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Brave New Start to the Year

January 8, 2013

by Christian Thwaites

of Sentinel Investments

Well that was fun. Negotiations went to the brink, we had politicians dropping the "F" bomb a few steps from the Oval Office, the Senate described as "sleep deprived octogenarians" by a congressman and an all around feeling that it was better than nothing. Welcome to the American Taxpayer Relief Act, which actually, er…raises taxes for everyone. That's right. No one in 2013 pays less than they paid in 2012. This is our best estimate of the fall out. It's definitely better than what was at risk back in November but it's still a net drag on the economy of around 1.0%.

Budget Item What was at risk ($bn) Hit to GDP What we got ($bn) Hit to GDP
1. Defense & sequester $54 0.3% Delayed TBD
2. New health care taxes $40 0.4% $24 0.1%
3. Tax increases for lower incomes $288 1.4% No change -
4. Tax increases for higher incomes $42 0.1% $42 0.2%
5. Payroll tax $108 0.7% $115 0.7%
Total $532 3.0% $181 1.0%

Source: Congressional Budget Office and various

A few points starting first with the obvious danger that three big issues are postponed a few months into a Part 2. These are i) the sequestration on spending cuts, mostly defense ii) the debt ceiling and iii) continuing resolution to keep the government funded. So everything so far is prelude for another round of acrimony. Second, the restoration of the payroll tax from 4.2% to 6.2% is perhaps the most regressive tax hike imaginable. Everyone pays it, except for some municipalities that have Social Security opt outs, yet only up to $113,000. This clips around $115bn from wages and salaries of $6.8tr so around 1.7%. This will hit after-tax income hard especially as compensation growth is barely 2.0% anyway. The net effect is a big fat zero for ordinary workers in 2013. Third, the drag on the economy is about the same as we've had for the last few years. Remember, despite headlines about out-of-control spending, the government component of GDP has slowed growth by about 0.8% for the last two years and the deficit had decreased 22% in dollar terms and from around 10% to 7% as percent of GDP. The reason the deficit has improved so quickly is because of the rise in income tax receipts, which requires either new jobs or higher pay and is far and away the quickest way to reduce deficits. Personal current tax receipts are 26% above their 2009 lows and still very low by historic standards. Here they are as a percent of GDP over the last 10 years:

Source: Federal Reserve Bank of St. Louis, Economic Research

The new taxes and some job growth should improve the fiscal picture a little and there's no real risk of a slip into recession. Unless of course Part 2 threatens already fragile confidence. There are some other things to like in the deal. TheAMTpatch looks fixed, the income and estate taxes are indexed and made permanent, dividends and cap gains rise modestly but far less than estimates and various favorable treatments of depreciation and leaseholds remain.

The first reaction to the news was a spike in risk assets, especially in US stocks which have held onto their gains of 8% since the November lows. Here's what happened in the three months either side of the big political events in the last few years:

When What SPX[1] return over 3 months
December 2010 Bush tax cuts up for expiry +9%
April 2011 Government spending authority expires +3%
August 2011 Debt Ceiling (-12%)
December 2011 Payroll Taxes up for expiry +8%
December 2012 Cliff +2%

In other words, markets seem to take the political theater in its stride which reminds us of bitter descriptions of No Man's Land in the Great War when writers would describe birds singing overhead, oblivious to the carnage below. If past is any guide, the debt ceiling debate is guaranteed to spook markets and there are already downgrade whispers. So the fears will remain and we are in for more drama.


A large part of the debate is about entitlements. Sometimes it's easier to call them "eligible" benefits because workers have typically paid into Medicare, Medicare, Social Security Disability and Old Age Survivors insurance. These are three of the big five government expenditures (the others are defense and interest) which make up 75% of government spending and count for $1.6tr. These expenditures are getting bigger. Here's the present value of scheduled benefits for people born in the following cohorts and the benefits to tax ratio (i.e. for every dollar paid into the system, how much do I get?):

Cohort Born in PV of benefits Benefits to Tax Ratio
1940s $141,000 0.75
1960s $214,000 0.8
1980s $273,000 1.0
2000s $383,000 1.0

The reason the ratio does not rise above 1.0 is because this measures payable benefits which are less than scheduled benefits and payable benefits can not rise above the hypothecated taxes collected for Social Security unless there's a surplus in the trust funds. The total outlays today are around 5% of GDP and are scheduled to climb to 6% by 2035 at which time the trust funds run out and payments drop back to 5%. A recentCBOreport summarized the whole Social Security dilemma neatly by showing that if payroll taxes increase by 1.9% or benefits are reduced by a similar amount, the problems for Social Security are solved. Completely. Until 2086.

This is why recent debate about changing the inflation measure for benefit payments is important. For now, benefits are indexed to wages but the case has been made to change it to a chain-weighted measure that allows for greater substitution. Here's how the two indexes look:

Source: Federal Reserve Bank of St. Louis, Economic Research

And yes, the Chain-Weighted Inflation is lower than Wage Inflation by about 0.3% a year. So expect a lot of debate on the entitlement structures as we enter the debt ceiling rows…which we think may make the Cliff negotiations look like a walk in the park.

And the real economy?

Progress. Starting with the headline employment numbers which were 155,000 new jobs, down from the revised November number of 161,000 (it had been 146,000). Over the last six months new jobs have summed to 958,000 compared to 877,000 in the first six months of the year for a total of 1.8m during which the labor force grew by 1.5m. So, this is about job growth hovering around the underlying growth in population which has been pretty much the trend since the recovery began three years ago. To some extent it could have been worse. We knew only 10% ofNFIBfirms added workers in November and they were especially pessimistic on the tax negotiations. Larger companies report through theISMsurveys with the manufacturing companies' employment index still showing weakness. Here's the December number with some rebound but way below the 2012 average.

Source: Federal Reserve Bank of St. Louis, Economic Research

Nothing in the economy to change the Fed.

And there was little in the reports to give credence to the overblown fears from last Thursday's release of theFOMCDecember minutes. The paragraph that worried the markets was the one that said "several [members] thought it…appropriate to slow or stop purchases well before the end of 2013." In Fed speak, "several" is more than a "few" and could mean up to five out of twelve voting members. But three things make it unlikely we're heading into any sort of tightening:

  1. The board members changed in 2013 to a generally more dovish group; Evans for Lockhart is quite a trade.
  2. There's nothing in the economic stats yet to suggest that the inflation or unemployment numbers are anywhere near the goals of 2.5% and 6.5%.
  3. The Fed hasn't even started QE4 buying yet; they're at least likely to wait awhile and determine the effects.

The immediate response from markets was to send an already weak bond market to nearly 2% on the GT10 and the dollar to a two month high. A lot of this is the market getting used to the Fed's new language which ties policy to outcomes and uses qualitative language. It's a lot easier for a market to deal with a rate goal put to a date than to a policy predicated on a "substantial" improvement in the labor market. Bottom line, no change to actions.


While the bond market held below 2%, there were a number of technical breakdowns. The prior resistance and support for the 10-year was around 1.55% to 1.89%. The When-Issued 10-year, which is the one setting the price range, rose to an intra day high of 1.98% taking out the recent highs. This means a new range could be more like 1.85% to as much as 2.40% which would be a price swing of around 4 points. This is why it pays to be defensive, nimble and trading in treasuries right now. Any move risks wiping out much of the coupon payments. As a point of comparison the Spanish 10-year printed last week below 5% compared to nearly 7% before the August "whatever it takes" speech. The total return has been around 15% compared to a loss of 1.5% for US GT10s. Such is the speed of change in world bond markets theses days.


Equity returns for the year were around 16%. But it had a low participation rate. We know that $150bn flowed out of equity funds in 2012 and was the fourth year in a row that investors pulled money from stocks. Valuations are quite attractive. Last time the S&P 500 was at the 1500 level in 2000 and 2007, earnings were around $54 and $83. Today they're closer to $100 on a 1460 price. It's been a slog but earnings are there and many companies are in much better shape financially, with lower input and labor costs. We're quite comfortable buying into the more economically sensitive stocks given the clearer, if not stellar, economic horizon.

Bottom Line: Still a moderate overweight to equities and corporates. There's political risk in the market but news out of Europe (bad but worse) and China (better but not great) are a good support.

Sources: Bloomberg, Bureau of Economic Analysis, Bureau of Labor Statistics, Capital Economics, Congressional Budget Office, CRT Ader, Federal Reserve Bank of St. Louis, Federal Reserve Board, FT Alphaville, FT Money Supply, High Frequency Economics, ISM Chicago, J.P. Morgan Market Intelligence, Pantheon MacroEconomic Advisors, TrendMacro, HSBC Global Research, The Economist, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

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