A Few Market Positives Jude Wanniski and Michael Darda October 1, 2003

The Bush administration may be bleeding badly on its Iraq policy, with the Democrats circling like sharks as the news gets worse by the day. It may well be that the President will not be able to figure out how to extricate himself from what Pat Buchanan months ago predicted would be a “tar baby,” a more accurate phase, perhaps, than “Vietnam quagmire.” But as long as his economic team does not do anything foolish in the period ahead, he will have clearer sailing toward re-election as the economic expansion accelerates at a steady pace. With a bit of luck, by next summer the labor market will be tightening up and employment will increase along with productivity and corporate earnings. Last week I noted a few market negatives tugging the major market indices down. There are some bright spots showing up, which helps explain the market burst of enthusiasm yesterday.

FSC TAX HOLIDAY: The Senate Finance Committee action Wednesday to provide a six-month tax holiday for multinational corporations that repatriate profits stashed abroad to avoid the 35% corporate tax rate was clearly a major reason for the DJIA’s 194-point surge yesterday. The committee also knocked three percentage points off the corporate tax faced by “manufacturers,” a response to pressures from labor unions and the NAM who have been citing the job losses in manufacturing. It’s not clear this latter measure will wind up in final legislation that must be enacted before the end of the year, to avoid World Trade Organization penalties over the illegal export subsidies of the Foreign Sales Corp. But the legislation proposed in the House Ways & Means Committee by Chairman Bill Thomas at least has a provision similar to the Senate repatriation measure and it seems a done deal that the tax holiday will be in the final version -- with the administration saying President Bush would not veto the broad bill just to kill the tax holiday. There still is no schedule for action by Ways&Means. Thomas, though, still seems to be determined to push his version through the committee on a straight party line vote and get it through the House in similar fashion. In “static terms,” it would be more “expensive” than the Senate version, and is opposed for that reason by Senate leaders. Thomas figures to get as much as he can in a conference committee. When the crunch comes, my guess is he expects there to be too many goodies at stake for both small business and big business to see it fail, especially with the WTO penalty hanging over their heads. We of course hope he succeeds, as he did this spring in using a similar strategy to get the dividend and capgains cuts through the Congress.

CALIFORNIA: With one-sixth of the $12 trillion national economy, California by itself has been a drag on Wall Street and the national economy for the last few years. Governor Gray Davis had a lot of help from the monetary deflation in driving down the state economy and producing a budget crisis, but his tax hikes and spending policies compounded the problems. Hence, the outrage of the citizenry and the recall petitions. In our report last week on the recall, we worried that the tangle of Republicans was complicating the best-case solution, which would be the departure of Davis and his replacement by a supply-side Arnold Schwarzenegger. Yesterday’s LATimes poll removed those concerns, with Davis now clearly headed for defeat in next Tuesday’s balloting, with Schwarzenegger the runaway favorite to succeed him in Sacramento. It would not surprise me at all that some of the market surge yesterday came with news of the poll, which ended talk of Davis chipping away at the negatives and getting close to defeating the recall. It was also nice to see Arthur Laffer’s op-ed in today’s Wall Street Journal, offering advice to Schwarzenegger on how to tackle the state’s financial problems with a radical tax reform. Don’t expect a radical tax reform right out of the box. Schwarzenegger would need a re-election with a GOP legislature to pull that off. But clearly the proposals he is laying out for his first 100 days will get the Golden State once again headed in the right direction.

WORLD ECONOMY: The end of the monetary deflation is now clearly feeding financial markets all over the world as the reflation kicks in. Gold at $384 is still a bit higher than we would like it to be, held up by market wariness of the administration’s soft-headed, soft-dollar policy. As long as there is only bark and no bite from the Treasury in getting compliance from the Asian countries, we can expect this issue to slowly fade as the economy expands. Remember the line from the Nixon administration: “Watch what we do, not what we say.” In the Nixon case, what was done was just as bad as what was said. In this case, we expect better done than said, at least in the monetary realm. The huge bond rally of the last few weeks most definitely should be over, with the 10-year note now at 4%.

Jude Wanniski

GOOD STATS: Some disappointing news on consumer confidence and regional manufacturing earlier in the week should not cast a pall over the big picture: Monetary reflation and the spring tax cuts are already boosting after-tax incomes, spending, and profits. After-tax personal incomes grew at a breakneck 14.4% annualized rate during July-August period. Personal consumption expenditures grew at a 7.2% average annualized rate over the same period. Unless some unforeseen disappointment occurs in the September data, we should be in for a 5%+ annualized GDP growth rate in 3Q03. The good news does not stop with incomes and spending. NIPA GDP profits (the most stringent measure of profits available) were up at a 44% annualized rate in 2Q03 after rising at a 16% annualized rate in the first quarter of 2003. This is the flip side of the "jobless recovery," as the growth that is occurring is flowing straight into the bottom-line profits of downsized firms. Because we have not seen a turnaround in initial jobless claims suggestive of a payroll recovery, profits should continue to rise rapidly until firms feel confident enough to begin plowing profits into permanent hiring. Robust profit growth also means that investment should begin to spread into the beleaguered manufacturing and transportation sectors as the gap between actual and potential growth narrows.

Michael T. Darda