What this means is that there is likely to be even more gridlock in Washington in the coming years. Regardless of whether or not the Republicans take over the majority in the House and Senate, it appears that they will gain some seats. Consequently, Congress will likely be unable to pass meaningful legislation that does not command the ever-elusive and increasingly rare bipartisan support. Thus, when this inconvenient fact is combined with an increasingly less powerful and popular President, chances are the kinds of reforms that the country really needs are not going to pass in the near future.
Now, we are probably not saying anything that most people do not already know. But, what is important are the specific details regarding which issues may remain unaddressed due to the impending logjam in Washington. As such, the purpose of this piece is to outline three specific items that may unfortunately not be resolved and then pontificate on the subsequent effect on investors and markets. The goal is not to offer policy solutions; we will leave that to politicians and those who run macro hedge funds. We also have no interest in blaming either party; we are just interested in the effect of a political stalemate on investors globally. In fact, our main objective is to highlight some of the risks and opportunities for our investors if there is to be a prolonged impasse when it comes to legislation in Congress.
The Bush Tax Cuts
To extend or not to extend? That is the question. The Obama administration wants to extend the cuts to those who make less than $250,000 a year. To that the Republicans contend that any tax increase, even if just for the wealthy, will deter consumption and investment and thus delay economic recovery. But, therein lies the conundrum. What if the Democrats are only willing to vote to extend the tax cuts to some and the Republicans will only accept a full extension of the current rates? In that case no legislation is likely to pass and the tax cuts will just expire on their own. What happens then?
Well, marginal income tax rates will increase, the estate tax will come back in full force, and capital gains tax rates will rise. In other words, investors will be faced with the trifecta of reduced income after taxes, having to re-think or adjust their estate plans and lower profits on successful investments that have yet to be realized. Additionally, if capital gain taxes are going to increase, the stock market may see a significant amount of selling at the end of the year as investors move to lock in the 2010 rates. Clearly, for an economy struggling to find its footing, the impact of an expiration of the Bush tax cuts could be quite destabilizing. As such, while the Bush tax cuts may have increased the government’s deficit problem (since they were not “paid for” by a reduction in government spending), the unfortunate truth is that any tax increase of this scale could derail the recovery and have a detrimental impact on the equity markets.
The Burgeoning Deficit
Of course, the flip side to extending the Bush tax cuts is that government needs revenue to help bring down the deficit. Specifically, the budget deficit for fiscal year 2010, which ended September 30th, came in at an astounding $1.29 trillion3. Therefore, by forgoing the opportunity to increase taxes, the powers that be in Washington are basically guaranteeing that the shortfall will remain at $1 trillion levels. For some, this is necessary given the malaise in the economy. In fact, many of those who believe in the policy prescriptions developed by John Maynard Keynes continue to suggest that even greater government spending is needed to get the economy humming again. However, even the Neo-Keynesians agree on the un-sustainability of the fiscal path the US has embarked upon since the beginning of the financial crisis.
Specifically, an ongoing deficit could impact financial markets down the road. For example, if the politicians in the nation’s capital are unable to agree on and effectuate a credible plan to reduce the deficit, there could be some severe consequences for those who have flocked to fixed income securities over the last year or so. Even though long term Treasury rates remain near historical lows, this situation is not guaranteed to last. If the US’s creditors begin to believe that Washington’s spending has gotten out of control and that inflation is likely as a result, they may start to demand higher rates to compensate them for the risk of accumulating and holding US Treasuries. If this happens, interest rates are likely to rise across the board. That means that mortgage rates, corporate borrowing rates and even rates on consumer credit could increase. Also, as rates rise, investors who bought fixed income securities could see the value of those investments drop. Furthermore, higher interest rates are likely to impact already strained consumers and eat into the profit margins of businesses. As such, it is unlikely that these developments would be seen as positive by stock market investors and the equity markets could see some near term selling pressure.
However, individuals and corporations holding cash or short term fixed income securities could be beneficiaries of an increase in interest rates. Currently, when inflation is factored in, the real yield on most cash accounts is slightly negative. Accordingly, savers are being punished in the low rate environment that persists today, especially retirees who live off of income produced by their savings and investments. But, in a perverse sort of way, if fears regarding the deficit serve to push rates up, millions of people who have limited exposure to the risky assets that have been rising in price and are sitting on cash will be the beneficiaries (at least in the short run).
The recent September unemployment data was rather dismal. The headline unemployment rate remained stubbornly high at 9.6% as the economy shed an estimated 95,000 jobs in September. Even more troubling was the fact that the U-6 unemployment rate, which captures the under-employed as well, jumped to 17.1% in September. Further, 41.7% of unemployed people had been out of work for 27 weeks or more4. As a response to this specific problem, Congress has passed extensions of unemployment benefits a number of times over the last year. However, the votes are becoming more contentious. The most recent bill that passed in July saw support from 272 House members while 152 opposed the bill5. But, even though the final Senate vote was 59-39 in favor of the extension, it took months to pass the bill in the Senate as a result of bickering between the parties regarding how to pay for the benefits6. Accordingly, if the Republicans were to gain seats, there is certainly the risk that future extensions would not be feasible. Regardless of one’s views on the merits of unemployment benefits, the truth remains that as people’s benefits lapse, they are unable to spend, invest or make rental or mortgage payments. Unfortunately, the population at risk includes 2.5 million people so the impact of their reduced income could have a meaningful impact on the economy, especially since the unemployment situation does not look like it is bound to improve anytime soon.
The question Americans must ask themselves is whether the government is doing enough to help stimulate the economy and create jobs? Unemployment benefits are clearly just a temporary solution to what looks like a structural problem within the economy. If it is true that certain financial services, retail, and construction-related jobs are not going to come back for many years, how are we going to reduce the unemployment rate? Infrastructure investment by the government to replace the US’s crumbling roads and bridges has been suggested as an option. Also, clean energy is often cited as a source of many new jobs in the coming years. The problem seems to be that the leaders in Washington cannot figure out how to agree on a way forward. Accordingly, virtually nothing is being done to either spur job creation in the private sector or create government work programs. This is at least partially a function of the gridlock in D.C. that may only become more pronounced if the Republicans win big in early November. But, in addition, there is no denying the fact that the huge number of manufacturing jobs that have been outsourced to lower labor countries has contributed to the current unemployment problem.
The Light at the End of the Tunnel
Given the circumstances cited above, it is hard to see much of a silver lining for equity investors. However, it is times of heightened and seemingly insurmountable uncertainty that provide unique opportunities to make long term investments. Many investors are extrapolating the current economic troubles years into the future. This has caused the stocks of world-class companies with fortress-like balance sheets and durable competitive advantages to trade at prices that imply a perpetual state of turmoil. Accordingly, while many people view the previously discussed problems as intractable, long term investors believe that global economies and markets are very dynamic and adaptable. Therefore, we believe in reversion to the mean and that a strategy of investing with a sufficient margin of safety and a multi-year time horizon is the best way to generate excess returns for our investors. So, while the media and politicians myopically focus on the next few months or weeks, we will continue to build positions in companies that we believe have the ability to excel and prosper in just about any economic environment.