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Weekly Economic CommentaryOctober 29, 2012

John Canally, CFAEconomist LPL Financial

Budget Debate?

HighlightsOur presidential and vice presidential debate word cloud emphasizes the importance of jobs and work, terms that were mentioned more frequently than the deficit.

The outcome of next week’s elections will go a long way toward determining the ultimate mix of revenue increases and spending decreases ahead.

Please see the LPL Financial Research Weekly Calendar on page 3

The LPL Financial Research Department has written extensively this year on the looming fiscal cliff, the potential for the upcoming elections to influence the resolution of the fiscal cliff, and the fiscal cliff’s impact on the economy today and early in 2013. This week, we will discuss to what extent the nation’s longer term budget woes have been part of the campaign, and how the election outcome may help to influence how these longer term issues get addressed.

Long-Term Budget Issues

In late 2010, after the mid-term elections that saw Republicans take control in the House of Representatives and narrow the Democrats’ seat advantage in the Senate, three different groups released detailed plans addressing the nation’s long-term budget issues. Each of the plans was received with a great deal fanfare from market participants, the media, and many of the so-called

“think tanks” in Washington. For a brief time, there was some conversation in the “Public Square” (i.e., the national discourse) about our longer term budget deficit issues.

However, the longer term debate over the budget waned in the “lame duck” session (the time between the congressional election and when the newly elected Congress convenes) following the 2010 congressional elections. And in place of that debate, the scramble to address the expiring Bush tax cuts, the risk of a government shutdown, and the extension of the funding for emergency unemployment benefits took center stage. Please see the Weekly Market Commentary from October 29, 2012 for more details and some historical perspective on the lame duck session of Congress.

Ultimately, the 2010 lame duck session did extend the Bush tax cuts and the unemployment benefits, and a government shutdown was avoided. But in doing so, the session set the stage for the toxic debt ceiling debate in August 2011, and set up the fiscal cliff that the economy faces in just over two months. What has been almost forgotten in the two years that have passed since these deficit reduction plans were announced is how we, as a nation, are going to address our long-term budget woes. How did the candidates do on this issue during the debates?

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Public Square Insights

We use the nearby word cloud [Figure 1] as a proxy for the “Public Square.” The cloud is derived from the transcripts of the three presidential debates between President Barack Obama and Governor Mitt Romney, as well as the vice presidential debate between Vice President Joe Biden and Congressman Paul Ryan. Some commonly used words are eliminated from the cloud, and other words like “Obama,” “Romney,” “America,” and

“American” are also excluded, to get at the true essence of the debate.

Aside from the word “people” (373 mentions), the words “jobs” (229) and “work” (170) were a key theme in the debates, suggesting that the campaigns think this election is all about jobs. Add in the word “economy” (101 mentions) and it’s clear that the campaigns believe the overall health of the economy is also crucial to the election outcome. Interestingly, the word

“China” (61) was used more than “education” (54), “families” (51) or “kids” (46), and “Iran” (46) got more mentions than either “Afghanistan” (35) or “Iraq” (33). But how did our longer term deficit problem rank with the candidates during the debate?

The word “deficit” does appear 57 times, about the same number of mentions as the word “budget.” While the word “revenue” (or its variations) got 20 mentions and did not make our word cloud, “spending” (and its variations) got 53 mentions and did make the cloud.

The word “loophole” was used 23 times, often referring to portions of the tax code that allow individuals or corporations to shield income from taxation, while the word “tax” was used in the four debates a total of 250 times. The word “Medicare” shows up 91 times — more than one-third of which were in the vice presidential debate. While not indicated in the cloud,

“Social Security” was mentioned 31 times across the four debates. Given their size in the budget, Social Security and Medicare will likely be part of any credible long-term plan to reduce the budget deficit. According to the nonpartisan Congressional Budget Office, by 2020, spending on Social Security and healthcare programs like Medicare will account for 60% of all Federal budget outlays, up from 45% in 2012.

1 Key Debate Themes

Source: Presidential and Vice Presidential Debate Transcripts, Commission on Presidential Debates 10/29/12

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2012

29 Oct � Personal income and consumption (Sep) � Dallas Fed Mfg. Index (Oct) � Senior Loan Officer Survey (Oct)

� Spain’s Rajoy meets Italy’s Monti in Madrid

30 Oct � Case-Shiller Home Price Index (Aug) � Consumer Confidence (Oct)

KocherlakotaDudley*

� Italy: Bond Auction � Japan: Central Bank Meeting � Japan: Unemployment Rate (Sept) � India: Central Bank Meeting � ECB’s Draghi Speaks in Frankfurt

31 Oct � Employment Cost Index (Sept) � Chicago Area Purchasing Managers Index (Oct)

Williams* � China: PMI (Oct) � China: HSBC PMI (Oct) � Norway: Central Bank Meeting � France: Bond Auction � Germany: Bond Auction

1 Nov � Challenger Job Cut Announcements (Oct) � ADP Employment (Oct) � Initial Claims (10/27) � ISM (Oct) � Construction Spending (Sep) � Vehicle Sales (Oct)

RosengrenLockhart*

2 Nov � Nonfarm Payroll Employment (Oct) � Unemployment Rate (Oct) � Factory Orders (Sep)

� G20 Finance Ministers and Central Bankers Meeting in Mexico City (Nov 3 – 4)

� China: Service Sector PMI (Oct)

Fed Global Notables

LPL Financial Research Weekly Calendar

U.S. Data

Hawks: Fed officials who favor the low inflation side of the Fed’s dual mandate of low inflation and full employment

Doves: Fed officials who favor the full employment side of the Fed’s dual mandate

* Voting members of the Federal Open Market Committee (FOMC)

Budget Plans

Three budget plans were released in late 2010 by:

� The President’s National Commission on Fiscal Responsibility and Reform (commonly known as Bowles-Simpson);

� Bipartisan Policy Center (commonly known as Rivlin-Domenici); and

� Pew-Peterson Commission on Budget Reform.

Each plan differed on certain aspects of the longer term fix for our budget woes. However, they all generally agreed that there are no easy answers and no quick fixes. The three commissions were populated by both Democrats and Republicans. Some hold (or once held) elected office; others served in the Federal government or were on the boards of the many think tanks in and around Washington. All were all focused on finding bi-partisan solutions to the problem.

For example, both the Bowles-Simpson plan and the Rivlin-Domenici plan noted that budgets cannot be balanced by eliminating waste or earmarks

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(just 1% of Federal spending), nor by just cutting domestic discretionary spending, nor by growing our way out of the deficit, nor by raising taxes.

In general, the three commissions concluded that in order to successfully tackle the longer term deficit problem, formerly politically untouchable areas must be on the table in any serious negotiation. These areas include:

� Social Security;

� Defense spending;

� Farm subsidies;

� Medicare;

� Medicaid;

� Personal and corporate tax rates; and

� Personal and corporate tax loopholes (like deductions for paying home mortgage interest and state and local real estate tax, or making charitable contributions).

The plans did vary on the amount of revenue increases (via some combination of higher tax rates, fewer loopholes, and more incomes subject to taxation) relative to spending cuts (across all categories of Federal spending) needed to achieve a long-term path toward fiscal stability. The outcome of next week’s elections will go a long way toward determining the ultimate mix of revenue increases and spending decreases that will set the country on that path. �

LPL Financial Research 2012 Forecasts

GDP 2%*

Federal Funds Rate 0%^

Private Payrolls +200K/mo.†

Please see our 2012 Outlook for more details on LPL Financial Research forecasts.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

* Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

^ Federal Funds Rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.

† Private Sector – the total nonfarm payroll accounts for approximately 80% of the workers who produce the entire gross domestic product of the United States. The nonfarm payroll statistic is reported monthly, on the first Friday of the month, and is used to assist government policy makers and economists determine the current state of the economy and predict future levels of economic activity. It doesn’t include: - general government employees - private household employees - employees of nonprofit organizations that provide assistance to individuals - farm employees

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Stock investing involves risk including loss of principal.

International investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.

Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

The Institute for Supply Management (ISM) index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.