Drag duo, no, trio

By John Bougearel, author of Riding the Storm Out and Director of Financial and Equity Research for Structural Logic

Fiscal drags combine with manufacturing drags in 2011 ~ these drags will subtract 2.5% from GDP in 2011

The manufacturing sector has pancaked in June and July after giving roughly a 1% boost to GDP over the last 4 quarters. Moody’s says we can expect to subtract that 1% mfg boost to the economy in 2011. “It’s becoming increasingly clear that the biggest lift from the inventory cycle is over. The inventory swing added nearly a percentage point to real GDP growth over the past year and is unlikely to add anything during the coming year. This will weigh on manufacturing output over the next several months.”

David Rosenberg adds that there will be a 1.5% fiscal drag in 2011, and reminds us of a third potential drag on the economy in 2011, the expiration of the Bush tax cuts. Bernanke floated a trial balloon to lawmakers suggesting they extend the Bush tax cuts last week, so we can expect the looming tax cut drag will disappear.  From Rosenberg: “we have at least 1.5 percentage points of fiscal drag coming out way next year so it will be interesting to see what it is that ends up preventing the U.S. economy from contracting.” Rosenberg warns that in two out of the three other aggressive tax hikes since WWII, the economy experienced hard landings. I do think lawmakers will extend the tax cuts because of the fragility, and ‘unusually uncertain’ outlook, but if not, there is a third drag. Final Q1 2010 GDP came in at 2.7%. Adv-GDP for Q2 2010 is estimated to come in at 2.5%. All told the first half of 2010 is growing at best at 2.5%. With the fiscal and mfg drags subtracting 2.5% from GDP growth in 2011, what will be there in 2011 to move the economy forward?

The takeaway is that without real and substantial job growth in the private sector, without growth in the mfg base, without gov’t stimulus, 2011 is poised to sputter. Oh, the SP500 can be expected to climb a wall of worry into Q1 2011 targeting 1313, but then what, another bear mkt? “I reckon so”, said the outlaw Josie Wales.  We should all enjoy the next stock market rally, but also remember to heed Rosenberg’s long-standing advice, these stock market rallies are to be ‘rented’ in secular bear mkts, and we are still in a secular bear mkt.

The Yen Carry Trade to buy US Treasuries in Q2 2010 is beginning to soften and can be expected to be unwound after the August 6 NFP or after the August 13 Retail Sales report. I don’t think we will see the Yen carry trade resume until 2011, when the anticipated drags on the US economy become reality.

Meanwhile, the overcrowded long gold trade continues to be unwound and is expected to persist into the first half of August, perhaps longer. Gold’s strongest correlation right now is the US Dollar. The dollar has been plunging along with treasury yields in Q2 and Q3 largely on the plunging US economic data in June and July. The dollar won’t really strengthen against the Yen until the carry trade unwind gets underway and that won’t happen until the summer doldrums data in the US bottoms. We won’t see a bottoming in most of the data until mid-August.

You can see on the gold chart below that gold reluctantly followed the dollar on a southbound trek at the end of the first half of 2010. Everyone wanted to hold the glittering gold in their portfolios until the first half of the year came to a close because it, along with treasuries were the best investments in the 1st half of 2010. Gold not so much so anymore! Another 6% lower and it will round-trip to unchanged on the year again. Equities just round tripped to unchanged on the year from way ‘down-under’ as they say in Australia this past week. Intriguingly, the 2009 yr close in Gold and the SP500 are both quite near 1100, they are sort of behaving like two ships passing in the night…..

Gold 240 minute
Gold 240 minute
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  1. Tax Lawyer

    Aaahh! One more post about how ending the Bush tax cuts to the wealthy will “drag-down” the economy and I will have my head hanging over the porcelain fishbowl while retching.

    The Bush tax cuts have been used to:

    1. permit wealthy investors to buy shares that were originally issued 20 years ago, from people who bought them from someone else, who bought them from…well you get the picture–nothing there is putting a dime back into the economy;

    2. to speculate in real estate–a non-growth jobless endeavor;

    3. to invest in Chinese or Indian companies;

    4. to buy mutual funds, which by definition purchase pre-existing shares;

    5. to buy commodities;

    6. to buy fixed income securities.

    Virtually none of this gets recycled into the economy to boost GDP growth or build new companies or technology, much less to help employ U.S. workers.
    The Bush tax cuts need to expire, and either the government needs to recreate a bigger stimulus, or we need to radically restructure the tax code to grow domestically based business.

    How about this idea: (1) capital gains on the aforementioned investment gains are taxed as ordinary income, AND subject to payroll taxes (just like working-people’s incomes are taxed); but (2) capital gains from an investment directly into the equity of a company or small business, where at least 60% of its employees/suppliers are U.S. citizens, go untaxed completely.

    This would fix our deficit, GDP and employment policies rather quickly. Of course the multinational out-sourcing uber-companies and Wall Street would scream bloody murder, and with the Citizens United ruling sitting out there, would have little chance of succeeding. I almost want to cry when I think of what this country represented during my childhood in the ’70’s and what a banana republic it has, I fear, irrevocably reverted to.

    1. Siggy

      We were not once a Banana Republic, we were once a Republic. Today we are more like a social democracy.

      Your points 1 thru 6 are all about money grubbing which is an activity incentivised by a debased currency.

      It’s all about purchasing power. Get a buck today, gotta spend it cause it wont buy a dollar’s worth tomorrow; for tommorrow you’ll need a dollar fifteen.

    2. NOTaREALmerican

      Re: The Bush tax cuts have been used to

      Yup. I’m getting sick of this argument too.

      It (the argument) still works on the peasants tho (for reasons discussed yesterday), which is why it’s still used.

      Of course, taking loot from “the rich” would probably only be used for more cool wars; which would end-up sending the loot back to “the rich” anyway.

      Without a functional republic, what’s the point of worrying about tax laws and loot redistribution.

      And you are right tho, it’s never going back. But, really, does it make a different to any individual living now – or in the immediate future – if America is a Republic (has democracy)? It doesn’t. Most people on here will be long dead before America has the exact same government as China. We’ll get there eventually, but not for many decades.

      (Queue: “Don’t worry be happy” song)

    3. RPB

      You make some good points, but to oppose the Bush tax cuts for your reasoning is droll. Most of those bullet points would probably provide capital reinvestment into the US economy (save #3).

      The real issue is that the tax cuts disproportionately benefit the wealthy over the poor.

  2. Cathryn Mataga

    The issue with tax increases is that the wealthy have more flexibility about how to distribute income from year to year. So what’s going to happen is that in the year prior to the tax increases they’ll cash out some of their fixed income securities and commodities or whatever else they’ve bought. Small business owners can delay expenses into the high tax years and take more profits in the low tax years. So I think, we should see a rise in income in the low tax year because of this, and then a drop in the high tax year.

    This income, of course, will go to buy essential but occasional high ticket items the wealthy need, you know, the diamond rings, fur coats, gold-plated toilets, expensive sports cars, and luxurious yachts. These occasional big expenses can also be moved to the year with lower taxes. So we’ll see a drop in consumption of goods for the extremely rich in the high tax year. That is, of course, until the demand returns — the wealthy tire of their current yacht and need a new one, maybe because the color is not quite right, or something like this. Maybe this evens out eventually.

    Me, I suspect a lot of pundits are predicting based on the Japan example. This is highly simplified, but in Japan initially the the problem is treated with zombie bank accounting and massive bailouts. Check. A few years in, there was a deficit freak out, with increased taxes and cut government spending. Check, looks like. Maybe this is just our destiny, and we’re somehow doomed to make the same mistakes following a burst economic bubble whether we want to or not. We’ll find out in a few years, I suppose.

  3. Siggy

    Are the ‘wealthy’ really wealthy; or, are they merely rich?

    If they’re merely rich then there will come a time when their riches will only support a subsistence life style.

    At that point in time our social democrate government will provide a stimulus package and/or a bailout. God forbid we should consider the mal-distribution of labor and capital.

    The cure, like the disease, is very painful and it will take more than a spoon full of sugar to make it palatable.

  4. Ronald

    Thanks Richard for your point of view the past couple weeks!
    Regarding the Bush tax cuts so the extend and pretend economy needs the wealthy to spend enough to drive up the GDP? What a plan!

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