Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

Month: December 2017

THE DAILY EDGE (19 December 2017)

Middle Class to Get 23% of Tax Cuts for Individuals Under GOP Bill

Middle-income households will get $61 billion in tax cuts in 2019 under the Republican tax plan poised for passage this week, according to an analysis released late Monday by Congress’s Joint Committee on Taxation.

That amounts to 23% of the tax cuts that go directly to individuals. By 2027, however, these households would get a net tax increase, because tax cuts are set to expire under the proposed law.

The calculations are based on JCT estimates of cuts going to households that earn $20,000 to $100,000 a year in wages, dividends and benefits. Those households account for about half of all U.S. tax filers, with nearly a quarter making more and a quarter making less. (…)

America’s most-affluent households, those earning $500,000 or more a year, which account for 1% of filers, would also get $61 billion in cuts in the first year, according to the JCT analysis. They would get a cut of $12 billion by 2027.

That includes income earned by pass-through businesses such as partnerships and S-corporations that pay taxes on individual returns. It doesn’t include the benefits of estate-tax reductions. (…)

While the middle class as a whole will see benefits, some people will end up worse off. Using an alternative measure of household income, the Tax Policy Center found that of those households in the very middle of the income distribution, making $48,600 to $86,100 a year, 91.3% would receive a tax cut next year. But 7.3% would receive a tax increase. By 2025, 10.9% would receive a tax increase. (…)

Here’s how the Tax Foundation sums it up for individuals:

  • On a static basis, the Tax Cuts and Jobs Act would increase the after-tax incomes of taxpayers in every taxpayer group in 2018. The bottom 80 percent of taxpayers (those in the bottom four quintiles) would see an average increase in after-tax income ranging from 0.8 to 1.7 percent. Taxpayers in the top 1 percent would see an increase in after-tax income on a static basis of 1.6 percent, driven by the lower pass-through tax rate and the lower corporate income tax.
  • On a static basis, the plan would lead to 0.3 percent lower after-tax income on average for all taxpayers and 0.6 percent lower after-tax income on average for the top 1 percent in 2027, due to the expiration of the majority of the individual income tax cuts, but retention of chained CPI. When accounting for the increased GDP, after-tax incomes of all taxpayers would increase by 1.1 percent in the long run.
  • However, by 2027, the economic growth effects of the tax bill will have largely been realized. Taking these effects into account, taxpayers as a whole would see an increase in after-tax incomes of at least 1.1 percent. The bottom 80 percent of taxpayers would see their after-tax incomes increase from 0.8 to 1.7 percent. The top 1 percent of all taxpayers would see a decrease in after-tax income of -0.2 percent on a dynamic basis, largely due to chained CPI, the alternative minimum tax, and the net interest deduction limitation.
U.S. Businesses Find Welcome Surprises in Tax Overhaul The final tax bill offers much of what large companies hoped to gain from the Republican overhaul, while late modifications dropped some provisions that most worried companies.

(…) Among the provisions that made business leaders happiest was one that went missing in the final bill: the corporate alternative minimum tax. (…) The [21%] rate takes effect on Jan. 1, a year sooner than proposed in the Senate bill. That promises firms an extra year of lower tax and avoids a delay that worried many tax experts. (…)

Lawmakers ultimately dropped another closely watched interest-deduction limit, which would have applied where a disproportionate amount of a company’s borrowing came in the U.S. The provision was designed to help prevent “earnings stripping,” or shifting profits to lower-tax jurisdictions.

Lobbyists and corporate tax executives are still working through changes to some of the bill’s most complex provisions, which attempt to limit efforts to shift corporate profits to low-tax foreign jurisdictions.

One, dubbed the base-erosion and antiabuse tax, or BEAT, is triggered at large companies where at least 3% of their tax deductions stem from payments to foreign affiliates, down from a 4% threshold in the Senate bill. A House-bill provision disliked by many companies—a 20% excise tax on many transactions with foreign affiliates—was scrapped altogether.

Private-equity firms kept capital-gains treatment for “carried interest,” or their share of profits from portfolio investments, but only if the investment is held at least three years. Today, the treatment applies after a year.

Life insurers no longer face an 8% surtax on taxable income, a provision included in the House bill. (…)

(..) But tech giants could be pinched by provisions in the new tax code aimed at curbing the use of low-tax foreign jurisdictions. “Those firms that have been the world leaders in avoiding taxes will find their tax rates going up,” said Edward D. Kleinbard, a former U.S. tax official who is now a tax professor at the University of Southern California law school. (…)

Tax Cuts and Jobs Act International Corporate Income Tax Rates
  • The tax bill is surely already impacting these forecasts

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The Senate Republican tax bill is built on shaky assumptions, such as sunsets of the individual tax provisions that the GOP argues will never actually happen. So the actual cost could be well above the official estimate of around $1.4 trillion — and credible analyses of the bill estimate that the additional revenue it creates through economic growth won’t come close to offsetting that cost. (…)

gop-tax-bill-could-be-more-costly-than-it-looks-2517513175.html
U.S. Home Builder Index Strengthens

large imageThe housing market remains in good shape. The Composite Housing Market Index from the National Association of Home Builders-Wells Fargo increased 7.2% to 74 during December, the highest level since July 1999, up 7.2% y/y. Expectations had been for a rise to 70. For all of this year, the index increased 11.2% following last year’s 3.8% rise. The NAHB figures are seasonally adjusted. During the last ten years, there has been a 67% correlation between the y/y change in the home builders index and the y/y change in housing starts.

The index of present sales conditions in the housing market rose 5.2% to 81 (8.0% y/y), also the highest level since 1999. The index for conditions in the next six months improved 3.9% (1.3% y/y) to 79.

Home builders reported that the traffic of prospective buyers index jumped to the highest level since December 1998, up 11.5% y/y.

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From the NY Fed service sector Business Leaders Survey

Best reading since the Financial Crisis:image

  • The business climate has markedly improved since the elections but many indicators of actual decisions made have not kept pace:

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  • These next charts plot expectations 6 months ahead. Wages are expected to rise, prices paid to flatten while prices received could rise a little. We shall see about that…

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The U.S. Is Left Behind on Trade The new Japan-EU deal will hurt a slew of American exporters.

Europe and Japan finalized a trade deal late last week that shows how Donald Trump’s protectionism will harm American companies and farmers. The agreement eliminates tariffs on more than 95% of products and reduces nontariff barriers. Europeans will gain access in particular to Japan’s lucrative agricultural markets that the U.S. lost by walking away from the 12-nation Trans-Pacific Partnership trade pact. (…)

The Japan-EU deal will eliminate quotas on European pork in Japan and cut the tariff to about 17% from 80% over 10 years, according to the U.S. Department of Agriculture. That will hurt American farmers, who currently hold 58% of the market for fresh and chilled pork and 63% for processed pork, while Europe provides 62% of Japan’s frozen pork.

While Europe isn’t a major beef exporter, it will get the same 15-year tariff reduction to 9% from 38.5% that was part of TPP. The EU will also be exempt from measures like the temporary 50% tariff that is being imposed on American frozen beef until the end of March. High-end EU beef producers could horn in on the market for USDA prime steaks.

European vintners will savor the elimination of Japan’s 15% tax on imported alcohol as soon as the agreement goes into effect. Also blessed are the cheesemakers, who will see a 30% duty disappear. The EU expects its processed-foods exports to Japan to increase in value by 170% to 180%. That will be sour grapes for Californian wineries and hard cheese luck for Midwestern dairy farmers.

Japan imposes no tariff on imported cars, but American carmakers have long complained that nontariff barriers stop the Watanabes from buying Detroit vehicles. Tokyo has pledged to reduce such roadblocks for European-made autos. The EU-South Korea trade deal that went into effect in 2011 included similar provisions, and European exports to Korea tripled in the following four years.

In return for Japan’s opening, Europe has agreed to zero out its 10% tariff on cars and 3% duty on car parts. The Japanese auto industry, which sends about 13% of its exports to Europe, sees opportunities to expand in a massive market. American carmakers were lobbying for similar treatment, but U.S.-EU trade talks have stalled and the Trump Administration seems happy to let them die.

Tariff reductions are important, but safety requirements and other regulations can pose a larger obstacle to trade. The EU-Japan deal promises to harmonize these rules for food, vehicles, drugs and medical devices. This threatens to leave American firms at a significant competitive disadvantage.

BTW, Canada also just signed a trade pact with the E.U.

Canada: Mr Poloz’s nightmare before Christmas

Mr. Poloz shared with a Toronto audience last week that youth underemployment was one of three slow-moving nagging issues that keep him awake at night. The BoC governor is apparently losing sleep over the fact that the participation rate of people aged 15-24 is only around 64%, the lowest in almost 20 years.

That’s one nightmare we cannot interpret. If Mr. Poloz is indeed having bad dreams about youth underemployment, than he probably consider Mrs. Yellen to be one of the world’s most reckless central bankers for hiking rates in spite of the extremely low youth participation rate in that country (a whopping 8 percentage points below Canada’s).

Yet, Mr. Poloz continues to claim that that the U.S. is closer to full employment than Canada! What’s more, our analysis reveals that the decline in youth participation in Canada since 2007 is exclusively driven by students (mostly those aged 15-19). For non-students, the participation rate has remained unchanged at around 87%.What’s wrong with having a bigger proportion of youth attending school?

Two decades ago, only 32% of Canadians aged 25-34 had post-secondary education. The proportion now stands at almost 62%, the highest in the OECD and about 15 percentage points above that in the U.S. The more educated the population is, the more likely workers are to remain employed as they move into prime age (25-54).

As today’s Hot Charts show, that’s exactly what’s happening in Canada. Nightmares notwithstanding, eventually reality will catch up with you. There are no compelling arguments for keeping real interest rates negative in Canada at this time. Incoming data (GDP, CPI inflation, Employment/wages and the BoC business outlook survey) may still convince the Bank of Canada to hike on January 17, 2018. (Stephane Marion, NBF)

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THE DAILY EDGE (18 December 2017)

U.S. Industrial Production Rose 0.2% in November

Industrial production—a measure of output at factories, mines and utilities—rose a seasonally adjusted 0.2% in November from the prior month, the Federal Reserve said Friday. This was slightly below the 0.3% rise forecast by economists.

October industrial production was revised up to a 1.2% gain from an initial estimate of a 0.9% increase. From a year earlier, industrial production rose 3.4% in November. (…)

Friday’s report showed output in the volatile mining sector jumped 2.0% in November, aided by a gain in oil and gas extraction that the Fed said “returned to normal levels after being held down in October by Hurricane Nate.” Without this rebound, industrial production would have remained flat last month, the Fed noted.

Manufacturing output, the biggest component of industrial production, rose 0.2% in November, a sharp slowdown from October’s 1.4% increase. (Charts from Haver Analytics)

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SENTIMENT WATCH

There were several surprises for investors when Republicans unveiled their final tax bill Friday, but the most significant is that they add up to a bigger boost to economic growth next year.

The bigger stimulus could fundamentally change how the market behaves in 2018. Sales and profits will be stronger than most investors expect. But with the unemployment rate low, wage pressures will mount faster, and inflation should pick up more. If the tax plan passes, as seems likely, it could lead the Federal Reserve to raise rates faster, putting the bond market at risk.

(…) The bill unveiled Friday front-loaded more than $200 billion in stimulus for next year. Economists had been penciling in a boost of about a third of a percentage point next year. Now that is looking way low. (…)

The cut in the corporate tax rate to 21% happens right away; the Senate bill had put it off until 2019. It lowers the top rate on individuals to 37%—lower than either the House and Senate plans. It also pushes individual rates down for most other people and increases the child tax credit, which are important because middle-class households are more likely to spend extra income than the rich.

Cornerstone Macro strategist Andy Laperriere estimates that all told, the tax cut for calendar 2018 comes to about 0.9% of GDP. The boost to growth will likely be stronger though. The one-time tax on overseas cash held by companies is technically a drag on growth, but in reality is shouldn’t directly affect U.S. demand. Excluding that, the tax bill could increase GDP by 1.3%. (…)

(…) In a preliminary analysis of the tax plan’s effect, based on the tax plans the House and Senate separately passed last month, Goldman Sachs strategists found that S&P 500 profits would get a 5% boost. The final tax plan doesn’t appear quite so generous—the corporate tax rate is set, for now, at 21% rather than the 20% congressional Republicans initially aimed for—but a ballpark figure of 5% still seems reasonable. (…)

Of course, it is possible that the tax plan boosts economic growth, which would add even more oomph to earnings than is readily apparent. (…)

From the FT:

  • Analysts and executives expect corporate earnings to be boosted by an average of about 10 per cent, with some companies set to see significantly higher benefits of up to 30 per cent, thanks to the proposed reduction in the main rate of US federal corporate tax from 35 per cent to 21 per cent.
  • Tax Bill a Boon to Commercial Real Estate Owners
  • Poll: Voters Increasingly Favor Democrats for Congress Asked which party they prefer to lead Congress after next year’s midterms, 50% said the Democrats and 39% said Republicans, according to a Wall Street Journal/NBC News poll that offers caution signs for the Republican Party.

The bill, which includes deep tax cuts for corporations, reduces the tax rate and provides a steep deduction for some businesses structured as partnerships, limited-liability companies and other so-called pass-through companies, which is how most real estate businesses are set up.

In fact, real estate businesses appeared to fare better than other pass-through businesses, which pay taxes through individual returns. Not only does the proposal drop the top individual marginal tax rate, but the plan also gives a 20% deduction on taxable income to pass-through businesses owned by individuals making less than $157,500 and joint filers making less than $315,000.

In addition, the bill gives some owners of pass-through companies who exceed those income levels another method of qualifying for that deduction that benefits private real estate partnerships with few employees and large real estate holdings, tax lawyers noted.

“If enacted, the commercial real-estate industry will have hit the jackpot,” said Steven M. Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution. (…)

Amid all this DC activity, we’re 2 weeks away from the end of Q4’17. Positive preannouncements are down somewhat but negative warnings are much lower than last year and than Q3’17 at the same stage.

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Which means that the apparent squeeze on profit margins is not actually hitting profits just yet…

…except in the grocery biz:

(…) “Our inflation at cost is still above our inflation at retail,” Mike Schlotman, CFO of grocer Kroger, told investors this month. “We didn’t pass all of it on.” (…)

Trailing S&P 500 EPS are now $128.23 for a Rule of 20 P/E of 22.7, pretty rarely seen historically.

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Let’s dare to be forward looking:

  • Using full 2017 EPS expected at $131.47 (+11.3%): Rule of 20 P/E: 22.2 = –9.9% decline to “20” fair value.
  • Using current 2018 estimate of $146.26 (+11.2%): Rule of 20 P/E: 20.1 = fairly valued one year out.
  • Using 2018E + 8% tax reform impact = $158.00 (+20.2%): Rule of 20 P/E: 18.8 = +6.4% upside to fair value one year out.

The above exercise keeps inflation unchanged, a highly heroic assumption if this tax reform meaningfully boosts consumer and corporate demand when the economy is already at 3% speed and unemployment at 4.1%.

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Given this tax reform and corporate America’s ability to grow profits, the risk to equities in 2018 comes more from rising inflation and interest rates than from an eventual recession and weak profits, although rising debt levels are adding significant leverage to any adverse economic development.

This WSJ article is based on a Boston Consulting Group survey report. Over a two-week period during late October and early November 2017, BCG surveyed 250 investors who oversee approx­imately $500 billion in assets, soliciting their outlook on and expectations for the global macroeconomic environment, equity markets, and the continued ability of companies they invest in or follow to create value.

(…) Nearly half of the survey respondents (46%) are pessimistic about equity markets for the next year, a substantial jump from 32% in 2016 and 19% in 2015. More than a third of investors (36%) are bearish about the market’s potential for the next three years, more than doubling the 2016 survey’s percentage of self-described bears (16%). (…)

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The most frequently cited reasons underlying this pessimistic outlook are macro factors such as rising interest rate levels (45% of bears), the US political climate (40%), and unstable geopolitics (31%). (…)

The 3% earnings growth that they expect to see over the next three years is the lowest earnings growth expectation we have seen in the nine-year history of BCG’s investor survey. (…)

Sun Meanwhile, Lowry’s Research remains positive, as its calculated “forces of Supply and Demand continue to suggest a healthy bull market”. Lowry’s technical analysis sees no “significant deterioration in the market conditions” and “a bull market that remains relatively healthy and with months more of new highs ahead.”

FIXED INCOME

The U.S. high yield default rate is poised to finish 2017 below 2%, its lowest level since the first quarter 2014, according to a new report from Fitch Ratings. The rate stands at 1.5% with just under $19 billion of defaults, a notable decrease from the $59.6 billion (4.7%) tallied last year when energy and metals/mining accounted for 84% of the total. This year, energy and metals/mining together generated only $3.9 billion while telecommunications registered the most defaults for a single sector at $3 billion.

“Retail bond defaults produced just $2 billion of volume, but that amount could double in 2018,” said Eric Rosenthal, Senior Director of Leveraged Finance. “The institutional leveraged loan market has been harder hit by retail defaults than high yield.” (…)

Overall, Fitch forecasts the U.S. high-yield default rate to end 2018 modestly above 2%. Broadcasting/media could generate roughly 40% of the total market default volume and post an 18% sector rate in 2018 (the sector default rate falls to 2% without iHeartCommunications Inc.). Fitch anticipates the energy default rate at just 2% next year, as the sector default cycle is on the wane.

The November TTM 30-day post default average issue bid price is at 59%, up from 27% one-year ago. The par-weighted price is comparable to the benign default periods of 2006-2007 and 2013-2014 when levels finished in the mid 60s. (…)

However, the loss of full tax deductibility of interest expense will adversely affect the aftertax earnings of a number of high-yield companies. About 26% of high-yield issuers will be worse off under the House plan and 36% will be worse off under the Senate proposal because of how the House plan allows interest expense to be deductible up to 30% of EBITDA, while the Senate’s version limits the deductibility of interest expense up to 30% of EBIT. (…)

The share of high-yield companies that are worse off because of the loss of the full deductibility of interest expense might become larger in the event benchmark interest rates jump sharply and/or high yield credit spreads widen materially. In addition, the less favorable tax treatment of business interest expense might become most apparent during a credit crunch, which, in all likelihood, would also be accompanied by shrinkages of both EBITDA and EBIT that automatically reduce the amount of interest expense eligible for deductibility.

In general, anything that increases the after-tax cost of debt also increases the risk of more defaults during the next bout of financial stress. Nevertheless, over time, businesses might be expected to adjust to the less favorable tax treatment of interest costs by assuming less debt than otherwise. For now, the market has been largely indifferent to high-yield’s potential loss of financial flexibility in view of how a recent high-yield bond spread of 369 basis points (bp) was thinner than its 2017-to-date average of 384 bp.

The total amount of global negative-yielding sovereign debt remains at elevated levels despite the European Central Bank’s (ECB) plan to reduce monthly asset purchases amid improving economic fundamentals in the Eurozone, according to Fitch Ratings. As of Dec. 4, 2017, there was $9.7 trillion of negative-yielding sovereign debt outstanding, up from $9.5 trillion on May 31, 2017 and $9.3 trillion one year ago. (…) Improving growth has led the ECB to plan to slow the pace of asset purchases to EUR30 billion per month beginning in January 2018.(…)

ECB net purchases of public-sector debt securities have been roughly 3.5x the volume of net issuance on average in 2016 and 2017, forcing holders of Eurozone debt to purchase other assets, such as US treasury securities.

(…) In Germany, a bond originally with 10 years to maturity will come due in January 2018 with a coupon of 4%. If reissued, with a coupon at current market rates, the German bond will have a coupon of around 30bps. (…)

Confused smile BTW, European speculative-grade bonds are now trading below 2.0% (e.g.: Volvo BB+ 1.8%, Energias de Portugal BB 1.6% and Leonardo S.p.A. BB+ 1.3%).

Trump to label China as a strategic ‘competitor’ Beijing accused of pursuing policies of economic aggression to weaken US

(…) While the national security strategy outlines a range of threats, most of the criticism is reserved for China and Russia, which are described as “revisionist” powers that are trying to “shape a world antithetical to US values and interests”. “China and Russia challenge American power, influence, and interests, attempting to erode American security and prosperity,” the document warns. (…)

  • Drawbridge up: Trump’s foreign policy

In 2006 George W. Bush unveiled a National Security Strategy (NSS), a 54-page statement of his worldview, linking America’s security to the global spread of democracy and economic freedoms. “We choose leadership over isolationism, and the pursuit of free and fair trade and open markets over protectionism,” he wrote. Donald Trump will today unveil an “America First” NSS trashing that optimistic creed. The Trump strategy is expected to accuse China of “economic aggression”, and to blame predecessors for admitting rising powers into a liberal trading order in hopes of promoting reform, only to see rivals cheat and hurt America. Expect talk of “competitive engagement” (raising fears of trade wars) and praise for strong, sovereign nations that fight Islamic terrorism, not warm words about furthering democracy. Supporters call Mr Trump a new Reagan, promoting “peace through strength”. But this angry, defensive new America is no shining city on a hill. (The Economist)

Pointing up Mr. Trump’s Trade War The president is right to emphasize reciprocity. His mistake is to focus on the balance of trade with individual countries rather than on the rules of market access

(…) The focus on the trade balance in trade negotiations is misguided. Trade is not like a ledger, where imports are the cost and exports are the benefit, and trade surpluses and deficits do not indicate that one country is “winning” and the other “losing.”

The trade deficit is driven by macroeconomic factors, not by trade barriers or trade agreements. (…)

In some circumstances, it may make sense to care about the overall balance of trade. If the trade deficit is viewed as a problem, the solution is for the U.S. to save more and spend less, like countries with trade surpluses, such as China, Germany and Japan. One component of America’s poor savings record is the federal budget deficit: When it grows as a share of GDP (due to a decline in revenues or an increase in expenditures), it contributes to the trade deficit.

But it makes no sense to care about balancing trade bilaterally with individual countries. A household may care about whether its overall spending exceeds its income, but it doesn’t care about balancing each component in its budget. Everyone runs a trade surplus with his or her employer. Everyone runs a trade deficit with the grocery store, except for the people who work there. It is nonsensical to balance your checkbook bilaterally; just try doing that with Amazon or Costco. (…)

With Canada, the U.S. does indeed have a trade deficit in goods, but it has an even larger trade surplus in services. Is this “very unfair” to Canada? Are we “taking advantage” of our longtime ally? What would Mr. Trump say if Canada said that we are obligated to intervene to reduce our surplus? (…)

Emphasizing deficits and surpluses has made our trading partners less willing to negotiate and to make concessions on issues of market access. And Mr. Trump’s precipitous decision to pull out of the TPP and his threats to withdraw from Nafta mean that the U.S. is now viewed as an unreliable partner. (…)

Commerce Secretary Wilbur Ross complains that cars assembled in Mexico receive better treatment in the EU than those produced in the U.S. The reason is simple: Mexico has a free-trade agreement with the EU, and the U.S. does not. Canada also just recently concluded a comprehensive trade agreement with the EU. Both countries now have a leg up over the U.S. in exporting to the EU. (…)

The more the U.S. stands apart from these trade negotiations, the more U.S. exporters will face discrimination in foreign markets. (…)

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