Andrew Busch

In an interview with Dow Jones, Standard & Poor’s Ratings John Chambers said, “It is very important for the credit standing of the United States that the Congress considers very carefully what the fiscal commission proposes…It is very important for Congress to take the required steps.” Chambers is the chairman of S&P’s sovereign rating committee that just downgraded Ireland from AA to AA-.

This follows up the comments by S&P in July that warned the U.S. does not have unlimited fiscal flexibility. S&P still maintains their AAA rating for the U.S. but clearly is increasing the rhetoric and pressure to act.

Why? Simply, the US has a deficit problem and a deficit commission. Both are in play with the US running a $1.4 trillion deficit and the President’s deficit commission set to make its recommendations by the end of the year. The Bipartisan Commission on Fiscal Responsibility is tasked with finding ways to reduce federal deficits. However, the first order of business seems to be ousting one of its members.

Former Senator Alan Simpson and current co-chair of the commission sent an email that is causing a stir and calls for his resignation. Sadly, he sent to the executive director of the Older Women’s League (OWL) and wrote: “I’ve made some plenty smart cracks about people on Social Security who milk it to the last degree. You know ‘em too. It’s the same with any system in America. We’ve reached a point now where it’s like a milk cow with 310 million (teats)!” Does this remind anyone of Lyndon Johnson?

Simpson has subsequently apologized, but the damage is done. Serious discussion about what the US can afford with Social Security and what it should pay appears to be taken off the table for the commission. Remember, the Congressional Budget Office has stated that Social Security’s annual expenses will exceed annual revenues (excluding interest) for the first time this year since the 1983 overhaul.

President Obama would do well to assuage rating agencies fears by making a statement to the contrary and putting the commission back on firmer ground. Otherwise by the end of the year, the commission will likely devolve into partisan bickering and the US credit rating will follow.

http://www.cnbc.com/id/15840232?video=1574423833&play=1

Today at 11:30 AM ET, I’ll be appearing on CNBC’s The Call to discuss corporate tax cuts.

As we stare into the economic double dip abyss, there are still some low hanging fruit to be picked by policy makers to aid the economy and business. With changes to the tax laws focused on increasing receipts to pay for spending, tax cuts seem to be out of favor. However, I think it would be a great time to discuss a cut in foreign tax earnings for US companies.

Under current law, US companies are subject to US tax on foreign earnings when distributed to the US unit as a dividend. Given lower tax rates in some countries abroad, this provision discourages companies from bringing these earnings back to the United States and keeps the funds offshore.

The last time we did this back in 2004-2005, it was called the Homeland Investment Act or American Job Creation Act of 2004 (AJCA) and was signed into law on October 22nd, 2004. The premise was to cut the corporate tax rate from 35% down to 5.25% to encourage companies that have earnings sitting overseas to bring them back to the United States for investment. The tax break was for only one year and was intended to boost capital repatriation that was to be directed into domestic investment and capital expenditures.

At the time and out of reach by the IRS, it was estimated that over $500 billion was held offshore by America’s top 500 firms in foreign accounts and other assets. The Joint Committee on Taxation estimated that revenue to the US Treasury would increase by $2.8 billion. After the bill was signed into law, big pharmaceutical companies like Eli Lilly ($8 billion), Bristol-Myers Squibb ($9 billion) and Schering Plough ($9.4 billion) said they would bring back funds.

The problem with this bill was that it was almost impossible to track the money once it had been brought back to the United States. One of the major concerns was that companies would use the funds to fund acquisitions and cut jobs. This would have to be addressed in new legislation. In 2009, there was a movement to bring back AJCA, but it was defeated for exactly these reasons.

What was the outcome of the 2004 AJCA? It wasn’t perfect. In 2005, $312 billion in qualified dividends occurred and over 800 companies took advantage of the tax break. The biggest winner was the US Treasury which saw tax receipts soar by $18 billion. For a Congress that’s thirsting for “Pay Fors”, this would seem to be a layup.

According to a study by Grant Thorton, there was little evidence to suggest that the tax break increased domestic investment by those firms. Therefore, the “job creation” aspect seems a bit of a stretch. Yet, $300 billion came back to the country and was used to aid US companies. Whether it was a direct link to investment or jobs, it really doesn’t matter. It had to have helped and didn’t cost the US taxpayer or increase the deficit.

For these reasons, Congress needs to grab this tax apple and take a big bite.

One of the symptoms of uncertainty that is pervasive in the economy right now is the large amount of cash that is sitting on companies’ balances sheets. According to FactSet, non-financial companies in the Standard & Poor’s 500-stock index are sitting on a record $2 trillion. The question arises: what will these companies do with all that money?

Along with strong profits, corporations are finding markets very receptive to high yield bond issuance as well. Two weeks ago, the high yield market had its largest week of issuance ever with $15.4 billion in deals. This has further fueled the amounts of cash on companies’ balance sheets. Remember, this was a market virtually shut down during the European sovereign debt crisis.

When stock prices are weak and companies anticipate a turnaround, one of the areas they put money to work is taking over their rivals or expanding their product lines. We’ve seen a spate of takeover news from BFP-Potash, Intel-McAfee, Miller-Fosters and Campbell-United Biscuits are all in the news. As a matter of fact, last week was the largest announced M&A week of the year with deal volumes running 20% ahead of 2009 according to the FT.

However, there is another use of this cash that is garnering investor interest. Stock repurchases and dividends are making a re-appearance on the investment scene. According to Thomson Reuters, the value of share 2010 repurchase programs has already more than tripled from 2009 to $142.7 billion. The WSJ reports that, “And one-third of S& P 500 companies increased their dividends this year, handing out an extra $12.7 billion after slashing them by $41 billion in the same period last year, according to S&P.”

Here’s an optimistic point from the WSJ article: “J.P. Morgan Chase estimates that if cash balances among S&P 500 companies were to return to normalized levels-about 7% of assets from the current 11%-it would result in spending of $428 billion. That’s almost as much money as companies poured into share repurchases for 2008 and 2009 combined.”

All of this cash generation and stockpiling will eventually be put to use and the fall should be a banner time for deals. Unfortunately, it is reflective of the lack of confidence by US businesses that they are not hiring for expansion. The good news is that this is part of the economy’s healing process and it will continue.

Yesterday, the Congressional Budget Office released their estimates for the federal deficit for 2010 and it’s deceivingly ugly.

“The Congressional Budget Office (CBO) estimates that the federal budget deficit for 2010 will exceed $1.3 trillion-$71 billion below last year’s total and $27 billion lower than the amount that CBO projected in March 2010, when it issued its previous estimate. Relative to the size of the economy, this year’s deficit is expected to be the second largest shortfall in the past 65 years: At 9.1 percent of gross domestic product (GDP), it is exceeded only by last year’s deficit of 9.9 percent of GDP.”

For those unfamiliar with the CBO, they are charged with scoring all things legislative to provide Congress with tabs on how the Fisc is impacted by their actions. However, there are certain boundaries that are placed on the CBO that can skew their analysis and generate more optimistic projected outcomes. As an example in the current report, the CBO makes this statement, “…the federal budget deficit would decline substantially over the next two years-to 4.2 percent of GDP by 2012…..Projected deficits total $6.2 trillion for the 10 years starting in 2011, raising federal debt held by the public to more than 69 percent of GDP by 2020, almost double the 36 percent of GDP observed at the end of 2007.”

If you don’t read the full report and a politician states the above, one would think that the federal deficit is not in dire shape or in need of radically fixing. Fortunately, the CBO is very good at stating their assumptions and these assumptions massively skew the result. Here are the assumptions to get the deficit to decline to 4.2% and 69% debt-to-GDP in 2020:

1. Current laws affecting the budget will remain unchanged.

2. Tax reductions enacted earlier in this decade that are currently set to expire at the end of this year do so as scheduled.

3. No new legislation aimed at keeping the alternative minimum tax (AMT) from affecting many more taxpayers is enacted.

4. The measures enacted in the past two years to provide fiscal stimulus to the weakened economy will expire as currently scheduled.

5. Future annual appropriations will be kept constant in real (inflation-adjusted) terms.

If we are conservative, we can say that at least 2 of these are false assumptions with the Bush tax cuts (some part) and AMT likely to be continued. The CBO somewhat validates this when they provide state the outlook for an alternative universe. “If, for example, the tax reductions enacted earlier in the decade were continued, the AMT was indexed for inflation, and future annual appropriations remained the share of GDP that they are this year, the deficit in 2020 would equal about 8 percent of GDP, and debt held by the public would total nearly 100 percent of GDP.”

For both of these estimates, the CBO uses an optimistic economic outlook such as, “After 2011, the projected growth of real GDP picks up, averaging 4.1 percent annually from 2012 through 2014.” Once you understand all the analytic constrictions and optimistic assumptions contained in the report, you also understand fully the implications. The US is in much worse shape than it appears as the amount of federal debt held by the public has skyrocketed by over 50% in two years.

It is this trajectory that causes angst and uncertainty over the direction of US fiscal deficits and taxes for voters, for business hiring and for the markets.

The optics on the US jobless claims data are terrible and will generate a renewed negative newsflow leading up to the US employment data on September 3rd. It is clear new jobs are not being created. It is clear that whatever economic prescription policy makers have attempted is past its “Sell By” date. It is clear that the policy direction forward for the US economy must focus on the creating the best conditions for small to medium sized firms. Remember, companies that are 5 years and younger generated over 90% of new hires between 1997 and 2007. These firms are the engine for new job growth in the United States, not General Motors or AIG.

Ostensibly, the main D.C. focus over the last 18 months has been on stabilizing the economy and re-regulation. The stabilization was successful, but laid the fiscal groundwork for uncertainty over deficits and taxes. The potential for increases in dividend, capital gains and personal income all weigh on small firms to varying degrees. In my view, it is not so much the amount of the change, but that the amount of change is unknown.

The re-regulation aspect is the major hurdle for small firms. When the government changes the rules for over 25% of a $14 trillion economy, it requires major shifts in strategies for all firms impacted. Large firms have the resources to plan and execute strategies dealing with the changes. Small firms do not. This is where most miss the mark in their analysis.

It’s like an eco-disaster: the smallest creatures are the most sensitive and die-off the fastest. They simply can’t adapt to the pollution that is now in the system. By increasing the incremental costs of hiring employees, this discourages small firms from adding that additional worker.

A policy shift is already forming and will most likely manifest itself after the mid-term elections. The markets will likely anticipate this shift starting between now and mid-September.

The San Francisco Federal Reserve has published a report that is generating a lot of buzz in the financial markets. Entitled, “Future Recession Risks”, the paper reviews the predictive capabilities of the US Conference Board’s Leading Economic Index. This report has been cited in several articles providing outlook for a double dip recession and generating additional angst for investors.

As most know, the LEI is published once a month by a private research group in New York City. It is composite comprised of 10 indicators that are known to swing up or down well in advance of the rest of the economy. The concept is to watch LEI and you’ll be able to anticipate where GDP is headed. Today, this is particularly salient given the debate over potential policy prescriptions in anticipation of a new recession that has yet to emerge.

The paper takes an interesting jumping off point: “The predictive ability of each LEI component varies wildly depending on the forecast horizon. For example, the spread between 10-year Treasury bond and the federal funds rate works best 18 months into the future, whereas the initial claims for unemployment insurance indicator works best two months ahead. Clearly, one should give more weight to the rate-spread indicator than the initial claims indicator when forecasting in the long run, but less weight when forecasting in the short run.”

From here, the paper makes adjustments to each indicator and also adds an “odds-ratio” to provide a corrective method to predict a recession.

Here’s the key conclusion: “….the likelihood of a recession is essentially zero over the next 10 months but that the odds deteriorate considerably over the following year. However, even at its worst, the probability of recession is never above 0.3, so that expansion is more than twice as likely as recession.” If you strip out the volatile stock market indicator, the probability of recession drops further.

The paper makes this statement on one key LEI component, the US 10yr Treasury minus the Federal Funds rate: “Historically, this spread, which summarizes the slope of the interest rate term structure, has been a very good predictor of turning points 12 to 18 months into the future. Specifically, an inverted yield curve has preceded each of the last seven recessions.” Given this, the authors still decide to exclude it in one of their alternative scenarios as they believe the yield curve is distorted by flight to quality demand for US Treasury securities.

In this LEI, the probability of a recession increases significantly and indicates that odds of a recession are just slightly more than expansion. It is this point that “Deflationistas” and “New Normalists” have grasped on to for support of their dour view of the future. Even if the yield curve is distorted, wouldn’t the medicinal effect of steep yield curve provide the economic tonic for improving banks balance sheets and decreasing corporate borrowing costs?

The answer is clearly yes. Banks are reporting record profits this quarter and last week the high yield debt market had a record, all time high issuance. Therefore, the exclusion of the spread is not valid, distorts the conclusions and brings to mind Mark Twain.

While the US economic recovery has clearly slowed from it’s earlier pace, the reports of its future death are greatly exaggerated.

As I wrote yesterday, the market is pricing in a slower US GDP for Q3. 50-75K private payroll growth is not enough to drop the unemployment rate, but it’s enough to avoid a double dip recession. It will just feel like a DD as it will dominate the newsflow due the upcoming US election. Yet…..in our 24/7 news cycle, I definitely feel that focus is myopic and trends toward the negative for impact. Therefore, we are going to need a sustained, positive theme to be established before a shift can occur.

The better-than-expected German & Eurozone GDP is a good start. The continued strength of Baltic Dry index is another. A stable to better-than-expected UofM consumer confidence will help as well. Looking out further, the economic data for the next two weeks out of the US is expected to show improvement over the previous month. The exception is existing home sales which comes out on 8/24 and is expected to drop 11.6%. Congress is on vacation and we shouldn’t get any major surprises or initiatives.

Therefore, I expect the strong negative theme to abate as we head into the end of the month and profits to be taken on short equities ahead of the US employment data on September 3rd.

Clearly, the numbers are a disappointment especially with the revisions. There appears to be a disconnect between the US ISM service&manufacturing data and the US employment data as the former was much stronger than the latter. Also, the increase in average hourly earnings and workweek are strong positives that go against the grain of the headline numbers. Finally, the strong CapEx numbers are not translating into job hires. The markets initial reaction is to sell US dollars, sell Canadian dollars and sell Risk. The euro has put in a new high and is now back to the level of May 3rd.

The first policy response should come next week with the FOMC meeting. I would anticipate that they will announce that they are reinvesting the maturing QE. The main question will be: will they put it in US Treasury securities or into CMBS. Also, you can anticipate Congress and the White House announcing new measures to stimulate the economy.

The employment story will be sliced&diced for the next 4 weeks until we get a new number. It will fuel the “Deflationists”, fuel the “Keynesians” and cool the summer equity rally.