David Rosenberg

Published on Wednesday, Apr. 21, 2010 7:00AM EDTLast updated on Wednesday, Apr. 21, 2010 7:01AM EDT

It is truly amazing how investors are missing the forest for the trees. A nascent recovery and V-shaped bull market completely premised on rampant government stimulus is going to have a payback. The day of reckoning is coming and sooner than many think.

Fixing the fiscal mess in the U.S. will not be achieved through spending restraint because spending is increasingly being dominated by locked-in mandatory entitlement spending and interest costs on the rapidly rising stock of public debt. Unlike the key propelling factors behind the onset of the secular bull market in 1982, which were tax reduction, less government and lower interest rates, we will see none of that going forward.

Not that the Fed will be raising rates any time soon, but they can't exactly be cut like they were in the early and mid-1980s. But taxes are going higher and on the most productive parts of society. The Bush tax cuts enacted in 2001 and 2002 expire on Jan. 1, 2011 – and according to our friends at Hoisington Investment Management, this will total $1.5-trillion (U.S.) in the ensuing decade or a 1 per cent hit to GDP annually.

On that date, top marginal tax rates for individuals earning more than $200,000 and families making over $250,000 will see their tax rates rise to 39.6 per cent from 35 per cent (the current 15 per cent rate on capital gains and dividends will also go back to 20 and 39.6 per cent, respectively, on Jan 1, 2011). A huge polarization is already emerging as the President's policies have allowed 47 per cent of households to avoid paying taxes – up from 38 per cent two years ago.

“The definition of “long-term” today seems to be the next quarter – but I think we should also be thinking about the end game because the markets are bound to start focusing on the tax bill from the bailouts at least six months before the marginal rate hikes kick in.”

Since the U.S. government got elected on a platform to redistribute income to the “have-nots,” expect that ratio to rise even further in the future. This is all reminiscent of how the New Deal was ultimately paid for – the top marginal tax rate soared in the 1930s (before the Second World War) from 25 per cent to 80 per cent. Maybe that's why the next secular bull market didn't start until 1954.

As for the here and now, can there really be any doubt that what we have on our hands is a U.S. government policy that is aimed at transferring losses and liabilities from the private sector to the public sector? The latest leg to the government's bailout policy has been to allow stressed-out homeowners to refinance into the Federal Housing Administration – with principal forgiveness for underwater borrowers and even for those who are current! This is a big part of the reason why mortgage-backed derivative swap indexes have been rallying in the past few weeks.

The Obama team is pursuing a strategy that basically transfers all the modified re-default risk from current bond holders to the FHA. As a result of this strategy, the U.S. taxpayer is now on the hook for a potentially huge loss profile. This is obviously an incremental positive to “cash flow” for a select group of homeowners and I estimate that absent this so-called stimulus and strategic defaults (which has added as much as $200-billion to household cash flow at an annual rate), consumer spending will be contracting. Unbelievable stuff.

But, the day of reckoning is coming soon for the upper-income echelons and investors (remember that there are still all those Americans that are not paying taxes today). Remember that the big tax grab starts on Jan. 1, 2011, and under the current plan, it will drain $150-billion or 1 per cent out of GDP annually for the ensuing decade. That tax bill is likely to rise even further than currently planned and hit the top band of the income strata as well as investment earnings.

If Ben Bernanke chooses to raise rates to the degree of fiscal tightening required, it would likely ensure we would see a repeat of the 1937-38 collapse. The definition of “long-term” today seems to be the next quarter – but I think we should also be thinking about the end game because the markets are bound to start focusing on the tax bill from the bailouts (as opposed to rallying around the bailouts) at least six months before the marginal rate hikes kick in.

Only now am I starting to hear alarm bells go off from some of the portfolio managers south of the border. The taxation issue and implications for the investment landscape are going to be a key issue in the second half of the year.