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Submitted by Jim Quinn via The Burning Platform blog,

“Companies are not going to leave the United States anymore without consequences.” – Donald Trump

The reaction to Trump’s deal to keep 1,100 Carrier jobs in Indiana has ranged from outrage to adoration. There are so many layers to this Shakespearean drama that all points of views have some level of credence. I’m torn between the positive and negative aspects of this deal. If you’ve read Bastiat’s The Law and Hazlitt’s Economics in One Lesson, you understand the fallacies involved when government interferes in the free market. Politicians and their fanboys always concentrate on the seen aspects of government intervention, but purposely ignore the unseen consequences.

 

First, I wholeheartedly agree with Scott Adams’ assessment of Trump’s move as a brilliant, visible, memorable, newsworthy ploy to sway public opinion and sending a message to corporate America that he means business. Trump beat Carrier like a rented mule during the entire presidential campaign for announcing they were closing their plant in Indiana and moving the jobs to a new plant in Mexico. The publicity was so bad, I ended up getting a substantial rebate when I had a Carrier air conditioner installed in the Spring.

I’ve seen Trump worshipers trying to show what a fantastic economic deal this was for Indiana and the country. They are only looking at the scenario of staying versus leaving. The other scenario is what exists today versus what will exist tomorrow. Those 1,100 jobs already exist in Indiana. They are already paying taxes and spending money in Indiana. The taxpayers of Indiana currently have no obligation to Carrier or the employees of Carrier.  With this new “fantastic” deal, the employees of Carrier are still employed, but now the the taxpayers of Indiana have a $7 million obligation to Carrier.

This isn’t a zero sum game. The $7 million is taken from the pockets of taxpayers and will not be spent in the greater economy of Indiana. This deal is absolutely a net loss for Indiana versus where they were before the deal. The people of this country are hypocritical when it comes to keeping jobs in the U.S. They want cheap electronics, gadgets, appliances and air conditioners. Therefore, they have been buying cheap foreign made products by the trillions for the last couple decades.

Carrier was moving to Mexico for the low labor and regulatory costs. This would have allowed them to sell the air conditioners made in Mexico at a lower price than if they are made in Indiana. Therefore, the consumers of these products would have spent less money on the air conditioners, leaving excess funds to spend on other products. The purchasers of Carrier air conditioners are not benefiting from this deal.

It is true that if Carrier had sent those jobs to Mexico, there would be a short-term negative economic impact on Indiana. The 1,100 people would have lost their jobs and would have utilized unemployment and probably food stamp benefits. Eventually, most of these people would have obtained employment elsewhere – some at lower paying jobs, some at higher paying jobs. Indiana has an unemployment rate of 4.4%, so there are jobs out there. Another company might be able to buy the existing Carrier plant for a great price, start a new production plant, and hire new employees. This is the unseen part of the picture.

The real issue here is why Carrier and thousands of other corporations feel the need to move operations out of this country. Since the passage of NAFTA in 1994 and China’s decision to provide slave labor to foreign corporations around the same time frame, American conglomerates have embraced the “benefits” of globalization:

• Close your plant in the U.S. and fire Americans.
• Open a plant in Mexico or China and hire locals at slave wages to do the same job as the fired Americans.
• Sell cheap products back into the U.S., undercutting the prices of smaller domestic producers and eventually putting them out of business – resulting in more American job losses.
• American conglomerate Ivy League educated CEOs listen to the advice of criminal Wall Street bankers and use their excess profits to buyback their stock and drive their personal compensation to astronomical levels.
• Capital investment by American conglomerates becomes virtually non-existent.
• Meanwhile, China steals the American technology and product designs and eventually produces knock-off products, undercutting American conglomerates.
• The Federal Reserve provides cheap and plentiful debt to Wall Street scum bankers, while Madison Avenue maggots convince Americans to accumulate debt to purchase the cheap foreign made goods.
• The production jobs shipped to China and Mexico are replaced with low paying service jobs in the retail and restaurant sector, sustained by the Federal Reserve debt machine.

Many, if not most, of those voting for Donald Trump want less government in their lives. Trump railed against corruption, government favoritism, crony capitalism, and special deals. For the last eight years we’ve witnessed Obama favor green energy frauds like Solyndra, use taxpayer funds to save union jobs at GM and Chrysler, provide tax breaks to wealthy buyers of Tesla luxury cars, purposely destroy the coal industry, and not prosecute one Wall Street criminal banker. This Carrier deal is just a different version of the government carrot and stick game used by every president.

This high profile deal is a symbolic message to Trump voters and American corporations, but it can’t become the standard operating procedure for his presidency. Government picking winners and losers, aligning with particular companies or industries, or attempting to manage the economy is nothing but an expansion of the corporate fascism we’ve been experiencing for decades. Trump needs to create an economic climate which will convince American companies to expand, invest, and hire more workers. He has already documented what really needs to be done:

• Reduce corporate and individual tax rates. If corporations are allowed to keep more of their profits, they are more likely to hire and invest in their facilities. Many new businesses are started by individuals, so lowering their taxes provides more resources for growing their businesses.
• The regulatory nightmare strangles small business owners, giving an unfair advantage to conglomerates. Wiping out thousands of useless Federal regulations will save existing businesses billions and allow fledgling businesses to get off the ground.
• Repealing Obamacare and replacing it with a more market oriented competitive healthcare system which reduces the outrageously high costs to companies and individuals would free up billions of investment or spendable funds for companies and individuals.
• Existing trade deals need to be renegotiated to make sure global trade is truly free. Wage arbitrage cannot be the sole basis for why companies decide which country to build their plants. China makes it extremely difficult for American companies to do business in China from a tax and regulatory basis. Any fair trade deal would address these inequities.

Donald Trump is successfully winning the public relations aspects of his new job, even before assuming power. I think he understands the bigger picture of what needs to be done to revive our stagnant, over-taxed, over-regulated, and government suppressed economy. Tax simplification, reducing the size of the Federal government, getting the Feds out of education, not policing the world, and cutting Federal spending would provide some of the resources to implement tax cuts and deal with Obamacare repeal.

Trump continues to infuriate ultra-liberals like Larry Summers and Paul Krugman with his wheeling and dealing, even before ascending to the presidency. Lame duck Obama looks even more lame, as Trump engineers deals as a private citizen benefiting the country. Time will tell whether this Carrier deal was just a symbolic line in the sand, or whether it is a sign of future government interventionist policies which will ultimately backfire. In the long run, the less government, the better.

“Practically all government attempts to redistribute wealth and income tend to smother productive incentives and lead toward general impoverishment. It is the proper sphere of government to create and enforce a framework of law that prohibits force and fraud. But it must refrain from specific economic interventions. Government’s main economic function is to encourage and preserve a free market. When Alexander the Great visited the philosopher Diogenes and asked whether he could do anything for him, Diogenes is said to have replied: “Yes, stand a little less between me and the sun.” It is what every citizen is entitled to ask of his government.”? Henry Hazlitt

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Only one thing for today really…

 

You have to wonder "who" stepped in at the European open and panic-bid with both hands and feet for Euros and US and EU equities…? As one trader mocked earlier, Brexit took 3 days to recover its losses, Trump took 3 hours, and Italeave took 3 minutes…

 

EURUSD ripped 300 pips from overnight lows…

 

Notably, European stocks did fade…but even Italian stocks (ex banks) only dropped a little

 

And of course, the reach for safe-havens such as bonds and bullion was an utter waste of time…

 

Someone even panic bid Italian banks at the open!!!

 

On the day, US Equities rallied with The Dow at another record high… Small Caps exploded in a short squeeze for their best day in 3 weeks!

 

But The Market BROKE 3 Times…

• FIRST – 0950ET: *NASDAQ HAS DECLARED SELF HELP AGAINST CHICAGO STOCK EXCHANGE
• SECOND – 1316ET:*BATS OPTIONS: BATS EDGX OPTIONS EXCHANGE HAS DECLARED SELF-HELP
• THIRD – 1448ET:*NASDAQ HAS DECLARED SELF HELP VS CHICAGO STOCK EXCHANGE

 

Bonds & Stocks followed one another broadly today…

 

Because why wouldn't you buy bank stocks – when the Italian banking system faces collapse with no backstop? (And oil stocks were up despite oil ending the day really ugly)

 

Bank stocks surged again (but credit crumbled)…

 

The long-end closed lower in yields (barely) as the short-end sold off in a turbulent day for bonds…

 

The yield curve flattened but bank stocks were bid…

 

The USD was notably weaker today led by EUR strength…

 

But we note that Yuan has now rallied for 8 straight days, recoupling with TSYs post-Election…

 

Crude prices jumped again to new cycle highs…

 

But…all those gains were puked after the NYMEX close…

 

Following the biggest USO (Oil ETF) fund outflow in 7 years on Friday (as investors "bail out" following the commodity curve's inversion)…

 

Finally we leave you with this…from Rhino Trading's Michael Block who offers the following perspecitve on why European stocks spiked the most since the Trump victory last month (largley a black swan event), courtesy of Barron's:

…[Apparently] the pattern of fading a potential crisis and then scrambling to cover and get long when everyone takes a breath and realizes that this time is not the apocalypse either still holds more than ever. I can’t justify any of this. The lesson investors and traders are getting is that everything is a buying opportunity and you need to not miss the boat. Brexit? Bullish. Trump winning the election? Bullish. Italy saying no to the referendum and the Prime Minister handing in his resignation? Bullish. Heck, all we need is a coup d’etat in India and the entire Belgian banking system to go kablooey and the S&P 500 will be at 3,000 by Christmas Eve.

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Something curious happened as Trump was “draining the swamp” – the man who by some accounts owns the swamp, Hillary Clinton’s billionaire backer Warren Buffett, may be about to get some $29 billion richer, if only on paper, thanks to Trump’s tax-rate cut policies which would boost the book value of Berkshire by as much as $29 billion.

According to an analysis by Barclays, Berkshire may soon enjoy a $29 billion boost to its book value under Trump’s proposed tax reform. “We would view this magnitude of increase as favorable for Berkshire shares since it is generally valued on price to book value,” Barclays analysts led by Jay Gelb said in a note to investors Monday first reported by Bloomberg. Berkshire’s book value was more than $270 billion as of Sept. 30; it would surpass $300 billion should Trump’s proposal for a 15% corporate tax rate be enacted.

Joining in the overall market frenzy, Berkshire has jumped about 8% in New York trading since Trump won the November 8 election, helped by the increasing value of Buffett’sholdings in bank stocks as interest rates climbed, however it appears the prospect of sharply lower taxes has helped.

Gelb’s analyzed Berkshire’s deferred tax liability of about $50 billion at the end of 2015, a figure that includes potential costs if Buffett sells investments that gained in value. The review doesn’t take into account the DTLs at some energy operations, where benefits wold be enjoyed by utility customers and not Berkshire shareholders. The value of the liability is based on the current 35 percent tax rate and would fall by about $22 billion at a 20 percent corporate tax rate and drop by $29 billion at 15 percent, Gelb wrote. Trump has called for cutting the business tax rate to 15 percent, while the House Republican “blueprint” for tax changes proposes 20 percent.

Some more details from the note:

Berkshire Hathaway’s book value could boosted by $29bn (11% increase) if the US corporate tax rate is reduced to 15% due to a decline in its deferred tax liability (our detailed analysis is on page 2). We would view this magnitude of increase as favorable for BRK shares since it is generally valued based on price-to-book value.

 

 

As of year-end 2015, Berkshire had a $63bn net deferred tax liability resulting largely from its unrealized appreciation on investments as well as depreciation and amortization on property, plant and equipment from is Burlington Northern and other capital-intensive businesses. We adjust this $63bn deferred tax liability to exclude $13bn from the Berkshire Hathaway Energy (BHE) business which is mostly regulated utilities. This is because the benefit of these reduced deferred tax liabilities would be expected to accrue to the benefit of the utilities’ customers rather than Berkshire.

 

Although a reduction in a deferred tax liability would not be a non-cash item, the company currently has $85bn of cash of which at least $60bn is viewed as being deployable for acquisitions.

 

As of YE15, Berkshire also had $10.4bn of undistributed earnings of its foreign subsidiaries. The company would need to maintain some of this cash to support its business. However, our sense is Berkshire would likely repatriate a portion of it if there were a low one-time tax on repatriated cash.

The full sensitivity analysis showing Berkshire’s benefit from dropping tax rates is shown below:

As Bloomberg also notes Buffett – like Trump and all other wealthy individuals – has long pursued strategies to limit tax payments made by Berkshire. Still, the billionaire supported Democrat Hillary Clinton in the presidential race, and has dismissed the idea that higher rates would discourage investment. He told shareholders in 2013 that when U.S. businesses say corporate taxes are too high, “I would have you take that with a grain of salt.”

The billionaire said at Omaha, Nebraska-based Berkshire’s most recent annual meeting that his company would thrive no matter who won the election. “Berkshire will continue to do fine,” he said at the April gathering. It now appears that he will do even better under a Trump administration.

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With the Italian referendum now in the rearview mirror, the market’s attention focuses on this Thursday’s second most important event, the ECB meeting on Thursday. Here the biggest question is whether, alongside the now widely expected extension of the ECB’s QE which is set to mature in March 2017, and which most analysts believe will be prolonged until at least September 2017, Mario Draghi will also announce some form of tightening or tapering of QE purchases or an eventual formal ending of its asset purchases, as Reuters hinted in a trial balloon report last week.

As readers will recall, on December 1 Reuters reported that in advance of its March 2017 meeting, the ECB was considering sending a “formal signal after its policy meeting next Thursday that the program will eventually end.” It added that skeptics of more stimulus on the bank’s Governing Council “have accepted that an extension beyond the current expiry date of March is inevitable given weak underlying inflation and heightened political risk.”

The question remains how to structure that extension.  According to report, much of the preparatory staff work had focused on a six-month extension at a steady pace of 80 billion euros per month, an option favored by many as growth is sluggish, inflation lacks momentum and political risk from key elections keeps the chances of market volatility high, three sources said. But some have indicated they would favor an extension at lower volumes, for example nine months at 60 billion euros a month, fearing that a straight extension could make the program appear open-ended, two of the sources said.

A compromise under discussion would be to signal the program’s eventual end, possibly in the bank’s forward guidance, indicating that the purchases cannot be extended indefinitely. Another option is not to specify monthly purchase volumes, essentially making them dependent on economic developments, the sources said, similar to what the BOJ has done with its curve control operation. That would allow the ECB to buy up to 80 billion euros without requiring it to spend the full amount.

Of course, any formal tapering announcement could jolt the European (and global) bond market, in a redux of the infamous 2013 Bernanke “Taper Tantrum”, which coming at a very sensitive stage for Europe, in the aftermath of the Italian referendum, seems unlikely.

The Reuters report laid out the tensions between the hawks, pushing for tapering, and the doves, who insist on simply extending the program as is, with perhaps some modest tweaks.

What do others think?  Below we lay out some summary scenarios as laid out by Wall Street banks:

According to Deutsche Bank, the ECB will announce a 6-month extension of the current €80bn QE programme (an extension from March 2017 to September 2017). This is likely to be complemented by a move to improve the supply of eligible bonds, perhaps by the removal or softening of the yield floor. This would facilitate a steeper yield curve and incentive transmission. In an alternative scenario DB economists believe that the market would react negatively to say a slowing in the pace of purchases to €60bn. The bank’s economists have derived three rules that need to be satisfied by spot and forward core inflation in order for the ECB to taper. The soonest these are likely to be satisfied is mid-2017. They go on to highlight that if the ECB’s above-consensus view on growth is correct, the euro exchange rate depreciates in line with DB’s house view and systematic financial crisis is avoided, tapering could be announced in June 2017. On the other hand if their below-consensus view on growth is correct and the growth/inflation relationship is weak, tapering could wait until end-2017. The last thing to note is today’s market reaction to the referendum result which also has the potential to influence Thursday’s meeting actions.

* * *

According to Bank of America, the central scenario is likewise of a 6 month extension at €80bn per month via minor tweaks in the capital key. The reaction of Bunds will ultimately be more a function of the changes to the securities’ lending programmes than QE itself. For the periphery, the bank distinguishes between Italy – where the referendum and the fate of the pending bank capital raises will dominate – and the rest. BofA believes that addressing repo issues should be at the top of the ECB’s priority list. Solving the richness of GC would make a straightforward 12 m extension in QE feasible. As Bank of America notes, figuring out what is priced in has become more difficult on the back of the repo squeeze in the front-end of the German curve – and not helped by conflicting ECB rhetoric. Schatz trades at -40 bp to OIS, a new post 2008 record. The market impact of ECB action next week therefore needs to be assessed against the following:

• Has the ECB taken credible steps to address the collateral squeeze in front-end triple-As in particular?
• Will the QE extension involve buying less German government bonds in future?
• Is QE extended in such a way that risk premia in the periphery can be expected to retrace or at least stabilise?
• Does the ECB maintain a sufficiently accommodative monetary policy stance such that current levels of breakevens and forward EONIAs can be justified

The tables below summarise the bank’s views on the reaction of both Bund yields and the German curve, as well as the periphery in four stylized scenarios. Its economists distinguish the different modalities of QE extensions and different approaches to the repo issues discussed in depth previously. The focus is on short-term market reactions, since it believes that a renewed commitment to large QE purchases (80bn/m for 6m) or long-term ones (60bn/m for 9am) will be a sufficiently positive surprise to the market to avoid the debate of how to assess fair value in the periphery in a world without QE.

The table below assumes a directionality in peripheral spreads. BofA believes that the biggest risk to the periphery is higher Bund yields. It therefore assumes that a flow driven repricing of Bund yields lower, will also have positive spill-over effects for the periphery.

The next table lays out what options deliver what extensions to the ECB. BofA highlights that with an effective policy addressing the richness of (German) GC, extending QE becomes very easy without  having to tackle exogenous constraints such as the depo rate floor, or indeed the capital constraint. Addressing repo issues should actually be at the top of the ECB’s priority list for next week. Solving the richness of GC should make the 4y sector available for purchase, which in combination with raising the limits on non-CAC bonds, makes a 12 m extension in QE feasible without getting into difficult political discussions (see purple cells in table below).

BofA concludes as follows: “Going into next week’s meeting, and with more than the usual uncertainty around the details of the announcement, the chosen rhetoric, the on-going repo issues, the Italian referendum and bank recap stories, we have little risk appetite.”

* * *

Finally, according to UBS, the ECB will play it safe next week, and will extend QE in its current format (€80Bn monthly) for six month until Sept 2017, echoing the other two banks. UBS says that while the new staff macroeconomic forecasts for 2017-19 will form an important basis for the decision, it thinks the members of the ECB Governing Council will have to take an even more comprehensive view, evaluate the broader balance of risks, and ask themselves whether the time is ripe for a reduction in monetary stimulus. In this context, the GC will also have to consider the implications of political events, such as the outcome of the Italian constitutional referendum on 4 December and the sharp rise in global bond yields which has probably led to an (unwelcome) tightening of financial conditions in Europe. UBS currently expects the ECB to taper after September 2017, perhaps over the course of one year. The Swiss bank does not think ECB policy rates will be cut further, but rate hikes are unlikely before 2019.

UBS notes that in his recent speeches, ECB President Draghi made the case for an ongoing strong degree of monetary accommodation. Speaking in front of the European Parliament on 21 November, he said “[T]he return of inflation towards our objective still relies on the continuation of the current, unprecedented level of monetary support, in spite of the gradual closing of the output gap. It is for this reason that we remain committed to preserving the very substantial degree of monetary accommodation necessary to secure a sustained convergence of inflation towards levels below, but close to, 2% over the medium term.”

The Swiss bank notes that its base case scenario of a six-month extension in QE in its current form does not mean that there will be no robust discussion about more hawkish choices, such as tapering or a reduction in the monthly asset purchases as the hawks on the GC will push for a reduction in QE, pointing to the relatively robust Eurozone economic data, rising inflation, and the weaker Euro. UBS notes, however, the conservative part of the Governing Council might be weakened on 8 December as the Dutch and Slovakian central bank governors will not be able to vote.

On the all important topic of whether the ECB will taper, UBS says that after September 2017, the time will come for the ECB to start scaling back the QE programme through tapering. The decision might potentially be taken as early as 8 June 2017 (or otherwise 7 September), along with an updated set of macro forecasts for 2017-19. As shown in Figure 1, “tapering” could take various forms, with different speeds, degrees of flexibility, and strength of forward guidance – and hence hawkishness. The base-case assumption is that the ECB would wind down the QE programme over the course of one year, from October 2017 to the fall of 2018. If and when the tapering process starts, the ECB will have to take great care not to create a major “tantrum” in the markets, with significant rises in bonds yields and losses in risk assets. Hence, the ECB will likely adopt a flexible framework where it does not commit too strongly to a pre-determined pattern of winding down QE.

Still, with inflation around the globe, if only according to various market indicators such as 5y5Y forward, ascendent around the world and in Europe, what happens if the hawks win the upper hand? The answer is shown in the following table laying out the ECB’s “menu” options for monetary policy normalization and tightening.

On the topic of rate moves, UBS says that its base-case scenario implies that ECB policy rates have bottomed out, with the depo rate at -0.4%, the refi rate at zero, and the marginal lending rate at 0.25%. However, the ECB has explicitly stated that rate hikes should only be expected once the QE programme has come to an end. Assuming that QE will run until the fall of 2018, we think that ECB policy rates will remain at current levels until (at least) 2019.

UBS’ Conclusion – the market has largely priced in its base case:

“we see a clear need for the ECB to act next week to maintain its accommodative stance via an extension of QE and ensure the implementation of purchases via changes to the technical parameters of the APP. In our opinion, the most likely changes to the QE design will be the removal of the deposit rate floor for QE purchases alongside an increase in ISIN/issuer limits on non-CAC bonds. These changes should be sufficient to implement QE purchases at least throughout 2017 in our view. Politically controversial adjustments to or deviations from the PSPP allocation key remain unlikely at the current stage. In general, we think the market is well priced for our baseline expectation and we stick to our views outlined in the 2017 Markets Outlook. Our strategic focus remains on steeper curves and gradually higher Bund yields. In terms of the risk scenario for next week’s GC meeting, we see some risks that a hesitation or a delay from the ECB to extend QE fosters unwarranted monetary policy tightening and will lead to a deterioration of risk sentiment alongside a flattening of core EGB curves driven by the front-end. EGB spreads vs. Bunds are unlikely to be hugely supported by changes to the PSPP allocation key and remain subject to political developments with the Italian referendum being the next sign-post.”

One thing to note having read all three reports is that virtually every bank is positioned exceptionally dovish, and expects virtually no hawkish surprises out of the ECB. Which means that if there is a surprise, the pain trade will be for the EUR to rise sharply higher from its recent levels, although what complicates a simple long EUR trade is today’s dramatic short squeeze in EUR pairs, after expectations of a far more dire market reaction to the Italian referendum, which however did not materialize, promptly a 300 pip move higher in the EURUSD, rising as high as 1.08, after dipping to 1.05 overnight.

In any event, all eyes are now on Draghi and what the former Goldman banker reveals in three days.

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Submitted by Lance Roberts via RealInvestmentAdvice.com,

In this past weekend’s missive, I stated:

“Following the election, the market has surged around the theme of ‘Trumponomics’ as a ‘New Hope’ as tax cuts and infrastructure spending (read massive deficit increase) will fuel earnings growth for companies, stronger economic growth, and higher asset prices. It is a tall order given the already lengthy economic recovery at hand, but like I said, it is ‘hope’ fueling the markets currently.

As you can imagine, I received quite  a few comments from readers suggesting that each percentage of tax cuts will lead to surging corporate earnings and economic growth. This was a point made by Bob Pisani recently on CNBC:

“The current 2017 estimate for the entire S&P 500 is roughly $131 per share. Thompson estimates that every 1 percentage point reduction in the corporate tax rate could ‘hypothetically’ add $1.31 to 2017 earnings.

 

So do the math: If there is a full 20 percentage point reduction in the tax rate (from 35 percent to 15 percent), that’s $1.31 x 20 = $26.20.

 

That implies an increase in earnings of close to 20 percent, or $157.”

Fair enough.

I don’t entirely disagree considering my recent prognostication of the S&P melting up to 2400 in the next few months.

However, I also want to take a step back for a moment and look at the reality of corporate tax cuts and their potential impact on the economy, and ultimately, corporate earnings.

First, of all, since estimates historically are on average 33% overestimated, such would suggest that future earnings per share will be closer to $106/share which suggest an S&P price of 2438 at 23x earnings. In line with my current estimates.

Secondly, and most importantly, changes to corporate earnings will come primarily from share buybacks and lower effective tax rates. This point should not be overlooked as long-term earnings growth, and a healthy market, is driven by changes in actual top-line revenue driven by a stronger economy and higher levels of consumption.

This is the focus of today’s analysis.

During the Reagan administration tax rates were cut in order to boost economic growth and activity along with a surge in deficit spending. The chart below shows the top tax brackets from 1913-Present.

Importantly, as has been stated, the proposed tax cut by President-elect Trump will be the largest since Ronald Reagan. However, in order to make valid assumptions on the potential impact of the tax cut on the economy, earnings and the markets, we need to review the differences between the Reagan and Trump eras. My colleague, Michael Lebowitz, recently penned the following on this exact issue.

“Many investors are suddenly comparing Trump’s economic policy proposals to those of Ronald Reagan. For those that deem that bullish, we remind you that the economic environment and potential growth of 1982 was vastly different than it is today.  Consider the following table:”

The differences between today’s economic and market environment could not be starker. The tailwinds provided by initial deregulation, consumer leveraging and declining interest rates and inflation provided huge tailwinds for corporate profitability growth.

As Michael points out, those tailwinds are now headwinds.

However, while Thompson’s have pulled a rather exuberant level of impact ($1.31 in earnings per 1% of tax rate reduction) a look back at the Reagan era suggests a different outcome.

The chart below shows the impact of the two rate reductions on the S&P 500 (real price) and the annualized rate of change in asset prices.

The next chart shows the actual impact to corporate earnings on an annualized basis.

In both cases, the effect was far more muted than what is currently being estimated by Wall Street analysts currently.

Furthermore, as I noted in this past weekend’s missive, given the primary expansion of the financial markets has been driven by monetary policy and artificially low interest rates, any benefit provided to earnings growth from lower taxes will be mitigated by reductions from changes in monetary policy. 

 

It’s A Consumer Problem

It is also important to remember that “Revenue” is a function of consumption. Therefore, while lowering taxes is certainly beneficial to the bottom line of corporations, it is ultimately what happens at the “top line” where decisions are made to increase employment, increase production and make investments.

In other words, it remains a spending and debt problem.

“Given the lack of income growth and rising costs of living, it is unlikely that Americans are actually saving more. The reality is consumers are likely saving less and may even be pushing a negative savings rate.

 

I know suggesting such a thing is ridiculous. However, the BEA calculates the saving rate as the difference between incomes and outlays as measured by their own assumptions for interest rates on debt, inflationary pressures on a presumed basket of goods and services and taxes. What it does not measure is what individuals are actually putting into a bank saving or investment account. In other words, the savings rate is an estimate of what is ‘likely’ to be saved each month.

 

However, as we can surmise, the reality for the majority of American’s is quite the opposite as the daily costs of maintaining the current standard of living absorbs any excess cash flow. This is why I repeatedly wrote early on that falling oil prices would not boost consumption and it didn’t.”

As shown in the chart below, consumer credit has surged in recent months.

Here is another problem. While economists, media, and analysts wish to blame those “stingy consumers” for not buying more stuff, the reality is the majority of American consumers have likely reached the limits of their ability to consume. This decline in economic growth over the past 30 years has kept the average American struggling to maintain their standard of living.

As shown above, consumer credit as a percentage of total personal consumption expenditures has risen from an average of 20% prior to 1980 to almost 30% today. As wage growth continues to stagnate, the dependency on credit to foster further consumption will continue to rise. Unfortunately, as I discussed previously, this is not a good thing as it relates to economic growth in the future.

“The massive indulgence in debt, what the Austrians refer to as a “credit induced boom,” has likely reached its inevitable conclusion. The unsustainable credit-sourced boom, which led to artificially stimulated borrowing, has continued to seek out ever diminishing investment opportunities.”

But it is not just the consumer that has leveraged itself to the point that debt service erodes economic viability, but the country as well. As shown below, there is a direct correlation between slower rates of economic growth and debt levels.

There is a logic to the Debt-to-GDP ratio increases within the historical context of two World Wars and the Great Depression. Likewise, the steadily decreasing ratio over the next 35 years enabled the tax cuts in 1964. In contrast, the Economic Recovery Tax Act of 1981 was followed by an 18-year secular bull market that began the following year and, paradoxically enough, by a reversal in the direction of the Debt-to-GDP ratio.

There were other epic factors that played roles in the reversal — among them the gradual transition from manufacturing to a service-based economy, the dawn of the Age of Information, and a gradual relaxation of both private and public concern about debt.

The increases in deficit spending to supplant weaker economic growth has been apparent.

While lower tax rates will certainly boost bottom line earnings, particularly as share buybacks increase from increased retention, as noted there are huge differences between the economic and debt related backdrops between today and the early 80’s. 

The true burden on taxpayers is government spending, because the debt requires future interest payments out of future taxes. As debt levels, and subsequently deficits, increase, economic growth is burdened by the diversion of revenue from productive investments into debt service. 

This is the same problem that many households in America face today. Many families are struggling to meet the service requirements of the debt they have accumulated over the last couple of decades with the income that is available to them. They can only increase that income marginally by taking on second jobs. However, the biggest ability to service the debt at home is to reduce spending in other areas.

While lowering corporate tax rates will certainly help businesses potentially increase their bottom line earnings, there is a high probability that it will not “trickle down” to middle-class America.

While I am certainly hopeful for meaningful changes in tax reform, deregulation and a move back towards a middle-right political agenda, from an investment standpoint there are many economic challenges that are not policy driven.

• Demographics
• Structural employment shifts
• Technological innovations
• Globalization
• Financialization 
• Global debt

These challenges will continue to weigh on economic growth, wages and standards of living into the foreseeable future.  As a result, incremental tax and policy changes will have a more muted effect on the economy as well.

As Mike concluded in his missive:

“As investors, we must understand the popular narrative and respect it as it is a formidable short-term force driving the market. That said, we also must understand whether there is logic and truth behind the narrative. In the late 1990’s, investors bought into the new economy narrative. By 2002, the market reminded them that the narrative was borne of greed not reality. Similarly, in the early to mid-2000’s real estate investors were lead to believe that real-estate prices never decline.

 

The bottom line is that one should respect the narrative and its ability to propel the market higher.“

Will “Trumponomics” change the course of the U.S. economy? I certainly hope so. It will be better for us all.

However, as investors, we must understand the difference between a “narrative-driven” advance and one driven by strengthening fundamentals. The first is short-term and leads to bad outcomes. The other isn’t, and doesn’t.

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With celebrations continuing at the site of the Dakota Access Pipeline protest (following the "Monumental victory" following the Obama administration's decision not to grant the construction permit), it appears the Trump administration has very different ideas.

Having confirmed Trump's support for the pipeline (not to do with his investments), Reuters reports a Trump advisory group proposes the politically explosive idea of putting oil-rich Indian reservation lands into provate ownership.

As we noted last night, after months of protests by the Standing Rock Sioux Tribe of North Dakota, among others, the U.S. Army Corps of Engineers today effectively shut down the project by refusing to approve the last remaining permit required to complete a segment running under Lake Oahe.  Per Reuters, the permit denial was heavily celebrated by protesters in Cannon Ball, North Dakota but means that Energy Transfer Partners will have to go back to the drawing board to identify a new route for the last segment of the 1,172 mile pipeline that is largely already complete.

Which followed a communications briefing from Trump's transition team saying that despite media reports that Trump owns a stake in Energy Transfer Partners (ETP.N), the company building the pipeline…

Trump's support of the pipeline "has nothing to do with his personal investments and everything to do with promoting policies that benefit all Americans."

 

"Those making such a claim are only attempting to distract from the fact that President-elect Trump has put forth serious policy proposals he plans to set in motion on Day One," said the daily briefing note sent to campaign supporters and congressional staff.

As a reminder, Native American reservations cover just 2 percent of the United States, but they may contain about a fifth of the nation’s oil and gas, along with vast coal reserves.

And now, as Reuters reports, a group of advisors to President-elect Donald Trump on Native American issues wants to free those resources from what they call a suffocating federal bureaucracy that holds title to 56 million acres of tribal lands, two chairmen of the coalition told Reuters in exclusive interviews. The group proposes to put those lands into private ownership – a politically explosive idea that could upend more than century of policy designed to preserve Indian tribes on U.S.-owned reservations, which are governed by tribal leaders as sovereign nations.

The tribes have rights to use the land, but they do not own it. They can drill it and reap the profits, but only under regulations that are far more burdensome than those applied to private property.

 

"We should take tribal land away from public treatment," said Markwayne Mullin, a Republican U.S. Representative from Oklahoma and a Cherokee tribe member who is co-chairing Trump’s Native American Affairs Coalition. "As long as we can do it without unintended consequences, I think we will have broad support around Indian country."

The plan fits with Trump’s larger promise of slashing regulation to boost energy production, but as Reuters notes, it could deeply divide Native American leaders, who hold a range of opinions on the proper balance between development and conservation. The proposed path to deregulated drilling – privatizing reservations – could prove even more divisive. Many Native Americans view such efforts as a violation of tribal self-determination and culture.

"Our spiritual leaders are opposed to the privatization of our lands, which means the commoditization of the nature, water, air we hold sacred," said Tom Goldtooth, a member of both the Navajo and the Dakota tribes who runs the Indigenous Environmental Network. "Privatization has been the goal since colonization – to strip Native Nations of their sovereignty."

 

Reservations governed by the U.S. Bureau of Indian Affairs are intended in part to keep Native American lands off the private real estate market, preventing sales to non-Indians.

 

"It has to be done with an eye toward protecting sovereignty."

The contingent of Native Americans who fear tribal-land privatization cite precedents of lost sovereignty and culture.

"Privatization of Indian lands during the 1880s is widely viewed as one of the greatest mistakes in federal Indian policy," said Washburn, a citizen of Oklahoma's Chickasaw Nation.

 

"With this alignment in the White House, Congress and the Supreme Court," he said, "we should be concerned about erosion of self determination, if not a return to termination."

But other tribes are more positive…

"The time it takes to go from lease to production is three times longer on trust lands than on private land," said Mark Fox, chairman of the Three Affiliated Tribes in Forth Berthold, North Dakota, which produces about 160,000 barrels of oil per day.

 

"If privatizing has some kind of a meaning that rights are given to private entities over tribal land, then that is worrying," Fox acknowledged. "But if it has to do with undoing federal burdens that can occur, there might be some justification."

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