Covenant Weekly Market Synopsis as of September 1, 2017

September 5, 2017

Investors looked past the increasingly belligerent North Korean dictator’s latest provocation (launching missiles over Japan) and the awful human and economic damage wrought by Hurricane Harvey. The S&P 500 gained 1.4% and the tech-heavy NASDAQ Index jumped 2.7% (it’s best weekly performance since December 2016 and a new, all-time high). International equities notched gains as well, though they lagged domestic equities.   If one believes the economy is on solid footing and corporate earnings will increase at a healthy pace over the next several years, the threat of war and a large storm shouldn’t derail that view. In fact, the annualized Q2 GDP growth rate was revised upwards to 3% (from 2.6%), supporting the “goldilocks” narrative (low interest rates and slow growth are “just right” for equities). Others aren’t so sure… in fact, a lot of people are voicing a less sanguine view of equity markets and the economy, including investment guru Warren Buffet. Last week Warren remarked that the expansion doesn’t feel like 3%, but more of the same old 2%. He’s also sitting on about $100 billion in cash, underscoring his struggle to find opportunities in a richly valued market.

For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.

 

Corporate Cash, Debt and Tax Reform – This is the week that Congress gets back to work. They have an ambitious agenda ahead of them that includes passing a budget, raising the debt ceiling, securing funding for addressing the damage from Hurricane Harvey, and tax reform. All of this will be happening as Kim Jong Un continues to show-off his new toys to the international community. Though odds are long that Congress will complete everything on their list, our representatives possess a real opportunity to lay the groundwork for a stronger economy going forward.

Headlines regarding corporate cash levels indicate companies are flush with cash and thus in a strong position to withstand an economic slowdown. Indeed, the amount of cash held by corporations is at record highs so the statement in and of itself is not inaccurate. Yet, it only tells half the story. The other half of the story is that corporations have taken advantage of low interest rates and borrowed $7.8 trillion since 2010 (source: International Monetary Fund). Combined with sluggish earnings growth, median net debt across S&P 500 firms is also close to a historic high of more than 1.5x earnings (see chart below). When expanded to a broader set of 4,000 firms that comprise about half of the economy-wide corporate balance sheet, the story is similar.

 

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Source: International Monetary Fund

 

What have corporations done with proceeds from the debt? For the most part it has been directed toward financial risk taking (defined as either purchases of financial assets or mergers/acquisitions and dividend payments/stock repurchases). The preference for financial risk taking over economic risk taking (e.g. investment in capital equipment and R&D) is highlighted in the chart below which illustrates the step function decline in capital expenditures beginning at the turn of the century. The reduction in capital expenditures is a key contributor to reduced productivity (researchers at the Brookings Institution estimate that this could explain about half of the productivity slowdown) and a headwind to an acceleration in economic growth.

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What impact might tax reform have on the types of risk management teams take? Unfortunately, if past is prologue, tax reform that simply reduces the corporate tax rate is unlikely to turn the tide from financial risk taking to economic risk taking. Tax cuts in the 1980’s and a tax holiday for offshore profits in 2004 both coincided with a surge in financial risk taking (M&A, dividends and stock buybacks) and had little impact on economic risk taking. Said differently, increased free cash flow from corporations was directed not toward productivity-boosting capital investment or R&D, but rather to financial engineering. Coincidentally, both of those periods were characterized by a rollback of financial and business regulations, similar to the deregulatory environment today. The chart below provides a historical perspective of the impact that tax reform has had on the types of risk that businesses pursue. Notably, this chart also highlights the decline in capital expenditures since 2000.

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The concern is that high levels of financial risk taking are associated with obvious increases in leverage. In the past, leverage cycles that have built up gradually, have ended abruptly in recessions, as was the case in both 2001 and 2008.

So what can be done? One idea is to implement tax reform in a manner that specifically stimulates economic risk taking. For example, Congress could pass tax reform that eliminates the tax deductibility of interest payments while simultaneously allowing for the immediate expensing of capital expenditures (currently capital expenditures are depreciated (i.e. deducted) over a multi-year schedule). This type of tax reform would:

  • Place equity financing on more even footing with debt financing. Since interest on debt would not offer a tax benefit, management teams would have reduced incentives to favor debt over equity. Over time, this could lead to lower overall corporate leverage and more stable balance sheets.
  • Encourage management teams to invest in productivity stimulating equipment and R&D since those expenses would immediately reduce tax obligations.

 

This approach is not a panacea.  Some industries will be hurt, while others will thrive under a new corporate tax plan.  However, if phased-in over a multi-year period, the negative impacts can be minimized.  Congress has an opportunity to set a new course for American businesses going forward. A course that could lead to a more stable economy and encourage investment in new technologies. A well-crafted tax plan has the potential to position the U.S. to continue in its role as the most innovative country in the world. It would be disappointing to let this opportunity slip away because of political infighting.

Be well,

Jp.