Thinking about 1996 Jude Wanniski December 26, 1995

The financial markets are clearly impressed with the determination of the House Republicans to keep the government closed down until the President keeps his word and presents a 7-year-balanced budget. This means there is almost no possibility of a business-as-usual continuing resolution that will avoid budget reconciliation. Wall Street is considering the 50% exclusion on capital gains as good as done, although questions remain on its effective date and indexation. We are assuming retroactivity to January 1, 1995, but no indexing to that date. At best, indexing would not kick in until January 1, 1996, which would give Treasury and Internal Revenue a year to prepare for the details of indexation. In the best case scenario, low cap stocks and emerging enterprises would benefit most from retroactivity and indexation.

On these assumptions, what might we expect in 1996? What will happen in the real economy? Where will the financial markets tend, given one scenario or another? What about the Federal Reserve, long-term interest rates, the price of gold, foreign exchange? How will the political year play out, and what will be the implications for Wall Street and Main Street? We’ve been mulling these questions and at least can offer this first analytical cut:

BULL MARKET: We reject the idea that the market will sell off in 1996 once a lower capital gains tax is secure. The bears have been spreading this tale, which most recently showed up in Floyd Norris’s “Market Watch” column in Sunday’s New York Times of December 17. The Norris argument is that the market climbed in January 1987, after a higher capital gains tax took effect. He fails to point out that there was a simultaneous drop, to 28% from 50%, in the top rate on ordinary income. This positive effect more than offset the negative effect of capgains taxation, which is discretionary and can be put off. In October 1987, the market crashed when Treasury abandoned the Louvre accord to defend the dollar, an event that effectively withdrew inflation protection from capital gains and sent holders of unrealized gains rushing for the exit. As 1996 opens, at least, there will be no such negative on the horizon that would threaten an increase in the risks to capital formation. 

REAL ECONOMY: Once the lower capgains rate is secure, expectations of increased returns to capital will translate into increased commerce. In this climate, individual tradesmen will expect the prices of real goods and services to rise -- as opposed to imaginary paper assets -- and will begin to bid for those goods with their own unutilized trade credit (another term for surplus capital). New enterprise will be inspired to activity, to supply those goods and services or close substitutes. Where they might not otherwise find capital available to sustain their early-going, they now will find that the higher reward to capital will increase the willingness of investors to take on risk. This dynamic will push more entrepreneurs into the marketplace and cause enterprise already underway to seek and find capital for expansion. These pressures will create increased demand for labor, real property and dollar liquidity. In our model, the markets now infer real GNP growth of 4% in 1996.

FED POLICY: Inasmuch as incipient growth in the real economy will create pressure for dollar liquidity, on the margin this will put downward pressure on the price of gold, the most monetary of real commodities. The gold price has not yet come down from its $385 range because expectations thus far have impacted only financial assets. A decline in gold, as it comes, also puts pressure on the fed funds target of 5.5%. The Federal Reserve can relieve this pressure by lowering the overnight rate in progressive steps and supplying more liquidity to keep it there. In the course of the year, the dollar price of gold may drift as low as $350, with the funds target coming down step-by-step to the 3.5% range. To that point, at least, the incipient deflation led by gold will cause no serious distress. This is because the economic buoyancy will lift demand for non-monetary commodities, such as petroleum, chemicals, pulp and paper. Commodity prices can firm at present levels as production volume expands. In this way, real wages can rise moderately without causing a surge in nominal wages. 

BONDS: In this scenario, which anticipates rising capital formation, increased productivity of labor, and even small declines in the price of gold, there is no inflation threat caused by economic growth. There may be statistical data showing up to worry market commentators who equate any kind of growth with inflation, but as long as Alan Greenspan is Fed chairman there will be no attempt to choke off a genuine expansion. The 30-year bond, which touched 5.87% two years ago, will easily rally beyond that if we can see a decline in gold to a $350 level. The budget restraint in the reconciliation we are assuming as part of this general scenario will also help government bonds, which will positively discount even hazy spending economies. In our model, though, most of the bond rally is due to the increased reward to capital formation implied by the lower capital gains tax rate. 

EXCHANGE RATE: We are most interested in the dollar/yen rate, which we believe shortly will go to the 105 range because of events in Tokyo. The scenario presented here on events in Washington, especially the dynamic that takes the dollar price of gold to $350, would cause the dollar/yen rate to travel toward 120. We are juggling quite a few variables to get to this point.

ELECTION YEAR: Once we introduce presidential politics to our analytical meanderings, the number of variables being juggled can take us into a never-never land. It is clear in the above scenario, though, that President Clinton is helped enormously by coming to terms with the Republican Congress on budget reconciliation. It is his only chance of being re-elected, we think, for a continued stand-off cuts against the electorate’s demand for fundamental change. As the year unfolds, the financial markets will be reacting to the chemistry of both the presidential and congressional races as we proceed to a new plateau in post-Cold War reorganization. The Kemp Tax Commission, which should report by January 8, will nudge both political parties in the direction of tax simplification. It may have more impact on the Clinton Administration than on the GOP Congress; the President sees the national drift toward a supply-side growth agenda and will be open to many of the ideas in the commission report, I think. If Bob Dole is the GOP nominee, which is now the conventional wisdom, he can only beat Clinton if the President runs against tax simplification, which he will not do. Given these options, the DJIA can approach 6000 in 1996. If Steve Forbes is the GOP nominee (and everything else being equal), his clearer commitment to the supply-side agenda could overtake not only Bill Clinton, but a DJIA of 7000.