No New Taxes? Think Again

The Investment Strategy Group provides regular updates on economic and financial conditions. In this commentary, we focus on the impact of the divergence of the macro economy from the micro economy.

At the time of this writing President Obama and congressional leaders of both parties have evidently agreed to a framework for a budget deal that would cut trillions of dollars in federal spending over the next decade and clear the way for an increase in the government’s borrowing limit.

While this move enables the country to skirt a default, most of the damage has already been done, at least as far as the investment community is concerned. A technical default would have been terrible, of course: We have commented before on the likely negative consequences, both for asset values and for the real economy, that would follow. But, more fundamentally, the circus of the last months has demonstrated that our political process is incapable of generating an intelligent consensus on tax and expenditure.

The implications are profound. Investors in US obligations, as well as in US-guaranteed obligations such as agency bonds, now anticipate a variety of problems. Chief among them are the potential for the US to be viewed as a second-tier lender, a perception that could impair liquidity and increase the prospect of runaway deficits that could trigger real defaults or, more likely, prompt efforts to eliminate debt by allowing inflation to surge. The US, in short, has lost credibility, while its debt has lost credit quality. Thus, we expect the US to pay higher interest rates across the entire yield curve in the future. And, because all other domestic interest rates are based on Treasury rates, every borrower in US dollars will pay more to borrow.

Higher Hurdles

Let’s estimate roughly what this extra cost might be. Total non-financial debt (the debt of all households, companies and local, state and federal governments) is about 240% of today’s gross domestic product (GDP). If the extra borrowing cost is only 1% – although we fully expect it to be more – then this adds 2.4% of GDP to interest paid. Remember, on average (that is, not during a recession), total federal revenues are a little less than 20% of GDP. This extra burden, then, is equivalent to a 12% increase in the federal tax take from the economy. Add the following fact: Corporations view “cost of capital” as a risk premium above the cost of debt. Hence companies contemplating whether to make an investment will face a hurdle rate that has risen by that same 1% and so will almost certainly decide to take advantage of fewer opportunities. Similarly, families will face higher mortgage, car and credit card interest bills, and so will buy less. There will be slower growth in the real economy and a prolongation of high levels of unemployment.

Redistribution of Wealth

All such changes also entail the potential for enormous wealth redistribution. The Federal Reserve’s current “zero interest” policy transfers real purchasing power from savers (who are earning yields below the rate of inflation on their savings) and transfers it to borrowers (including, especially, our big federal borrower). A jump in the yield curve will shift the transfer of money the other way. Savers will earn more on investments with a floating yield or a fixed yield set after (but not before!) the jump in rates.

Anyone unfortunate enough to own a long maturity bond today will take a large capital loss when interest rates rise. Insurance companies and pension funds are particularly vulnerable. And, if the rate that investments must earn to repay the cost of capital rises, stock prices will fall until their returns (on this now lower base) meet the new target. Because the stock market anticipates changes, we expect that a lot of this reasoning is already priced into stocks.

In this environment, much of the baby-boom generation will find that it is even further from having sufficient assets on which to retire comfortably.

Send a thank-you card to your congressman, your senator and the president.

George Feiger, CEO of Contango Capital Advisors and the author of the preceding article, has recently been quoted by media outlets including BBC NewsHour, Bloomberg News, Bloomberg TV, Chicago Tribune, CNNMoney.com and The Globe & Mail. Mr. Feiger’s past positions include Global Head of Onshore Private Banking for UBS, Global Head of Investment Banking at SBC Warburg and senior partner at McKinsey & Co. Formerly an associate professor of finance at Stanford University’s Graduate School of Business, he holds a PhD in economics from Harvard University.

Contango Capital Advisors is the wealth management arm of Zions Bancorporation (www.contangoadvisors.com). Contango Capital Advisors is an affiliate of Zions Direct.