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Market Commentary

The Real State of the Union
February 13, 2013 David R. Kotok, Chairman and Chief Investment Officer

“The gap between small and large business surveys is unprecedented and is worrisome because the small business sector tends to drive domestic job growth.”  BCA research, Daily Insights, February 12, 2013.  For details see: www.bcaresearch.com .

BCA updated their series that compares the National Federation of Independent Business (NFIB) survey with the Institute for Supply Management (ISM) survey.  For two decades the surveys tracked each other closely.  NFIB asks if this is a “good time to expand.”  ISM compiles a “new order” index.  Now, these two series have a wider divergence than at any time in modern history.  ISM is in a declining trend.  NFIB is low-level and flat.  Neither series is encouraging.

NFIB also asks about hiring intentions.  Their series is coming off a multi-decade low and is on a slightly improving trend.  It is not robust.  ISM has an employment survey index.  It has been declining from its peak two years ago, when divergence between the two series reached record proportions.  While narrowing from that extreme since, the series remain very divergent by historical reference.

Bottom line: the economic recovery is still upwardly trending, but it is weak.  No surprise.  President Obama was silent last night on how his failure to extend the 2% payroll tax cut has kicked every single working American in the gut.  The Republicans who responded to the president were also silent on this issue; they are gut-kickers, too.  Both parties have failed the American people.  Meanwhile, the political impasse and the class warfare continue unabated.  We have no expectation that the partisan divide will close.  Nor do we expect any softening of the rhetoric from either side.  All the politics of the next two years will be focused on the 2014 election in the House of Representatives.  That battle is already engaged.

Separately, Fed Vice-Chair Janet Yellen has reaffirmed the Fed’s view:  “It deserves emphasis that a 6.5% unemployment rate and inflation one to two years ahead that is 0.5% above the committee’s 2% objective are thresholds for possible action, not triggers that will necessarily prompt an immediate increase in the FOMC’s target rate.”  Key words here are “possible” and “not triggers.”  Yellen is saying that current Fed policy is likely to persist longer than many think.  Some internal Fed staff studies point to a base case of normalization being re-achieved in 2019.  There are lots of assumptions that go into that estimate, and there are many scenarios that could accelerate or defer it.  Key is that the Fed is committed to a long stretch before the majority of the FOMC moves policy away from the present QE direction.

To sum up, very low interest rates will continue for some time.  The Washington mess will persist for the next two years, and then some.  Fiscal contraction will occur at some level and in some amount.  A fiscal expansion will NOT happen.  Tax policy from the White House is now focused on the details in the tax code and not on radical changes to it.  The tax bracket rate fight is over for the next two years.

The attack on the tax-free bond continues.  What remains unsaid by the White House is that dilution or removal of the tax-free status of state and local bond issues results only in higher property, sales, and local income taxes.  The schools, sewers, hospitals, turnpikes, and fire stations need to be funded and built.  The money needs to be borrowed.  If the tax advantage of a tax-free bond is diluted, the interest cost of finance rises.  Washington, who is kidding whom?

These are a few of the things that went unsaid in the State of the Union message and the two responses to it.  It is sad to say, but our national governance is underwhelming.

David R. Kotok, Chairman and Chief Investment Officer

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