Forward Markets: Macro Strategy Review

January 2nd, 2013
in contributors, syndication

by Jim Welsh, Macro Strategy Team, Forward Markets

Editor's note: This was written before the end of 2012 so the Congressional cliff dance result is not reflected in this article.

Happy New Year!

We would like to wish you and your family a year of good health and contentment in 2013. And we will do our best to add a bit of prosperity.

The U.S. economy may get a lift in the first quarter of 2013 from an unlikely source - the fiscal cliff. This may be hard to believe but in the upside-down world of disincentives, it's likely to be a pleasant surprise. As we discussed last month, the Congressional Budget Office (CBO) uses static accounting to estimate future spending and tax receipts for the next 10 years. The CBO assumes taxpayers will make the same choices year after year, irrespective of tax increases or decreases. That's not how it works in the real world, however. Most human beings are wired to respond to negative disincentives and positive incentives, and respond they do. The fait accompli of higher taxes come January 1, 2013 has motivated corporations to announce special dividends before year-end, and pull forward dividends due in 2013 into 2012 just so shareholders can benefit from lower tax rates in 2012. According to Bloomberg, $21 billion in extra dividends have been announced as of December 13, with more likely to be distributed before the end of the year. Investors who earn more than $250,000 per year are surely more likely to cash in long-term capital gains before January 1 since their capital gains tax rates may jump from 15% to 23.8%, an increase of almost 60%, in 2013. Anyone earning more than $250,000 who has a degree of income flexibility has been tempted to pull 2013 income into 2012.

Follow up:

The urge to accelerate 2013 income into 2012, the realization of long-term capital gains and the surge in dividend distributions by corporations will result in a sizeable jump in income before year-end. The federal government is effectively offering a Black Friday "tax-cut doorbuster" that ends at midnight on December 31. The irony is that tax receipts will surge, which will likely narrow the 2013 budget deficit more than the expected increase in tax rates would. Congress could conceivably keep all the tax rates in place, even for the wealthiest Americans, since tax receipts will be higher this year (2012) than currently budgeted. Potentially, Congress could reap more tax revenue by simply threatening to enact a huge tax increase every January 1 since tax avoidance is obviously a powerful behavioral incentive.

Concern over the looming fiscal cliff has been building for months. Just in case viewers aren't up to speed, CNBC is displaying the days, hours, minutes and seconds until the fiscal cliff arrives. We haven't heard anyone criticize CNBC for subtlety, or for not doing their part in elevating the level of consternation. Business executives of large and small companies have responded to the uncertainty with decisive indecision. They want to know if Congress can actually do their job after three years of failing to pass a budget. They also want to know the details so they can plan accordingly. After growing 11% in 2011, business capital spending has slowed in 2012, as noted in the chart below. In the third quarter, spending on equipment and software declined at an annual rate of 2.6%. This was the first negative quarter since the recession ended in June 2009. We suspect the reluctance to increase business spending extends to hiring as well. Although we have no way to quantify whether this reluctance represents 5,000 or 10,000 jobs per month, we have no doubt employment growth has been negatively affected in recent months.

According to the Federal Reserve, nonfinancial U.S. corporations held $1.7 trillion in cash and other liquid assets at the end of the third quarter. The Business Roundtable, an organization comprised of big company chief executives, represents companies holding large amounts of cash on their balance sheets. In their view, the confidence executives need to increase business investment and hiring could be realized if Congress is able to craft a compromise on tax increases and entitlement reform that realistically lowers the budget deficit by $4 trillion over the next 10 years. We believe many small business owners would likely echo this view.

A portion of the income boost from dividend distributions, capital gains and strategies to pull income forward into 2012 could be converted into consumption demand in early 2013. The cash on corporate balance sheets represents pent-up demand for business equipment, software and new jobs. The silver lining of the fiscal cliff is that each member of Congress only needs to fulfill their constitutional responsibility of passing an annual budget that provides for the fiscal soundness of our country's future. By merely doing the job they were elected to do, Congress can easily exceed the bar of low expectations they have earned.

By the time the books are closed at the end of this year, average annual GDP growth will clock in at 2%. This is weak, especially after factoring the amount of fiscal and monetary policy stimulus inserted into the economy. Since the end of 2009, the Fed has kept interest rates barely above 0% as well as launched the second round of quantitative easing (QE2), Operation Twist and the open-ended QE3. At its December meeting, the Fed expanded QE3 from $40 billion in monthly purchases of Treasury bonds to $85 billion. Possibly in response to commentary about "QE3 to infinity," the Fed announced it would scale back its purchases once the unemployment rate falls to 6.5% or inflation, as determined by the Commerce Department's Bureau of Economic Analysis in its Personal Consumption Expenditure report, rises above 2.5%. It's been four years since the Fed first introduced quantitative easing, and investors seem to have adjusted to the new monetary world order. Over the last few years the Fed has been joined by the Bank of England, the European Central Bank and the Bank of Japan with new vigor. One of the stated goals of any quantitative easing program is to boost stock prices, which has come to pass in the U.S., and to a lesser extent in Europe. Japan's recommitment to quantitative easing has given its equity market a lift, and China's stock market reversed in December after testing its 2009 low.

While the Federal Reserve's extraordinary policy initiatives have not translated into a self-sustaining economic expansion, they have helped the most interest-sensitive sectors. Annual auto sales have rebounded significantly, although they remain more than 10% below their prerecession levels. According to research firm R.L. Polk, the average age of all vehicles in operation is a record high of 11.2 years. This is due to people holding on to their cars longer because of financial considerations and improvement in quality by carmakers. But the data does hint at a measure of pent-up demand if consumers felt more confident about the economy. Housing has also benefited from record high affordability as a result of the 30% decline in home prices and record low mortgage rates. Household formation is also supportive, since demographic data suggests that there should be about 1 million more households occupied by younger people than there are. Many college graduates who have not found a job have been forced to live with mom and dad, a life path mom and dad did not envision. This suggests that if job and earnings growth improves, the demand for homes would increase.

Despite the improvement in vehicle sales and housing, the primary reasons a self-sustaining expansion has not taken hold is the depressingly low level of job creation and earnings growth more than three and a half years after the recession ended in June 2009. This has led to an unprecedented level of dependency on government assistance programs, with unemployment benefits extended to 99 weeks and 46 million Americans receiving food stamps. For the majority of recipients, these programs have been very helpful. Of course, there are those who take advantage of government assistance. Overall, these programs have been supportive of GDP growth since 2009, as an analysis of personal income reveals.

The charts above compare total disposable income to income less transfer payments and net income. Prior to the recession, income transfers added a little over 2% to income, so the ratio of net income to total disposable income was 97.96% in 2007. As the recession deepened in 2009, unemployment soared, causing income to plunge (green line). The decline in earnings was mostly offset by unemployment benefits, which supported total disposable income (red line). This helped keep aggregate demand stronger and the recession from being significantly weaker. The level of government support can be seen in the ratio (blue), which fell to 89.92% in February 2010 from 97.96% in 2007. Consumer spending represents almost 70% of GDP. In early 2010, government income transfer programs represented more than 8% of total disposable income. This suggests that GDP could have been as much as 4% weaker or worse, which would have increased the risk of a depression.

Recently, the ratio has improved to 92.38%, as a result of job growth and two million people exhausting their unemployment benefits. This underscores the problem and challenge presented by current labor market conditions. Dependency on government assistance programs like unemployment benefits needs to be reduced, but Congress must be careful on how it is done. If transfer payments supporting total disposable income are lowered too quickly, aggregate demand may weaken too much. This will slow GDP growth and increase the risk of recession. We continue to expect Congress to limit the 4% hit to GDP from sequestration to something closer to 1.5%. As discussed previously, some of the drag to GDP could be offset in the first quarter as business spending improves and consumers spend some of the extra income received in 2012. Whatever Congress does, there will be a drag on GDP, making it unlikely GDP growth will be above 2% in 2013.

Obviously, if Congress does not achieve a budget compromise for any period of time, the risk of recession will rise. From a macro perspective, whether a recession in 2013 or 2014 is the result of congressional missteps or any other factor, the policy repercussions would be significant. When the financial crisis erupted in 2008, the Fed lowered interest rates from 5% to near 0%, and launched a series of sequential quantitative easing programs. Congress authorized spending programs resulting in $1 trillion in deficits that have averaged 8.2% since 2010. In the face of another recession, fiscal and monetary policy options would likely become even more extreme. We have little doubt that Congress would authorize more spending and larger deficits, which the Fed would fund by increasing its monthly purchases of Treasury bonds. We shudder at the thought of these potential acts of desperation.

Federal Budget Redux

After a litany of campaign rhetoric and endless shouting about the fiscal cliff, there appears to be a great deal of misinformation and half-truths that both parties are more than happy to dispense as fact. Members of both parties approach the subject of the budget with an ideological bent that precludes objectivity. Given some of the comments by members of both parties, we fear many do not grasp the threat posed by $65 trillion in unfunded liabilities. We have endeavored to present information in chart form so that readers can learn more about budget history, and ideally analyze the budget challenge we face with a better understanding and more objectivity.

Between 1947 and 2012, federal government spending averaged 19.11% of GDP, while tax receipts averaged 18.22%. During this 66-year period, our economy experienced significant changes. Inflation and interest rates soared from low levels in the early 1950s to unheard of levels in 1981, only to fall to historic lows in recent years. There have been 10 recessions, ranging from shallow and short to pronounced and extended. Politically, both parties at times controlled the White House, majorities in Congress, and briefly both the White House and Congress. The top marginal income tax rate reached a high in 1953 of 92%, and a low of 28% between 1988 and 1990. This 66-year stretch was marked by the Korean, Vietnam, Iraq and Afghanistan wars, as well as the Cold War and extended periods of peace. Despite all of these changes, the level of federal spending and tax receipts remained remarkably stable, with the exception of brief fluctuations above and below the averages. This consistency over more than six decades and amid such diverse circumstances suggests that spending of 19.11% of GDP and tax receipts of 18.22% represent a natural equilibrium. As such, they could easily be long-term goals of budget negotiations.

As of September 30, 2012, spending was 22.7% of GDP and tax receipts were 15.7% of GDP, leaving a budget deficit of 7% of GDP. Comparing the historical averages with the current level of spending and tax revenue, it is obvious we have two problems that require two solutions. Spending as a percent of GDP needs to decrease and tax receipts need to increase. Unfortunately, so far, one party is opposed to tax increases, while the other party is content with just talking about tax increases with almost no mention of spending reductions.

While we're no fans of higher taxes, we support raising taxes on the top wage earners for two reasons. If we are to make meaningful progress on our short-term and long-term fiscal problems, additional tax revenues are needed to boost tax receipts to the historical average of 18.2% of GDP. The ideal solution is stronger economic growth, which may get an assist if Congress passes a comprehensive budget that boosts confidence. However, we also need to address the problem of income inequality, which we feel could be more important than tax rates. A review of income distribution over the last 100 years is revealing. After peaking at 23.9% in 1928, the percentage of pretax income going to the top 1% of wage earners fell below 15% in 1942, dipped under 11% in 1952 and didn't climb above 11% until 1983, and 15% in 1995. The most recent peak occurred in 2007, when the top 1% received 23.5% of total pretax income. These figures are based on IRS data as analyzed by Emmanuel Saez, an economics professor at the University of California, Berkeley, and Thomas Piketty, an economics professor at the Paris School of Economics, and were provided to us by Philippa Dunne from the Liscio Report ( To dismiss the almost identical peaks in the percent of income going to the top 1% in 1928 and 2007 as coincidence seems foolish. Conversely, blaming the economic disequilibrium that followed both peaks is too simplistic to be taken seriously. Major economic dislocations are the result of many imbalances that collectively cause an extended period of subpar growth. Since many of the imbalances are interconnected, it takes more time to work through them than after a normal recession.

One of the imbalances we should be addressing is the level of income inequality. Median income is now back to the level it was in 1995. This is one reason the middle class is experiencing financial distress. According to the nonpartisan Tax Policy Center, 46.4% of workers pay no federal income taxes, but that is because their income is so low. According to IRS data, the top 10% of wage earners pay more than 70% of total personal income taxes, so the tax code is already fairly progressive. Our economy would be stronger if a larger amount of income was going to the middle class, as was the case for much of the period between 1942 and 1995. Since median income is just under $50,000, the 2% increase in the Social Security tax will lower disposable income by $1,000 next year. In the short term, increasing taxes on the top wage earners to replace the $95 billion in higher Social Security taxes in 2013 would help the average family.

Ninety-five percent of Republican members of Congress have signed the Americans for Tax Reform Taxpayer Protection Pledge. Signors pledge that they will do the following:

"One, oppose any and all efforts to increase the marginal income tax rates for individuals and/or businesses; and Two, oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates."
We agree in opposing tax increases for the middle class, but to oppose any tax increase in a time of budget crisis is putting this pledge above the country. Is this pledge always supportive of the common good? For any member of Congress, the most important pledge should be:
"I pledge Allegiance to the flag of the United States of America and to the Republic for which it stands, one nation under God, indivisible, with Liberty and Justice for all."

The Democrats are fond of referencing the economy's performance during the 1990s when Bill Clinton was president, much like the Republicans like to reminisce about how well the economy did in the 1980s when Ronald Reagan was president. There is no question the economy had a great run during the 1990s, and it definitely helped the federal budget. In 1999 and 2000 the federal budget was in surplus, the first time a surplus had been recorded since 1969. As you can see on the chart titled "Total Federal Spending and Receipts as a % of GDP," the blue tax receipt line crossed above the red spending line during those years. In large part the budget surplus was possible because the level of government spending as a percentage of GDP was low, coming in at 18.2% in 1999 and 2000, comfortably below the long-term average of 19.11%. President Barack Obama campaigned on many issues, but the primary economic message he delivered was his plan to raise taxes on those earning more than $250,000 to the same tax rates that existed under President Clinton. We understand and support the need for more tax revenue. In fairness, though, there should be an equal amount of focus on the level of spending during Clinton's presidency, if his record is used to justify higher tax rates. The CBO has estimated that the increase in taxes on the wealthiest Americans will generate $800 billion in tax revenue over the next 10 years, or roughly $80 billion annually. This will make a small dent in the projected $1.1 trillion deficit for 2012.

The chart above shows the allocation of expenses from last year's budget and each category's trajectory over the past 50 years. Defense spending has fallen from representing almost 50% of the 1962 budget to less than 20% in 2011. Entitlement spending, which includes Social Security, Medicare and safety net programs, has climbed from 26% of the budget to almost 60% last year. Of that total, 20% went to Social Security and 21% was spent by Medicare, Medicaid and the Children's Health Insurance Program (CHIP). Another 13% of the budget was spent on earned income and child tax credits, Supplemental Security Income for the elderly and disabled, unemployment insurance, food stamps, school meals, low-income housing assistance, childcare assistance and various other programs. Benefits for federal retirees and veterans totaled 7% of budget outlays last year. Each of these programs is a compassionate response to help fellow Americans. Unfortunately, CBO projections suggest that as a nation we will not have enough money to meet the future obligations of these worthy programs. According to the CBO, unfunded liabilities total $65 trillion over the next few decades. The longer Congress delays in addressing the growth in entitlement spending, the fiscal problem will only become larger and more difficult to manage.

After reviewing the trajectory of entitlement spending over the past 50 years, it should be clear that entitlement reform is unavoidable in order to narrow the projected budget deficits during the next 10 years and stabilize our nation's fiscal future. However, in a poll taken in early December by American pollster IBD/Tipp Poll, 79% of respondents were opposed to reducing Medicare spending, and 75% were against lowering Social Security benefits. Most Americans are far more interested in sports and reality TV than learning about and understanding the nuts and bolts of the federal budget. Lacking that understanding makes it difficult for Americans to appreciate the threat to our country posed by $65 trillion in unfunded liabilities, and why some measure of collective sacrifice is needed. The following quote from former first lady Rosalyn Carter is timely:

"A leader takes people where they want to go. A great leader takes people where they don't necessarily want to go, but ought to be."
President Obama has said the election was a mandate to raise taxes on the wealthiest Americans. We hope the administration aspires to be great and that it follows President Obama's re-election mandate to educate the American people on entitlement reform. It needs to lead the effort to stabilize our nation's future.

Global Economy

In 2013 the global economy will be influenced by what happens in the U.S., as a degree of fiscal austerity becomes a headwind on U.S. growth. Europe will remain in recession for at least the first half of 2013. Growth in China has stabilized as expected and is likely to hold in the range of 6 to 8%.

Macro Strategy Team

Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can full as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

The new direction of investing

The world has changed, leading investors to seek new strategies that better fit an evolving global climate. Forward's investment solutions are built around the outcomes we believe investors need to be pursuing-non-correlated return, investment income, global exposure and diversification. With a propensity for unbounded thinking, we focus especially on developing innovative alternative strategies that may help investors build all-weather portfolios. An independent, privately held firm founded in 1998, Forward (Forward Management, LLC) is the advisor to the Forward Funds. As of September 30, 2012, we manage $5.7 billion in a diverse product set offered to individual investors, financial advisors and institutions.

©2012 Forward Management, LLC. All rights reserved.

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