Mid-Year Update: Taxation should be about raising the maximum amount of revenue for the government in the least economically disruptive way.

Equities of all persuasion saw mid-year losses after a first quarter surge.

MARKET RETURNS

Year-to-date (1/1/10-07/02/10)*
Dow Jones Indus Avg. -7.38%
S&P 500 -8.44%
NASDAQ -7.96%
Russell 2000 -4.23%
MSCI World Index -11.33%
DJ STOXX Europe 600 -6.55%

Year-to-date (1/1/10-07/01/10)
90 Day T-Bill 0.09%
2-Year Treasury 1.46%
10-Year Treasury 5.91%
ML High Yield Index 2.79%
JPM EMBI Global Diversified 5.40%
JP Morgan Global Hedged 4.42%

Year-to-date (1/1/10-07/01/10)
U.S. $ / Euro (1.26) -11.9%
U.S. $ / British Pound (1.52) -6.2%
Yen / U.S. ($ 87.74) -5.7%
Gold ($/oz) ($1,210.68) 10.4%
Oil ($72.01) -9.3%

*Returns reported as of 9:15 a.m. Pacific Standard Time

What accounts for the second quarter downturn?

Various theories are being put forward.
One is that corporations are pulling pro fits forward into 2010 to avoid the higher taxes coming in 2011. Yes, it is still possible to manipulate earnings despite Sarbanes-Oxley, you just have to be smarter than before.
Another possible reason for the decline is the fear of a double dip recession starting early next year. This is supported in part by numerous factors including robbing 2011 results by the earnings manipulations described above, expiration of the Federal economic stimulus (yes, even bad stimulus has some effect on the economy) and uncertainty arising from the fallout expected from the financial reform legislation now pending in Congress and the actual fallout from the health care legislation.
Finally, there is the expectation that corporate earnings and competitive position internationally will be negatively affected by the higher corporate tax rates
in 2011. The often repeated mantra that ‘the more you tax something the less of it you get’ is running into opposition by the Obama administration which is more concerned with ‘fairness’.
Taxation should be about raising the maximum amount of revenue for the government in the least economically disruptive way. Fairness should be addressed on the spending side of the ledger. To mix the two politicizes revenue raising and invites special interests to corrupt the taxation process with social engineering thereby doing greater harm to the economy.

Individual investors have still to be heard from since they are expected to take profits on their holdings before year-end to avoid higher tax rates.
Such individuals may well opt to sit on the cash proceeds from such tax sales until the outlook clarifies. This will only add to short term market weakness.

Despite the fact that Congress seems to be playing a losing hand, they seem unlikely to change course before the November elections.
Should the Democrats lose control of the House of Representatives, we can expect a major market rally since a stalemated Congress would be a welcome relief for the markets.
This may be short lived, however, since a lame duck Congress may well try to finish their agenda before leaving office (think carbon tax or a VAT). In short, equities don’t look promising between now and November and don’t look all that great for next year.

A healthy position in cash and gold still look like safe bets.

Interest Rate Outlook

At mid-year we see ten year Treasuries below 3% and thirty year Treasuries below 4%.

What would possess an asset manager to buy 30 year Treasuries with a locked in yield of 4% when the outlook for inflation over the next few years promises to make this a loosing proposition if not a disastrous one?

The only answer I can devise is fear and special situations.

Fear by those who have gotten burned in the financial crisis and therefore consider credit risk in the short term more important than market risk over the longer term.

Special situation buyers include insurance companies who are matching long term
payout commitments on annuities with the interest payments on the Treasuries.
Other special situation players would be hedge funds playing the carry trade game where they buy these Treasuries with short term loans at 25 basis points. It is this group who represent the greatest threat to the interest rate outlook since they
will unload their positions en masse the moment they see a turn in rates.
This is why I feel an interest rate rise will come suddenly and not be dependant on actual inflation. It may in fact be a cause of the inflation.

Considerable media attention has been given to the municipal bond market in recent weeks.
We see yields on ten year AAA munis going from 3.91% at year end 2008 to 3.25% at year end 2009 to 3.13% at mid-year 2010.
Much of this decline is due to the high demand for tax free munis by individual investors in high tax states as well as generally, given the pending tax rate rises in 2011.
The decline in muni yields is also influenced by the continued perception that munis are safe because they have always been so. This perception is due some re-evaluation.

Municipalities have rarely faced the kind of budget pressures they are experiencing today because of the revenue declines resulting from the recession. Added to this is the retirement of government employed baby boomers, whose pension liabilities have gone mostly unfunded.

This is an increase in current expenditures which is not discretionary and growing rapidly. It promises to create a budget crisis at the city and county level since these entities now face a cash expense they can no longer ignore.
Warren Buffet, who rushed into the bond insurance business during the financial crisis has since backed away. He notes that in the coming budget crunch, municipalities will likely stiff insurers or bondholders before firing employees. Bankruptcy filings may also prove to be more palatable politically than cutting services.
In any case, don’t think that past history is the best indication of what the future holds for municipal bonds.

Thanks to Richard Lehmann at incomesecurities.com and Payden & Rygel [paydenrygel@payden.com]for the data tables

Government's Most Destructive Policy Yet

Right now, the so-called Waxman-Markey bill is snaking its way through the greasy halls of Congress.

"Waxman-Markey" is the name given to the new "cap and trade" bill designed to limit America's carbon emissions. It looks like it's the most expensive thing to hit the economy since the financial crisis began.




Even the normally mild-mannered Wall Street Journal called it "one of the most ambitious efforts to re-engineer American social and economic behavior in decades, presenting risks and opportunities for a wide array of businesses from Silicon Valley to the coal fields of the Appalachians."

First off, the stated objective of cutting carbon emissions by 83% by 2050 will go down in history as outrageous – akin to when Who drummer Keith Moon drove his Lincoln Continental into the pool at the Holiday Inn. I think members of Congress must be smoking the same thing Moon was.

To show you how patently ridiculous such a goal is, I turn to Questar's CEO, Keith Rattie. Questar is an oil and gas company. Rattie is an engineer. He has been in the business since the 1970s. He walks us through the basic math in a speech he made at Utah Valley University on April 2 called "Energy Myths and Realities." Rattie uses Utah as an example:


Utah's carbon footprint today is about 66 million tons per year. Our population is 2.6 million. You divide those two numbers and the average Utahan today has a carbon footprint of about 25 tons per year. An 80% reduction in Utah's carbon footprint by 2050 implies 66 million tons today to about 13 million tons per year by 2050. If Utah's population continues to grow at 2% per year, by 2050, there will be about 6 million people living in our state. So 13 million tons divided by 6 million people equals 2.2 tons per person per year.

Question: When was the last time Utah's carbon footprint was as low as 2.2 tons per person? Answer: Not since Brigham Young and the Mormon pioneers first entered the Wasatch Valley and declared, 'This is the place.'
You can extend this math over the whole country – a growing mass of 300 million people. To meet the Waxman-Markey bill's goals would mean we have to go back to a carbon footprint about as big as the Pilgrims' at Plymouth Rock circa 1620.

So I think the bill is absurd. I think it is also a great blow to what is left of American industry. But this is the way the world works. Politicians do dumb things.

Agriculture. Agriculture, for whatever reasons, is exempt from the new rules. So farmers don't have to worry about those manure pools out back or the flatulent cows emitting methane all over God's green meadows. Those big tractors? Burn up that diesel! Agriculture is a winner by virtue of not losing, like a hockey team that skates to a tie.

Steel. Big loser. U.S. Steel, AK Steel, and even foreign steel companies with U.S. operations all get a big kick in the family jewels on this one. Steelmaking emits all kinds of carbon dioxide. The worst-case scenario here is that the U.S. simply won't be making steel at some point in the future. The plants will all go to Brazil. China is already the biggest steel producer in the world. Now we just handed the country a bunch of new business. Avoid big steel in the U.S.

Oil refiners. Losers. This is an industry in which it is hard to make money most of the time as it is. Now, under the new bill, refineries are really screwed. Basically, they are on the hook for about 44% of U.S. carbon emissions. They would be among the biggest buyers of carbon emission allowances. I think with one stroke of the pen, the U.S. government just made the U.S. refining industry that much smaller. Lots of these older refineries will just have to close. U.S. imports for gasoline will rise.

I think the refinery industry already sees the writing on the wall. This is one reason why Valero, the biggest U.S. refinery, has been quick to get into the politically favored ethanol business. It's also expanding overseas. Avoid the refineries.

Trading desks. Winners. It figures. As if the government doesn't help financial firms enough, it is going to hand them a nice tomato in trading carbon credits. The head of Morgan Stanley's U.S. emission trading desk said: "Carbon, while relatively small, is a critical piece of our commodities offering." So some financial firms with trading desks in carbon get a nice little payday.
To sum up, this is only the beginning. At the end of the day, this obsession with carbon footprints means that Americans are going to have to pay a lot more for products that use fossil fuels. It means we are going to pay a lot more for energy. Obama and his crew can draw up whatever fantasies they want, but they can't repeal the laws of economics, which, like forces of nature, win out every time.

So there will be plenty of losers.

Obama climate plan could cost $2 trillion

UPDATED:

President Obama's climate plan could cost industry close to $2 trillion, nearly three times the White House's initial estimate of the so-called "cap-and-trade" legislation, according to Senate staffers who were briefed by the White House.

A top economic aide to Mr. Obama told a group of Senate staffers last month that the president's climate-change plan would surely raise more than the $646 billion over eight years the White House had estimated publicly, according to multiple a number of staffers who attended the briefing Feb. 26.

"We all looked at each other like, 'Wow, that's a big number,'" said a top Republican staffer who attended the meeting along with between 50 and 60 other Democratic and Republican congressional aides.

The plan seeks to reduce pollution by setting a limit on carbon emissions and allowing businesses and groups to buy allowances, although exact details have not been released.

At the meeting, Jason Furman, a top Obama staffer, estimated that the president's cap-and-trade program could cost up to three times as much as the administration's early estimate of $646 billion over eight years. A study of an earlier cap-and-trade bill co-sponsored by Mr. Obama when he was a senator estimated the cost could top $366 billion a year by 2015.

A White House official did not confirm the large estimate, saying only that Obama aides previously had noted that the $646 billion estimate was "conservative."

"Any revenues in excess of the estimate would be rebated to vulnerable consumers, communities and businesses," the official said.

The Obama administration has proposed using the majority of the money generated from a cap-and-trade plan to pay for its middle-class tax cuts, while using about $120 billion to invest in renewable-energy projects.

Mr. Obama and congressional Democratic leaders have made passing a climate-change bill a top priority. But Republican leaders and moderate to conservative Democrats have cautioned against levying increased fees on businesses while the economy is still faltering.

House Republican leaders blasted the costs in the new estimate.

"The last thing we need is a massive tax increase in a recession, but reportedly that's what the White House is offering: up to $1.9 trillion in tax hikes on every single American who drives a car, turns on a light switch or buys a product made in the United States," said Michael Steel, a spokesman for House Minority Leader John A. Boehner. "And since this energy tax won't affect manufacturers in Mexico, India and China, it will do nothing but drive American jobs overseas."