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Presidential Hurdles

11/12/2004 12:00 am EST


Jack Ablin

CIO, Cresset

"As grueling as the Presidential campaign was, the last few months will be a cakewalk compared to the work facing President Bush in the next four years," says Jack Ablin, chief investment officer for Harris Private Bank. Here, he outlines the major financial hurdles ahead.

"While international issues have received front and center attention in recent years, several domestic issues have been festering. They need to be addressed squarely now, because if left unchecked, our economic well-being could be undermined. First to be addressed is the national savings rate. For decades, the average rate at which consumers save has been declining. In 1981, Americans saved 8.5% of the national income, according to a New York Times report; by 1998, that rate had declined to 6.5%; but by the end of 2003, the net savings rate had plummeted to a mere 1.2%. In the past 20 years, as consumers watched interest rates head south, they embraced credit. Consequently, household debt which now stands at $9.7 trillion—has grown by 39% since our previous Presidential election four years ago.

"Before Americans can be expected to increase their savings rate, they will need to reduce their own debt. After all, the ‘ownership society,’ a key element of President Bush’s re-election platform, is predicated on private savings accounts for retirement and healthcare. Of all American workers who have 401(k) accounts, only 8.4% are making the maximum contributions currently allowed. The conclusion: 401(k) plans appear not to offer attractive enough incentives for saving. On the other hand, the deductibility of mortgage interest is a very strong incentive to borrow. Home ownership is close to 70% among American households. Perhaps with additional and different incentives, household savings can increase, as well.

"What’s so bad about a low savings rate? After all, doesn’t the spending it encourages help our economy? The answer is a bit of a paradox: Yes, in the near term, spending does help our economic growth. (Case in point: After the 9/11 attacks, there was a constant linkage between patriotism and consumption, spurring spending and short-term economic gains.) But for the longer term, savings is critical, because they are utilized for domestic investments. An inadequate savings rate will raise capital costs for investors. Fortunately, our current investment gap is being filled by foreign investors whose savings rate is substantially higher than ours.

"Another challenge President Bush faces is the future of Medicare and Social Security. According to a Government Accounting Office study, the present value of Medicare’s prescription-drug benefit alone exceeds $8 trillion. That’s almost twice the outstanding US Treasury debt. The oldest Baby Boomers turned 58 this year, and massive retirement rolls are around the corner. As the ranks of the retired soar, fewer workers’ payroll taxes will be available to support them. In 1950, for every one Social Security beneficiary, there were 16 workers paying into the system. In 2003, those workers had declined to 3.3 workers. And, using current projections, looking ahead to the year 2033, it will be only two workers’ payroll taxes supporting each Social Security beneficiary. But, again using current projections, even before we reach 2033—it's estimated that by 2019—payroll taxes will be insufficient to support the total of Social Security obligations.

"President Bush has supported and campaigned on establishing private savings accounts to supplement government benefits. In the long term, shifting more control to individuals is a good idea. But in the near term, the shift would carry a tremendously expensive price tag, costing the government nearly $2 trillion in payroll taxes to transition. Fed Chairman Alan Greenspan has been outspoken in his opposition to this proposed change. He believes the projected shortfalls can be avoided if we simply modify the current system by implementing additional and necessary measures for example, retirement age shifts, payroll tax increases, and benefit changes.

"Our nation’s reliance on imported oil puts us at a strategic disadvantage, especially when oil prices are as high as they are today. Global demand, fueled primarily by increasing consumption in China and India, are unlikely to subside. Conservation is a likely first step, with automobile fuel efficiency standards as a place to start. Gasoline and diesel fuel last year accounted for 57% of US oil consumption, according to a Bloomberg News report. Yet Congress, four times since 2001, failed to pass legislation requiring auto makers to build more fuel efficient vehicles. Raising fuel-economy standards by just one mile per gallon would cut US oil consumption by 143 million barrels per year.

"In the past four years, the federal budget has moved from surplus to substantial deficit. At the movement, the deficit exceeding $400 billion—represents nearly 5% of our gross domestic product. While defense spending related to the war of terrorism indisputably has put a dent in the budget, tax cuts and domestic spending in 2002 helped propel our economy out of the doldrums. However, our deficit position greatly reduces our financial flexibility if we should enter an economic downturn. The President faces tough choices. He has advocated making permanent the tax rollbacks that currently are due to expire in 2008. What he must do is find the right balance between spending programs and tax cuts.

"One looming problem is the Alternative Minimum Tax; its current ‘fix’ will expire in 2005. The Urban Institute estimates that 18.6 million Americans will be hit by AMTs higher tax rates next year. This issue needs to be a top priority. Economic growth on its own will be a catharsis. As long as the economy grows in excess of 3%, the administration should find it easier to reduce the budget deficit as a percentage of gross domestic product. For the last six quarters, the economy has grown above that rate.

"So in light of these factors, what is our financial strategy? Marching forward into President Bush’s second term, we expect that both volatility and uncertainty will decline. As corporate management feels more comfortable forecasting the economic and political environment, we anticipate a greater commitment to capital spending and hiring. Meanwhile, the prospect of an ‘ownership society’ may well provide a welcome catalyst for stocks. One of the primary planks in President Bush’s platform is a shift of more responsibility for Social Security away from government, to the individual. Armed with a portion of their payroll taxes, Americans would be able to invest those new found dollars the way they currently invest their IRAs. A fair portion of these proceeds could find their way into our equity markets, providing huge liquidity. This would be a positive for stocks. But there's a hitch: Where will the government find the dollars it no longer will receive as payroll taxes in order to fund current benefits it is paying out to Social Security beneficiaries? The answer: by borrowing more. Therefore, if the President's plan comes to fruition and alternative proposal of simply modifying the current system is not adopted—anticipate a strong upsurge in equities at the expense of higher interest rates.

"For now, we have a neutral opinion of equities in general. Valuations are reasonable, but the peak in earnings growth is behind us. We continue to anticipate moderate economic growth’ just not at the pace we witnessed earlier this year. Bottom line: We are not overly enthusiastic about equities for the next few quarters. That said, given current valuations, we don’t believe there’s that much risk in owning stocks at these levels. We believe that equities will remain in a holding pattern until there is a catalyst to move them higher. Perhaps the ‘ownership society’ is that catalyst."

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