In Arthur Laffer’s opinion column, “Tax Hikes and the 2011 Economic Collapse,” which ran in The Wall Street Journal, he feels our economy is in for a double-dip recession. Laffer maintains that with 2011 income tax increases, people will accelerate their income and bonuses to 2010, thereby avoiding the higher income tax brackets. Laffer cites similar occurrences during 1983, when the economy took off after two flat years when people deferred income waiting for Reagan’s Economic Recovery Tax Act to become effective, and in 1992, when people accelerated income to avoid the effects of the anticipated increase in the top rate from 31% to 39.6%.
While it is true that people accelerated near $15 billion in income, Laffer fails to mention that this was 0.18% of our overall economy.
As a businessman, you can report as much profit as possible this year and delay your capital expenditures until 2011, so our feelings are that 2011 will be a good year for corporate spending. However, payroll taxes are not expected to rise for corporations until 2013. Companies will almost always try to time their capital expenditures to lower their taxes. However, not many individuals can do that.
We are concerned about tax increases, which may slow growth. We anticipate growth to be slower in 2011 with lower GDP, corporate profits should be healthy and consumer expenditures should not rise as fast as they have in the past. People may be tapped out; however, corporations should have no problem getting credit. Corporations will likely have credit and cash and three main choices: pay dividends, hire more employees and buy other companies. In our opinion, all three are positive for the economy.
The government has and will likely continue to raise tax rates on income earned from off-shore investments and profits earned in other countries, so we expect to see a repatriation of cash. Companies may receive benefits to invest that cash domestically, which may end up creating jobs.
While we have been expecting higher interest rates, others are much more pessimistic saying our economy is headed for a 1970s-style inflation. We believe what is happening is inflationary, but perhaps not in the near term. This is a rare occurrence where money supply is very high, but the banks are not lending. The minute banks begin to lend, we suspect The Fed will tighten the supply of money and the interest rates will shock you. It also may happen very quickly just like the recession—the economy will be rosy one quarter, and in the next quarter you had no growth. One day the consumer price index will be up at an annual rate of 6%, from 1-2%. If both extremes are right, we are left with stagflation, a condition of slow economic growth and relatively high unemployment accompanied by a rise in prices.
In order to invest through a period of stagflation, investors need to be in a position to avoid long term bonds. Our opinion is to invest in equities. Even though the tax rates are going up, we prefer companies that pay dividends because they have a strong cash flow to maintain growth. They are not as susceptible to a decrease in value as interest rates rise. The stock market might not be red-hot, but in our opinion, it is the best place to be during inflationary times.
When you look at our country’s debt in relation to our Gross Domestic Product, easily you wonder how long it can go on like this. We feel that it is not control of the House or the Senate, but it is the kind of Republican and Democrat that is elected that will matter. Those who want to be in—or to stay in—office should become more fiscally conservative.
We feel there will be a swing to the right. Currently, Speaker of the House Nancy Pelosi (D-Ca.) cannot push any legislation through as there are a number of Democratic votes siding with the Republicans. Likewise Senate Majority Leader Harry Reid (D-Nev.) has some Democrats siding with the Republicans as well.
We do not think the United States will face a future similar to the situations Greece or Great Britain have faced with rioting in the streets. What we think we will see is more individual cities declaring bankruptcy because they are not getting any support from the states. Many cities simply go into a receivership where elected officials are advisers to a business manager who is hired to run the finances. Detroit has not been running their city financially for several years now.
But what happens to municipal bond holders when a city goes into receivership? They wait it out and get paid as muni bond holders are a priority. Very few general obligation (GO) bonds have failed. It takes three years, on average, for a bondholder to be paid if a city were to fail. GO bonds and GO revenue bonds are issued with the belief that a municipality will be able to repay its debt obligation through taxation or revenue from projects. A city will issue GO bonds to pay for water and sewer projects, and those historically have been paid back. Industrial revenue bonds are a bit riskier because a city will float a bond issue to pay for a factory or hospital to build and operate in a town. Those bonds are supported by the revenue of that factory or hospital. If a town goes into receivership, contracts may be broken the factory may leave and the bond may default.
We still stand by our target of 1,300 to 1,330 on the S&P 500 for 2010. While we still have high unemployment, we have earnings momentum with the upcoming earnings season. It is a capital goods recovery, not a consumer recovery, which we still find healthy. The more capital goods we have relative to consumption in the long run, it means growth in the future.
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