WHAT MIGHT WE BE MISSING?

By David Karp, PagnatoKarp ?

When we have opinions that differ from many investors we need to ask ourselves what might be missing. While we applaud some of the current administration’s economic initiatives, we struggle to share the market’s optimism over their eventual success. To provide insight into why that is, we summarize the major economic proposals and the potential benefits and consequences of each.

As the fiduciary of our clients life’s work, PagnatoKarp must navigate the financial markets and manage an investment portfolio with the dual goal of protecting your principal and growing your wealth. To accomplish this mission, we must grasp the intricacies of the financial markets and deeply understand how politics, economics, human behavior and a host of other factors affect those markets. Many times, our view of the state of the economy and the value of investments is relatively consistent with the consensus. There are other occasions, like today, when we have opinions that differ from many investors. In these times, we need to be especially vigilant and ask ourselves what might we be missing. 

The stock market appears extremely optimistic about prospects for President Trump’s, Reagan-like growth and reflationary policies. While we applaud some of the administration’s economic initiatives, we struggle to share the market’s optimism over their eventual success. To provide insight into why that is, we summarize the major economic proposals and the potential benefits and consequences of each. 

Tax Reform/Corporate Profit Repatriation 

The administration is proposing a simplified tax structure that would include reducing corporate tax rates and the highest personal tax rates as well as repealing the estate tax. They are also discussing a one-time exemption that would allow corporations with foreign-generated profits held offshore to bring them back to the U.S. at a relatively low 10% tax rate. This is commonly referred to as repatriation. While these plans would certainly provide an economic boost, President Trump has made it clear he is not asking for a free lunch. He understands the fiscal deficit is a major problem and has proposed various measures such as border adjustment taxes and eliminating interest deductibility to offset the loss of tax revenue. While there will be winners and losers, gauging the net impact to the economy and the markets is murky until more concrete proposals are put forward.

When considering tax revenue, it is paramount to remember that federal debt outstanding currently stands at 105% of GDP and total debt outstanding, including consumers and corporations, is over 300% of GDP. Furthermore, it is forecast to grow rapidly in the future due to projected funding gaps in entitlement programs such as social security. Budget deficits are rarely repaid. They tend to be accumulated over time, resulting in an ever-growing debt burden. Over the last 30 years, low interest rates have enabled this debt to grow with a perception of minimal fiscal harm. Since 1995, Treasury debt outstanding has quadrupled, yet the amount spent annually on interest expense has changed little. Consider that a 1% increase in interest rates will result in a 50% increase in the nation’s interest expense. If tax cuts are successful in generating economic growth, it is likely that interest rates will rise and exert funding pressure on the U.S. Treasury. 

The prospect of rising debt levels concerns us for more than these obvious reasons. Foreign nations, who as a class are the largest holders of U.S. Treasury debt, have been recently net sellers of U.S. Treasuries as shown below. If this trend continues, and there are reasons to believe it might, our concerns about higher interest rates and budget deficits multiply. 

President Trump’s proposal to allow a one-time, repatriation of foreign profits is a great idea if executed properly. If incentives are established to reward those companies to invest repatriated profits towards productive investments, the resulting benefits could be economically substantial. Unfortunately, given current corporate actions and the results of prior repatriation acts, profits will likely be returned to shareholders and not towards capital investment or labor. While returning profits to shareholders provides a temporary boost to company valuations, it does not provide for the future growth of the corporation or the economy. 

De-regulation 

Not knowing which regulations will be altered or erased and which ones will continue to be enforced makes it difficult to opine on regulatory reform. That said, government regulations produce friction in the economic engine. The cost of that friction is borne by consumers and corporations alike. 

A cost/benefit “scoring” of regulations is problematic as the costs are typically incurred by one party and the benefits accrue to another. At times, the benefits are known and immediate while the costs are paid in the future and largely unknowable. Sometimes the reverse is true. Most of the discussion around regulatory change is focused on the repeal of Dodd-Frank. This law was enacted after the financial crisis of 2008-2009 to increase the oversight, risk management and compliance of financial firms and strengthen the banking system. The largest banks and many other financial institutions have been outspoken about the costs this legislation imposes and its ineffectiveness in achieving the stated objectives. While we sympathize and tend to agree with those perspectives, we must also consider that the intent is to make the financial system stronger. Glass-Stegall, a Depression era regulation that restricted depository institutions’ ability to venture into financial markets, was repealed in 1999 via the Graham Leach Bliley Act. While the benefits of removing Glass-Stegall limitations accrued to the banks and the economy immediately, it also increased the severity and cost of the 2008 financial crisis. 

Trade/Border Adjustment Taxes 

Trade pacts forged over the last forty years have been designed to allow corporations access to cheaper labor abroad while eliminating certain tariffs. Corporate profits benefited but largely at the expense of the domestic workforce. Changing the terms of foreign trade was a clear objective expressed by President Trump and one his supporters back fervently. 

Border adjustment taxes appear to be the preferred method for the administration to “level the playing field” with respect to trade. Like other proposals, border adjustment taxes will be beneficial for some corporations and detrimental to others. The tax is designed to incentivize companies to move production back to the U.S., thus providing domestic jobs. Given the tight labor market in the U.S. as evidenced by low unemployment and record low levels of jobless claims, it seems reasonable to question whether the labor force can willingly and ably fill these jobs. Secondly, will the higher wages paid to U.S. workers relative to foreign labor entice companies to aggressively pursue robotic solutions and thereby minimize the benefits to U.S. workers? 

From a macro level, there is concern that border adjustment taxes boost the value of the U.S. Dollar. Dollar strength is good for the consumer as it makes imports cheaper, but in doing so, it also makes the imports we are trying to curtail more viable. Of greater concern are the estimated $10 trillion of loans based in U.S. dollars made to foreign borrowers. Those loans, often referred to as the “global carry trade”, are not only sensitive to interest rates but, more importantly, the value of the U.S. Dollar. Consider that the interest and principal on these loans must be paid back in U.S. Dollars. A 30% increase in the Dollar results in a 30% increase in the interest expense and principal due to their currency weakening versus the Dollar. The Asian crisis of 1997 was a direct consequence of a stronger Dollar. China, which is purported to be home to one-third of the “global carry trade,” would be at great financial risk if these funds were to suddenly return to the U.S. 

Infrastructure Spending

Of the President’s plans, spending on infrastructure has the greatest potential and excites us the most. However, we must hedge our enthusiasm by noting there is a big difference between repairing a bridge and a new project that produces future dividends. Fixing a bridge is necessary but from an economic perspective, there is little to no productivity gain in doing so. The economy receives a temporary jolt as the money spent by the government is distributed throughout the economy. What few politicians mention, however, is that debt must be used to fund the projects. The scale of the infrastructure plan being discussed at this stage is somewhere between $500 billion and $1 trillion. Although direct federal spending would be employed to finance some portion of the plan, the administration intends to also provide tax incentives to attract the private sector under a model of public-private partnerships. This would allow private companies to undertake projects, receive tax credits and receive payments either through tolls or set state payments over a number of years. Either way, capital employed for these purposes is not available for use in productive ventures elsewhere. 

The Hoover Dam, by way of contrast, is an infrastructure project that provided immediate economic relief but also produced value for decades to come. By providing electricity for a vast swath of the southwest, new businesses and commerce were able to flourish in an area that was previously largely uninhabited. The economic dividends are still evident to this day. The more “Hoover Dams” that are included in the project list, the more optimistic we will be. 

Summary

Many are likening President Trump’s proposals to those of Ronald Reagan. They correctly identify the similarities of their proposals, but few mention the stark differences in the economic landscape of the two periods. When Reagan took office, interest rates were in the double digits, baby boomers were in their twenties, and productivity growth was robust. Today, debt has risen to crippling levels, interest rates are historically low and the baby boomers are slowly retiring and becoming an economic burden on younger generations. Investors betting on Reagan were blessed with the ability to buy equities at single digit price multiples to earnings. In comparison, investors believing in Trump’s policies must make their bet with valuations that are on par with those of 1929. Even if the administration successfully passes large parts of their economic agenda will the benefits meet the lofty expectations set by investors?

Gratified by many of the economic policy proposals of the new administration, we are skeptically optimistic that even gradual changes would prove beneficial to the economic outlook which in turn might cause us to take a more aggressive investment stance. We must remind ourselves that removing decades of gridlock and freeing markets to function normally will be neither simple nor pain-free. We are supportive of changes that will reinvigorate economic growth but remain conscious that those changes will not come without a cost. 

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We leave you with “The Lowest Common Denominator". This article discusses debt and the interest rate hurdle that is bound to make a durable economic recovery so difficult.