This past week, I attended an Investment luncheon to hear Greg Valliere, the chief political strategist with the Stanford Washington Research Group. He had a number of important things to say regarding the economic implications of political decision-making in Washington and of this year’s U.S. presidential election. I agree with most of his analysis and will write the rest of this blog entry from his vantage point. Where I disagree or have a specific point to make, I will preface my comments accordingly.
His three big themes were:
- There has been a dramatic rise in the size of government, especially in regulatory agencies
- Taxes are going to rise — in particular capital gains taxes
- The election in November has big implications on investment strategy
Current Economic Situation
According to Valliere, we have just witnessed one of the biggest increases in the size of government in modern U.S. history. Now, I’m not talking about the increases due to the War on Terror — that’s been going on for nearly seven years now — but rather what’s happening right now. And it’s all because of the subprime crisis.
Basically, the U.S. Federal Reserve simply was caught asleep at the switch and was not aware of how important the subprime sector was and the potential for contagion in other asset markets. Now, we have a full blown crisis on our hands and the Fed has done what it can to contain the damage by lowering interest rates to 2%, by lending to investment banks, by taking on questionable collateral in exchange for rock-solid treasurys, and by bailing out Bear Stearns.
But, now the Fed is done. Interest rates are not going any lower because the Fed is constrained by rising inflation. They are also worried about the Dollar. Their next move — and this won’t be for another 10-11 months at least — will be up. That said, all the risks are to the downside in the economy.
My comment: what I take from these statements is that the Fed wishes it could do more given the downside risks to economic growth. But, it is constrained by the low dollar and rising inflation, especially with prices at the pump where inflation has its most visible and problematic manifestation. That means that, as much as the Fed wishes it could support the economy, it simply cannot and will not. This is not good for stock market investments, especially in cyclical companies. One needs to be as defensive as possible (consumer staples, TIPS, cash).
Valliere called the Fed an “activist Fed.” But felt this was a good thing generally. The Fed generally acted appropriately including its machinations in the JP Morgan- Bear Stearns shotgun wedding. He did not see the Bear Stearns deal as a ‘bailout,’ saying that if you thought it was a bailout, you’d have to ask Bear Stearns investors what they thought (having lost 90% of their money).
Big Government
So, with that as a backdrop, we can get into Valliere’s macro issues. The first example of big government is the housing bailout measures put forth by Chris Dodd. The pure politics of the issue means this bill will not be vetoed. This is the first example of how the subprime crisis is leading to big government.
My comment: The politics of it all means no sane politician would be caught vetoing a bill that gives millions of Americans relief on a key election issue with an election only six months away. George W. Bush may be a lame duck but he’s cares enough not to sacrifice the Republican’s chances in November by vetoing a bill that will aid millions and being seen as hard-hearted. And the tax rebate checks, while a drop in the bucket in terms of the stimulus the U.S. economy needs and likely to have no effect on the economy at $150 billion in a $14 trillion economy, will have a substantial impact on the size of the federal budget deficit. This is another sign that the subprime crisis has ushered in an era of big government.
The biggest change, according to Valliere, is in regulation. There will be a marked increase in Government regulation regardless of who’s in power in 2009. First, U.S. Treasury Secretary Hank Paulson’s regulatory proposal is “dead on arrival.” In this economic environment, much more is desired. Congressman Barney Frank will have the biggest say on this issue and he wants much more regulation and “punishment.”
My comment: This means that the de-regulation era has effectively ended. Big mergers will be eyed suspiciously. The cost of doing business will increase as red tape and regulation increases. All of this is bad for anyone looking to make a boatload of money based on capital gains in a new bull market. I happen to think that the pendulum does need to shift substantially away from de-regulation, but this will certainly mean an end to inflated asset prices in the capital markets.
As far as regulation goes, I predict a ‘super-regulator’ is in the offing a la the Department of Homeland Security (DHS). This bout of big government is going to produce a federal agency akin to DHS because people are going to want to see an all-powerful federal agency formed that can effectively keep the capitalist wolves at bay when they overreach. This is a transformation that I view with some dread because I believe that, while de-regulation had swung way too far, big government is a problem, not a solution.
Valliere finished his big government theme by mentioning the enormous increase in the federal budget deficit for FY 2008. We are going from about $160 billion to $500 billion in ONE year. This is truly remarkable and his testimony to the size of the government increase.
So, that’s Valliere’s theme #1: the subprime crisis workout means big government regardless of who is in power.
Taxes
Theme #2 is taxes. Valliere said that even John McCain will not be able to withstand an invigorated Democratic congress. Bush’s tax cuts are set to expire in 2010. This means that unless some legislation is proposed, voted for by congress, signed by the new President and enacted, all of those tax cuts will expire. This gives the Democrats in general, and Charlie Rangel in particular, a lot of leverage.
First, the Top Rate on ordinary income is definitely going higher. 35% may go to it’s pre-Bush level of 39.6% McCain may have to accept a compromise at 37-38%.
Second, capital gains is a big story. If Obama wins, they are going from the current 15% to the mid-20s. And then you’ve got Dividends, which were taxed at the rate of ordinary income before the Bush tax cut and are now taxed at 15%. That’s a huge difference. Valliere does not see the rate shooting up to 39.6% but it will go up substantially as well.
Interestingly, a subject where Valliere was clear was on these tax changes being retroactive. Even if the new President gets legislation through congress quickly, we’re talking June before a comprehensive new tax bill is signed, sealed and delivered. But, this bill may well be retroactive to January 1, 2009 if it is Barack Obama as President. Retroactive bills have been done before, so this is not a novel idea. Any way you look at it 15% is history.
My comment: I agree that capital gains taxes are going up. First, Obama is on record in the last ABC debate as having said that he would raise the capital gains tax to at least 20% (where it was under Clinton, after he lowered it) if not 28% (where it was when Clinton came to the White House in 1992). McCain will be forced by a Democratic Congress to accept a deal of some sort. Remember, the Democrats have huge leverage here because these cuts are automatically going to lapse in 2010. So, absent new legislation, starting in 2010, the capital gains rate will be 20% and the dividend rate 39.6%.
As for the equity of this, that’s a whole second discussion. I feel it is equitable to somewhat equalize capital gains, ordinary income and dividend tax rates because it gives people fewer opportunities for tax arbitrage. Having widely different rates is discriminatory because it allows individuals who can earn their money through one channel to receive a vastly different effective tax rate than others earning income through different channels. The best equitable solution is a flatter rate structure near 25-30% that is tax neutral. Deficit spending is not something to be proud of, so any tax rate cuts must be accompanied by spending cuts.
The most important implication of these developments is it will mean a selling torrent in November and December as people look to lock in gains. If people expect a capital gains tax increase that is retroactive to January 1, 2009 to go into effect, they will lock in capital gains before that date. This is a guarantee. So, I see Valliere’s assessment as very troubling for the stock market come year end 2008.
Valliere also addressed the Estate Tax as well. He said that the federal government was simply not going to abandon the estate tax. He sees a rate of 35-40% with a high exemption as the likely outcome.
My comment: Estate taxes are not about revenue but equity. Estate taxes are not huge money makers for the Treasury. However, the concept of capital gains being passed between generations leads to fears of consolidating wealth and power and is alien to the American psyche. Americans will not stand for a tax policy without estate taxes on principle alone.
The AMT is a huge tax generator. According to Valliere, it’s worth $900 billion over 10 years. Therefore, given the size of the deficit, he does not see its being abolished anytime soon. More likely, it will be phased out over time.
The third rail of politics is Social Security and Medicare. We fund Social Security through payroll taxes. These taxes are limited to the first $100,000 of income.
My comment: That’s not going to cut it, as the structural generational changes in the U.S. mean that Social Security will be in deficit soon. People are living longer and having fewer children. So that means the country is getting older.
Obama is a brave politician according to Valliere for addressing this issue. With Obama as President, he sees the payroll taxes being assessed on income up to $200,000.
My comment: we have the lowest effective tax rates on individuals in the OECD. Don’t believe anyone who implies that America is overtaxed as Valliere did. A gentlemen of 80+ in the room hit back at Valliere, implying that we get a good deal and he was proud to be an American.
The last tax issue is corporate taxes. They are going down. Even Charlie Rangel wants 31%. McCain wants 25%.
My comment: The UK is suffering a rash of corporate defections because of high corporate tax rates. There is a lot of talk in the British press about companies leaving or threatening to leave the UK as a result. The point being — we are in a global corporate world where companies can choose their base for taxation. There is a solid point in being competitive on corporate tax rates.
Politics
Valliere admits to being partial to Hillary Rodham Clinton. He thought she would be the next President and is on record as having said so in ’07. He felt she would be the strongest President amongst the candidates. However, during his whole speech, he never mentioned her,nly referring to McCain. [I assume he did this because people inside the beltway all believe she has no shot at being nominated.] He chalked up her problems to:
- Bill Clinton, his gaffes and surprisingly poor campaigning skill
- Her positioning as an inevitability nominee
- Internal campaign problems
- Barack Obama’s being “adroit”
- Obama’s winning “a lot of states where nobody lives.”
Valliere said that he imagines someone high within the Democratic apparatus close to Clinton will pull her aside and ask her to quit after the primaries. He mentioned Rahm Emanuel, James Carville and Ed Rendell as the ones most likely to take on this role. He imagines they will tell her it is in her best interest to quit gracefully because she has three jobs to contend for:
- Senate Majority Leader- Harry Reid is unpopular
- Governor of New York. Spitzer and Patterson have not been stellar.
- Nominee for 2012
He believes she will bow out gracefully by mid-June and that everyone will be singing “Cumbaya” at the Democratic Convention come August.
He sees the Democrats scoring significant victories in the Senate. They will get 4-5 seats, maybe 6. But, they will not hit the [filibuster-proof] magic number of 60. In the house, the Republicans are going to have huge problems. States of notable interest are VA, NH, MN, CO, NH, OR, and ME. All of these are at risk. The big problem is Republican retirements.
My comment: Two retirements are especially noteworthy. Former House Speaker Dennis Hastert (R-IL) left early to get a cushy job because he knew what was coming for Republicans in 2008. So he left while the getting was good despite the fact that he left his seat prey to the Democrats, who took it in a special election. The same thing goes for Former House Speaker Tom Delay (R-TX).
Valliere says the Democrats will take at least 12 seats in the house giving them a 50-seat majority.
My comment: This is a big story because it means Democratic control of Congress will be strengthened.
Valliere also sees a lot of headwinds for McCain. But, he thinks you have to respect a man who condemns ethanol subsidies in Iowa and tells Michigan workers jobs are never coming back. His problems are:
- Age
- Temperament
- Health
Temperament: the Democrats will hit him on his ties with Phoenix developers and lobbyists. Both of these issues could cause a McCain volcanic eruption for which he is known [My comment: McCain has been known to drop the F-bomb on even Republican colleagues when hot under the collar].
Health: he has had melanomas 5 different times and you can see that one side of his face has been fully reconstructed. Therefore, his running mate selection is crucial. Mitt Romney has to be on the short list.
Overall, these are not fatal headwinds.
My comment: this seems a fair depiction. I would also say that McCain is vulnerable on his association with Bush policies, one of many reasons Condi Rice is a non-starter as VP. And he is vulnerable as a flip-flopper given his policy stance changes since his last run in 2000. Romney being seen a flip-flopper for tacking hard right as well could present problems with moderates and independent voters.
Biggest McCain problems are:
- The economy may not come back. Valliere believes in a 2nd-half recovery. But, will it be enough, especially on jobs, to rescue McCain? In 1992, Bush I lost because it didn’t come back in time.
- There’s the Bush Ball and Chain. He has the approval ratings of Nixon post-Watergate and Truman during the Korean War. The next elections led to huge change in both cases. Dwight D. Eisenhower, the Columbia University president and former War hero who had never held national office became President after Truman in 1953. In 1976, Jimmy Carter, a peanut farmer, became president.
- History: since FDR. The pattern is 8 and out. People don’t like parties to be in power too long. The only exception is Bush I.
Obama’s problems:
- He has not been fully vetted
- “Harvard Disease”: this is a problem of Harvard turning out smart people who don’t seem to connect because they are seen as arrogant and condescending.
The wildcard is Iran. The U.S., Israel or both could strike before Bush II leaves office. From Israel’s national security point of view, would you rather have the threat of a nuclear enemy who wants to wipe you off the map eliminated during a Bush or an Obama administration?
Investment Themes
- Freddie and Fannie will benefit from an Obama administration.
- Big Pharma loses with Obama because of price controls.
- Alternative energy wins with Obama (although McCain is also lukewarm on ethanol.
- Tax breaks for oil & gas are out with Obama, so that’s a negative for big oil
- Hospital Stocks will rally because of McCain
- Defense: In a contrarian call, Valliere saw McCain as bad for Defense because he is a fiscal hawk with national security credibility. The national security vulnerabilities of Obama may cause him to be more liberal on defense spending.
My comment: all interesting ideas, but not necessarily ones I agree with 100%. I think Fannie and Freddie will fail or be nationalized. And I think McCain is good for defense.
Valliere’s ideas were well-constructed and his logic was internally consistent.