Month: February 2018

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

FEBRUARY 21 , 2018

 

Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

Last week, we discussed derivatives trading in Volatility, and the role of that trading in the market turmoil of early February.  In this issue of  IntelDigest, we review other factors which will likely have great effect on the Economy and Markets going forward.  Specifically, we address the current outlook on Inflation, Federal Borrowing, and Interest Rates.

We will certainly discuss each of these elements in much greater detail during 2018.  For this briefing, let’s see where each stands today.

 

Inflation

The core annual rate of Inflation in the U.S. is just under 2%, which is right on target for the purposes of The Federal Reserve.  There have not yet been signs of any appreciable increases in inflation in major sectors of the American Economy, such as housing or commodities or the equity markets (when low interest rates are factored in).

Since the 2008-2009 Financial Crisis, which threatened to sink world economies in a dangerous  Deflationary  spiral, central banks have pursued a policy of Extremely Low Interest Rates, coupled with unprecedented waves of money printing.  This provided a flood of cheap money, with the goal of increasing Inflation  by boosting corporate borrowing, increasing consumer spending, and elevating asset prices.

Although world economies have slowly recovered over the last nine years,  Inflation  (both general prices and wage inflation) has remained stubbornly low.

Low Inflation and Low Interest Rates have kept bond yields down, encouraging investors to move their money into the equities markets, where one could earn a comfortable dividend yield versus bond yields.

The result has been an unprecedented Bull Market in stocks. When the markets were roiled in early February, some analysts opined that the initial sell-off on February 2 was spurred by release of the monthly unemployment numbers, which showed evidence of wage inflation.  One narrative was: Inflation is rising, so The Fed will raise interest rates and tighten monetary policy in order to “nip it in the bud.”  That would choke off economic growth and tank the market.

They drew a direct line from Higher Inflation to Higher Interest Rates to investors abandoning equities for bonds and other commercial instruments which will start earning decent interest … like the Good Old Days.

However, the signs of some wage inflation are unlikely to upset the equity markets.  The higher wages are primarily a result of stronger business metrics.  The U.S. economy is expanding, and business owners have recently received the gift of lower income tax rates going forward.  Businesses can afford to pay higher wages to attract quality employees. Higher wages will be more than offset by tax breaks and stronger business activity.

Although  Inflation  is expected to play a significant role in The Economy next year, we’re just not there yet.

 

Federal Government Borrowing

The Department of the Treasury recently announced that its 2018 borrowing requirements will be dramatically higher than last year.  This is the first time in nearly a decade that Federal “debt issuance” has risen significantly.

This week, on the first day that the “floodgates” were opened, the government issued nearly $151 Billion of short-term Treasury bills, the largest single auction in history.  The plan is to issue a total of $258 Billion of short-term and long-term debt this week.

This is just the beginning …

Congress and the Trump Administration have committed to rising budget deficits.  The Federal government is expected to issue a mind-boggling $1.3 Trillion in new debt this year.  This is a record amount … even more than the Obama Administration when it was working to pull the country back from the financial brink.

Debt issuance is expected to rise even further over the next few years.

To make matters worse, this new supply of government paper will hit the market at the same time that The Federal Reserve works to unwind its massive bond portfolio.

Economics 101:  rising supply and falling demand results in lower bond prices.  As bond prices and bond yields (interest rates) trade inversely, this suggests that interest rates will go a good deal higher over the next several years.

 

Interest Rates

As noted, the two greatest influences on Interest Rates are:

1. The United States Treasury must increase its borrowing dramatically, for this year and for several years into the future.

2. The Federal Reserve has signaled that it expects to raise short-term interest rates by 1.5%-2% (incrementally) over the next 24 months.  And, it will seek to reduce its balance sheet by selling into the market Billions of Dollars of bonds which it has accumulated over the last nine years.

We have already experienced a significant increase in the 10-year Treasury note, which has doubled since the summer of 2016.  It now stands at its highest rate in four years.

This is important, because the 10-year Treasury is a “benchmark” rate which affects a wide range of financial instruments, from mortgages to corporate bonds. Consequences of a higher 10-year Treasury include higher borrowing costs for … just about everybody!

Cheap credit has underpinned the equities markets, and allowed both corporations and governments to borrow huge amounts of money.  The Debt Service on all that borrowed cash is about to become lots more expensive.

Interest Rates were expected to go higher this year.  These recent developments indicate that rates could go much higher, sooner than expected.

 

Begin to Reduce the Risk in Your Portfolio

In these circumstances, we do not expect that The Fed will allow short-term rates to run up precipitously.  However, The Fed does not control long-term rates … those are determined by markets.  And, rising rates of any duration will eventually tip the Bull Market over.

Higher rates will cause businesses and consumers to decrease consumption, and some investors will begin to sell stocks and transition into safer government debt.  That will suck the air right out of the U.S. stock market, and lead to the next recession.

So, investors who hold bonds must be cognizant of bond durations, and focus on bonds with shorter maturities.

And, begin to trim interest-rate sensitive stocks … primarily higher yielding stocks such as real estate investment trusts (REITs), utilities and energy stocks … which are often the first to lose value as Interest Rates rise.

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

FEBRUARY 14 , 2018

 

Contact Richard Power with comments or questions. IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

 

In this issue of  IntelDigest, we address the recent action in the investment markets.  As a matter of course, we provide periodic updates on markets and The Economy, with emphasis on prospects going forward.  And, we will return to such analysis in the coming weeks.

Today, we look at the recent market turmoil.  What does it mean?  Does it signal the end of the long Bull Market?

 

Fundamentally Sound Markets

To start, we believe that the equity markets are fundamentally sound, and the “Melt Up” in the markets still has several months to run.

Conditions haven’t changed much since we wrote (on November 8 and December 6) that certain factors support the continued “Melt Up” of equities, both domestically and internationally, for another few months:

* low Interest rates

* improving economic conditions around the world

* strong earnings in the largest U.S. corporations

* positive technical indicators signifying continued strength … the Advance/Decline Line and market breadth moving up

And now, the potential for massive gains in Corporate America from provisions of the Tax Cuts and Jobs Act of 2017 (TCJA).

 

So, What Happened?

Since the calendar turned to February, we have experienced three days where equities markets dropped precipitously (2-4% per day), causing unease among investors.  However, we see this as normal corrective behavior within the Bull Market.

After all, the S&P 500 had rallied more than 40% over the prior 24 months, without so much as a 5% decline.  This has been an unprecedented winning streak.  Markets go Up and Down in the ordinary course of events … a normal market correction has been long overdue.

The overall direction of the equities markets is still Up, for the reasons set forth at the beginning of this article.

 

The Real Cause of the Disquiet

Besides, recent events have had little to do with market fundamentals, and can be attributed to “Financial Gambles Gone Bad.”  Many assumed that news on higher inflation spurred the initial sell-off on February 2.  We’ll talk about Inflation next week;  but, we believe that a form of Gambling set the markets on edge.

You have all heard about derivatives.  They were at the center of the 2008 Financial Crisis.  And, we believe that a form of derivatives caused the recent market unrest.

A derivative is a financial contract which derives its value from an underlying asset … essentially, “side bets” which traders and investors may make on market movements.  Sounds innocent, doesn’t it?

Derivatives are written on stocks, bonds, currencies, commodities, Treasury notes, interest rates, et al.  The most notorious were Collateralized Debt Obligations, primarily packaging real estate mortgages, which turned the world upside-down in 2008.

As long ago as 2002, Warren Buffet stated that, “… In our view … derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”  In other words, derivatives can be dangerous if they become over-extended, or if misused.  These strategies used to be restricted to professional futures traders.  Now, millions of traders … many of whom lack sufficient understanding of the dangers … have the ability to “place bets” with derivatives.

We believe that the tsunami of selling which hit the markets earlier this month was caused by derivatives action related to the CBOE Volatility Index (VIX), commonly referred to as the “VIX.”  Since 1993, the VIX index has been considered a premier barometer of investor sentiment and market volatility.  VIX futures contracts and options were introduced in 2004 and 2006, respectively, ushering in an age when virtually anyone with a computer can place bets on market volatility.

 

Volatility Derivatives Trigger Chain Reaction

The long bull market has been uncharacteristically stable for the last 24 months, resulting in record-low volatility.  So, the use of “short volatility” strategies has been unusually high. Essentially, these involve futures contracts, option contracts, and even exchange traded funds (ETF) which trade as easily as stocks and allow traders to make long-term, highly-leveraged bets on sustained market quiet.

As long as volatility stayed dormant, traders would make money, sometimes lots of money.  However, at the beginning of February, volatility started to move up on news of a minor uptick in inflation data (again, we’ll discuss the prospects for inflation next week).  It seems that a Chain Reaction of panic selling was started among volatility traders.  As traders sold shares to offset their volatility risk, the market naturally fell lower.  This caused more volatility, leading to more market selling.

Eventually, buyers stepped in to take advantage of the discounted stock prices, but not before steep declines had occurred in the markets, triggering panic on Wall Street.

The irony is that there was no political or geopolitical news, or financial news on the underlying stocks, causing the downturn.  Many investors engaged in panic selling simply because the overall markets were trading lower.  Market action was driven by math, rather than objective analysis;  by futures contracts and algorithms, rather than by rational investment decision-making.

There is always the danger that a market panic could result when forced selling leads to more volatility, leading to more forced selling as futures dealers try to balance trades which have gone bad.  However, the rational investor should understand:

* low Interest rates continue to undergird the health of the equities markets

* world economies are stable

* large corporations, especially in the U.S., are enjoying growing profitability

Under these conditions … which we expect to perpetuate through most of 2018 … we do not fear corrections in the markets.

Lower stock prices represent lower risks and better opportunities.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

FEBRUARY 7 , 2018

Contact Richard Power with comments or questions. IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

 

We did not publish  IntelDigest  last week because of travel.  In this issue, we review analyses of major provisions of the Tax Cuts and Jobs Act of 2017 (TCJA).  Will the legislation attain the advertised benefits for American taxpayers and the economy?  Or, have the benefits been reserved for the special few?

Initial Impressions of The New Tax Law

We discussed Tax Reform proposals in  IntelDigest  on several occasions last year, including the December 20 issue:

“… we supported changes which would facilitate American business putting more private money into growing the American economy.  We still believe that lowering tax rates on businesses … large and small … has the potential to increase the competitiveness of U.S. corporations in world markets, and allow smaller businesses to employ more Americans …

“… IF these tax cuts prove to be stimulative to the economy, and IF business owners truly plow their new-found tax savings into business expansion and hiring thousands of workers, then we will have taken a large step toward attaining 3-4% growth in the American economy in the coming years.

“… However, we also believe that massive changes in individual taxation are not warranted at this time, most especially because of the likelihood that this wholesale Tax Cut package will add another Two Trillion Dollars to the national debt in the next few years …

“The fear is that these tax changes will:

* amount to nothing less than a redistribution of resources from the Middle Class to multinational corporations, millionaires and billionaires, and the same banks which were responsible for the 2008 Financial Crisis;  and

* drive up the cost of premiums in the health insurance exchanges.”

In our last issue, on January 24, we reviewed technical aspects of the Tax Cuts and Jobs Act of 2017 (TCJA).  Herein, we’ll look at the probable outcome of some provisions of the TCJA, which applies for the 2018 tax year and later years.

All That Debt

Unfortunately, Congressional Republicans have created new problems by passing massive tax cuts without coming up with new revenue to offset the cost.

In the news today, the U.S. Senate is touting a two-year spending deal which will increase federal spending and the National Debt.  The TCJA will add an additional Two Trillion Dollars to the Debt.

What happens when the next serious recession hits this economy?  There will be pressure to expand unemployment benefits, lower interest rates again, and enact other traditional types of fiscal stimulus.  Such measures become more difficult and less effective as the Debt grows ever larger.

Just a few years ago, Congressional Republicans portrayed themselves as “budget-conscious.”  The GOP fought hard to pass sequestration, a measure to cut federal government spending.  In 2011, some members even threatened to default on the federal Debt rather than to add to it.

Today, they say that the tax cuts will boost the economy so much that the additional revenues would offset the tax cuts.  Basic Arithmetic differs.  The Debt will continue to grow;  and, a future Congress will likely extend the tax cuts past 2025.

Worsening Income Inequality

Income inequality drives American workers, providing motivation for working hard and getting ahead.  However, wealth is increasingly loaded at the top of the income chain today, while the middle is hollowing out.  Income inequality is winning the battle versus the American worker.

Intelligent tax policy would be designed to push income inequality back toward historical norms.  Unfortunately, the new tax law will make the rich richer still, and the rest more resentful.

The current Republican-led government has turned back to “supply-side economics,” which had a modicum of success during the Reagan Administration when the highest tax rate was 70 percent.  Tax cuts were effective at such high levels; they could boost growth enough to offset federal losses of revenues.

However, “trickle-down economics” does not work as well today, when tax rates are half what they were in the 1980s.

Tax cuts for the wealthy are much larger than tax cuts for lower-income workers, in both dollar and percentage terms.  It is true that upper-income taxpayers pay more taxes, so they should save more when tax rates decline.  However, their tax payments will also drop more in percentage terms than lower- or middle-income taxpayers.

Wealthy taxpayers tend to use tax cuts for savings/investment.  This will help buoy the stock markets, but will not drive demand or create jobs.  Upper-income taxpayers will also benefit most from cuts in the corporate tax, which will inflate stock prices and returns for those who can afford to own stocks.

A greater tax cut for the Middle Class could drive demand and create more jobs.

Taxes on Businesses

The maximum corporate tax rate is cut to 21% (previously 35%), which brings the U.S. tax rate more in line with other developed nations.

Also, a major feature of TCJA is allowing multinational companies to repatriate large cash stockpiles which had been kept outside the U.S.  The total amount held by American companies overseas has been estimated at $2.6 Trillion! Under the repatriation provision, companies will have a limited time to bring those assets home and pay a tax rate of 15.50% on cash (8% on equipment).

Many large corporations have already stated that they will NOT use the tax cuts to create jobs.  The chief executives of Cisco, Pfizer, and Coca-Cola would instead use the extra cash to pay dividends to shareholders.  The CEO of Amgen will use the proceeds to buy back shares of stock.

The corporate tax cuts will boost stock prices, but only a small number of companies (e.g., Amazon, Apple) propose to create new jobs.

Business Tax Games

Many private business owners get a new tax break which allows them to deduct 20% of their income, effectively lowering their tax bill well below what they’d pay if their income were taxed as regular wages.  So, more people are likely to change their reporting status, stretching the definition of a “business.”

This comes as funding and staffing at the I.R.S. are both down, because of hostility toward the agency from Congressional Republicans.  The inevitable outcome will be a surge in tax cheating, resulting in a growing sense among honest taxpayers that the system is “rigged.”

True ‘tax reform’ would have made the system more fair;  our shiny new tax laws are arguably less fair.

Taxes on Individuals

TCJA generally helps businesses more than individuals.  Business tax cuts are permanent, while the individual cuts expire in 2025.  This creates a Fiscal Cliff to come in 2025, which Congress could have avoided if it had had a smidgen of fiscal discipline in 2017.

On the positive side, the tax rates have been lowered in most tax brackets, and exemption amounts have been increased for the Alternative Minimum Tax (AMT) on individuals.

The Tax Policy Center breaks down the individual tax benefits as follows:

Those in the lowest-earning one-fifth of the population would see their income increase by 0.4 percent;  the next highest one-fifth would receive a 1.2 percent boost;  the next two quintiles would see their income increase 1.6 percent and 1.9 percent, respectively.  The biggest increase, 2.9 percent, would go to those in the top-earning one-fifth of taxpayers.

TCJA makes the progressive income tax system more regressive.  Tax rates are lowered for everyone, but they are lowered more for the highest-income taxpayers.

The primary structural changes on individual tax returns come “below the line,” meaning that they appear AFTER Adjusted Gross Income (AGI) is calculated.   Significant changes have been made to the Standard Deduction, Itemized Deductions, and Personal Exemptions, effective through 2025.

TCJA doubles the Standard Deduction to $12,000 for a single filer and $24,000 for Married Filing Joint returns.  At the same time, all Personal Exemptions are eliminated!  The increase in the Standard Deduction would benefit approximatley six million tax filers, according to Evercore ISI.  But, for many income brackets, that won’t offset lost deductions.

For smaller families, these changes … along with lower tax rates … will generally result in a tax savings.  However, families with several children will generally pay more because of the loss of the Exemptions.

Open Warfare Among Governments

TCJA also puts a $10,000 cap on State and Local Taxes (SALT), which will force some taxpayers to adopt the Standard Deduction, and others to pay higher taxes.  Many taxpayers have Itemized Deductions which far exceed even the new higher Standard Deduction.  They pay a combination of State and Local income taxes, real property taxes, personal property taxes, and sales taxes which can amount to $15,000-30,000.  Add in mortgage interest and charitable contributions and deductible medical expenses, and these taxpayers MUST itemize.  So, the $10,000 cap on SALT is a burden on many taxpayers.

High-tax states will suffer from the $10,000 cap on SALT, a provision which Republicans knew would disproportionately affect Democratic-leaning states.  Some states are creating novel approaches to dealing with these provisions, such as allowing state and local tax payments to count as deductible contributions to charity.

Expect clashes between the Congress and state legislatures on a multitude of issues in the coming months.