Sell Bonds, Buy Stocks: An Investment Strategy Built on Pro-growth Tax Cuts

by Larry Kudlow

For once, top Obama economic advisor Larry Summers got it right. Warning opponents of the big tax-cut deal, Summers told reporters, “Failure to pass this bill in the next couple weeks would materially increase the risk that the economy would stall out and we would have a double-dip recession.”

Too bad Mr. Summers didn’t advise the president to cut taxes across-the-board two years ago, rather than push for the misbegotten $800 billion government-spending package. That policy dismally failed to ignite a real economic recovery or to lower the unemployment rate.

But it’s never too late to promote good policy. And echoing Summers, in recent months any number of demand- and supply-side economists warned of a double-dip (or nearly so) unless the Bush 2003 tax cuts were extended. The economy would be demoralized from a rollback of incentives to work, invest, and take risks. Plus, roughly $600 billion of cash (including the alternative minimum tax) would be drained from the private sector.

Whether Obama is really changing his stripes and abandoning class-warfare, big-government spending remains to be seen. But at least he is out there defending the huge tax-cut package, which is pro-growth, along with a South Korean free-trade deal, which also is pro-growth. Certainly it’s a turn for the better for the White House.

In the wake of the tax-cut announcement, a number of Wall Street forecasters are upping their growth estimates for 2011 and beyond. The consensus seems to have lifted real GDP by nearly a full percentage point. And if the economy can grow by 3.5 to 4 percent, the likelihood of a sizable decline in unemployment literally grows stronger.

Recent polling data show overwhelming public support for the turn toward pro-growth tax cuts. The most recent Gallup poll reveals that 66 percent of voters support the deal. That includes 67 percent of independents, 52 percent of Democrats, and 85 percent of Republicans. Surveying likely voters, Scott Rasmussen finds that 56 percent favor the tax-cut deal while only 29 percent oppose it. Even political liberals are split on the issue: 43 percent favor the tax-cut extension, and 41 percent are opposed.

However, there is a rump revolt going on in the bond market, where tax-cut naysayers say rising Treasury yields indicate that the biggest fear is a hike in the deficit. Since the Obama tax-cut announcement, 10-year Treasury rates have jumped over 30 basis points to about 3.25 percent. However, three-fourths of that market-rate increase comes from a jump in real interest rates, according to the Treasury inflation-protected securities (TIPS) market.

That’s exactly what should happen. Keeping marginal tax rates down for successful earners, investors, and small-business entrepreneurs will increase economic growth. Therefore, the economic-growth component of bond rates reflects that by normalizing upward.

It’s a positive sign, not a negative one. It has little or nothing to do with the deficit, which actually will shrink as the economy grows faster. In fact, the Congressional Budget Office estimates that 1 percent faster growth reduces the ten-year deficit outlook by nearly $3 trillion. Low-tax growth must be part of the deficit solution.

The rise in real interest rates from growth-oriented tax cuts is also helping support the dollar. And all that, in turn, continues to boost the stock market. It wouldn’t be surprising if the tax-cut push for stronger growth moves Treasury rates to 3.5 or even 4 percent as the economy gathers steam from refreshed incentives.

So sell your Treasury bonds. But stronger growth amidst record profits will drive stocks higher.

The Obama/GOP tax-cut package is really a bit of pro-growth shock therapy. The vast majority of folks worried that the Bush tax rates would expire and the economy would face a debilitating tax hike. In this sense, freezing the tax rates provides an incentive effect, and at the very least instills more confidence.

At least for the next couple of years, before real flat-tax reform is possible, tax rates will be held at historically low levels. Thus, a major uncertainty factor has been removed.

Of course, the tax-cut deal is far from perfect. But a price has to be paid for a compromise that will enhance economic growth. And yes, the budget deficit is an ongoing problem. But as we listen to people like Wisconsin Republican Paul Ryan, the new House Budget chairman, it is clear that deep spending cuts are on the way in the new year.

So common sense suggests selling bonds, buying stocks, and holding onto the dollar. This new investment strategy builds on a long-overdue tax-cut-extension package that surely will lift the economic spirits.


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Posted Dec 12th 2010 at 2:41 pm in Economics, taxes | 118 Comments