President Obama signed the bill last week to extend the Bush tax rates for another two years. About the only people pleased by that fact were the Congress critters who voted for the extension and the occupants of the top tax bracket who were spared the inconvenience of meeting with their tax attorneys and CPAs to find a way to avoid the tax increase. President Obama surely wasn’t happy about breaking a campaign promise and there was a bi-partisan minority that opposed the bill, albeit for radically different reasons. Some Democrats opposed the bill because they blame lower taxes and less government for everything and some Republicans opposed the bill because two years wasn’t permanent and the extension raised the deficit. The Republicans didn’t explain how making the rates permanent would reduce the deficit but luckily for them, intellectual consistency isn’t a pre-requisite for public office. To be fair, the Democrats didn’t explain how increasing the demand for tax shelters would help the economy either.
Markets barely reacted to the signing and that means that either it was so widely expected that it was already discounted or that – and this seems a more likely explanation – it was a non event from an economic perspective. Markets have rallied strongly over the last couple of months but it is quite a stretch to believe it was in anticipation of this. I actually think the more important bill was the one that didn’t pass last week. The pork filled omnibus budget bill for 2011 went down in flames last week as Republicans found out that voters weren’t kidding about wanting to get rid of earmarks. Mitch McConnell, having failed to round up the usual suspects to vote for the porkfest, sounded like Captain Renault in Casablanca last week as he expressed shock that somehow earmarks for his home state had managed to find their way into the bill. Shocked, shocked he was.
Economic policy is however improving at the margin and both bills are responsible to some degree. Passing a tax bill that does nothing to help the deficit while rejecting a spending bill that also wouldn’t help may not seem consistent but it does send a message. The deficit problem isn’t that we aren’t taxed enough but rather that politicians, like most people spending OPM (other people’s money), can’t control their spending urges. I would also point out that the Republicans’ new found fiscal sobriety on spending came after considerable howling from the grass roots about the tax bill. Extending the Bush tax rates for the upper brackets was not supported by a majority of voters in either party. Voters are serious about getting a handle on the budget problems and politicians who ignore them should just start polishing up the old curriculum vitae now.
But this is merely a beginning on a road to better policy and if there isn’t follow through next year I suspect markets will react negatively to that development. For now, gold has dropped a bit while stocks and bond yields have risen. Those are potentially positive signs but more positive changes in policy are needed to extend those trends. Positive changes in economic policy have the potential to shift capital from unproductive safe havens to more productive activities. Gold is the canary in the coal mine and even the anticipation of better policy could lure capital out of gold. The value of the dollar – and therefore gold – is affected by changes in demand as well as supply. Positive changes in fiscal policy would ease some of the fears about the effects of Fed policy on the value of the dollar and allow capital currently parked in gold to be reallocated. So as President Obama and Congress start to talk seriously about tax reform next year, keep an eye on gold and you’ll know when the discussion is heading in a positive direction. By the way, being a cynic and a keen observer of the gold market, I think investors may have gotten a little over exuberant about the possibilities of reform and better economic performance. The gold market is not yet confirming their optimism.
Those are long term concerns though and in the short term the economic statistics continue to improve if only modestly. Retail sales in November rose 0.8% which was even better than what I expected from watching the Goldman and Redbook weekly reports. Ex-autos and gasoline, sales were up 0.8% so this wasn’t a jump primarily about higher gas prices. Of course, inflation may have had some impact but this looks mostly like higher volumes. The business inventory report would seem to confirm that view. Inventories rose 0.7% but sales were up 1.4% so the inventory to sales ratio actually ticked down a notch to 1.27.
Speaking of inflation, both the PPI and CPI reports this week continued to point to a potential margin squeeze. Producer prices are rising much more rapidly than consumer prices, up 0.8% and 0.1% respectively for November. Intermediate and crude goods prices are rising even more rapidly. If producers can’t pass along higher prices something has to give. It will be either margins and lower corporate profits or higher productivity and fewer workers. Neither would seem positive for stock prices.
The news on the housing market was mixed. Mortgage applications fell 2.3% last week but the purchase index was down 5% as higher mortgage rates (thank you QE II) seem to be having an effect. Housing starts were up 3.9% to an annual rate of 555K while permits fell 4% to a 530K annual rate. At best, housing can be described as bumping along the bottom; at worst it may be headed for another dip. Either way, it doesn’t look likely to be adding much to economic growth anytime soon. I hope I’m wrong about that.
On the goods producing side of the economy there were three pretty positive reports last week. The Empire State manufacturing survey and the Philly Fed version were both better than expected. Both showed gains in the general business conditions but the Philly version was more positive on the details with both new orders and backlogs rising. Employment growth was weak but the workweek was extended; remember what I just said about rising producer prices meaning either lower profits or higher productivity? The one major negative in both reports was exactly the price pressures seen in the PPI. Industrial production though confirmed both these surveys, rising 0.4%.
Jobless claims fell slightly on the week to 420K but remain above the levels associated with robust employment gains. Nevertheless, claims have been falling pretty steadily and that fed into the leading indicators which were up 1.1% and points to better growth in the new year. Another major plus was the steepening yield curve which has only gotten steeper since this report. QE II is largely responsible for that so to the extent that our economy is dependent on borrowing short and lending long, it has surely been a success.
Stocks were up on the week but muted with gains in the 0.5% range. Bonds did have a fairly significant rally at the end of the week from very oversold conditions but all that really did was get them back to about where they started. Commodities were also quiet as currency movements were subdued. Bullish sentiment remains elevated and I raised more cash last week. As I said above, I think investors may be jumping the gun in turning more bullish. There is a chance that the politicians do something positive via tax reform next year but it sure isn’t a done deal and I have little confidence that even if they do something it will be the right thing. We may be at a significant inflection point in economic policy – or we might not. It is too early to tell and way too early to position a portfolio in anticipation. Given the choice between betting with the crowd that the politicians will do the right thing and taking the contrarian view, I’ll take the under every time.
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