January Blahs
Jude Wanniski and Paul Hoffmeister
January 20, 2005


There isn’t really much good news on the political front to encourage the equity markets. Yes, the economy is still expanding and except for softness in one company or another, corporate earnings have been up to snuff. But even that bit of good news on the economic side of the political economy is offset by upbeat assessments from the Fed’s governors on how they can continue to raise interest rates to rebuild their preferred yield curve. Here are some of the political downbeats we’ve been observing.

REPATRIATION: We reported last Friday that the 111-point drop in the Dow was almost certainly due to the Treasury Department’s release of the regulations that must be followed for multinationals to repatriate profits parked abroad in order to take advantage of the temporary tax holiday. Our assumption was that the rules as drafted by Treasury bureaucrats were so onerous that Republicans in the House and Senate who had worked so hard to get the legislation passed would be up in arms to discover what had been done and would press Treasury Secretary John Snow to backtrack. The feedback I got from Capitol Hill, though, indicates the relevant players there knew exactly what the regs would look like and bowed to the political wishes of the Bush administration that the regs “look good” to those in Congress who insisted the repatriated profits be invested in areas directly tied to “job growth.” Bottom line: There will be “no fuss” from Capitol Hill, as I was told, but that it has been assumed that “because money is fungible, companies that want to get around the regs will be able to find ways to do so.” 

A closer look at the regs. It is taking management committees time to study the regs and then determine whether it is worthwhile to repatriate profits. Here is what they are finding, as one of our clients who did study the 40-page report tells us: 1) Not only can they not pay dividends or buy back stock, companies can’t even hold it in cash or marketable investments!  They have to spend it! 2) Once they have approved a plan, they are not permitted to modify it.  If business conditions change, tough!  3) The CEO and Board must sign off on the “reinvestment plan”, probably making them legally liable if someone finds a problem. Now THERE’S an incentive to go down this road. 4) While they may not return money to shareholders, they can use it to pay down debt, based on the concept that debt reduction leads to “financial stabilization for the purposes of U.S. job retention or creation”. So Hewlett-Packard or Sun Microsystems, which have plenty of debt, can repatriate funds to improve their balance sheet, but Microsoft, which has no debt, cannot. 5) While there appears to be some loopholes that would allow companies to get around the spirit of this regulation, it seems to make sense only for companies that are less financially secure (another form of “corporate welfare”) or the rare company that is growing faster in the U.S. than internationally and therefore can economically make better use of the funds in the U.S. business  -- I dare someone to find 10 such companies.

SARBANES-OXLEY: We keep hearing from Treasury Secretary Snow that the worst piece of legislation in the President’s first term is so onerous in the burdens it places on publicly-traded firms that relief is on the way. In case you did not notice, the sharp decline in equities yesterday afternoon followed a Bloomberg report saying Senate Banking Chairman Richard Shelby finds no need to revise Sarbanes-Oxley, even though some companies are protesting its costs and rules: “‘I don’t think you can have any substitute for integrity in the capital markets,’ and Sarbanes-Oxley has helped protect investors against corporate fraud, said Shelby… The 2002 law gave new powers to the Securities and Exchange Commission and created the Public Company Accounting Oversight Board to regulate the accounting industry. ‘Sarbanes-Oxley is just two years old, and I believe that the SEC and the PCAOB have been working pretty well in that regard,’ Shelby said.” This isn’t the final word, but it is a most discouraging word.

THOSE FED RATE HIKES:  In recent weeks, various FOMC members have unequivocally stated their support for a continuation of measured rate hikes, showing that a consensus is virtually in place to proceed.  Even worse, St. Louis regional president Bill  Poole wonders if the “measured pace” should be dropped for a more “vigorous reaction” if inflation statistics worsen. A monetarist, Poole probably sees, as do we, that the Fed’s balance sheet (reserve bank credit) has expanded ever since it began its current inflation-fighting strategy but he has drawn the wrong conclusions. Fed officials should be worried that raising short-term interest rates will slow economic growth. A 1996 Fed study by Estrella and Mishkin notes that the spread between the ten-year Treasury and three-month T-bill is a simple and reliable predictor of recessions two to six quarters ahead.  Since 1971, our work shows that an inverted ten-year/fed funds spread has preceded 5 out of 6 economic contractions. At least the Fed’s current tone does not imply an inverted yield curve. If that were the case, the market would price in that scenario more harshly than we are seeing lately. In large part, Wall Street’s weakness since 2005 began reflects the market’s pricing in a 3.5% funds rate by year’s end, and its implications for slower growth.

SOCIAL SECURITY TAX HIKE? In the last few days there have been reports that G.O.P. House leaders, including Ways&Means Chairman Bill Thomas, have been saying there will probably have to be an increase in payroll taxes if there is to be Social Security reform this year. This probably means the current $90,000 cap on earnings subject to the tax would be lifted, another bummer. A story in today’s New York Times by Edmund Andrews covers the various considerations. The President has vowed no increase in taxes, but the way this is being played -- with Social Security reform separated from tax reform – suggests the administration will be offered gridlock or a tax increase and will take the latter. With Thomas wilting, it could get worse. Blah.