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Eye on the Market | July 25, 2011 J.P Morgan Topics: US debt ceiling negotiations, a more ambitious European bailout plan (finally), and how large cap growth stocks and rising corporate profits are patiently waiting for both of them to end White Castle. Twenty five years ago, I had a friend with a peculiar way of responding to seeing things he didn’t like on TV: he would throw White Castle hamburgers at the screen. I always thought this was a bad way to waste a good hamburger, but I had one of those moments the other night when watching news reports on debt ceiling discussions. Media outlets have referred to President Reagan’s scolding of Congressional Republicans for delaying debt ceiling increases, and the 18 increases that took place during his Presidency. The implication: reservations about raising the debt ceiling are as irresponsible now as they were then. This is a disingenuous argument; in the 1980’s, the debt ceiling being debated was 50% of GDP, and had no bearing on the solvency of the United States. Today, the proposed increase raises the debt limit twice as high, measured relative to GDP or government revenues. While a default is a very bad idea (deserving of a White Castle hurling of its own), unconstrained debt growth with no plan to slow it is bad as well. Some suggest we not worry about debt growth, since demand from foreign central banks and the Federal Reserve would keep yields in check. That logic is irresponsible at best. Debt limit legislation is a rocky but healthy way for a democracy to decide whether mega-deficits are in the long-term public interest. Debtlimitdebate of the 80’s: anentirely different discussion Percent Multiple 110% 8x 100% whe 90% Reagan scolds Debt limit to 80% Congressional GDP 6x Republicans for not -_ 10% 5x raising the debt 60% ceiling AX 50% =r Debt limit to 3x 40% gov. receipts 30% —> ex 20% 1x 1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 2010 Source: OMB, BEA, J.P. Morgan Private Bank. Over the last few days, the Gang of Six plan, the Reid-McConnell plan and the Obama-Boehner plan have all been raised up the flagpole and then lowered. By the end of the process, we’re still looking for deficit reduction of $3 trillion+ over 10 years (relative to the CBO Alternative case in which there is no deficit reduction at all). However, Congress is running short on time, and may have to do a smaller debt ceiling increase/deficit reduction first. For now, we wait to see the balance of spending cuts and revenue increases’ will be agreed to. Last week’s Profiles in Courage piece walked through the history and dynamics of this process, so we won’t repeat that here. Here’s our take on what has been proposed so far, with the caveat that many plans are not crystal clear what baseline they are using’, or what steps they recommend to get to that baseline first. What's on the menu? US long-term debt scenarios All tax cuts extended; AMT indexed to inflation; Netdebt to GDP, percent no Medicare reimbursement cuts 105 Cuts to discretionary and entitlement spending Reid-McConnell, Phase | ‘ 100 95 90 85 80 75 70 Top two brackets return to 2001 levels: phase- out of itemized deductions; some discretionary spending cuts; Medicare reimbursement freeze Discretionaryand entitlement cuts (CPI chain t— weighting), limit on itemized deductions, “bracket creep" (faster migration to higher tax brackets) All tax cuts return to 2001 levels; AMT no longer Gang of Six @ indexed to inflation; Medicare reimbursement 2 ee cuts to Doctors proceed as planned 65 Tax rates lowered, combined with reduction in 2010 201220138 2015 2016 20182019 2021 deductions to generate net tax revenue increase; Source: CBO, news reports, Gang of Six proposal, J.P. Morgan Private Bank. cuts to discretionary and entitlement spending Pres. Budget Boehner 1 Plan CBO Baseline ’ On the AMT: the Tax Policy Center estimates that if the AMT is not indexed to inflation, it would impact 31 million filers in 2012 (and raise $132 billion in revenue), compared to 4 million filers in 2011 (and $39 billion in revenue). * For example: the Gang of Six state that they used the President’s budget as a baseline (scored by CBO in March 201 1), reduced deficits by $3.7 trillion, and ended up with a 71% debt/GDP ratio; but they do not explain how they get to the President’s baseline in the first place. 1 HOUSE_OVERSIGHT_025221