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The Taper Non-Event

Market mavens have been warning us about Federal Reserve (Fed) accommodation being moderated over the near future. In everyday language, this means that they expect the Fed to print less money in
order to “wind down” the aggressive accommodation that has taken place for the last four years. Hence the term “taper.” Presently, the Fed buys approximately $85 billion worth of Treasury securities and mortgages each month with newly “created” dollars. The market fears center on the belief that the gradual slowing of this new money creation will precipitate a higher interest rate spiral which, in turn, will cause another recession.

Certainly, there are other issues concerning investors (the most recent being the Syrian Civil War), but the fear of the Fed taking away the punchbowl presently overrides all others.

Frankly, our view is that this concern is based on the wrong assumptions. These assumptions emanate from the experience of rapidly expanding Federal operating deficits over the last few years, and without the Fed purchasing much of this continuing deficit, we will quickly face another credit downgrade or worse. To the contrary, we feel that the deficits are actually shrinking, and talk of a balanced budget may become a key news issue going into the off-year election next year. We actually think the numbers that are finalized by this coming Fiscal Year End will begin to show a surprising deficit shrinkage. This surprising deficit news will not result from any design or action taken by the Administration alone, but rather from a confluence of events and separate actions precipitated by players in our free economy, Congress, and the Administration.

As 2012 gave tax payers a clear warning of higher impending taxes commencing in January 2013, many individuals decided to take gains and income in 2012 in order to pay taxes at lower rates, rather than waiting and paying higher taxes in the future. Additionally, many opted to pay 2012 taxes in order to liquefy estates and transfer assets to heirs under higher lifetime exemptions. Many corporations paid billions in special dividends to take advantage of lower tax rates for stock holders. In short, all this activity resulted in abnormally high tax payments in April of this year. The IRS actually received a one- time windfall in tax revenues.

As a result, many individuals are likely paying higher estimated taxes at this year’s higher rates on income estimates derived from abnormally high levels in 2012. This creates another “windfall” for the IRS with each quarter’s estimate payments in 2013.

Additionally, economic growth is creating higher income for many corporations and individuals who, in turn, must pay taxes at this year’s high rates. Much of our economic growth is coming from the energy boom created by domestic shale oil production. Without this boom, it is questionable as to whether we would have experienced any growth at all. Nevertheless, the aggregate numbers will show higher tax revenues coming from higher economic growth taxed at higher rates.

On the spending side, the mandatory sequester that commenced in January is working fantastically! Government spending, with all the griping and fear mongering, has effectively been curbed. We’ve always maintained that spending was the cause of our deficit problem, and the numbers will prove this point. As sequester is a ten-year exercise, it cuts into the natural compounding within the budget. The numbers through July 2013 compared to the end of July 2011, show that the deficit as a percent of GDP (Gross Domestic Product – a proxy for the economy) has dropped from 8.3% to 4.2%. In the same timeframe, government spending has dropped from 23.3% of GDP to 20.7%, while revenues have increased from 15.1% of GDP to 16.5%. Keep in mind that these numbers include only seven months of sequester and higher tax rates. The differences promise to be even more dramatic by year end.

This combination of extraordinary high tax receipts, high economic earnings coming from a new technology boom in energy production, and a mandatory spending restraint in the form of a sequester will likely bring us to a smaller than expected deficit and possibly even a surplus in our operating budget by this time next year.

As to the stock market, many companies have probably hit profit margin peaks, making earnings growth more difficult to come by, especially in a slow growth economy. Companies benefitting from infrastructure improvement, or providing support to the booming domestic energy sector will likely have good earnings. It is no longer a rising tide that lifts all boats. Selection will become more critical. Bonds may have a rally once the deficit picture becomes more well-known, but this is likely to be only a “trade” which must be sold.

Yes, we can already hear the political rhetoric, claiming success from “well-designed” economic and tax policy. Nothing would be more disingenuous, and inaccurate. The truth is that we are fortunate for different reasons. We must be careful to continue the sequester, avoid taxing the newly revived domestic energy sector, and brace for lower tax revenues in 2014, after things normalize. As my golf buddies frequently remind me, it’s better to be lucky than good.

Finally, what about Taper? If we’re right, the Fed won’t have much to buy with newly printed dollars, making tapering a moot point. Market mavens would do better worrying about how Washington handles the debt ceiling, the budget process and the wonderful deficit situation. There’s plenty there to worry about…

About the Author


Harlan J. Cadinha
Founder, Chairman and Chief Strategist
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