Wealthy Lock In Low Gift Levy as Time Runs Out on 0% Estate Tax - Bloomberg

As we get closer to year-end, and no resolution on taxes seems near, taxpayers are being forced to make gifting and other estate planning decisions based on what seems to be the most likely scenario (in my opinion): we go back to 2001 tax rates.

For individuals, this means that the estate tax (which is currently 0%) goes back to 55% at levels above $1 million. In addition, gift tax rates also go up to 55%, from the 35% level this year. For the ultra-wealthy, this may mean that gifting this year may make the most sense, as this article from Bloomberg notes:

Estates are exempt from all taxes for 2010, and the rate shoots up to 55 percent next year unless lawmakers act in a post-election session. That means the best tax-reduction strategy, short of dying in 2010, may be to transfer assets to family members this year and lock in a historically low gift-tax rate of 35 percent.

The article goes on:

“This is the lowest rate that the gift tax has ever been at; it’s only going to get higher,” {said one estate attorney}.

Gift taxes have long been matched with estate taxes to prevent the wealthiest from ducking the Internal Revenue Service after death. Americans can give away a total of $13,000 this year without any tax consequence, up to a $1 million lifetime maximum. When the allowance is spent, gifts are taxed at the same rate as estates. The exception: the 0 percent estate-tax rate prevailing in 2010, which is accompanied by a 35 percent gift tax, equal to the top marginal rate on ordinary income.

Wealthy Lock In Low Gift Levy as Time Runs Out on 0% Estate Tax - Bloomberg

Back to the Future? Fed weighs a more focused response

Earlier this week I talked about Federal Reserve policy in the first part of the twentieth century.

Up until 1951, one of the main tasks given to the Fed was to target interest rates on U.S. government debt. It was thought the our government should never have to pay more than 2.5% on bond obligations. And so, by law, Congress told the Fed to intervene in the bond markets whenever interest rates threatened to move higher.

Now it appears that there is serious discussion in Washington to resume this policy, although this time it would be to try to stimulate economic growth.

According to The Washington Post:

...Instead of just announcing that it will create, say, $500 billion out of thin air and buy bonds with the money, the Fed could instead announce it will target a certain interest rate and then buy Treasury bonds so that rates in the marketplace reach that level.

For example, the Fed could announce that it aims for three-year Treasury debt that now carries an interest rate of 0.56 percent to instead be 0.25 percent. It would then buy Treasury notes in whatever amounts were needed to get rates to the target level.

That would help the economy by lowering rates for a broad range of borrowers, including Americans looking to take out a mortgage and companies looking to use debt to finance expansion. It is a strategy that Fed Chairman Ben S. Bernanke endorsed in a 2002 speech, when he was a governor at the Fed, explaining policies the central bank could take to make sure the United States does not fall into Japanese-style deflation.

Fed weighs a more focused response

I'm not sure I know all of the economic implications of this policy would be, but it certainly is a sign that Bernanke is thinking about less conventional methods to try to get our economy going. However, I suspect that if the Fed is going to be actively buying Treasurys, interest rates will probably be moving lower.

The Specter of Protectionism: World Faces New Wave of Currency Wars - SPIEGEL ONLINE - News - International

I thought this was a very interesting piece from the German magazine Der Spiegel.

In the U.S. we have tended to view our huge trade deficits very benignly, with one exception: China.

According to Congress, and to many other public figures, the Chinese have unfairly benefited from an undervalued currency which has made U.S. goods in China less attractive.

When viewed from outside the U.S., however, the American position is hypocritical. Quoting from the article:

There is, however, also a fair amount of hypocrisy behind the latest American initiative. Nobody has controlled the currency markets as much as the US has in the past. The US Federal Reserve still continues to print dollars to finance skyrocketing government debt. The fact that this erodes the value of the US currency is something that the Americans seem not to care about. Of course, this makes imports into the US more expensive, but it also makes American exports cheaper and enhances the competitiveness of US companies.

The article also notes the problems that the Chinese face with regards to American demands that they allow the yuan to appreciate:

The Chinese want to avoid at all costs suffering the same fate as their neighbor Japan. After caving in to pressure from the US, in 1985 the former Asian superpower agreed to increase the exchange rate against the dollar. Within one year, the value of the yen had increased by some 60 percent. In order to balance out the negative consequences of the revaluation for the country's export industry, the Bank of Japan lowered interest rates to nearly zero, thereby triggering a huge speculative bubble on the stock exchange and the real estate market. Even today, Japan has still not recovered from the prolonged crisis that ensued.

The pressure on Japan also failed to bring the US much relief. American industries, particularly in the automotive sector, still couldn't effectively compete with manufacturers like Toyota and Honda.

The Specter of Protectionism: World Faces New Wave of Currency Wars - SPIEGEL ONLINE - News - International

While I continue to hope that cooler heads prevail in the U.S. Senate, and that a ruinous trade war can be avoided, recent political rhetoric seems to make this less likely. It is easier to bash the Chinese than to address the very hard fiscal questions that confront both federal and municipal governments.

The yield on the 10-year Treasury note has plummeted again this morning, and is now trading at 2.40%, the lowest level since January 2009. Yields are dropping on the expectations that the Federal Reserve is going to follow the example of the Bank of Japan yesterday, and aggressively intervene in the credit markets to try to push interest rates lower. While this may help our economy, it surely takes the currency wars up another notch, since lower yields reduce the attractiveness of the U.S. dollar.

Yes, Interest Rates Can Move Even Lower

Many investors I speak with, including most of my clients, believe that it is just a matter of time before interest rates move higher.

The problem, as my friend Bob Quinn explains to me, is a behavioral finance phenomena called "framing". Most of us have only known higher interest rates than today's levels in our lives, and so we assume that the prior experiences will be continued into the future.

But it wasn't always so. A generation before ours was much more familiar with lower interest rates, and today's levels would have seemed normal.

For example, in the years after the Federal Reserve was created, one of the tasks assigned to our central bank was to make sure that the interest costs on federal government debt remained low. I found this background on a website named enote.com:

The final step in the modernization of the Federal Reserve System was the Treasury Accord of 1951. Before the accord, the system acted as a buyer of last resort for Treasury debt. If investors demanded interest rates on government bonds above a ceiling (set to 2.5 percent at the time of the accord) the system would step in to buy the residual debt. With government spending hitting new records during the Korean War, this support rule demanded an inflationary monetary policy. Under the terms of the accord, the Federal Reserve System was relieved of the responsibility of keeping interest rates low.

In short, throughout much of the first part of the twentieth century, no one thought that the U.S. government should pay any more than 2.5% for its debt. This rate, by the way, is exactly where the 10 year Treasury note is trading this morning.

Turning to more modern times: as we all know, Japan has been mired in a depressing deflationary economy for the last 20 years. Multiple efforts to restart their economy by government officials have failed but they continue to try. This morning the Bank of Japan cut interest rates back to 0% to try to both weaken the yen as well as provide economic stimulus.

Here's an excerpt from today's New York Times:

It took about four years for the Japanese economy to hit rock bottom after its spectacular asset bubble burst in 1990, and another four for deflation to take hold in 1998. The following year, the Bank of Japan responded by lowering its policy interest rate to zero; by that time, however, the country’s economy was so depressed that even zero interest rates could not bring about recovery.

Critically, it was not until another five years later, in 2003, that the central bank sharply increased its purchases of financial assets to expand the money supply, setting the stage for a gradual recovery. Despite stable economic growth of about 2.5 percent between 2004 and 2007, however, deflation did not disappear completely.

Still, emboldened by a nascent recovery, the Bank of Japan raised its lending rate in July 2006, increasing it to 0.5 percent the following March — a step that some economists and politicians called premature.

Before that debate had fully played out, however, the global economic crisis ravaged Japanese export markets, plunging the country into its worst recession since World War II. In December 2008, the Bank of Japan cut interest rates to 0.1 percent.

Bank of Japan Cuts Rates to as Low as Zero Percent - NYTimes.com

I continue to believe the bigger risk to investors is lower, not higher, interest rates. Savers who keep their assets in a money market fund or short maturity bonds may feel safe today but may find their wait for higher interest rates in the next few years to be quixotic.

It's hard to get rich earning 0.37%, which is where the Treasury 2 year note is trading.

Simon Johnson and The Next Financial Meltdown

I went to a Boston Security Analysts luncheon today to hear Professor Simon Johnson of MIT.

Mr. Johnson is a widely published and quoted author, with articles in many leading magazines. I first came across his work a couple of years ago through an article that he wrote for the Atlantic magazine, where he compared the problems in the U.S. to those he confronted through his earlier work as an economist for the IMF.

Professor Johnson is the co-author, with James Kwak, of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown, a bestselling assessment of the dangers now posed by the US financial sector.

It was a thought-provoking talk, filled with insights has gleaned not only through his work but also his global contacts. Johnson has testified numerous times in front of Congressional subcommittees with regards to our banking system, and how we should address the various issues confronting us.

He started his talk with three points:

• Despite the widely-held belief that the financial crisis is over, he does not believe that it is. All of the factors that lead the problems in 2008 and 2009 are still in place;
• He also does not agree that the most recent financial sector regulation (the Dodd-Frank bill) fixed any of the issues.
  
• "Too big to fail" is not the issue - "too big to save" is the problem.

This last point was one that Johnson spent considerable amount of time on.

At some point, he said, countries cannot afford to simply bail out huge banks that get themselves in trouble. He pointed to Ireland, which is taking on a huge fiscal burden and imposing tough austerity measures on its population to bail out the country's three banks. The same is true in England, where the Royal Bank of Scotland is costing taxpayers large sums.

The official view in Washington, according to Johnson, is that what happened in 2008 was a "perfect storm" (a term that he hates, as do I) of bad economic events. Now, he said, government officials believe that the storm has passed, and that Dodd-Frank (creating new financial regulation) will make sure that such events will no longer be able to happen.

A minority view (which happens to be his) is that we spent the last 40 years "tweaking" the banking system to allow banks to take on more risk and increased leverage. The events of 2008, then, were not just the result of the economy being unlucky, but rather events that were the result of failed policies of the prior years.

And what, asked Johnson, was the result of these failures?

The title of his book explains it: 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown.

Johnson notes that the leaders of the 13 largest banks in the United States were summoned to Washington in the fall of 2008 and bailed out completely for their actions. No CEO jobs were lost, no pension benefits denied, no board memberships suspended - the U.S. government (and the taxpayers) allowed each of the leaders of the large banks to walk away from the consequences of their actions.

Contrast this favorable treatment with the way that the head of General Motors, Rick Wagoner, was treated after the government took the bankrupt automaker over. While all seemed to agree that he was a capable leader, someone had to take the fall, and as CEO of a company that the government was bailing out he had to go.

So where are we now? All the same leaders are in place, and all have plans to grow even larger. Today the top six banks in the U.S. control almost two-thirds of the assets of the country; 20 years ago, this percentage was just 16%.

In the last 30 years, Citigroup has failed three times. First, in 1982, as the result of bad loans made to Latin and South American countries. Second, in 1989-90, as the result of poor commercial lending. And, third, in 2008 as the result of bad residential mortgage decisions. And yet the same management practices are allowed to go on, with largely the same board.

Professor Johnson said that this not an anti-business view that he holds. Instead, he is very much pro-business. However, he said that it is simply unhealthy that a few large financial institutions hold so much power and influence that all agree - including Johnson - that they would be bailed out again in the next crisis.

One final point: there have been a number of articles noting that TARP wound up costing much less than feared. To Johnson, this view misses the point. True, the dollars directly relating to the bank bailout were less, but the U.S. fiscal debt burden has soared from 40% of GDP to 80%, with no real economic benefit to anyone. Unemployment remains high, GDP for 2010 will probably be equal to 2006, and the outlook that most have for the future is for very sluggish growth.

Johnson compared the big banks today to Big Oil in 1902. Then, Theodore Roosevelt felt that Standard Oil was too big, and could endanger the health of the US economy. The business leaders at the time argued with him, but eventually he prevailed, to the benefit of society.

Now is the time, said Johnson, for business leaders today to take similar action, and try to take the steps to prevent the next crisis. He pointed out that it can take a long time for a crisis to develop; in the early 1920's, for example, the U.S. experienced a boom period, and the stock market moved sharply higher over the next few years. However, by 1929 the system was untenable, and a decade of economic misery followed by a world war resulted. He feels that if we act now we can prevent such another series of calamities.

Awash in Cash and Profits, Corporate America Keeps Borrowing

As dismal as much of the recent economic news has been (especially for the consumer) corporations are actually not faring too badly. True, top line growth (i.e. sale) has been flat but margins remain healthy and, if anything, are expanding.

By ruthlessly cutting costs, moving production overseas, and using the Internet to improve production, earnings for many sectors in the economy have been pretty decent.

We won't know for a couple of weeks, of course, whether the third quarter will be as good as expectations, but it seems at this point that company profits will be O.K.

Here's a story from this morning's Wall Street Journal discussing this:

U.S. companies are rebounding quickly from the recession and posting near-historic profits, the result of aggressively re-tooling their operations to cope with lower revenue and an uncertain outlook.

An analysis by The Wall Street Journal found that companies in the Standard & Poor's 500-stock index posted second-quarter profits of $189 billion, up 38% from a year earlier and their sixth-highest quarterly total ever, without adjustment for inflation.

As companies begin reporting results for the third quarter, just ended, the strong growth is expected to continue, albeit at a slower pace, S&P said.

http://online.wsj.com/article/SB10001424052748704523604575511864156149040.html?mod=WSJ_hpp_LEFTWhatsNewsCollection

At the same time, corporations have been issuing records amount of debt, but simply hoarding the cash rather than investing in plant and equipment, or hiring new workers.

This is the quandary the Fed finds itself in; in cutting interest rates to historic low levels, the Fed is trying to spur job growth. Unfortunately, all that seems to be happening now is corporations are borrowing the money but holding onto the cash.

Moreover, while many homeowners are refinancing their existing mortgages (assuming they have equity in their homes), sales of new or existing homes has turned sluggish again, after the expiration of the tax credit incentives.

Here's an excerpt from an article in yesterday's New York Times:

Corporations keep saving, waiting for the economy to perk up — but the economy is unlikely to perk up if corporations keep saving.

This situation underscores the limits of Washington policy makers’ power to stimulate the economy. The Federal Reserve has held official interest rates near zero for almost two years, which allows corporations to sell bonds with only slightly higher returns — even below 1 percent. But most companies are not doing what the easy monetary policy was intended to get them to do: invest and create jobs.

Companies Borrow at Low Rates, but Don’t Spend - NYTimes.com

Market Thoughts Starting the Fourth Quarter

According to Nigel Tupper of Merrill Lynch, global equities in the month of September 2010 were up +9.4%, which marked the fifth best month for the MSCI World Index since the inception of the index in 1988.

Small cap US stocks did even better: Steve Desanctis (also of Merrill) notes the following:

September's rise of 12.5% was by far the best ever for the Russell 2000 and second best when we use small-cap returns going back to 1926. Only September 1939 was better and when we have had a strong ninth month of the year, subsequent performance for the fourth quarter tends to be better than average at 4.3% versus 2.9%.

Last week I wrote a post discussing why the consensus might be wrong, and why we might still see a fourth quarter rally. If you missed it, here's the link:

Random Glenings: 10 Reasons to be Bullish on Common Stocks

There is no question that the economic data remains subdued, and unemployment remains depressingly high. However, given the dearth of interesting investment alternatives, US common stocks may surprise on the upside.