With the elections over we can now turn our attention to how President Elect Obama is going to potentially affect our investments.
Given the magnitude of the economic challenges his administration will face, it will be interesting to see how President Obama handles taxes on dividends & capital gains, which are both set to expire on January 1st, 2009. If left alone dividend rates will rise to match standard income tax rates, while capital gains taxes will increase to 10 or 20%, depending on a filers' income level. Currently they are zero and 15% depending on the filers' income level.
In terms of investment themes, oil looks to be an attractive investment opportunity. Crude oil prices have come down substantially in the last year and Obama appears reluctant to aggressively develop our own oil resources, which may help drive prices back up. The opportunity is not without potential threats, specifically a possible windfall tax on oil companies that Obama has suggested. Fortunately there are many different ways to get exposure to crude oil prices and navigate an uncertain tax environment.
Another side of Obama's energy policy is likely to center on Alternative/Clean energy. Fortunately, here too there are many ways to gain exposure to solar, wind, nuclear and even technologies designed to make carbon based energy production and usage cleaner.
With less potential near term impact on capital gains than dividends, assuming he does not raise rates further, it may be more efficient to focus some taxable investing on growth versus income. That is unfortunate given the attractive dividend yields and uncertain growth opportunities found in today's market.
The more daunting challenge for investors is the unfolding credit crisis. The global economy is under tremendous pressure and government intervention so far appears to be coming up short. The research I have reviewed recently indicates we may have much further to go before a recovery can take hold.
Desmond Lachman of American Enterprise Institute presented data recently that suggests residential real estate inventories are still at record high levels (11 months) and more supply is coming on line as foreclosures surge and demand declines. He suggests prices could fall another 10-20% before the market stabilizes, sometime in the 2nd half of 2009 as illustrated in the chart below.
Nouriel Roubini, professor of economics at New York University, founder of Roubini Global Economics and a respected international economist expects the total fallout from the credit crisis to total $1-2 trillion. He believes the problem has already spread to credit cards, automobile, and student loan sectors. Leveraged municipalities are also at risk and he expects corporate default rates to surge. He believes the next phase is already underway and involves credit and trade contraction spreading to emerging market countries, with a dozen or more in or headed to a state of crisis. He believes more downside surprises are in store from a variety of economic reports and corporate earnings will disappoint to the downside. His biggest concern is in the credit default swap (CDS) market where hedge funds and other participants still pose a financial crisis risk.
John Makin, a principal at New York based hedge fund Caxton Associates, and an advisor to the Federal Reserve System and Bank of Japan is considered an expert on central bank policies. He is concerned government policy decisions to date have not made much of a difference in addressing the credit crisis. While LIBOR rates have come down, there is still very little inter-bank lending taking place. He believes banks may be more inclined to use the cash infusions for mergers and acquisitions. He referred to the Taylor Rule, which is a guideline for targeting Fed interest rates based on GDP growth and inflation. The trouble is the Fed cannot lower rates below 0% and currently the Taylor Rule suggests a Fed target interest rate of -2%. It is currently at 1%.
Chris Whalen, co-founder and managing director of Institutional Risk Analytics, outlined what he is calling the three phases of the credit adjustment. He thinks we are about half way through the adjustment, having completed the loss recognition phase. We are now in the second phase where losses are realized and Q3 bank losses climbing rapidly. The final phase will involved credit losses broadening beyond mortgages. He also called out a concern with the CDS market, calling it the next financial crisis. The CDS market is magnitudes larger than anything that has been dealt with so far and it is not well understood. His concern is that corporate defaults could suck liquidity out of banks for years. He used the graph below to illustrate problems in the banking industry.
The IRA Banking Industry Stress Index combines standard measures of bank performance (profitability, default rates, capital adequacy, loan exposure, and operating efficiency) and is at its highest level in 20 years. He believes at least two of the largest remaining commercial banks will need additional liquidity injections. You will find many additional banking industry resources at the IRA website.
I believe the evidence suggests we have not seen the final chapter of the credit crisis and helps explain why markets have not been able to compose themselves. Volatility remains high and long-term technical indicators remain bearish.
President Elect Obama and his administration have a difficult task ahead. Decisions made early in the process will likely have a significant impact on this first term and the ability of the U.S. economy to recover; a result Americans would welcome.