Some Common Cents for August 11th, 2017

August 11, 2017, by John Norris

During a conference call on Monday, I told our wealth management associates the markets were/are as boring as I had/have seen them in my career. A steady diet of modest economic growth and acceptable, if unremarkable, earnings will do that. Further, there is really nothing on the foreseeable horizon to suggest any significant change.

Yesterday, the stock markets sold off, and a number of people have asked me whether this is the start of something more, um, sinister. Despite being almost a decade ago, if you can believe it, the near collapse of the global financial system in 2008 is still very fresh in the collective memory. To that end, most folks don’t seem to be too worried about something like a 5-10% short-term correction. In fact, I might even argue they are kind of expecting it to some degree.

No, they are worried about being a decade older, and not having enough time to make back a 40%, or more, hit to their portfolio. This is completely understandable.

As I type and in my opinion, the biggest systemic threat to the markets is a financial crisis emanating from Europe. It isn’t a question of whether or not this will happen, it is only a matter of when and the severity. I have told folks we will be discussing this in greater earnest by the end of 2018, and that whatever unfolds will not or should not be as pronounced as the meltdown in 2008.

There will be more on this topic later, but suffice it to say I am not currently losing sleep. Even so, when it starts to unfold we will say: “how could a prolonged period of negative interest rates not have ended badly?” After all, it is just math.

Of more immediate concern are two things: 1) the growing tensions with North Korea, and; 2) the creeping suspicion that perhaps the GOP isn’t going to be able to get anything meaningful done on tax reform before the end of the year. To my way of thinking, the latter is more of a problem than the former.

Don’t get me wrong, the current situation with Pyongyang is worrying. First, it is troublesome the North Koreans’ nuclear capabilities have advanced as far as they have. Second, I find it baffling the Chinese have allowed it to happen, seriously. After all, having a bellicose buffer state is one thing, and having a seemingly unhinged nuclear neighbor is quite another. Third, understanding stunts like these are how Pyongyang unites the country and stays relevant in global affairs, it is kind of surprising to see the US respond exactly how the powers that be in the DPRK wanted. While bizarre and brutal, these people aren’t morons (you don’t develop atomic weaponry and missile systems by being a complete idiot), and had a pretty good inkling how President Trump would respond to such, um, provocations.

In truth, I imagine Kim Jong-un thinks each salvo, literal and figurative, is worth $3-5 billion, maybe more, with the added benefit of galvanizing his population. Outside of the infinitesimal possibility Donald Trump wipes Pyongyang off the map, there really isn’t any downside for the North Koreans to behave in the manner they recently have. They don’t have much to lose, really.

On the other hand, the GOP potentially has a lot to lose. While it will likely keep the Senate in 2018 (namely due to the fact it only has 8 seats up for election compared to 23 for the Democrats), a 24 seat swing in the House during a midterm election wouldn’t be unprecedented, at all. So there is that. However, perhaps more than anything, the events of the last two years have put a pretty fine point on an open secret: the current two party system doesn’t adequately reflect contemporary political reality or thought. There are far more colors on the palette than just red and blue, with any number of shades of purple.

For one, I was hopeful about the prospects of significant tax reform in 2017. Chief among these were: 1) a reduction in the corporate income tax rate; 2) a reduction in the repatriation tax of corporate earnings in foreign subsidiaries of US multinational corporations; 3) a sharp reduction in the capital gains tax, and; 4) a complete overhaul of the Alternative Minimum Tax (AMT).

First, a reduction in corporate taxes would/could/should lead to an increase in earnings and, therefore, earnings per share (EPS). Since investors pay some multiple for EPS, any increase in it, EPS, will lead to a larger increase in overall societal wealth, potentially substantial. This is a good thing, isn’t it? Further, the relatively higher corporate tax rate in the US (35% at the corporate level), encourages those multinationals who can to manufacture/produce in countries with a lower tax rate….particularly if the foreign country in question has a free trade agreement with the United States.

Second, it is beyond comprehension why our tax code makes it financially advantageous for corporations to borrow money to pay dividends, etc., which is what the repatriation tax does. Instead of tapping cash in foreign subsidiaries to meet domestic operating needs, US companies borrow the money to do so much more cheaply than the tax bill they would receive by bringing the cash ‘back home.’ Further, they get to deduct the interest expense on the borrowing, which reduces their tax bill to the IRS. So, the government doesn’t get the money and the company increases its debt load. Okay, I understand this reduces the company’s overall ‘cost of capital,’ but it seems like such an easy fix. Slash this rate and at least get something, as opposed to up to 35% of nothing.

Third, the capital gains tax inhibits the free flow of capital throughout the financial system. Period, and end of discussion. I have been doing this for a long time, and I can’t tell you how many conversations I have had with investors with low cost basis stock who are loath to sell it due to the tax, and for good reason. If I think Company X (low cost basis stock for client) is going to underperform the market by 10%, total, over the next 3 years, it is ordinarily better for the client to hold onto it rather than sell it and pay up to 28.8% (in Alabama) of the gain to the government. So, the government doesn’t get the tax and the client doesn’t get the 10% upside. No one wins.

Fourth, the AMT has morphed beyond its original intentions from way back in the day, which was essentially to ‘punish’ 155 high income households who claimed so many deductions and exemptions they didn’t pay any Federal income tax. Unfortunately, this tax wasn’t adjusted for inflation for decades, meaning more and more people became subject to it….literally millions, and many of them are far from living the ‘Lifestyles of the Rich & Famous.’ To that end, in 2015, the exemption rate for households was $83,400. So, what was originally intended to be a way to keep a select few from gaming the tax code has morphed into an additional tax on, increasingly, the second quartile of income earning households. Basically, a punitive tax for the few is now a punitive tax for the many, and we could probably debate my use of the word punitive until the cows come home. IF we have to have an AMT, put it at the threshold for the highest marginal tax rate, let it serve its original purpose, and be done with it.

Earlier in the year, the talking heads said to expect some kind of tax reform package come August. Well, August is now here, and the New York Times has recently written the Administration wants a bill on the President’s desk “by Thanksgiving.” Okay, I suppose we are working on government time, but the headlines make one wonder whether the GOP will be able to get its act together to do some very basic tax reform, of what I would consider the low hanging fruit variety.

Combined, these reforms would have likely had a positive impact on the financial markets, and, clearly, that would help me professionally. So, I won’t deny there is a conflict of interest in my comments. As the comedian Dana Carvey might have said during his impression of George Bush, Sr.: “Not gonna do it.” However, common sense is common sense, regardless of profession.

Common sense would also suggest fundamental reform of the tax code is probably not going to happen any time soon. It is far too complex and heavily laden with special interests. Why does it have to be so complicated? So much so, I have read even the IRS estimates it costs roughly $400 billion annually to comply. On the one hand, that is ridiculous and inefficient. On the other, there are a lot of people making a living out of that $400 billion, and they will do what they can to protect themselves and their industries. So, a complete overhaul is out the question. You don’t have to understand Washington to get this, just human nature.

So, if I feel that way, why was I hoping for some kind of reform? Well, because it seems so apparent it would benefit the US economy, which would benefit our society and government tax coffers, and could be politically easier to attain IF they kept it simple. I have scoured the data and found one thing to be pretty much true across the board and time: tax receipts increase when the economy grows and wealth expands. We can debate tweaking marginal tax rates for the highest of income earners and this or that tax bracket, and probably never come to a clear conclusion. I can provide data which, on paper, would suggest or defend both sides of any argument.

I suppose I was hopeful we could start chipping away at an unnecessarily complicated impediment to economic efficiency. The reforms I listed would, in my opinion, have been the easiest to argue/defend without completely upsetting the political apple cart and stepping on too many special interests. Perhaps we will eventually get something, but who knows what the end result will be. It certainly won’t be as simple as my recommendations.

Let me leave this topic with this one from a recent The Economist/YouGov Poll of 1500 American adults taken between August 5th and 9th. The question being: Overall, do you approve or disapprove of the way that the United States Congress is handling its job?

Of those respondents who identified Republican, only 18% either strongly approved or somewhat approved. 17% neither approved nor disapproved, and 10% weren’t sure. That means the remaining 56% (when rounded to the nearest number) either somewhat disapproved (28%) or strongly disapproved (28%) of the way the Congress is currently handling its job. By comparison, 59% of Democrats and 58% of self-identified Independents felt the same way, which isn’t much of a difference. Further, only 54% of registered Republicans held a very favorable or somewhat favorable view of the entirely of Republicans in the Congress, and only 12% of independents felt the same way. Finally, only 7% of independents approved of the way the Congress ‘is handling its job.’

Admittedly, one poll from one organization doesn’t the be all and end all make. However, if I were GOP leadership I would be or would start paying attention. The numbers for registered GOP individuals are bad enough, but the data for how self-identifying independents view the Republican Party should be downright troublesome. The people in purple aren’t picking up what the Republicans are putting down. They ain’t smell what they are cooking, or something along those lines. These are the swing votes, which will be key in the 2018 midterm elections. Again, while it will be extremely hard for the Democrats to get control of the Senate, a 24 seat swing in the House of Representatives isn’t beyond comprehension.

I suppose it is up to the GOP to figure things out on its own.

In closing, the end of the week finds me feeling pretty much the same as I did at the start. There is nothing in the tea leaves which suggests a sudden slowdown in US economic activity just, well, because. We are on a steady course for continued moderate GDP growth, which should produce enough corporate profit to keep investors from fleeing stocks en masse. No, stock valuations aren’t cheap, but bonds are worse, and cash isn’t even keeping up with inflation. There aren’t any immediate/imminent global financial system woes, but there likely will be by the end of the decade, and so on and so forth. Yep, I am back where I started, even if the markets didn’t cooperate as we would have hoped these past 5 days.

With that said, IF Washington can somehow, mercifully, get some type of meaningful tax reform passed by the end of the year, you know, we might just get another leg up on this rally and a little more starch in the economy. While this increasingly seems a little less likely with each passing day and public blowup, I am still somewhat hopeful….down from strongly hopeful from a previous poll.