Tax Cut Just One Reason For Optimism

12/20/2010


What a difference a tax cut makes.

According to the consensus forecast published by Blue Chip Economic Indicators, economists were expecting real U.S. economic growth of 2.5% in 2011, down slightly from the 2.7% growth expected for 2010 and significantly below the levels typical at this point in an economic recovery.

Then President Obama announced he would back a tax compromise that extends the Bush tax cuts to all income groups. And as a nice cherry atop the tax-cut parfait, the plan includes a reduction in employee Social Security payroll taxes.

The tax news sent economists scurrying to lift their 2011 growth estimates.

To be sure, the plan is not a done deal, with lots of Democrats and a few Republicans unhappy with Washington's latest sausage-making and threatening to stall the deal. Still, it seems likely that the proposal will reach the president's desk in something approximating its current form before year-end.

Some have blamed the tortoise-like pace of economic growth on uncertainty about taxes, an argument that no longer holds as much water.

And with that uncertainty waning, the dual spigots of consumer and business spending should open up in 2011, right?

Perhaps. Investment spending should benefit from record corporate cash holdings. Improved personal balance sheets, a bump in disposable income (courtesy of the payroll-tax cut), the elimination of tax uncertainty, and the confidence that comes with a decent stock market should embolden consumers to keep spending.

Of course, handicapping the economy is never a sure thing. And the litany of “what-can-go wrongs” is long. Atop the list is the unemployment rate, which continues to hover around 10%. Don't look for that rate to improve much in 2011, in part because the tax proposal extends unemployment benefits an additional 13 months. As the old saw goes, whenever you subsidize something, you get more of it.

Can the economy grow with 10% unemployment? The short answer is yes. Unemployment reflects capacity in the labor market, and excess capacity for a commodity often dampens prices for that commodity.

Downward wage pressure, while not a feel-good for workers, does wonders for corporate profits. Indeed, American businesses earned profits at an annual rate of $1.66 trillion in the third quarter, according to a Commerce Department report. That is the highest level recorded since the government began keeping track over 60 years ago.

Further problems in Europe's credit markets and economies could also affect the U.S. economy. The euro zone accounts for nearly one-fifth of U.S. exports. But despite the region's problems, stock markets in that part of the world do not forecast economic disaster.

The FTSE Eurofirst 300 Index, which measures the performance of Europe's largest 300 companies by market capitalization, has reached two-year highs. And the Euro Stoxx 50 Index, covering 50 stocks from 12 euro zone countries, is down just 6% from its two-year high.

Other factors that could cause economic turmoil include interest rates and energy prices. Yields on Treasury bonds have surged in recent weeks, with the rate on the 10-year Treasury moving to a seven-month high of 3.5% from 2.4% in early October. Interest rates generally rise as an economy improves, so higher rates are not necessarily bad news.

On the other hand, energy prices represent one of the big unknowns for the economy. Oil prices are at two-year highs. Higher energy prices represent a direct tax on consumers' disposable incomes.

While a review of data can produce both bearish and bullish arguments for the economy in 2011, one big positive is the performance of the stock market. Because it is anticipatory, the stock market represents perhaps the best predictor of future economic activity. The Dow Jones Industrial and Transportation averages are trading at two-year highs. As long as the stock market maintains its upward trend, it is quite likely the economy will follow its lead in 2011.


Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com