It’s a bit daunting – and
perhaps delusional – to attempt to forecast
the capital markets’ outlook after a year
when asset prices were up so much. But it
is that time again, and that’s what we’re
supposed to do. So here goes.
Our Highlights (and
Lowlights)
· Last
year’s predictions were pretty good, in
contrast to the previous year’s.
· The
recession bottomed in June-July, and the
economy is picking up momentum. Real U.S.
GDP growth in 2010 should approximate +4% -
nice, but tepid, not unlike the recoveries
that typically follow severe, balance sheet
driven recessions.
· Monetary
policy should remain accommodative for some
months and could extend into early next
year. The Fed continues to worry about
deflationary forces, the fragile banking
system and high unemployment levels.
· When
market short term rates are essentially zero
and the yield curve’s steepness is near
record levels, you should own risk assets.
Despite their huge run up, the cyclical bull
markets in equities, spread products and
commodities still have some life.
· Corporate
bond spreads have compressed significantly
over the past year but should continue to
contract to normal levels as the economy
recovers. Total returns will be decent but
nothing like last year’s.
· U.S.
equity valuations have moved into neutral
territory – not particularly compelling or
worrisome.
· Equity
returns should be positive this year and
will likely fall within a range of +5% to
+15%. If it looks like the wide range
reflects some reticence on our part to
predict, you’re right.
· The
spread of equity valuations across the
market has contracted to normal levels.
This suggests that opportunities exist
throughout the universe, rather than in a
few groups or strategies.
· Emerging
markets, after a huge run up in 2009, have
corrected sharply, partially in reaction to
China’s first round of monetary tightening.
We should expect more tightening by emerging
country central banks throughout this year.
However, as an asset class, emerging market
equities should outperform those of the
developed markets in 2010 once again.
· While
the underlying liquidity, economic and
profit trends are favorable for risk assets,
uncertainty remains uncomfortably high.
Global financial imbalances, the inevitable
onset of the removal of stimulus, further
tightening in China, the assault on the
private sector in Washington and the
prospects of massive Federal Government
deficits as far as the eye can see head our
list of concerns.
· The
significant increase in government spending,
which will exceed 24% of GDP this year and is
projected to contract to a still-too-high 23%+,
is well above our long term average of 20.7%.
This, combined with a $2 trillion tax increase
on upper income individuals and corporations,
will shift resources from the highly productive
private sector to a much lower value added
government sector. This alarming migration in
fiscal policy has serious long term implications
for our economic growth, asset values, stature
and national security.
· Last
year we said buy Washington D.C. real estate –
seriously. That’s the locale where employment
is growing the most rapidly. Maybe in our next
life we should return as a D.C. real estate
broker.
Last Year’s Picks
· We
were right that the recession would end;
however, it ended earlier than we thought –
mercifully.
· We
weren’t sure whether equities would enjoy a
meaningful rally in a bear market or begin a new
cyclical bull market. We think it was the
latter.
· We
said reflation plays, i.e. the beneficiaries of
improving global economic activity, should lead
the way. They did.
· We
were correct when we thought that corporate
bonds would produce equity-like returns. A
Barclay’s index of a blend of investment and
speculative grade bonds was up +23%.
· We
thought equities would be up on the year and
possibly, up a lot. And they were up a lot,
bouncing 60%+ off the March 9th lows.
· We
said that the beneficiaries of reflation,
specifically the technology sector, should lead
the way. That worked – semiconductors gained
+92%, semiconductor equipment +76% and
Electronic Manufacturing +81%.
· We
said the equities of stable earnings growers
would lag. They did – Food Retail +5% and
Household Products +12%.
· We
also thought emerging markets would continue to
outperform, and a broad index of those bourses
was up +75%.
· We
were concerned that private sector deleveraging
would limit future earnings growth. We still
are.
· We
were extremely anxious about the explosion in
government spending and the “increasing
probability of the public sector becoming a much
larger factor in our lives and its participation
in overall economic activity. We are most
alarmed at the anti-capitalist vitriol which
seems to be gaining momentum. The history of
those societies which embrace large government
at the expense of the private sector is not
encouraging”. This remains our biggest concern
– by far.
The Economy
The global economy, led by the
developing countries, is solidly in recovery.
China and India are clearly booming but so are
most emerging economies. For example, Thai
industrial production has surged at a 40% annual
rate over the past 11 months while Korea’s is up
35% year over year. Emerging economies account
for 35% of global GDP and 51% on a purchasing
power parity basis.
There’s even some life in the
developed economies. U.S. real exports grew at
an 18% annual rate in the fourth quarter, and
Japanese industrial production is up 31% over
the past year.
The U.S. economy is poised to
grow, albeit from very depressed levels, at a
decent rate in 2010. Typically, economic growth
following severe recessions is strong, ranging
between +5 and +7% over the course of the next
year. This snapback won’t be as strong – more
likely +4% in 2010. This Great Recession is a
classic balance sheet recession driven by
collapsing asset values which have severely
impaired highly leveraged individuals and
entities. Recoveries following financial
recessions are almost always tepid.
Chart I

Source: BCA Research
Most recoveries have been led by
a revival in consumer spending. Not so this
time. As we all know, her debt levels are too
high and net worth too nicked to lead anything.
This recovery, at least in its early stages,
will be driven by the business sector –
inventory replenishment, capital spending and
exports.
Inventories have been cut to the
bone. Inflation adjusted inventories have
declined by -7.5% over the past 7 quarters, the
largest decline – by far – in the post-War
period.
Chart II
Real Inventories Peak-to-Trough
Source: ISI Group
Inventory liquidation slowed
substantially in the fourth quarter and added
+3.4 percentage points to the overall +5.7% gain
in real GDP. We suspect that at least modest
stock building is underway and should contribute
to GDP growth throughout the year.
The corporate sector severely cut
capital spending during this recession to a
level no higher than depreciation. To the best
of our knowledge, that’s only happened one other
time in the post-War period. Spending on
equipment and software – the lifeblood of our
competitive advantage – was drastically
curtailed. In fact, the capital stock in
that category actually fell in 2009. We
doubt that has happened since the Great
Depression.
Chart III

Source: BCA Research
The ratio of Equipment and
Software capital stock to potential GDP has
fallen to the lowest level since the 1970’s.
Firms clearly cut back much more than normal and
are now under-invested.
There is plenty of incentive to
invest in new plant and equipment. The dramatic
drop in capital costs has left them well below
the corporate average return on capital. This
gap is back to record levels.
Chart IV

Source: BCA Research
Auto sales could add
significantly to GDP over the next year or so.
Sales in the last two years have fallen below
the scrappage rate, the first time in history.
So, the stock of cars on the road has actually
fallen. As employment, incomes and net worth
increase, this pent-up demand for autos should
result in a pretty good bump in sales growth.
Chart V

Source: BCA Research
Significant headwinds to the
expansion remain. The fragility of the banking
system persists, the unsold stock of new homes
and vacant properties is daunting, small
business owners continue to be very cautious and
consumers are over-leveraged and must save
more. The current savings rate is 4.8% and is
heading higher over at least the next several
years. We wouldn’t be surprised to see it reach
7-8% as consumers repair their balance sheets.
Chart VI

Source: BCA Research
Monetary Policy
Monetary policy is set to remain
accommodative through most of this year and
possibly into next. The recovery is too young
and not likely to be vigorous, the banking
system is too fragile, consumers too leveraged
and the real estate markets in most parts of the
country are just too sick.
Chart VII

Source: BCA Resource
We feel that those who are
worried that asset markets have or will soon
enter into a new bubble phase are much too
premature with their concerns. Zero cost short
term borrowing rates and the record steepness in
the yield curve strongly suggest that the Fed
is concerned about asset prices – they’re
too low.
Chart VIII
Source: BCA Research
In some ways, monetary policy is
dysfunctional. Despite the massive increase in
banking system reserves, banks aren’t lending.
Consequently, the monetary multiplier
(M-2÷Monetary Base) has collapsed. This has
happened not only in the U.S. but in the other
developed economies as well, resulting in a
significant slowing in money supply growth
rates. Monetary authorities won’t worry about
withdrawing accommodation until the huge pool of
bank reserves gains some traction and the money
multiplier rises.
Chart IX
DEVELOPED ECONOMIES MONEY
US M2, Eurozone M3, Japan M2
GDP Wts. Y/Y % Jan 1.3% e

Source: ISI Group
Domestic Equities
All great bull markets are rooted
in easy monetary policy. And this one is no
exception. At zero short term interest rates
there’s nowhere for the prices of stocks and
other risk assets to go but up. Throw in rock
bottom valuations and the sheer panic of
investors last March, you have the perfect
cocktail for a massive rally. And that’s what
we had. The S&P 500 rose 60+% from its March 9th
low to its January high while the median return
for all stocks was a double. The bull market in
emerging equities, which began earlier, was even
more impressive as many bourses rose between
100% and 200%.
Conditions are largely favorable
for equities. Liquidity remains abundant as Fed
policy is still accommodative, retail investor
cash positions are high, the stress in the
financial system has lessened significantly and
earnings gains are surprisingly good. Only
investor sentiment is elevated (a contrary
indicator), but that seems to be dampening
during the late-January-early-February
correction as we pontificate.
Chart X

Source: BCA Research
Some pundits believe equity
valuations are stretched. We don’t. We like to
look at a number of valuation tools which
contrast their levels versus history, versus
fixed income alternatives, etc. The Bank
Credit Analyst has conveniently done that
for us in Chart XI. As we note, most of the
seven valuation exercises that they show are
pretty much at average historical levels.
Consequently, their aggregate valuation
indicator is squarely on its 50 year average.
Chart XI

Source: BCA Research
We mentioned that individual cash
holdings are still very plentiful. Although the
ratio of cash to the aggregate Wilshire 500
market value has dropped from its March 2009
high – which was entirely due to the huge rally
in stock prices – it is still about 65%, well
above its historical average.
Chart XII

Source: BCA Research
The recovery in profits these
last three quarters has been very impressive to
say the least. Corporate net income is rising
at close to a +35% annual rate and is being
driven almost entirely by unprecedented cost
cutting. Head counts have been chopped
unmercifully, so that productivity is soaring
even with only modest gains in output.
Consequently, unit labor costs have declined
about 3% year-over-year.
Chart XIII

Source: ISI Group
Managements have spread the pain
across their entire cost structure. Amazingly,
aggregate S,G & A expense has declined for
the first time ever. And investors have
rewarded those companies that have been
proactive in slashing S,G & A spending with
above average market performance over the past
year.
Chart XIV

Source: Empirical Research
Investors are rightly concerned
about the vulnerability of the equity market
once the Fed begins its tightening phase. And
that is quite likely to occur sometime over the
next 12-15 months, but definitely towards the
latter part of that timeframe. So how worried
should we be? An examination of the previous 11
tightening cycles in the post-War period
suggests it’s not as bad as one might think. At
least initially. In the first six months
following the onset of the tightening, the
market declined in only two of the 11
occurrences. The range of returns was +19.0% to
(5.0%) with a median gain of 7.4%. The
median increase in the Fed Funds rate covering
all occurrences was +125 basis points.
Chart XV

Source: BCA Research
The long term median P/E for the
S&P 500 on forward earnings is14x. A reasonable
2001 earnings expectation, in our view, is
$80-$85. Fourteen times the midpoint of those
earnings would leave the S&P 500 +8.4% higher
than current levels (1066) by 2010 year end.
Add the dividend yield to that, and the total
return would be +10%. Not bad. It should
handily beat government bonds and moderately out
perform spread products.
Of course the multiple could be
higher—or lower. But, we find it difficult to
argue for much of a multiple premium over that.
By the end of this year, we’ll be that much
closer to Fed tightening, and it’s quite likely
that investors will be increasingly concerned as
the Federal Government deficits mount.
Last March the level of risk
aversion was about as extreme as we’ve seen it.
Credit spreads had exploded, the VIX (a measure
of stock market volatility) was extremely
elevated and the range of equity valuations was
at a record level. Consequently, on March 9th
of last year the prices one had to pay for the
riskiest assets were at rock bottom levels.
Eighteen months earlier there was a big premium
for buying risk, so it was those assets that
were exorbitantly priced and suffered the most,
as many declined (50%)-(90%) in price. All of
that reversed itself in the middle two quarters
of last year. The prices of junk soared while
the returns on quality assets lagged pitifully.
So, the worst performers of 2008 were the best
last year and vice versa. The data below
calculated by The Leuthold Group shows the
perfect monotonic negative correlation of
returns by decile:
Table I
The Upside Down Market

Source: The Leuthold Group
Equity valuation spreads have
compressed from near record levels to near
normal levels today. This suggests that there
are few concentrated sectors – by industry
group, style or strategy – that are deeply
under-or-overvalued. A more level playing field
should reward good bottom-up stockpicking, an
environment which is much more conducive to the
Dalton, Greiner approach to equity management.
Chart XVI

Source: Empirical Research
Valuations are pretty similar
across the capitalization spectrum as well.
Normalized the price/earnings ratio for small
caps is at parity with that of large caps, which
is modestly above its long term average of 86%.
We don’t think this valuation differential is
large enough to make a clear cut case for
favoring either large caps or small caps.
Small cap companies have been
more aggressive than their larger counterparts
in cutting overhead. Consequently, as revenue
growth picks up as the recovery evolves, their
operating leverage will be greater. Although
their valuations are at a premium relative to
history, faster profit growth should offset it.
Chart XVII

Source: The Leuthold Group
Emerging Markets
There is little disagreement
among investors that emerging markets are where
the action will be over the next decade. We
would agree. Economic growth will continue to
be superior in those countries, and their
capital markets will mature significantly. Over
the past five years those countries in secular
bull markets (the BRICs, etc.) share of global
GDP increased 10 percentage points to 46%.
Chart XVIII
Secular Bulls vs. Secular Bears
Source: Ned Davis Research
Reflecting their superior
economic growth and massive accumulation of
foreign reserves, emerging country stock markets
significantly outperformed those of the
developed countries, particularly the U.S. and
U.K., over the past five years.
Table II
Secular Bulls vs. Secular Bears

Source: NDR Research
Foreign exchange reserves,
largely dollar denominated, exploded in the
emerging economies this past decade to $5
trillion and are about twice those of the
developed countries. This reserve accumulation
is a direct result of their very large current
account surpluses while the U.S., U.K. and some
other developed countries are running deficits.
In the absence of major realignment of currency
exchange rates, these surpluses will persist and
the foreign reserves will continue to grow. And
we doubt that there will be any serious
realignment in the relative values of the major
currencies over the next few years.
Chart XIX

Source: ISI Group
There are some potential bumps in
the road for emerging equity markets near term.
In a recent ISI poll, almost 40% of the
participants thought that Asia ex-Japan would be
the best performing regional stock market in
2010, while 25% thought Latin America would be,
which suggests that what we wrote above is no
revelation. Meanwhile, only 18% thought the
U.S. market would lead and only 1% thought
Europe would be the best market to place one’s
bets. So, if you’re a contrarian….
Chart XX
Source: ISI Group
The big run up in the emerging
markets over the past 15 months has eliminated
all of their undervaluation and then some. So,
their stocks are no longer cheap and have become
vulnerable to corrections. And to this point,
those markets have been slammed in the late
January-early-February period as we write.
Chart XXI

Source: BCA Research
We’ve been predicting emerging
market outperformance for a number of years.
And because of their superior economic
performance, that, of course, has been the
case. Now, being long emerging market equities
has become a very crowded and somewhat
over-valued trade. Normally, that would scare
us away. Maybe it should this time. But it’s
not, and we think those markets should be the
best performers – albeit with a much lesser
margin – again this year.
Bonds
The yield on the 10-year Treasury
bond (currently 3.55%) would normally be higher
than it is today. But conditions aren’t
normal. The huge structural imbalances of the
global financial system which have resulted in
the very large accumulation of foreign reserves,
particularly among developing countries, is the
primary culprit. A substantial portion of those
reserves end up in dollar denominated assets –
like U.S. Treasury paper. For the 12 months
ended 9/30/09, foreigners bought almost 50% of
the net issuance of Treasuries which undoubtedly
was a major reason behind the rather benign
behavior of longer maturity interest rates.
There are some other factors at
play which are keeping a lid on government bond
yields. Most importantly, private credit
demands have collapsed. The deleveraging of
both the business and household sectors has
actually resulted in a net liquidation of
privately issued debt. Consequently, the huge
surge in government debt issuance has been more
than countered by the plunge in private debt.
Chart XXII

Source: BCA Research
The real issue for the longer
term maturities markets will surface as private
credit demands revive in the second half of the
year. Unfortunately, the alarmingly huge
issuance of Federal Government debt will persist
and collide with the growing appetite of private
borrowers. The market will only clear at higher
interest rate levels. We expect the 10-year
Treasury rate to reach 4% (or more) by the end
of the year. We’d like to stake out a claim
that this prediction is in the minority. That
would be disingenuous because it’s not. A
recent ISI survey reveals that 80% of their
respondents believe that rates will be at least
4% by year end.
Chart XXIII
80% Survey Respondents
Believe10-yr Yields Will Be Above 4%

Source: ISI Group
Corporate bond returns were
spectacular in 2009 as record high spreads
compressed dramatically. But they’re not quite
back to normal levels, and we believe they will
head there before this year ends. The steady
improvement in the economy will pave the way for
the peaking in corporate default rates, which
should serve as the greatest spread depressant.
Also, investors continue to search for yield as
short term rates are near zero which makes the
corporate bond market inviting. Somewhat
offsetting the further compression of spreads
will be the increase in the 10-year yield.
However, corporate bond returns, while well
below those of 2009, will better Treasury
returns but fall shy of equity gains.
Chart XXIV

Source: ISI Group
Commodities & Currencies
The secular bull market in
commodities is likely to persist until central
bank tightening broadens significantly. But
that probably won’t happen until 2011, and the
U.S. Federal Reserve will be one of the last
banks to remove accommodation. However, higher
commodity prices are very dependent on vigorous
emerging economy growth – particularly China.
The Bank of China, as the world knows, has
recently enacted its first tightening measure
which will surely be followed by others as it
attempts to fine tune a modest reduction in
accommodation. Higher commodity prices will
depend on skillful execution of their monetary
measures to ensure strong economic growth
without overheating.
Chart XXV
The Commodity Secular Bull Market
and U.S. Stock Market Trends

Source: Ned Davis Research
The Chinese have been stockpiling
commodities for some time now. Cheap credit
costs, concern about availability and
speculators have combined to push commodity
inventories to very high levels. Tighter credit
is likely to encourage at least some unwinding
of speculative positions which would put some
pressure on prices.
Chart XXVI

Source: BCA Research
Oil prices, according to Bank
Credit analyst research, are close to Fair value
of $80-85 a barrel. However, if global growth
is decent over the next 12 months and China and
other EM’s keep buying, as we expect, the risks
are on the upside. We think lower oil prices
await widespread global central bank
tightening. And that’s probably a year off.
Chart XXVII

Source: BCA Research
Currency speculators have flocked
to the dollar in recent months as investors have
temporarily moved away from the reflation trade
and become more risk averse. This flight to
perceived safety will not persist in our view.
While there will definitely be some tightening
measures initiated by the emerging market
central banks, our Fed will be slow to abandon
current policies. Moreover, the huge current
and prospective fiscal deficits are never far
from the top of everyone’s list of risks. And
Moody’s recently cautioned investors that if
these deficits persist, the U.S. risks a credit
downgrade on its debt. That would be serious.
We expect the dollar to resume its secular
decline in the coming months, particular against
the Emerging Asian and commodity currencies.
What Else Do We Worry About?
1.
Global Financial Imbalances
The issues surrounding the global
financial imbalances are well known. However,
they persist. And they will continue to
dominate global financial flows until there is a
narrowing between the very high savings rates of
the emerging countries and the low rates of the
developed economies. The U.S. is far and away
the world’s largest debtor as its over-spending
and under-savings have resulted in massive
current account deficits for a number of years.
These deficits are ultimately recycled back into
dollar denominated assets by the surplus
countries. This buying has contributed
significantly to the low interest rate level of
the 10-year Treasury bond, the instrument off
which the world prices its assets. Lower rates
mean higher asset prices for most everything
which in some instances, could lead to the
dreaded – when they burst – bubbles.
Chart XXVIII

Source: BCA Research
World financial leaders
understand the importance of reducing these
imbalances. However, the process will be slow
and painful. Savings rates won’t turn on a
dime. No doubt, the U.S. savings rate will rise
over time as over-leveraged individuals and
corporations address their wobbly balance
sheets. This will naturally slow our overall
growth rate, resulting in all of the unwanted
consequences – persistently high unemployment,
weaker asset markets, lower returns on equity,
etc. But it will help to keep inflation in
check.
Clearly, part of the adjustment
process will be currency realignment. The
currencies of the under-savers must depreciate
against those of surplus countries which will
further impair our relative standard of living.
2.
China
A well known short seller never
misses an opportunity to publicize and bash his
favorite short idea. We heard him recently on
CNBC – as well as several times before – and his
current area of focus is China. His thesis,
which is not without merit, is that China is in
the midst of a gigantic over-investment cycle.
Investment spending in China accounts for about
2/3 of GDP which is huge by any standard. But
China has invested in its public and private
capital for years which has produced very
desirable productivity growth.
Our short seller wouldn’t argue
this point. His concern is that China is now
over-investing and will end up with massive
over capacity of about everything. He likens
the current China investment bubble to that of
1980’s Japan, which ultimately ended in a long
bout of deflation. And, given China’s position
of economic dominance, such a bad ending would
have severe ramifications for the global economy
and markets.
Our friends at the Bank Credit
Analyst recently examined this premise of
Chinese over-investment. Their supposition was
that if there were a troubling investment
bubble, then it would naturally have bloated the
capital-to-output ratio and put downward
pressure on the marginal return on capital.
Such is not the case. In fact, the
capital-to-output ratio has been quite stable
over the past 15 years. And it is about six
times as efficient as that of Japan and three
times that of the U.S.
Chart XXIX

Source: BCA Research
Something that we are
uncomfortable with is the alarming increase in
Chinese bank credit. The +20 percentage point
acceleration in credit has also concerned The
Bank of China as it recently implemented its
first round of tightening by raising bank
reserve requirements.
Chart XXX

Source: BCA Research
Even when one factors in that 1/3
of the increase in bank credit was to facilitate
the government’s stimulus program, it’s still
worrisome. Shanghai real estate prices have
spiked in recent months, and the bears have been
quite vocal about that. However, mainland China
real estate prices are not particularly out of
line with most major urban centers elsewhere.
So, while we remain concerned about the
possibility of bubbles surfacing in China, asset
valuations are far from there now. The Bank of
China must walk a fine line between
accommodating sufficient economic growth and
avoiding fueling inflation (which is OK for now)
and asset bubbles. It could be tricky.
3.
Deficits, Taxes and Other Anti-Growth
Initiatives
“The national budget must be
balanced. The public debt must be reduced; the
arrogance of the authorities must be moderated
and controlled. Payments to foreign governments
must be reduced, if the nation doesn’t want to
go bankrupt. People must again learn to work,
instead of living on public assistance.”
Cicero,
Roman author, orator and politician
106 BC-43BC
“A democracy cannot persist as a
permanent form of government. It can only exist
until the voter’s discover that they can vote
themselves largesse from the public Treasury.
From that moment on, the majority always votes
for the candidate promising the most benefits
from the public treasury with the result that a
democracy always collapses over lousy fiscal
policy, always followed by a dictatorship.”
Alexander Fraser Tytler,
Scottish lawyer and writer, Cycle of
Democracy (1770)
How’s that for some very relevant
wisdom from the history books? Developed
country governments are in the midst of an
unprecedented borrowing binge. Much of the
explosion in borrowing is a result of the
various recession-fighting measures and
automatic stabilizers. But not all of it. In
the U.S., the Obama Administration has
concurrently launched its very ambitious
domestic initiatives agenda which will require
vast amounts of new spending.
Government deficits for the
advanced G20 economies are projected to reach 9%
of their aggregate GDP this year and next. This
contrasts with 1.9% in 2007 and the previous
peak of 5% in 1993. The U.K. and the U.S. are
in the worst shape, followed closely by Japan,
France and Spain.
The numbers in the U.S. are, in a
word, grim. The OMB estimates a Federal deficit
of $1.6 trillion, or 10 ½% of GDP this fiscal
year. While declining, these deficits will
remain alarmingly high throughout the forecast
period. R. Glen Hubbard, the Chairman of the
Council of Economic Advisors during the Bush
Administration, estimated in a recent WSJ
Op-Ed piece that if enacted, these budgets would
reduce GDP by 4% over the next three years and
raise long term interest rates by 100 basis
points.
The increase in the Government
Debt/GDP ratio that is a consequence of all this
spending will create serious problems and
challenges. The OMB estimates that Federal
Debt/GDP will increase by 20 percentage points
from current levels to 73% by 2015. Kenneth
Rogoff, a Harvard economist, says that 80% is
the tipping point. At that level of debt
burden, interest rates soar, asset prices
plunge, the currency collapses and the economy
is in crisis. Horrifying to contemplate.
The good news is that almost
every serious observer knows that this can’t
happen. The question is how to solve it. And
the gap among the proposed solutions is
canyon-like. The Obama Administration has
latched on to a very public populist,
anti-business, anti-capital formation and
anti-high income earners message. Its proposed
tax increases on the above of $1 trillion on
individuals and $375 billion on corporations
will get him his domestic program spending
initiatives and the horrifying deficits.
So to reduce them, there either must be even
more new taxes or significant spending cuts. So
far, we’ve seen no serious, meaningful spending
reduction proposals. It’s reprehensible that
Federal civilian full time employment (mostly in
our Federal Agencies) has risen by +14.5%
over the past two years while the private
sector has lost 8.5 million jobs.
The increase in the Federal
Government’s share of GDP from 21% to 25% is
shifting a huge portion of our economy from the
productive private sector to the government
sector. This shift in resources will create a
significant drag on our economy as Glen Hubbard
noted. Moreover, tax increases are never good.
Penalizing upper income earners, most of whom
own their own businesses, and on the capital
providers will discourage investment and
hiring.
These serious anti-growth
initiatives and their implications are not lost
on investors, entrepreneurs, corporate
executives and consumers. In our view,
this negative impact on
expectations represents the single largest
impediment for our markets, economy and standard
of living.
We’re talking about fiscal
projections which extend 10 years. But to
investors, the problem is now.
This will be a more challenging
year. The markets will be more volatile as
investors struggle with the anticipation of
central bank tightening, deficits, anti-growth
initiatives, sovereign debt problems, the
further deterioration of commercial real estate
prices and the absence of compelling values in
most asset markets. However, the path of least
resistance for most financial asset markets is
up – for now.