The prevailing consensus around yesterday’s global stock market rally seems to be that it was inspired by some constructive talk coming out of the G20 meeting. That might be true to some extent, as there were signals that political leaders are at least aware of the risks of a 1930s style contraction of global economic integration. However, it might also have been spurred by a development in the U.S. Senate regarding cap and trade legislation.*** According to Capitol Hill Reports:
Several GOP senators did win approval of their amendments, including freshman Mike Johanns (R-NE), who secured adoption of language prohibiting climate legislation involving a cap-and-trade system from being considered under the fast-track and filibuster-proof procedure called "reconciliation."
"[N]ow it will be possible to have the full and open debate this issue deserves," Johanns said after yesterday’s 67 to 31 vote in favor of his amendment.
This measure appears to slow the push towards an emissions management system that in our view would lower the aggregate value of existing equity, at least in the short to intermediate term. It might also have a net negative impact on economic production (though some forecast that the long term cost of doing nothing would be higher), and it will certainly lower household incomes, although no one can say with certainty what the cost to households would be. There’s a GOP talking point that puts it at $3,100 annually per family, while other studies put it below $500 on average. In any case, we suspect that some of the ~7% rise in equity values from Monday’s lows, most of which occurred yesterday, could have been driven by this development.
However, there are at least two reasons for caution following this move up. First, as the Capitol Hill Reports story points out in a sidebar:
…There is no guarantee that [Sen. Johanns'] amendment — or any other amendment adopted during Senate floor debate — will find its way into the final version of the FY 2010 budget resolution. House and Senate Democratic leaders will have the final say on which provisions to keep, modify, and/or strike during the conference negotiations, which are expected to begin over the two-week Easter recess. It is also important to note that the annual budget resolution does not have the force of law, and therefore neither do the amendments adopted during committee and floor consideration that end up being preserved in the conference report. The final FY 2010 budget measure will provide only a broad framework for legislation drafted later this year, with the committees of jurisdiction deciding specific spending, tax, and authorizing provisions.
A second reason for caution is that this impressive equity rally (20%+ over four weeks) is getting a little long in the tooth by traditional measures. If cap and trade and/or other potentially costly measures work their way back into legislation in April, we could see a similar downside reaction. There’s also a risk that a legislative down draft could be timed coincidentally with the old (though not foolproof) stock market adage to "sell in May and go away".
Our current view of things hasn’t changed much, although as we’ll outline in a future Idle Speculator piece, our worst cases for the economy and equity markets are off the table barring any new developments. Our general outlook:
- The U.S. economy should bottom in late 2009 or early 2010, the global economy in 2010.
- Output and profits could rebound more sharply than expected, given the deep and sudden contraction they’ve been through.
- U.S. employment should begin to rise some time in 2010, although it looks very unlikely that it will return to a 4-5% level any time soon. At the margin, this will intensify longer term demographic and fiscal challenges, and contribute to social unrest in the short to intermediate term.
- Mister Market, going through one of his periodic bouts of depression, is still offering to sell attractive assets at steep discounts to their actual value. It’s a wonderful time to be a stock picker, though that’s an anachronistic misnomer, given how much more there is for sale in markets these days.
- Our calculation of expected U.S. stock market returns is now only slightly below historic average returns. But demographics and the risk of additional shareholder dilution will be a drag on long and short term performance, respectively. Less developed markets and economies continue to offer the most attractive long term opportunities, with far more attractive demographics overall, plus rising productivity and low valuations. Policy making in mature economies (the U.S., Europe, and Japan) will continue to pose significant risks to developing regions, but from a long term perspective, the periodic crises they cause (including the present one) should be viewed as compelling investment opportunities.
*** Our back of the envelope event analysis indicates that the legislative events around cap and trade are a plausible factor in yesterday’s returns. That doesn’t prove anything, of course, it just allows us to say that the evidence doesn’t appear to disprove it.
Post script 4/6/2009: An interesting letter to the editor in the WSJ today regarding cap and trade from Greg Ebel, CEO of Spectra Energy Corporation, who argues that a revenue-neutral carbon tax is preferable to a cap and trade system:
Murphy’s Law says that any system that can be gamed, will be gamed, and at the worst possible time. A cap-and-trade system is inherently and entirely gameable. The financial derivatives associated with emissions credits would be traded in a new hugely complex, multitrillion-dollar carbon market. So if you liked what traders did to our financial system with mortgage-backed securities and credit-default swaps, then you’ll love what these traders will do to our environment.
There’s some hyperbole at work in Ebel’s letter, and some of it could be motivated by competitive concerns. We also believe that investment bankers, rating agencies, insurers, and policymakers are more culpable than traders for the mortgage mess, though this could be a semantic argument. But Ebel’s point about gaming is absolutely valid, and there are plenty of real life examples, including energy markets and Enron. A true externality – like carbon emissions, if curbing them is as critical to human well being as proponents say – is th
e ideal target for taxation. And as we’ve argued previously, the optimal tax rate is most likely to be found via referendum. But the revenues from such a tax should accrue to citizens as broadly as possible. With cap-and-trade, there’s a significant risk that privileged firms will be able to enrich themselves without making the revenue capture any more efficient.