the sequester: stock market implications

what it is

It’s a mandatory package of federal government spending cuts totaling $1.2 trillion (less assumed savings on associated debt interest) in equal installments over nine years beginning in 2013.

50% of the $110 million in spending cuts are to be taken from the military (which, by the way, accounts for a staggering 25% of total government outlays), 50% from everything else.  Social Security, veterans benefits, Medicaid and similar “entitlement” programs are exempt from cuts.  Medicare is not, but reductions, if any, are limited to 2% per year.

where it came from

Negotiations over raising the debt ceiling in 2011 spawned the sequester.  Democrats and Republicans were unable to agree on $1.2 trillion of future budget cuts back then.  So the two sides set up a “supercommitee” with a deadline to iron out differences.  At the same time, Congress passed the sequester, a kind of legislative doomsday device, that would go into effect if no agreement was reached. The idea was that the sequester was so unpalatable to both sides that they would be forced to reach some better outcome.  Of course, they didn’t.

The sequester was supposed to go into effect on January 1st.

Last year’s fiscal cliff talks postponed the start for two months.

This morning President Obama has proposed an as yet unspecified plan for pushing the sequester back further.

stock market effects

In theory–and, in my view, in actual fact–the failure of all sides in Washington to have even the bare bones of a plan to reduce a dangerously large federal deficit means that investors are placing a relatively low PE multiple on the earnings of publicly traded corporations.

The beginning of any fiscal restraint would presumably result in a lower level of near-term results.    And companies dependent on government largess would certainly be hurt.  But the earnings negative would be offset–and probably more than offset–by Wall Street awarding a higher multiple to those profits.  (The market’s reaction would be caused by a combination of relief that Washington was becoming more responsible and that a source of uncertainty had been eliminated.)

Reaction to the upcoming sequester has varied by government body:

–Politico recently reported that the military has been accelerating its spending since the start of the current government fiscal year.  The implication is that the generals and admirals are gaming the system–figuring they’d create a situation where mandated cutbacks would use up such a large amount of their remaining budget that Congress wouldn’t dare to let them happen.

–On the other hand, I’ve been noticing that 4Q12 earnings for government-dependent firms (BMC Software comes to mind) are already being depressed as their federal customers are already cutting orders in anticipation of the sequester being triggered.

what to do

The sequester represents only about 15% of the total fiscal cliff.  So it’s not the dire depressant to domestic economic activity that the cliff as a whole would have been.  And it appears to be turn out that, in true Washington style, the sequester is being pushed farther down the road.  Even if the sequester is triggered, a domestic recession isn’t on the cards.

A significant reduction in government spending this year (and beyond) is inevitable, however.  What I found telling about 4Q12 results is that Wall Street has reacted very negatively to the company announcements that this was already affecting results.

I think we all have to clearly understand, for all the stocks we hold, how much of their profit comes from government sources.  I’d be wary of any that have significant (say, 20% or more) government earnings and that are not already trading at a discount multiple.

the fiscal cliff: why not just raise income tax rates?

There are several arguments–some theoretical, some the fruit of bitter experience–against raising income tax rates beyond a certain level.

To be clear, personally I don’t think they apply in the present argument about how to close the current US annual $1 trillion+ Federal deficit.  After all, the country seemed to run perfectly fine in the 1990s, when rates were higher.   So I don’t see how turning the clock back to the status quo ante can be so bad.  (Following that logic would also imply rolling back the extra healthcare benefits enacted at the same time.)

I suspect that the biggest stumbling block is that patronage politicians know very well how to divide up shares in an ever-expanding economic pie (who wouldn’t?) but are incapable of agreeing on how to apportion mutual sacrifice.  It doesn’t help matters that, in my view, Republicans have an antediluvian economic philosophy and Democrats have none.

Nevertheless, there’s a limit to how high rates can be pushed.

how can higher tax rates be bad?

When rates reach a certain point:

1.  people start to work less.  I had an eccentric uncle (one of my favorites) who quit his brokerage house back-office job (the only position Irish Catholics would be hired for) and supported himself for the rest of his life investing his own portfolio–turning $400 into $1 million+.  Why leave?  …he was so incensed at the income tax he was paying on overtime.  Uncle Harry wasn’t your typical worker.  But if you’re losing, say, 70% of your incremental income to the tax man, what’s the point of doing extra work?

2.  people spend increasing amounts of time on gaming the tax code, diverting economic energy from more productive uses. Behavior can get crazy.  In the UK in the early 1980s, companies were buying suits and renting them to their executives rather than giving pay raises, because the tax on incremental individual income was so high.  If history runs true, the loophole-ridden US tax system would spawn huge amounts of new tax shelters–very profitable for promoters, disastrous for the purchasers.

3.  tax avoidance accelerates.  I was sitting next to the Spanish finance minister at a lunch early in my career.  I naively suggested that his country would have to raise income taxes in order to close a troublesome budget deficit.  The minister looked at me like I had dropped from the moon.  He explained that income tax rates in Spain were already as high as they could go.  Experience showed that pushing them higher resulted in lower tax receipts.  Very many people would begin to hide substantial amounts of their income from official eyes through off-the-books transactions.

4.  people leave the country.  In the US, we can see this behavior on the state level, in the steady migration from high-tax areas like New York, New Jersey or California.  France, which has recently raised the top income tax rate on high earners to 75%, is now seeing the wealthy starting to renounce their French citizenship and move elsewhere in the EU, like the UK or Belgium.

dissecting the fiscal cliff

I’m back home, in the land of electric power and heat, but no internet or TV.  I’m using my phone as a mobile hot spot, but I can’t seem to get a look at the layout of this page.  Sory if the numbers below are hard to see.

Hurricane Sandy humor:

–a runaway Coca-Cola truck knocked down a utility pole on our street on Saturday, splaying live wires all over the place.  Luckily it wasn’t the more important one the big tree knocked down during the storm.  PSEG cleaned up in a matter of hours.

–I called/chatted with Comcast to find out about restoration of internet/TV service.  The two people I spoke with were very nice but said they had no idea.  Both confirmed that Comcast continues to charge customers for service even though there is none.  You have to call them and ask for a refund!!!  Why am I not surprised?

Today’s post:

“Economic Effects of Policies Contributing to Fiscal Tightening in 2013”

On November 8th, the Congressional Budget Office issued an update on its fiscal cliff analysis, titled “Economic Effects…”.  The report makes several points:

1.  “driving over” the fiscal cliff isn’t a good idea

The problem is the domestic economy is still very weak.

The CBO predicts that continuing Washington stalemate would cause a short but sharp recession in the US during the first half of next year.  Growth would resume from the crunch, but from a lower level, in the second half.  But this would be by a small enough amount that real GDP would still end up in the negative column for the full year.

More important, unemployment would spike upward to an estimated 9.1% a year from now, postponing the return to economic normality for the country (meaning reduction in the unemployment rate to 5.5%) until early in the next decade.

2.  the status quo isn’t so hot, either

Continuing the current situation where Washington continually spends more than it takes in will ultimately force interest rates in the US–both for the government and for private borrowers–higher than they would otherwise be.  Maybe a lot higher.  At some point we’ll have a repeat of 1987, when domestic lenders refused to buy any more government debt and the long bond spiked to 10%.  The CBO implies that this is only a remote possibility at present.  But as the debt grows the problem becomes progressively harder to solve.

3.  the long-term solution

(I haven’t seen anyone write about this.)  For the CBO, two moves are important.

–broaden the tax base, don’t raise rates.

–reduce entitlement spending.

4.  in the short term, however…

(short = the next two years)

…postpone part or all of the fiscal cliff elements.  Address the deficit issues in an aggressive way in 2015, when the economy will presumably be healthier and unemployment lower. That way, we have a much better chance to get chronic unemployment under control.  If so, we’re likely to reach full employment in 2018–a time when we can attack the government fiscal mess in a more serious way.

5.  components of the cliff

The numbers are the boosts to real GDP that each would likely provide:

extend expiring income tax provisions for everyone          +1.4%

do so, but omit high-income earners                        +1.3%

extend payroll tax reduction, emergency unemployment benefits             +.7%

eliminate defense spending cuts               +.4%

eliminate non-defense spending cuts          +.4%.

my take

–The CBO analysis doesn’t take anticipatory effects into account.  In other words, it doesn’t address the issue of whether the slowdown in growth we’re now seeing in the US is adjustment in advance to the worst-case (“driving over”) scenario.  If so, the positive economic effects of breaking the logjam in Washington could be greater than the CBO estimates.

We can certainly see effects in the number of M&A deals being done before yearend—DIS/Lucasfilms is a good example.  But there are lots of others.

–Whether income tax rates rise for high-income filers has very little economic significance.  +/- 0.1% in GDP growth amounts to a rounding error.

–From a stock market perspective, the Obama-proposed increase in the tax on dividends is the key possible change that I see.

–Generally, I’m skeptical about arguments that depend on “fairness,” because I think the concept is so perspectival.  In a lot of cases, “fair” equates to just “I get more and you get less.”  Having said that, I think one of the most un-fair things in the tax code is Romney-esque carried interest, whereby high net-worth financiers turn ordinary income into capital gains.  I wonder if that loophole will be closed.