Glassman Wealth Services LLC

The global media is enamored with the Chinese growth story, but in reality this should not be an enormous surprise.

For much of the past 2000 years, India and China were the dominant economies on the global landscape. Economic superpower status changed abruptly during the industrial revolution, but as The Economist pointed out, “Why they fell so far behind may be more of a mystery than why they are currently flourishing.”

Over the past several months, bond and equity markets have been on starkly divergent paths.  Investors are growing increasingly concerned that perhaps the bond market knows something that the stock market is overlooking.  In reality, the answer may be simpler than we realize.

As of the middle of last week, Citi research discovered that global equities are up roughly 6% while global government bonds yields are down 25 basis points.  In the U.S., the situation is even more dramatic with yields down nearly 1.5% since the peak in late April.

There are seemingly two explanations for the recent turn of events.  The first is corporations.  Corporate cash at nonfinancial companies is up 26% through March to $1.8trln, the largest such increase since at least 1952. 

Emerging from one of the most severe recessions in the last century, companies are more than willing to hoard cash and favor a  ‘wait and see’ approach before resuming expansion.   Cash levels at S&P 1500 companies are well in excess of $1trln now, but, where does that extra cash wind up?

According to a recent survey from CFO.com, 74% of short-term cash is placed in bank deposits, money market funds or U.S. Treasury securities. 

 The second reason bond yields are falling is that individual investors continue to sell equities in favor of fixed income securities.  Through July, investors took $33bln out of domestic equity funds, with much of that finding a home in the perceived safety of taxable bonds. 

This is hardly the first time such an occurrence has happened.  In fact, Citi found a number of occasions since 2000 where global bond yields fell as global equities rallied.  In a majority of those instances, the equity markets were right.  Equities continued to rally and bond yields eventually rose.

There is reason to believe that equities offer the more compelling opportunity going forward.  Forgetting the impact of price appreciation, the average dividend yield on the DJIA was 2.94% as on August 13^th, compared to a current yield of 2.62% on the 10-year Treasury. 

The last time the DJIA had a higher yield than the 10-year Treasury was in late 2008/early 2009.  It is relatively uncommon for the DJIA to exhibit a higher yield, although, in the early part of last century it was a common occurrence. 

The Treasury market has been susceptible to a number of technical factors in recent months, from the recent announcement by the Federal Reserve to purchase treasuries to huge individual investor inflows.  Yields could certainly fall further if the economy enters a second recession, but the likelihood of that is marginal at the moment.

In our Monthly Economic report, we take an in-depth look at the changes in our markets and the effects of economic policy nationally and globally. This broader perspective provides greater clarity in understanding the forces that affect investment performance and future expectations. Click Here for our July report.

An interesting development has come to the forefront in the past several weeks.  Democrats who were previously in favor of allowing the Bush-era tax cuts to expire at the end of this year are suddenly swimming in the opposite direction, with several favoring extensions to the tax credit given the poor economic backdrop.  It is easy to find supportive arguments for both camps, but the simple reality is that economically restrictive policies will create a drag on growth at a time when the economy can ill afford them. 

The preceding graph details what taxpayers can expect in the upcoming year, barring any extension of the Bush-era tax cuts.  President Obama has already detailed a willingness to extend the relief for those making below $250k. 

While individuals making more than $137k only represent a small portion of taxpayers in this country, they account for roughly 30% of all consumer spending.  Considering our excessive use of debt in every imaginable form, it should come as no surprise then that consumption accounts for 71% of GDP.  

The combination of higher taxes and a weak economy is translating into lackluster spending figures for those higher income individuals.  Even accounting for a 33% surge in daily spending during the month of May, spending among individuals making more than $90k a year is still almost 30% below its May 2008 peak.  The increase in May was likely a result of “thrift fatigue,” whereby consumers finally reach a point at which they no longer feel like saving.  This proves to be a very temporary phenomenon.

The administration argues that allowing the tax cuts to expire would generate $800 billion of additional revenue over the next 10 years.  This is a tidy sum at a time when the federal debt is skyrocketing, but if we learned anything in recent decades, it is that a government with access to more money will spend rather than save the incremental dollars of savings.  Until the government learns how to cut back and spend more efficiently, a seemingly impossible task, the new revenue will go the waste.

What these numbers also fail to account for is what happens if the upper income brackets decide to become permanently more frugal and a double-dip recession ensues?  The additional dollars of revenue generation would no long matter if we are pushed into 20 years of deflation, similar to what Japan has endured.  

It should also be pointed out that the US is already home to one of the top marginal tax rates in the entire world.  Even the oft-ridiculed Europeans are nipping on the heels of the US, after rates in the European Union fell from an average of 41% in 2003 to 36% by 2009. 

Democrats understand not only the need to aid the economy, but also realize the difficult battle they face in the upcoming mid-term elections in November.  According to the website RealClearPolitics.com, Senate Democrats are dangerously close to losing their majority and right now, Democrats are expected to retain 49 seats, with 43 going to the Republicans.  That leaves exactly 8 seats to determine who controls the Senate. 

The situation in the House is even more tenuous, with 202 seats in favor of the Democrats, 201 to the Republicans and 32 viewed as tossups.  

This is not simply a case of higher taxes or the viability of the Democratic majority.  Uncertainty around whether or not the tax break will be extended or allowed to expire simply adds to the layers of investor unease.

According to Barclays, assuming the tax cuts roll off at the end of the year, Price/Earnings multiples could contract by one point, from 12x consensus earnings to 11x.  Only one point you argue, but with consensus earnings at $96 for 2011, that represents a roughly 100 point differential in the S&P 500. 

Democrats understand not only the need to aid the economy, but also realize the difficult battle they face in the upcoming mid-term elections in November.  According to the website RealClearPolitics.com, Senate Democrats are dangerously close to losing their majority and right now, Democrats are expected to retain 49 seats, with 43 going to the Republicans.  That leaves exactly 8 seats to determine who controls the Senate. 

The situation in the House is even more tenuous, with 202 seats in favor of the Democrats, 201 to the Republicans and 32 viewed as tossups.  

This is not simply a case of higher taxes or the viability of the Democratic majority.  Uncertainty around whether or not the tax break will be extended or allowed to expire simply adds to the layers of investor unease.

According to Barclays, assuming the tax cuts roll off at the end of the year, Price/Earnings multiples could contract by one point, from 12x consensus earnings to 11x.  Only one point you argue, but with consensus earnings at $96 for 2011, that represents a roughly 100 point differential in the S&P 500.

With consumers at the upper end of the tax bracket finding themselves dis-incentivized to spend money and the economy in a dangerously perilous position, now is not the appropriate time to rollback prior tax cuts.  The 2.4% growth rate in GDP during the second quarter only served to confirm that the economy is gasping for breath and additional restrictive policies will only compound the situation.