Covenant Weekly Market Synopsis as of February 17, 2017

February 20, 2017

Domestic economic data releases were generally upbeat this week while a flock of Fed speeches (seven in all) did little to impede the stampeding bull market. Global equity markets rose about 1.5%, pushing MTD gains north of 3% and domestic indices to new highs. Yields on longer-dated U.S. Treasuries ticked higher (though remain lower than at the beginning of the month). Precious metals managed to eke out a small gain, while WTI Crude declined by just under 1% to $53.88 per barrel. It’s worth noting that OPEC countries exceeded their commitment to reduce oil production by a million barrels in January (the reported reduction was 1.1mm barrels), however, domestic production has been ramping up. According to the widely cited Baker Hughes Rig Count, through last week the number of rigs operating in the U.S. increased by 237 rigs from this time last year. Increasing domestic oil production (aided by improved technology enabling economic oil extraction at lower market prices) will stymie OPEC’s efforts to push oil prices meaningfully higher.

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Corporate Tax Reform – Consistent with President Trump’s campaign commitment to overhaul the corporate tax code, Republicans in Congress are developing a plan to do just that. Their plan consists of:

  • Reducing the federal corporate tax from a top rate of 35% to 20%;
  • Allowing businesses to depreciate capital expenditures immediately, rather than over a multi-year schedule;
  • Eliminating interest expense tax deductions;
  • Implementing a “destination-based cash flow tax”, also known as a “border adjustment tax (BAT)”.


It is this last element of the Republican’s proposal that is generating the most confusion and hence bears further explanation. Under current U.S. tax law, domestic corporations are taxed on the difference between worldwide revenues and worldwide costs. Under the new proposal, taxes would be calculated only on the difference between revenue generated in the U.S. minus costs incurred in the U.S. The following simplified example highlights the impact of a BAT by comparing three types of companies:

1) A purely domestic company who produces and sells product only in the U.S.

2) An exporter who produces product domestically, but sells internationally (“Pure Exporter”)

3) An importer who manufactures overseas, but only sells product in the U.S. (“Pure Importer”)



The impact of the BAT (which provides a credit for exporters, a tax on importers, and no impact to domestic manufacturers selling domestically) is illustrated in the “Border Adjustment Rebate / Tax” line item and is assumed to be 20%. In this simplified example, the BAT dramatically increases exporter’s margins, while decimating the margins for importers.

Of course, this example ignores currency effects and a BAT would prompt upward pressure on the US Dollar. If one assumes that the dollar appreciates by 25% [the inverse of the BAT Rate calculated as 1/(1-BAT), or 1/(1-20%)], the stronger dollar would perfectly offset the subsidy to exports (less demand for relatively expensive US-produced products) and reduce import costs (the stronger dollar makes overseas production cheaper). In theory, the stronger dollar would restore importers’ and exporters’ profit margins back to their original level. However, economies (especially ones as complicated as the global economy) do not operate on a theoretical basis, and implementation of a BAT will have broad implications on global commerce… some intended and some unintended. For example, if the USD were to appreciate by 25%, it would reduce the value of assets Americans own abroad, while domestic liabilities would be unchanged. BCA Research estimates this scenario would result in a paper loss on the U.S. of about 13% of GDP. Yikes!

Given the known impacts and potential for unintended consequences of a BAT, why are Congressional Republicans considering it? The answer is to generate tax revenue to help pay for the proposed Federal corporate tax rate cut (from today’s 35% level to 20%). Under the current system, corporations have the ability to “play games” with overseas costs and revenues that can reduce tax revenue for the U.S. government. Imposing a BAT provides the IRS with improved transparency into taxable transactions, while disincentivizing exporters from “fudging” overseas sales levels since it would reduce the amount of the subsidy they would receive. With an annual trade deficit of approximately $500 billion (i.e. the U.S. imports $500 billion more than it exports annually), it is estimated that the 20% BAT would raise an additional $100 billion in tax revenue. The extra tax revenue would allow for a reduction in the corporate tax rate, without causing a massive spike in the Federal deficit. That is to say, the corporate tax rate reduction could be subsidized by proceeds from the BAT.

Corporations want tax reform; individuals want tax reform. However, absent throwing fiscal discipline to the wind and allowing the country to become even more indebted, Congress and the President will have to make some very tough decisions. Some companies will be hurt and some will benefit; it will be the same for individuals if the government addresses personal tax reform. The point is that there is a wide and deep canyon between talking about tax reform and delivering it. The complexity and the political ramifications are key reasons why the thorny issue of tax reform has remained unaddressed by previous administrations.  It will be fascinating to watch how President Trump and Congress attempt to thread the needle with their approach. (Data and commentary was sourced from BCA Research’s article, “U.S. Border Adjustment Tax: A Potential Monster Issue for 2017”).



Weekly Economic Data Summary: Data released this week supports our “Good, but not great” growth theme, suggesting a continuation of positive real GDP growth trending around 2.5%. Inflation data for January, per the Producer Price Index (+0.6% month-over-month) and Consumer Price Index (+0.6% m/m) confirmed forecasts that a rise in energy prices (based on year-over-year comparisons) would boost inflationary readings. Note, we expect this energy-induced tailwind to fade by March or April. Retail Sales exceeded expectations, rising 0.4% in January on top of an upward revision to December sales. Note, that January’s Retail Sales gains marks the first time since 2014 to see five consecutive months of sales gains – the consumer is alive and well, yet we’ll find out in a few weeks if consumption is being driven by a rise in discretionary income (sustainable) or is being financed by increased borrowing or a drawdown in savings (both unsustainable). Industrial Production missed expectations, declining 0.3% in January while Capacity Utilization declined from 75.6% to 75.3% (80% is considered the threshold that begins to generate inflationary pressure). Meanwhile, Housing continues to exhibit strength with Housing Starts 10.5% higher than January 2016 and an unanticipated 4.6% rise in Building Permits.


Be well,