3% contraction in the first half of 2013 (which meets the definition of a recession) and a 2.3% expansion in the second half. The estimated growth in real GDP for the year would be .5%. The CBO warns that as a consequence of the spending cuts, the unemployment rate is projected to rise from 8% to 9.1% by the end of 2013. Keep in mind that these figures are projections from one group and should not be taken as facts.    If you have read our past memos, you know that the United States' spending problem is one of our hot buttons and in our opinion, the number one reason our country is in such bad shape. At the end of September 2008, our total outstanding debt was $10,000 billion (I'm going to phrase this in billions because the word "trillion" seems to have lost its meaning lately). As of last month, the total outstanding debt number is now $16,000 billion. That is an increase of 60% in just 4 years! And what has all that spending done for us? Given such a dramatic increase in such a short period of time, surely our government can find some way to shave $109 billion off of next year's budget without bringing on a recession. To put it in perspective, the total outlay for this year is projected to be $3,796 billion.    Now let's shift our focus from the spending side to the tax revenue side. Allowing the tax cuts to expire would raise taxes by $316 billion on more than 100 million Americans. Maybe a better term is not fiscal cliff but taxmageddon. There's no way that this economy could digest a tax increase of that magnitude. The White House has called for a mixed deficit reduction plan which includes the extension of all the Bush tax cuts for all families who make less than $250,000/year as well as some spending cuts. Republicans disagree with the $250k income cap and argue that would be a tax hike on small business owners. Romney has proposed extending all Bush tax cuts and postponing all spending cuts until he get in office (if elected) at which point he would construct his own deficit reduction plan.    Here's our take on the tax situation. If Congress were to let the tax cuts expire for those who make over $250,000, the CBO estimates the additional tax revenue in 2013 would be around $42 billion. When facing the decision of whether to raise taxes, the cost-benefit analysis should certainly be considered. Ernst & Young predicts that tax increases on the affluent would cost around 710,000 jobs and cut wages. Raising taxes on the wealthy causes them to redistribute their capital and use it in ways that are not as beneficial to the economy in an effort to shelter those monies from taxes. The risk of higher unemployment and lower taxable incomes hardly seems worth the benefit of only reducing the current year's deficit by less than 4% ($42b/$1,130b). No amount of tax increase on the rich could ever get us out of our debt crisis. We have to get to the root of the problem which is overspending. Our government has proven time and time again that access to more revenue and credit only feeds its spending addiction.    Despite the fact that several members from both parties have said Democrats and Republicans will have to compromise to reach a deal after the election, no leaders from either party have shown any willingness to do so. And there is definitely a cost to indecision which will likely affect the economy before 2013 begins. Households and business will most likely begin to change their spending habits in anticipation of the changes, which could reduce GDP by .5% by the end of 2012 according to the CBO. One lesson to be learned over the last few years is that Americans do not respond to temporary fixes. All of these stimulus attempts over the last several years (from the random tax rebate checks we all received back in 2008 to First Time Home Buyer and Making Work Pay credits) have done nothing but delay the inevitable and add to our outstanding debt. We cannot spend our way out of this mess!    The bottom line is that with either choice, the U.S. will still be in a precarious economic situation for the foreseeable future. Our spending problem is going to take years to fix, but we have to start somewhere.  The election results in November will tell us a lot about this country and the direction it is headed.

*All projections came from either the Congressional Budget Office or Treasury Direct.

Managing for the Total Return

It seems hard to believe that we are only a few months away from the fifth anniversary of the market collapse that marked the beginning of the economic malaise we still find ourselves in today.  The stock market as measured by the Dow Jones Industrial Average reached its peak of 14,165 back in early October 2007.  The following year and a half saw that average fall more than half and bottom out just above 6,500.  Since then, stocks have thankfully recovered much of those losses but are still roughly down 11% from the 2007 levels. 

It’s anyone’s guess when the stock market will have fully recovered, but we think that will likely happen sometime next year.  That implies that stock investors will have seen zero price appreciation in over five years.  That’s a long time.  It’s especially a long time if you’re retired and depending on some amount of appreciation to supplement your income.  In addition, this will have been the second time in less than a decade that stocks have experienced a 50% decline. 

When the tech bubble burst in 2000, stocks sold off for the following three years and then fully recovered (except the NASDAQ index) over the next two.  This means that any of the cumulative gains over the past dozen years have occurred in barely two years.  This has been a real problem for savers and has discouraged many people from investing in stocks at all.  This is understandable because if you spread those couple of years’ gains over twelve years, the per-year return doesn’t look so good.  In fact, it’s pretty lousy. 

Modern portfolio theory has constantly preached that the best real returns are to be had in the stock market over the long term.  The problem is that there isn’t a definition as to how long the long-term is.  Here lies the problem for anyone making regular withdrawals from their savings. 

As many of you have heard me say, the only time you care about what something is worth is the day you bought it and the day you sold it.  From this perspective, cash flow planning is where investment management and financial planning come together.  Successfully done, a good retirement plan will: 1. Provide a relatively steady income stream independent of the market 2. Allow you to adjust your income for inflation (maintain your purchasing power) 3. Do this for a lifetime.  These goals can only be achieved through a total return perspective - i.e. a combination of cash income and share price appreciation.  

In today’s interest rate environment, this is becoming increasingly difficult to achieve because of the Federal Reserve’s monetary policy.  The Federal Reserve has pushed down short-term rates to all-time lows in response to the financial crisis and ensuing recession.  Even before the crisis, the Fed had set rates extremely low.  Many believe (us included) that the years of easy money policy have been a big contributor to the debt meltdown in the housing market and on Wall Street.  Now, in addition to holding down short-term rates, the Fed has embarked on “Operation Twist” which is a program to manipulate the long end for the interest rate curve too.  These policy goals are achieved through the Fed’s open market activities.  This is where the Fed actively buys and sells its own bonds and a select few other issues to influence the process in the secondary market.  Price changes in turn affect the yield. 

In the Fed’s defense, their actions are largely driven by the federal government’s atrocious fiscal policies and global economic condition.  The huge annual deficits and a lack of any long term tax policy has put the Federal Reserve in a difficult predicament of having to print money via quantitative easing and eroding the value of the dollar.  All the while they are risking the inflationary impact which undermines their price stability mandate.  Inflation has thus far been tame but only because of the crisis in Europe.  It’s only a matter of time before expanding the money supply will lead to higher prices.

Investors have now been put into a position where their traditional reinvestment opportunities are yielding less and less.  Every time a bond matures or a security gets called, investors are faced with lower and lower income prospects.  These policies have created a perverse situation where the most financially responsible individuals in the economy (savers) are being punished to benefit (bailout) the least financially responsible (debtors).  It’s a bad deal all the way around, but one we’re going to be faced with for a while.

As investment managers, we’re often asked by our clients what can be done about this.  It’s challenging to say the least.  The lack of stock market returns and increased volatility has led us to focus on current income over the last few years.  We’ve had a lot of success as evidenced by that fact that most of our client accounts have moved past their 2007 values.  We have accomplished this by focusing on mortgage related investments and bank preferred stocks.  However, as the mortgages continue to payoff and the preferred stocks are getting called, we have had to expand our universe of what we consider fixed income investments.

For now, that means taking on more risk in the effort to replace this income.   We accomplish this is by looking to use a greater amount of alternative investments such as master limited partnerships (MLP), real estate investment trusts, bank loan funds, high yield bonds, corporate bonds, and dividend stocks.  While each of these have their own set of nuances and challenges, they share the ability to potentially generate better levels of cash flow than can be produced by more mainstream bond-like investments.  Here’s an example of two of these:

Master Limited Partnerships (MLPs) - An example would be the ALPS Alerian MLP.  This exchange traded fund is the largest MLP ETF in the market with assets of $3.2 billion.  MLPs are a type of publicly traded limited partnership.  As a limited partner, a person provides capital, and in return, receives a periodic pay out from the company’s revenue.  These MLP ETFs typically track the performance of natural gas and crude oil pipeline operators.   We have chosen to begin adding this asset class because while the yield is excellent (currently 6.25%), it also offers us diversification in properties that tend to move independently of other asset classes such as stocks, bonds and commodities.

Bank Loan funds - An example of one we own is PPR (ING prime rate trust).  This exchange traded fund invests in senior loans that are typically issued by lower investment grade companies.  We typically own this asset class because it pays a healthy dividend (currently paying + 7%) and offers a floating interest rate.  This helps us two ways:  we make income now and have the potential to make more once interest rise in the future.

The only downside to these alternative investments is that they come with more short-term share price volatility than the traditional bond portfolio.  But we’re comfortable with this as long as we’re afforded the time to ride out those price fluctuations.  This is a similar strategy that we’ve used with several of the equity positions that we hold.  The international sector, for example, has been quite volatile in the past twelve months. It would have been nice to have avoided those price swings, but doing so would have meant guessing on timing those trades and giving up on an almost 4% income stream. 

We believe a total return perspective pays off.  A portfolio’s total return is the combination of both income and capital appreciation.  The two work together but in very different ways and over very different time horizons.  Don’t focus on one or the other but instead look at the cash flows over the short-term and the capital appreciation over the long-term. 

Obamacare Lives Another Day

Unless you spent the day adrift at sea, I'm sure you have heard that the Supreme Court upheld President Obama's health care reform bill. Even though the day was filled with plenty of news and analysis about this decision, we thought we'd chime in with ours too.

While there were several parts of the law that were under review by the Supreme Court, the most controversial part surrounded the individual mandate. Just to refresh your memory, here's a quick recap on the individual mandate. The Patient Protection and Affordable Care Act was signed in 2010 and imposes a health insurance mandate set to take effect in 2014. This mandate requires all individuals who can afford health insurance to purchase a comprehensive policy that meets minimum coverage requirements. Traditionally, many healthy (and usually young) Americans have opted to carry no insurance or high deductible insurance (catastrophic policies) in the past. This was obviously a financial decision because those people felt they could pay out of pocket for the minor things and either didn't think something bad would happen or had insurance to cover the really expensive healthcare. Those choices are no longer legal. The law states that individuals who can afford health insurance (defined as those above the poverty line for whom the minimum policy will not cost more than 8% of their monthly income) must purchase minimum coverage. Those who can't afford it will be provided that insurance, paid in part or entirely by the Federal government.

From day one, this act has been very controversial with the biggest question being whether or not the act violates the Constitution by requiring everyone to purchase something in the private sector. The authors of this law depended on the Commerce Clause in the Constitution to legitimize this requirement. The clause states that the U.S. Congress has the power "To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes." Opponents of the mandate claim that the decision not to do something (i.e. not buy health insurance) is economic inactivity and therefore not a behavior the federal government can regulate. Supporters of the mandate argue that the decision not to purchase health insurance has an economic impact and therefore can be regulated.

While yesterday a divided Supreme Court did uphold the constitutionality of the individual mandate, they also made a very important clarification. The court concluded the "penalty" for not purchasing insurance is in fact a tax. As a tax, the mandate is allowable under Congress' taxing authority. This is something that supporters had blatantly refused to admit. In an interview with George Stephanopoulos back in 2009, when asked if he rejects that the individual mandate is a tax increase, President Obama's response was "I absolutely reject that notion." Never mind the fact that the penalty is based on your taxable income and collected by the IRS.   As the saying goes, if it looks like a duck, swims like a duck and quacks like a duck, it's probably a duck.

Because this debate has centered on the healthcare law, most of the news and analysis has been focused on upholding the individual mandate. However, I think the real story here is that this is the first time that the court has established a boundary to the Commerce Clause which has been one of the most congressionally abused sections of the Constitution. For decades, Congress has used the Commerce Clause to justify all means of regulation. They have said that their power to regulate is given due to the fact that whatever they were trying to regulate had an economic impact and thus fell under the Commerce Clause. Economic impacts are unavoidable. Every day that you get out of bed you create some economic impact, no matter how small. When you turn on a light switch, you've just purchased electricity. When you brush your teeth, you've just purchased water and toothpaste. You have to eat and so on. So you can see that taken to the extreme, there is no end. This decision has at least recognized a limit. Chief Justice Roberts writes that construing the Commerce Clause as the Obama Administration argued "would open a new and potentially vast domain to congressional authority. . . . The Framers gave Congress the power to regulate commerce, not to compel it, and for over 200 years both our decisions and Congress's actions have reflected this understanding."

Taxing people for not doing something is an interesting concept, however, and I think this is going to open up a whole other can of worms. According to Chief Justice Roberts, the penalty is merely a tax on not owning health insurance, no different from "buying gasoline or earning income," and it thus complies with the Constitution. This is a large loophole though. The result is that Washington has unlimited power to impose new purchase mandates and the courts will find them constitutional if Congress calls them taxes, or even if it calls them something else and judges call them taxes.

The more immediate impact of the Supreme Court decision is that, barring a political party change, the Affordable Care Act will continue to move forward. This, honestly, worries us. Anyone who has read what we've written in the past couple of years knows that we view the explosion in deficit spending and borrowing as the single biggest threat to this country's prosperity and our client's long-term retirement. The ironically named Affordable Care Act will do nothing to make healthcare more affordable. More specifically, it won't bring down the cost of healthcare. It will make it more affordable to those who will receive free or subsidized insurance, but the rest of us will continue to see our premiums rise. Those changes will occur at the payer level (insurance companies) but not at the provider level (doctors and hospitals).

I'm certain that the real goal of this whole process was to expand healthcare services to as many people as possible and had little or nothing to do with controlling the cost. There's probably no better evidence than the fact that the law will impose a new 2.3% sales tax on medical equipment. Why would you raise the price of something that you're trying to control the cost of? Obviously this is to help pay for the real goal of expanding coverage.

The government is now going to start picking up the tab in part or in total for approximately an additional 16 million people. This is going to be very expensive. While all the additional taxes (everything from medical devices to tanning salons) will help offset some of these costs, they will in no way come close to covering them. There is no way of estimating the cost of this new entitlement or how much those costs will change over time, but there are a couple examples - Medicaid and Medicare. These two examples are not pretty. Both are the single biggest budget busters at the state and federal level. Many of the new insurance recipients will be placed into the Medicaid program which means the government will be directly paying for their healthcare. The others will have most or some of their premiums paid by the government. Very few of the current uninsured will pay their entire premiums.

The total amount spent in the U.S. on health care as a percent of GDP is 17.4%, which is higher than any other nation. Medicare spending accounts for 3.7% of GDP and this number is increasing at an alarming rate. A recent CBO study estimated that Medicare will cost $1 trillion annually and be bankrupt by 2022. Meanwhile states are desperate to get their budgets in balance but Medicaid spending has nearly doubled over the last decade. On top of already skyrocketing costs, the Affordable Care Act seeks to expand Medicaid eligibility from those with income up to 100% of the poverty level to those with income up to 133% of the poverty level. However the Supreme Court just ruled that participation in the expanded Medicaid program must be voluntary and several state governments have declared they will not participate. The bottom line is without drastic changes in healthcare costs, both Medicare and Medicaid are simply unsustainable and will cripple our economic growth. For a country that is running 1.2 trillion dollar deficits and borrows 40 cents of every dollar it currently spends, this does not portend well.

In conclusion, I think most would agree that providing healthcare access to as many as possible is an admirable goal. There are aspects of this law which many will benefit from. My personal belief is that because, as a society, we won't let people just die on the street but instead will take care of them, as a member of that society everyone should be required to contribute towards that care in the form of carrying insurance. Bankrupting the country in pursuit of this is not going to help anybody.