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 September 2008 It Really Does Matter
This year is no exception. In fact, the contrasts haven't been this stark since Ronald Reagan swept into office in 1980. On the one side is one of the most liberal individuals in the senate campaigning on the populist appeal of "change", while the other party is fielding a more moderate candidate trying to focus on more conservative ideals. All else being equal, investors shouldn't prefer one party's candidate over another. Investors fare better with free markets and less government intrusion. Over the past few decades, this has more closely aligned with the republican platform than the democrat positions. This is also no exception this year. Taxes, trade, and the overall role of government have a major impact on investors net (after-tax) returns. These are the issues to watch as well as the ones to consider as investors cast their votes. Choices made this November will have a profound effect not only over the next four years, but over the long-term, too.
Taxes Arguably, the consumer has been the driving force of the economy over the past ten years. Without undaunted consumer spending, the 2001 recession would have been deeper and longer lived. The recovery in the middle of the decade would have been considerably less robust and the today's credit crisis would have been the catalyst for the next recession. Throughout it all, consumers were willing to go out and buy whatever they wanted, even to the extent of a negative savings rate. But $4 a gallon gasoline is changing that. Higher education or rent costs affect particular groups, but higher energy prices affect just about everyone. The more you pay for gasoline, the less you have to spend on anything else.
Yet here's an important point that's often overlooked by popular analysis: The fact consumers are spending more on energy doesn't mean the economy is losing this capital, it's simply being reallocated to energy. In other words, consumer spending is continuing, it's just being redirected to a specific area of the economy, energy. There are definite parallels with the current U.S. tax system. Rising energy prices, like a tax, prevent consumers from spending their limited resources on what they want, forcing them to instead pay for things they must. With the economy teetering on the verge of recession, this isn't the time to increase taxes. Remarkably, that's precisely what democrat candidates -- led by the presidential ticket -- want to do. The Bush tax cuts are scheduled to expire and if anything, a democrat controlled Congress and White House would speed their trip to oblivion. The democrat platform is on record seeking a tax increase for "The Rich". This includes higher taxes on capital gains and dividends, and perhaps an increase in the earnings subject to Social Security payroll taxes. "The Rich" are defined -- depending on who's speaking or where you look -- as couples earning over $250,000 and individuals making more than $200,000 a year. This may or may not be the definition, but regardless, whenever taxes are increased for one segment of the population, they're ultimately paid by all. Why? Because The Rich have the means to hire fancy tax lawyers and accountants who can find them ways to avoid paying higher taxes. It's the middle class that doesn't have such options who end up picking up the slack. In addition, when was the last time you were offered an job by a poor or lower-income individual? Probably never. It's The Rich who are running businesses -- many of them small, sole proprietors -- who have to make the hiring decisions, and if their tax burden is increased, they suddenly lack the resources to create new jobs or perhaps even maintain the workers they currently employ. So taxing The Rich has a way of taxing us all. In essence, "The Rich" actually encompasses every American taxpayer. Although such schemes are often proposed based on "fairness", these claims are really nothing more than an attempt to appeal to middle income voters through "class warfare". The short-term net effect is more revenues for the government (more about that in a moment), not the noble income redistribution promised.
Economic Growth Like so many naive notions, this one's great in theory but impossible to implement outside the classroom. No government can turn spending off and on like a spigot. Many programs and investments once started continue to demand additional funding year after year regardless of the position in the economic cycle. In addition, politicians have a much easier time explaining spending increases to their constituents than spending cutbacks. Once enacted, most spending programs are virtually set in stone.
But there's a bigger problem in relying on government spending to shape fiscal policy: Other factors play a bigger role in determining GDP. One of John Maynard Keynes greatest contributions to economic theory was to clearly state that economic growth as measured by GDP (GNP in his lifetime) is primarily determined by four factors: (1) Private consumption, (2) government spending, (3) capital investment, and (4) net exports. Although government spending can tie up a considerable amount of capital, it's neither the biggest component of GDP or the most reliable determinant. Consumer spending, private consumption in Keynes' terms, is currently the largest component of GDP, hovering around 70%. That should come as no surprise given that it was ongoing consumer spending which kept the U.S. out of a deeper recession at the start of this decade, smoothed over the effects of 9/11, and has tempered the effects of the credit crisis. Throughout it all the consumer kept buying goods and services, allowing the economy to grow. At 70% of the total GDP, as goes the consumer, so goes the economy. It should also come as no surprise that over the past 20 years, capital investment has the highest correlation with GDP. As indicated on Chart 1, the correlation between the two is a remarkable .74 over the past ten years. It's even higher over the past two and five-year periods (.85 and .75, respectively). Essentially this is telling us that U.S. growth is most predictable when businesses are reinvesting capital back into the economy. This allows for increased capacity and expansion through an expanding capital base.
This shouldn't be a surprise, but it is to Keynesian politicians. They want to raise taxes on consumers and businesses, two main economic drivers. This is not a good solution, particularly now when economic growth is sluggish. Additional hits to these sources of growth could be all that's needed to spark the next recession. It's a bad idea at a bad time.
Exports and the Dollar When the credit crisis emerged over a year ago, the Federal Reserve rushed in to add stability to the financial markets. To do so, they had to add liquidity, and do it quickly. In the process the Federal Funds Rate was rapidly slashed from 5¼% to today's level of 2%. At the same time, foreign central banks were actually raising their benchmark lending rates in an effort to stem commodity induced inflation. The differential between domestic and foreign rates drew investment dollars overseas, and the reduced demand left the U.S. dollar in a weakened state. A positive side effect was the fact that our foreign trading partners saw their currencies rise in relative value, making U.S. goods cheaper. This, then, is the source of the recent rise in exports. Unfortunately, this can end just as abruptly as it started. There are two reasons for this, one is a result of the market, the other is a result of misguided politicians. Let's consider the latter first. There's a rising protectionist sentiment in Congress. Some senators and representatives are including it in their speeches along the campaign trail. In general it's a reaction to some of the perceived unfair trade practices of our foreign trading partners. Although protectionist measures may seem to be the correct response, they rarely are. Instead, foreign trade is no different from any other market: The freer the market, the more efficient it is. Free market issues aside, anything to curb U.S. exports will again have a decidedly negative effect on GDP at a time when growth is hard to come by. As Chart 2 clearly shows, net exports have been a major factor in maintaining the recent growth. In fact, in August's revision of second quarter GDP, the value was nudged up to 3.3% from the prior estimate of 1.9% primarily because of thriving exports. This is not the time to limit exports. Of course that may not be an issue debate much longer. The market may see to that. Although the dollar has been remarkably low for quite some time, it's recently reversed course against the currencies of our major trading partners. Chart 3 shows the significant gains it's made against the British pound in the past few weeks. The market gives, and the market ultimately takes away.
Indications have been growing over the summer months that foreign economies, especially in Europe, are showing signs of weakness. Britain in particular has been wracked with the same type of real estate problems as here in the States, also with the same effects on financial institutions. Now there's increasing evidence that economic growth is on the decline as well. Foreign central banks are facing increasing pressure to begin lowering benchmark lending rates in an effort to stave off recession. Up until now, most have been keeping a stiff upper lip, focusing on inflationary threats posed by rising commodity prices. Some of this has lessened as commodities -- especially crude oil and gold -- have declined significantly from their mid-summer peaks. Against this background, many believe the EU and the Bank of England will soon be bringing benchmark rates back in line with those in the U.S. As this happens, the dollar will regain lost ground against its counterparts. As Chart 3 so clearly shows, it's already being baked into the exchange rates, and it's only a matter of time before the banks act. So even if no protectionist legislation emerges, net exports are likely to come under pressure from a strengthening dollar. Protectionist measures will only speed the decline and increase the threat to struggling U.S. economic growth.
More Than Campaign Promises In a country where millions of people cast their ballots, it's easy to become cynical. Yes, sometimes it's difficult to separate the wheat from the political chaff and indeed, you may wonder if it's worth the effort. But as you can see from the potential impact of a few bad economic ideas, investors should be concerned. They should be very concerned. Search this site! Just enter you key word or words:
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HETHER YOU WANT TO OR NOT, as an investor, every four years you have to think about politics. Although the events in Washington may seem far removed from what transpires on Wall Street, the former can have a major impact on the latter. Congress ostensibly makes the laws, but the quadrennial presidential election actually carries more weight.
