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Big Government and Tax the Rich
During his acceptance speech, President Barack Obama eloquently voiced the need for America to return to the successful economic policies of the Clinton Presidency, when the nation prospered and people came before Wall Street. He referred to several actions he hoped to embark upon to help America get back to that place: raising the tax rate on the highest earners, increasing the capital gain tax rate, revising the health care system, and spending on infrastructure projects. When Clinton entered office, he also proposed raising taxes on the highest earning Americans, expanding spending on the nation's infrastructure, and redefining the nation's health care system. During the campaign trail, President Obama often praised the Clinton economy and stressed that the prosperity the country experienced during the Clinton years was largely a result of the above policies. Given rising concerns about the Federal Debt and the annual trillion dollar budget deficits, President Obama recently proposed a new set of taxes on banks, and supported the "Volcker" Rule, which seeks to limit commercial banks' activities. With this pivot towards populism in mid-January, even on the heels of the stunning Massachusetts Senatorial Election, the stock market reversed earlier monthly gains and started its current slide. Given the growing importance that Washington Policy has taken in shaping market returns over the past 12 months, we thought it instructive to review the Clinton years in order to put President Obama's economic agenda in perspective.
The Early Clinton Years
Similar to Obama, Clinton entered office as a result of a nation tired and weary of a President Bush. Also similar to Obama, Clinton spent his first year working on Health Care Reform, with Democratic majorities in Congress. Clinton raised taxes on the wealthiest individuals, and began public works programs to reduce unemployment. While many consistently praise Clinton for how he handled the economy, his first two years in office are often conveniently forgotten. Looking at unemployment, which is one of the critical metrics the market seems fixated on lately and by which Obama and the Democrats will be evaluated on in the upcoming November election, Clinton's initial economic policies were a failure. Unemployment during Clinton's first four years in office averaged 6.8% compared to 6.3% under George H.W. Bush's only term (http://www.bls.gov/cps/prev_yrs.htm). This is particularly telling, as Clinton entered office with an economy on the mend, and with real GDP growing over 4% in the year prior to his taking office, yet he still fell short of Bush's economic record regarding employment. Collectively, Obama's policies to raise taxes on income and capital gains, combined with increased welfare payments via tax credits for those not paying taxes, and health care reform, track closely the polices Clinton advocated early in his first term. Not surprisingly, the track record for such policies was not very constructive for the economy, as unemployment worsened and ultimately created a mood in the electorate that was very anti-incumbent, leading to a change in Congressional leadership.
Smaller Government and Lower Capital Gains Taxes
Ironically, Clinton's economic success came as he dealt with a Republican Congress starting in the second half of his first term. More ironically, that success resulted in large part from a set of policies that Obama still consistently vilifies, and seeks to undo. During this period, Clinton created the economy that led Alan Greenspan to remark how Clinton was the best "Republican" president in a long time. The defining economic policy driver of Clinton's second term was aggressively cutting the capital gains tax. Though Clinton was politically forced to mold his policy to this new direction due to the sweeping success of House Republicans and their Contract With America in 1994, Clinton will forever reap the benefits. The Contract With America sought to reduce capital gains taxes by 50 percent. The final version of the Taxpayer Relief Act of 1997, reduced the top rate on capital gains tax rates by approximately 30%. Also in late 1996, Clinton and Congressional Republicans agreed to welfare reform that further reduced the role of the federal government in everyday life. The result of lower taxes, and a smaller federal government under President Clinton was nothing short of miraculous. During Clinton's second term, unemployment fell about 30% from his first term to an average of 4.5%.
Another perspective about the Clinton years is revealed through the stock market. While Clinton was enacting the policies he advocated during his first campaign, the stock market underperformed its historic average of 9% annual gains, and instead only grew at approximately 5% a year. However, when it was clear that President Clinton would work with Republicans on an agenda that promoted business growth, the market became much more favorably disposed, returning 20% annually during the last six years of his Presidency. While in retrospect it is clear monetary policy played a role in those market gains, it is also clear that the reduction in capital gains taxes created an environment to invest, rather than hoarding assets in real goods. Aside from making investment more attractive, the reduction in the capital gains tax rate signaled to businesses that Washington was on their side and wanted them to succeed and prosper. It is telling that as they currently stand, President Obama's policies are diametrically opposed to the ideas that produced the Clinton economy he often praises. Further, Obama's rhetoric and proposed policies are also opposite those of Clinton. By signaling that he will pursue populist policies, Obama is creating an environment where businesses will be very weary to grow and expand their business out of fear that Washington will punish them for their future success.
Expanding the Welfare State as an Economic Plan
In an interesting rhetorical move, President Obama has seemingly embraced Republican ideals, by recently claiming that his economic plan has reduced taxes for 95% of Americans. While clever, such rhetoric is very questionable. After all, how can 95% of the population receive income tax reductions, when approximately only 55% of the 150 million taxable population pay federal income taxes? This makes no sense. While it is of course physically and/or logically impossible to cut income taxes for those that do not pay them, President Obama works around this by providing refundable tax credits to individuals that pay no taxes. Such an expansion of welfare is ironic, as President Clinton worked very hard to reduce and eliminate welfare.
What is Next
With elections coming in November, it will be interesting to see how President Obama shapes his rhetoric and actions in the months ahead. The Clinton model would lead Obama to strike a much more moderate stance and work together with the opposition to craft solutions that likely will stimulate economic growth. Unfortunately, unlike Clinton who had a Republican majority in Congress, Obama still does not have a tangible opposition to use as a straw man to berate publically, while working out deals privately. Currently the Democratic party continues to control Congress, which limits President Obama's ability to accept ideas outside his party's normal orthodoxy and alienate his core supporters. This likely explains why Obama's tone has not really changed regarding his "big ticket" reforms and his desire to allow tax rates to increase in 2011 as the current income, dividend, and capital gains rates will "sunset" and be replaced by the Pre-Bush rates.
Looking Out Over 2010
While there are many subplots that will drive the market in 2010, a dominant one will center on government spending and deficits, both domestically and abroad. As an example of how serious the market seems to be about this, Portugal recently encountered problems rolling over its debt, and markets in Europe and the US responded by selling off 4% to 5%. This has prompted emergency meetings among European financial officials to develop a plan to deal with countries violating the maximum debt-to-GDP ratios authorized under the Euro agreement. This resolution will likely weigh on the market, given the fear of a "double dip" recession caused by a lack of confidence in the fragile world economy.
We believe the markets will be focused on the economy and the battle being fought between inflationary and deflationary forces at the moment. Regarding the economy, we believe the first step to truly stimulate investment and hiring by business would be for Washington to change its rhetoric and adopt a view that business success is a good thing for the country and should be embraced and praised. The majority of Americans want their employers to grow and prosper and also want to feel they work for fair and just companies. To view business as an enemy that must constantly be guarded against will only lead businesses to question the wisdom of expansion and investing, especially when it seems Washington changes the rules based on a whim. We believe that absent a more "business-friendly" Washington, the economic recovery will be weak and future market returns will be below average.
AFG's Portfolio Performance
The majority of Americans want their employers to grow and prosper and also want to feel they work for fair and just companies. To view business as an enemy that must constantly be guarded against will only lead businesses to question the wisdom of expansion and investing
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