Markets Have Political Risk

Richmond Fed President Lacker says he doesn’t see a case for QE 2. Chicago Fed President Evans and Philadelphia Fed President Plosser concur. Lacker says the numbers are coming in fine and that patience is in order. He supports a 1.5% inflation target (lower than other governors). These Fed governors recognize that it often takes 12-18 months before changes in Fed policy can be seen in the economic data. Lacker and the others seem to be saying, “Give peace a chance.”

Bernanke, on the other hand, feels a strong compulsion to address the Fed’s second mandate: maximum employment. He notes that prices are only up slightly over 1% year-to-date, giving the central bank plenty of room with which to work.

We think some kind of action by the Fed next week is inevitable. However, it is getting harder and harder to gain consensus about each incremental government stimulus initiative. We make the following observations:

#1 If the Fed backs away from QE2, markets are very vulnerable.

#2 The debt limit will be an early agenda item for the new congress. Lame ducks may extend the limit temporarily and leave this high profile vote to the new Congress. New members whisked in on a Tea Party agenda may be loathe to agree to higher debt limits.

#3 FNM and FRE require more government money. Like $225 billion more. It is my understanding that, while no one is talking about it, this will require congressional approval. Same deal – new tea party folks may balk.

All three of these issues have the potential to create significant uncertainty and send share prices lower. If Congress extends government funding until the new Congress takes over and does nothing else during its “lame duck” session, there are certain, serious consequences. The Bush tax cuts expire as of year end, and therefore tax rates are scheduled to go up January 1st. Income tax rates will increase across all income levels. The tax rate on dividends will increase from 15% to the regular income tax rate – up to 39.6% for high-income earners. Capital gains taxes go up from 15% to 20%. The estate tax will go back to a 55% top rate with a $1,000,000 exemption. There was no federal estate tax in 2010. In 2009, the top rate was 45% with a $3.5 million exclusion.

As the new mix of Democrats and Republicans begins to posture and parry with each other, we hope that they will focus quickly on crucial matters at hand. If the Federal Reserve continues to believe that additional monetary accommodation is necessary to sustain economic growth, then it makes NO economic sense to engage in contractionary fiscal policy.

Overall, we remain constructive and we are buying individual stocks. But we continue to believe that we have a long road to recovery. We believe that stocks will be the best performing asset class over the long-term. A 2.5% 10-year Treasury bond is an emotional trap with potentially disastrous consequences.

Even with mortgage rates at 4%, housing prices are not increasing and may move lower. Housing took us into this mess. Housing can keep us in this mess. And we won’t emerge until housing stabilizes. This morning Bernanke said that broad home ownership is only good if it is sustainable. The homeownership rate averaged around 60% over many decades but got as high as 69.2% in 2004. If we are reverting to the mean, we need to keep in mind that reversals seldom stop at the mid-line.

Hoping for responsible government!

Hang in there,