Post 2012 Election

The 2012 election re-elected President Obama and did not significantly alter the composition of Congress.  Republicans still control the House while the Democrats retain control of the Senate.  This leaves the same actors to negotiate a way to get the budget deficit under control while averting the recession that would result from a full implementation of the looming fiscal cliff.  Any deal on averting the cliff will include increased taxes for those at the top brackets.  The decisive nature of the election puts the onus to compromise on House Republicans and may result in a deal sooner rather than later.

The election also indicated that the Democratic Party, with its support among younger people, single women and minorities, is gaining an Electoral College advantage that will only grow stronger over time as the traditional Republican base continues its demographic decline.  The combination of the Obama re-election combined with the prospect long term secular trend supporting future Democratic presidencies, while not a cause for panic, does at the margin change the environment for taxable investors.   Economist Michael Drury of McVean Trading & Investments, LLC recently observed:

We see the next several years as a repeat of the 1950s: with lots of volatility, low interest rates and inflation, and growing market power for dominant firms. The fifties were part of the long sweep from FDR to Reagan where rising taxes and government regulation were the trend – not only in the US, but around the world. From Reagan/Thatcher to Lehman, those trends were reversed – much as they had been during the post-Civil War sweep culminating in the Panic of 1893. After 1893, the US entered a period of strong regulatory and anti-trust sentiment until WWI – which was followed by the brief but spectacular Roaring Twenties. These sweeps are not of any determined length, but they reflect deep underlying changes in demographics and economic fundamentals. The political reality for the Republican Party today is that the Electoral College now is heavily biased toward the Democrats. In the last six elections, they have carried the East Coast (except NH), West Coast and Industrial Midwest every time. Add in NM, NH, and IA, which were won five of six times, and they start with 247 of a needed 270 electoral votes. The new Hispanic strategy of carrying NV and CO gives them a lock (at 272) without even thinking about OH, FL, or VA — never mind NC.[1]

The prospect of a long period of Electoral College dominance by the Democratic Party raises fears among the business community of higher taxes, increasingly burdensome regulation and most importantly the creation of an environment hostile to the entrepreneurship necessary to deliver the economic growth required to put government finances back in order.  While bad public policy remains a risk, it is important to remember how far the US economy has come in the past 50 years.  Conservative columnist David Frum recently pointed out:

Compare the United States of 2012 to the United States of 1962. Leave aside the obvious points about segregation and discrimination, and look only at the economy.  

In 1962, the government regulated the price and route of every airplane, every freight train, every truck and every merchant ship in the United States. The government regulated the price of natural gas. It regulated the interest on every checking account and the commission on every purchase or sale of stock. Owning a gold bar was a serious crime that could be prosecuted under the Trading with the Enemy Act. The top rate of income tax was 91%.

It was illegal to own a telephone. Phones had to be rented from the giant government-regulated monopoly that controlled all telecommunications in the United States. All young men were subject to the military draft and could escape only if they entered a government-approved graduate course of study.[2]

Most of the conservative victories of the 1970s and 80s regarding the broad societal benefits of free enterprise vs. government planning remain unchallenged.  The issue for public debate centers not on capitalism itself, rather on the proper amount of social insurance for a middle class anxious about its economic future.

The most obvious conclusion of the election is that marginal tax rates on income and capital gains will increase.  Capital gains, due to the 3.8% Medicare Tax implemented by Obamacare, will at a minimum increase to 18.8% January 1.  If the Bush Tax Cuts are allowed to expire, the Federal capital gains rate would increase to 23.8%.  While tax proposals from both parties have retained a lower tax treatment for dividends, the expiration of the Bush tax cuts would also result in a reversion to dividends being taxed as ordinary income.

With the prospect of rising tax rates on ordinary income, the relatively high yields on municipal bonds provide an obvious alternative to Treasury bonds and investment-grade corporates.  Prior to the financial crisis, investment grade municipal bonds traded at yields of 80-90% of comparable maturity Treasury bonds.  Currently one can buy a diversified municipal bond portfolio that offers a higher absolute yield than Treasuries or investment grade corporates.  If income tax rates increase, the value of the Federal income tax exemption will also increase.

With interest taxed as ordinary income, credit or high yield bond strategies only become less attractive to taxable investors if the spread between taxes on capital gains and ordinary income increases. If both rates increase proportionally, the attractiveness of taxable fixed income strategies relative to equities does not change, provided inflation remains at current levels.  Inflation exacerbates the bite of high taxes, as taxes are accessed on nominal, rather than real yields.  For example, an investor who pays a 40% tax rate on a 5% yield in a 3% inflation environment has received a zero real return.  Equities, as a real asset, offer better long term protection against inflation than fixed income investments.

Outside of mutual funds, taxable investors can only deduct management fees to the extent they exceed 2% of their Adjusted Gross Income (or not at all if they fall into Alternative Minimum Tax).  This means that fees have to be paid with after-tax dollars.  At the current 15% capital gains rate, it takes $1.25 of investment gains to pay $1 in management fees.  If long term capital gains rates increase to 23.8%, it will require $1.32 to pay $1 in management fees.  Alternative strategies with high fees that generate ordinary income will be particularly disadvantaged.  A hedge fund charging a 2% management fee and generating ordinary income through its trading activities currently needs to generate 3.07% for its investors to break even after fees and taxes.  At a 40% tax bracket this hurdle increases to 3.33%.  This places a rather large hurdle for the profitability of investments that can work under this structure.

Comstock’s strategy of constructing a core portfolio of high quality stocks with satellite positions in more opportunistic and higher growth investments while maintaining an adequate liquidity reserve remains the optimal investment solution for this environment.  Cash and other “safe” assets offer only the certainty of losing relative to inflation. Despite the volatile political and economic climate, technology and entrepreneurship will continue to create wealth.

[1] McVean Weekly Economic Update, November 9, 2012