U.S. stocks were sparked by the tax compromise between the White House and Senate Republicans (for most of the session at least), more than offsetting the previous night’s news of weaker Eurozone growth to come and higher Chinese interest rates.  However traders faded the rally in the final hour of the session, erasing essentially all of the broad market’s earlier gains. 

We came closest to that pre-Lehman level of 1250 on the S&P 500 since the crisis began, until the market backed off.  The Dow Industrial Average was up 87 points at its best, but ended the day down by three points. 

Word was that federal investigators were ramping up their insider-trading probe and that’s what caused stocks to erase gains.  Instead, the late-day weakness was more likely driven by the reaction in the bond market as rates jumped, weighing on sentiment as the day wore on – the 10-year jumped 20 basis points (bps) and was up 25 bps at its worst; up another 8 bps points early this morning. 

We remain in an extremely tenuous economic environment and one must be aware of what better news on the policy front does to not only interest rates but commodity prices as well.  In short, unprecedented monetary easing can cause commodity prices to keep rising, sapping the benefit from the more short-term stimulus measures within the tax compromise.  And even though rates remain extremely low, the housing market probably can’t withstand much increase.

These higher rates are going to happen, either now or later.  Thus we need a big bang move to reform the tax code, making it more efficient and pro-growth, and major improvement on the spending side of the budgetary ledger.  In addition, there are all kinds of growth inhibiting regulations that must be cleared.  These improvements will occur because they will have to in order to get capital formation, jobs and income growth to levels that allow us to manage future challenges – just mildly higher interest rates being one of those challenges  and what this means for public-sector debt refinancing. This goes beyond the federal situation as state and local fiscal realities are in a state of mayhem. 

Industrials and consumer staple shares led the market higher.  Utilities and energy were the laggards. 

The CRB Index closed down slightly as the prices for silver, OJ, cattle and gold pulled back. 

Market Activity for December 7, 2010

The Compromise

There was a lot of excitement overnight Monday that flowed into Tuesday trading after the President announced a tentative agreement with Senate Republican on taxes and unemployment benefits.  The compromise would extend current income tax rates on labor and investment income for two years and maintain higher business spending expensing allowances for a 13-month extension of long-term unemployment benefits and a two percentage-point reduction in payrolls taxes (social security taxes) for one year.  While this merely maintains the status quo with regard to labor and investment income, it certainly clears uncertainty and that’s something that has been vastly underestimated (the high level of uncertainty) with regard to retarding economic growth.

Also, the estate tax rate would move to 35% for estates above $5 million --- below that mark would be exempt.  This is substantially higher than the current rate of zero, but an improvement from the 55% it would have reverted to. 

The extension of the labor and investment income tax rates is really the big one.  Obviously, it would be better to make the tax code more efficient (eliminate deductions) and both lower the rates and reduce the number of brackets. But again, this will certainly help as it clears uncertainty – big changes aren’t really possible, not yet; again, that will come. 

Further, the bonus depreciation on property (can depreciate up to 50% in the first year rather than over five years) and higher expensing allowances on business equipment.  While nice policy in my judgment that can only help in boosting business spending, it would have been much better to see a substantial reduction in the corporate tax rate.  This would be a huge job creator, but again, we can only have hoped for the status quo for now rather than the changes that will really help our growth potential over the longer term. 

On the unemployment benefits and reduction in the payroll tax rate, these are the kind of things that boost activity in the very near term but carry payback consequences.  It’s an offshoot of the typical Keynesian-type stimulus that is normally delivered via rebate checks.  The plan will almost certainly boost spending and probably takes the risk of double dip off the table as that consumer activity will help just enough to keep GDP from printing a negative reading or two in early 2011.  This will offset the continued and accelerating cut backs in state and local government spending, specifically as the federal assistance to the states runs out. 

Unfortunately, the payback comes as these benefits and tax reductions (referring to the jobless benefits and payroll tax reduction) are taken away again a year from now.  And of course, it does more damage to the deficit – the payroll tax reduction puts Social Security even deeper in the hole.  This is unlike a permanent reduction in income and investment tax rates that keep more money in the private sector. Such policy drives job growth and increases the tax base; therefore, government receipts are driven higher and with just a little common sense on the spending side of government’s budget ledger, you have deficits fall in a substantial manner. 

Consumer Credit

The only economic release we had yesterday was the Federal Reserve’s report on consumer credit, which showed an increase of $3.4 billion in October (was expected to decline by $1B) after a $1.2 billion increase in September, which was revised lower from the $2.1B increase initially reported.

Bottom line is all of the increase in consumer credit over the past two months (which follows the deepest contraction in the data’s 67-year history) has come from the non-revolving segment – auto and student loans.  Revolving credit – credit cards – has contracted for 26-straight months.  This data does not include home loans. 

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900