Current long term capital gains tax rates are at 15%. Taxes on interest income are at your ordinary income tax rate. So, here’s how the math goes. If you owned a bond that matures in 2012 with a 6.75% coupon on it that you bought in late 2008 around 100, it’s probably worth at least 112 today. If you sold it, you would record a long term capital gain of 12 points; that gain would be taxed at 15% which means you would owe tax of $1.80. If, on the other hand you held the bond until maturity, you would earn 6.75% in interest income 2011 and 6.75% in interest income in 2012. Now, we don’t know for sure what Congress will do with the Bush tax cuts, but you can bet if you pay a marginal tax rate of 25% in 2010, you probably won’t pay much lower in 2011. So, let’s assume Congress extends the Bush tax cuts into 2011. You would pay $1.69 in taxes on your 6.75% interest income in 2011 and another $1.69 in taxes in 2012, for a total of $3.38—substantially higher than the $1.80 you’d pay by selling the bond now.

Low opportunity cost; lower tax liability. Two reasons to sell those bonds in taxable accounts.

Mike Timm

What it does mean is that we are not interested in owning longer maturity bonds; we find much more interesting the equity of companies who can actually issue those bonds during such uncertain times. We confirm our call from last month: “Attractive valuations; respectable dividend yields; solid balance sheets; international exposure; growth potential: all good reasons to consider large cap multinational company stocks over low yielding bonds in the current environment.” Additionally, we now intend to selectively sell some of our high premium corporate bonds and temporarily park those proceeds in cash.

Rick Morgan, Ryan Comstock, Mike Timm

Things to watch for as signals to suggest an inflection point; a plethora of 50-100 year maturities being issued by corporations, investment grade corporates tightening to yields fractionally less than govts. (15 or so), bb high yield coming into the 75 basis point spread to governments in the 5 year maturity. Also watch for when bad economic news is announced and bonds DON’T rally.  One thing we can agree on the distance we have come from 15% to the current level and the unanimity of the bond trade.

Conclusion: We are very close to an inflection point or there is truly something nasty lurking out there. 

Rick Morgan
Principal

As recently as 2005 American’s were saving only 1.1% of their personal disposable income.  This would turn out to be a trough in the savings rate after a long and gradual decline from roughly 10% in the early 1980’s.  Going into the recession, market pundits complained Americans were spending too much and saving too little as no one was prepared to handle the layoffs that ensued.  In the courses required to become a financial planner I had it drilled into me class after class to always have an emergency fund to fall back on.  This is found by taking your total liquid assets and dividing them by your total monthly non-discretionary expenses; an answer of 6 to 9 months is generally considered a safe and desirable level to have on hand.  This made certain that you could support yourself for at least 6 to 9 months while searching for employment.  This is effectively what many European countries with debt troubles are trying to do right now.  They are cutting back expenses in order to build up that emergency fund so they will be better equipped to handle future economic cycles.  Our banks are doing this right now as well.  Unfortunately, that means higher restrictions and fewer loans to small businesses at the moment.

Coming out of the recession, now that the savings rate has climbed almost fourfold to 4% in the U.S., many are now worried that Americans are saving too much and need to start spending more in order to prop up GDP.  As we have written in previous letters, consumer spending makes up roughly 70% of our GDP.  This is similar to the argument Tim Geithner brought to the G20 meeting that looks like it fell on deaf ears. 

Could we get all the way back to a 10% savings rate?  Maybe.  What is more likely to happen is that we will fall some place in between the current 4% rate and the 10% rate of the early 1980’s.  State pensions and what is left of pensions in the corporate world are beginning to retool requirements and calculations.  One of the ways they are doing this is by requiring new entrants to pay a higher % of their pay into the pension.  Effective July 1^st, a state workers union in Mississippi covering over 3,300 workers will now be requiring employees to contribute 9% of monthly earned compensation into their pension up from 7.25%.  This in itself raises the savings rate.  Those future retirement hopefuls not in pensions have also realized what a recession can do to their nest egg and could potentially start saving/investing increased amounts in order to make sure they avoid outliving their retirement assets.  Total U.S. consumer credit is down over 5.5% since reaching a peak in mid-2008 and for the month of May the drop in consumer credit was $9.1 billion versus a much smaller expectation of $2.3 billion.  U.S. consumers are getting their houses in order just like the US banks and just like many European countries.

What could pick up the slack in consumer spending for the US GDP?  We can think of one possible answer.  In China the last two months have been filled with strikes by workers fed up with their salaries.  It seems like once a week a story is published about a Chinese manufacturer raising their salaries by 30%.  This is evidence of a growing middle class.  Match this with the recent announcement that China is going to slowly let its currency start to appreciate and even more buying power is created.  This increase in Chinese demand could eventually filter through to U.S. products and replace some of the gap created by the increase in U.S. savings rate.

U.S. Savings Rate as a % of Disposable Income

~Ryan Comstock, CFP®

Why would we want to drill for oil in the Gulf of Mexico anyway?  Can’t we just buy more oil from foreign countries?

For the last ten years 40% of the world’s oil discoveries outside of the U.S. have occurred in deepwater drilling.  During 2009, oil production from the federal waters of the Gulf of Mexico totaled about 1.6 million barrels/day, and accounted for 31% of U.S. oil production.  The U.S. Energy Department forecasts that by the year 2035 offshore oil production from the lower 48 states will increase by over 80% and account for approximately 38% of U.S. oil production. Additionally, production from the federal Gulf of Mexico accounted for 11% of total domestic marketed natural gas production.

Yes, we could just prohibit drilling for oil in the Gulf of Mexico going forward; this would eliminate the environmental risk of blown-out deepwater wells spilling oil into the Gulf waters.  But the cost in terms of our trade deficit would be huge.  Assuming a $75/barrel oil price that results from a permanent drilling moratorium and which would eventually cause U.S. oil production from the Gulf to cease, and that we would need to replace the lost domestic oil production with imported crude oil, the increase to our trade deficit would total nearly $44B annually. Every barrel of oil that we do not produce in the U.S. is a barrel that we need to import.

In terms of employment, we could say goodbye to the jobs of the 100+ people who work on each drilling rig.   Add to that the oil services supply chain, which includes helicopters, supply boats, caterers, equipment manufacturers, etc., etc.  The Minerals Management Service estimates that offshore operations provide direct employment of 150,000 jobs. No doubt countries that already have ongoing offshore drilling activity would benefit from a permanent ban on deepwater drilling in the Gulf of Mexico.  If such a ban were to occur, you could expect an exodus of floating drilling rigs (and jobs) out of the Gulf of Mexico and towards offshore West Africa, the North Sea, and offshore Brazil.

The deepwater Gulf of Mexico is one of the few oil-rich basins in the world that is open to investment by the major oil companies and smaller independents, that is near existing infrastructure, and that offers a stable tax regime.  In fact, Apache Energy recently agreed to acquire Mariner Energy, one of the leading independent oil and gas exploration and production companies in the Gulf of Mexico, precisely because of Mariner’s exploration prospects in the deepwater Gulf of Mexico.  Apache believes that the Gulf of Mexico offers significant growth potential  in a world class basin.   Advanced seismic technology has significantly increased success potential and growth in deepwater infrastructure has reduced development costs.

Given that the environmental and economic costs of this oil spill already exceed those of the Exxon Valdez, we can expect more federal government regulation of offshore drilling in those areas outlined above.  Additionally, it is increasingly likely that it will be at least a year before the government permits deepwater drilling of any kind to resume.  Because the oil and gas from the Gulf are an integral part of our nation’s energy supplies, the interruption in its operation will put additional pressure—and create additional opportunities—in on shore reserves.  As you know, we have written extensively about the opportunity we see in natural gas, and this unfortunate disaster in the Gulf will no doubt elevate the prospects of these gas reserves so that they become more central to any future U.S. energy policy.

James G. Tatakis
Assistant VP, Research

Is this a temporary bump or a more significant turning point?  I would say it has the potential to be bigger than a bump in the road.  Globalization has taught us one thing: decoupling is gone for good, so the US cannot grow at an above normal rate indefinitely while Europe is in recession and Asia is touching the monetary brakes.  Though all parts of the world are not necessarily at exactly the same point in economic expansion, eventually they are more likely than not to be moving in the same direction.  Are all regions still moving in the same direction?  Not exactly.

Low inflation is here for even longer.  Low interest rates are here for even longer.  Is deflation now back on the table?

Leading Indicators:

If we think back to February of 2009, near the lows, what indicators were we paying attention to that told us that perhaps the US stock market might be about ready to turn around?  Commodity prices, performance of Asian stock markets, leading economic indicators, and monetary policy were among the most important.  Most of our thinking was focused on the macro picture, as all stocks, regardless of quality, were being hit the same (analysts estimated at the time that over 90% of any stock’s movement was attributable to the market, and only 10% attributable to the company’s prospects).  Commodity prices had turned up, Asian stock markets (particularly China and Korea) had turned up, leading economic indicators looked as if they stopped going down at a rapid rate, and monetary policy was highly accommodative.  The first two (commodity prices and Asian stock markets) historically had led US stock market direction by as much as six months.  Leading economic indicators began to turn not too long after the US stock market turned.  And, of course, the lagged effects of monetary policy characterized by quantitative easing had begun to kick in.

Now, let’s look at those same four indicators today.  Commodity prices rolled over in late April, breaking through their 200 moving average in May; the Chinese stock market is down 24% from its cycle peak in August 2009; the Empire Manufacturing PMI (a leading indicator) turned over in May vs. April; and monetary policy around the world started, before the Greek debt problem, to move toward tightening (China, India, Australia, Brazil and others having actually raised rates).  Granted, we have a whole rash of additional LEIs to watch for over the next couple of weeks, so one data point does not a trend make.  However, the Chinese stock market performance combined with the commodity rollover should give us pause.  What works best in an environment that looks more like “late expansion” and “early contraction” rather than “early expansion”?  Defensive stocks like staples and healthcare.

Europe:

We have frequently said that the European mess is noise negatively affecting our market and that the ways in which the EU, IMF, and ECB have tried to deal with the sovereign debt issues in Europe have changed daily (sounds a bit like the US response with the TARP funds’ quick shift from buying toxic assets to recapitalizing banks) and therefore make the effects on our market difficult to anticipate—musical chairs, I think, was a phrase someone used to describe it.

I would contend that what is happening now in Europe was something we in the investing world were well aware of, but thought would not materialize for a while.  Excessive debt as a % of GDP is something that plagues all developed countries around the world, some worse than others.  In the PIIGS, in the rest of Europe, in over 40 states in the US, in the federal government of the US, and in the UK, we all are struggling with the effects of Keynesian economic theory.  Thinking that we would eventually grow our way out of the deficit/debt problems, we tried to fix a debt originated problem with more debt (our CIO Scott Schermerhorn wrote about that in an Insights piece  a couple of months ago!).  But we haven’t had enough time to grow our way out of the debt.  All developed countries are wrestling with large public sector wages and social welfare obligations.  Reining those expenses in will instigate generational and cultural conflicts, the magnitude of which is another unknown.

What will European countries do?  Greece is trying to institute austerity measures; Spain and Portugal have already passed tighter budgets.  However, think of what these tighter budgets will do to economic growth in these countries: slow them down.  Spain already has a 20% unemployment rate; severe austerity measures will exacerbate already difficult employment and growth issues throughout the weaker countries of Europe.  We can expect slower GDP growth from the region of the world least likely to have had a modest recovery in the best of circumstances.  How will this potential economic weakness affect those companies who have a significant portion of its sales in Europe?  Given the strength of the dollar vs. the euro (another headwind for US exporters), it cannot be positive.  As an example, MCD gets 43% of its revenues from Europe, KO is at 33%–and these two names are in our higher quality, decent dividend, more visible earnings category.

We watch the bonds of these weak countries as the best indication of what the bond vigilantes are thinking the prospects of success in the IMF/EU/ECB rescue package is going to be.  Much as the Fed’s massive purchase of government and agency bonds in 2008-2009 provided a bid for US Treasuries, the ECB’s recent open market purchases of European sovereign debt has kept rates on those bonds under control.  Ed Yardini’s (Yardeni Research) sources tell him that “foreign holders of Greek and Portuguese debt have seized on emergency intervention by the ECB to exit positions, leaving Eurozone taxpayers exposed to the credit risk.

This situation is pretty complicated.  But, the bonds of these countries may well start to show stress if the markets do not think the rescue package will be successful.  It didn’t really help when the Germans today prohibited short selling of euro denominated sovereign debt.  Different cultures, different economies, one currency dominated by Germany and France.  Should be interesting.

Inflation:

The recent weakness in commodity prices erases the last vestige of pressure in the CPI near term.  So the Fed, watching resource utilization and inflation in the US, should feel no immediate pressure to raise rates.  The problems in Europe should act as a deterrent to higher rates anytime soon as well.  Until there is more clarity in Europe, those countries who have raised rates may take a break near term.

All information is provided for informational purposes only and should not be deemed as a recommendation to buy the securities mentioned.