Week Ending 01.12.2017
- US tax reforms will have widespread repercussions. There will be winners in the corporate sector but also others that may not find it easier, particularly multi-nationals.
- The changes to individual tax rates do little to shift the income disparity in the US that is both an economic and political challenge. More jobs are not the answer for the US, it is better wages that are required.
- Across the globe economic data shows both a degree of robust health, but also self-limiting factors, such as debt, employment and demographics. It may be why many economists believe the current growth rate is as good as it gets.
The US tax reform is expected to go to the Senate Friday morning (overnight our time) with indications that enough Republicans will support the bill.
It is worth revisiting the source of US federal revenue to put it in perspective. Investment markets will focus on the corporate impact, while the US media is most likely to discuss the individual. Corporate tax only makes up 10% of the revenue source.
How different taxes fund the government
Our comments are based on the current proposal, and there may yet be some changes, though reports suggest the major differences have been ironed out.
The cut in the corporate tax rate from 35% to 20% is a large increment, yet there are many deductions that in practice left the median tax rate of US companies already in the 20% range. Therefore, the impact will depend substantially where the net impact is greatest, such as domestic banks, local manufacturers and service providers. Conversely, the energy sector is most likely to be disadvantaged. That may yet change given the importance of the energy based states to the current administration.
The non-partisan Tax Foundation estimates that if every tax corporate deduction was eliminated, the US tax rate could be cut to 28%, implying a net benefit to industry. The largest deductible components are shown in the table below.
In addition, new investment will be immediately deductible for the next five years, offset by limitations on interest expensing. Overseas profit is subject to a one-time 10% or 12% tax to encourage repatriation of profits held in other jurisdictions. This will create a new tax liability in these companies’ accounts.
The treatment of multinationals is another murky area. There are a host of items in the bill including the treatment of the cost of internal supply chains that are in foreign regions, restrictions on interest deductions and a base tax of foreign earnings above a notional return on assets. How this will impact on a number of large companies, particularly in the IT and pharmaceutical sectors (that shifted their head office to low tax countries such as Ireland) is yet to be determined. The auto and IT are another two where the global supply chain could create difficulties.
Individual tax brackets will be reduced and generally fall, bar the highest tax bracket. High income earners have for some time pointed out that the top 20% pay 70% of federal taxes. However, that is largely a function of their earnings, where higher income earners have increased their share of the total pool. The top 1% of US households’ pre-tax income is equivalent to the total of the bottom 40%, having doubled this share since 1980.
Individual changes within the tax reform include three of note. It is proposed that a standard deduction will be allowed for most households rather than itemising single expenditures. To pay for that, many of the current deductions would be disallowed.
The second is the so-called pass through rate, which will be set at 25%. This is for small business and proprietors to avoid paying individual tax rates. In practice, most of these businesses already pay 25% or less, as illustrated in the left-hand chart below. However, there is small proportion that end up paying a large amount of tax (right hand chart).
Tax Policy Centre Model, 2016
While at face value a sensible reform, many commentators believe that wealthy individuals will restructure their affairs so that they can claim the lower pass through rate and undermine the total tax income. Even without this risk, this reform will cause a sizeable shortfall in tax revenue.
The final and possibly most contentious issue is the deductibility of state and local taxes. This has a major impact on some states, such as Massachusetts, California, Connecticut, New Jersey, Oregon and Virginia. Removing the tax deduction would raise higher income earners taxes by between 2-5% or require a major cut in services in those states. The demographics of the US could take a notable shift on this alone.
- The US tax reform is a net win for the corporate sector, but not uniformly so. The greatest impact may yet be on multinational companies or those headquartered in foreign jurisdictions. This will inevitably have a bearing on the performance of companies depending on how the impact falls.
- Household spending may see a small uplift, though the forward estimates show that by 2020 many middle-income households will be worse off.
- The US budget deficit will almost certainly rise, unless there is a meaningful and prolonged increase in GDP. It also neglects the growing unfunded liabilities in state pensions and social security that is likely to become a focal point in this decade.
Economic releases this week did not add much new to direction. Australian housing approvals ticked up in October, with a helpful skew to free standing homes rather than apartments. Credit growth was up 5.2% year on year. Housing credit is up 6.5%, well above incomes, which implies household debt to income is still heading into record territory. Conversely, business credit is muted at 4% growth.
Business capital spending (ex-mining) is on a gentle upward trend and as we have noted, can utilise cashflow for some of this, which should keep lid on the corporate debt cycle.
The US private consumption price index edged up, while personal spending growth moderated. Household income growth has been solid, but not enough to fund all spending growth in recent times and the saving rate is now heading back to its low of 3% from 6% two years ago. The extent of economic growth is inevitably going to be a function of private income levels and savings; to date the indications are that this will be a cap as to how far GDP can be extended without some meaningful upward move in wages.
In Europe, the debate has turned to the extent to which the current growth rate can be sustained. Many point to the self-limiting factors – demographics, inflexible labour markets, slow reform on structural impediments and an over reliance on exports. The manufacturing sector is doing well, so much so that shortages now may curtail any further improvement. It is the services sector that has lagged and would have to see growth for Europe to again exceed expectations in 2018.
Fixed Income Update
- The US yield curve flattens to its lowest in 10 years.
- Issuance of CLOs (Collateralised Loan Obligations) increase as concerns are raised about falling standards in the originating of the underlying loans.
- Despite negative to low yields in Europe, a pick up in the FX hedge makes these securities attractive to Australian investors.
While we have discussed this point regularly in recent publications, it is worth revisiting the shape of the US yield curve, which has been flattening throughout 2017 as the spread differential between rates on the short end of the yield curve and the long end converge. Last week the margin between the 2 and 30-year Treasury yields fell below 1%, which is the lowest in ten years. On a shorter measure of the curve, the 2-10 year differential fell to approximately 0.50%.
Low inflation in the developed world, global uncertainty, central bank stimulus (albeit being pulled back) and buying from pension funds and other financials with long term liabilities have kept long-dated treasuries well bid and yields capped. As equities rise, asset allocators have also been de-risking portfolios and buying up long dated treasuries. At the short end of the yield curve, the Federal Reserve Bank has been raising interest rates, pushing up yields and narrowing the gap with longer-dated maturities and effectively taking out the term premium. These factors give cause to the flattened shape, but will it lead to an inversion (where long term rates are below short term rates)? If so, the US will have to defy history to avoid a recession, as this has led to this outcome every time since the second world war.
Two and 10-year Treasury Yield Spread
Collateralised loan obligations (CLOs) got a bad reputation from the financial crisis. As global interest rates remain at their lows, the demand for yielding fixed income assets has seen the resurgence of these securities in the new issue market. The sale of CLOs, which are pooled leveraged loans, has increased in 2017, with $100 billion of new bonds issued into the market, up from $60 billion the prior year.
These higher yielding assets have enjoyed price stability in recent years, with hedge funds and pension funds said to be the main buyers. However, some express concern as to the changing structure of CLO’s which are predominately made up of “covenant-lite loans”. Findings from research house ‘Covenant Reviews‘ highlights the drop in standards of the underlying loans, as companies with high debt levels have the ability to take on more debt. While these loans are still structured so that they have fixed maturities and interest paid throughout the life of the bond, in many cases there are no restrictions on the company borrowing further. A cap on debt levels was once a standard requirement in the writing of these loans.
As CLOs represent a pool of these loans, there is a high level of complexity, and can create problems if buyers do not understand the risk. We don’t recommend any funds that buy these securities, yet we are aware of the contagion that can happen in markets when securities such as these come under pressure.
While negative yield bonds still make up a large proportion of the European government bond market, a favourable move in the cross-currency swap from EUR to AUD is adding a considerable uplift and makes these bonds attractive to Australian investors. As European investors seek out higher paying investments in offshore markets and subsequently hedge their FX exposure, this results in increased demand for one side of the basis swap. The supply and demand dynamics has distorted the pricing parity of the AUD/EUR cross currency basis swap, leading to an additional 0.45% uplift for Australian investors. In addition, the European sovereign bond curve is currently steep, elevating returns for Australian investors willing to take on a longer maturity (e.g. ten years) and hedge it against a one year basis swap. While many of the funds we use have been underweight Europe in the last two years, we may see this shift as they take advantage of this anomaly in markets.
Hedged Returns on European Bonds
- The announcement of a banking Royal Commission is likely to see the sector under ongoing pressure and scrutiny over the next 12 months.
- Aristocrat (ALL) reported a strong full year result, although is now branching out into new segments (where its competitive position may not be as great) via acquisition to diversify its earnings base.
- BHP Billiton’s (BHP) investor briefing highlighted some of the smaller-scale, but high-returning options that the company has in its Australian asset base.
The Federal Government announcement of a Royal Commission into the banking and financial services sector was the latest blow to the major banks, which have struggled to perform in a benign credit growth environment with an increasing regulatory burden. While the expectation of a Royal Commission had been building in the last few weeks, the sector nonetheless came under further pressure following its confirmation, while the disparate performance across the sector (Commonwealth Bank fell the most) was notable for identifying which banks may face the most scrutiny.
On a more positive note, the draft terms of reference is narrower than expected and specifically relates to misconduct by financial institutions. This approach makes some sense given that there are already existing inquiries that are underway that may have created some overlap. While it is too early to predict the outcomes or the potential earnings impact across the sector, some of the consequences may include:
- improved lending standards which may further restrict credit growth;
- a lower capacity to reprice mortgages while the focus remains on the sector;
- a distraction for management from implementing their various strategies; and
- the costs involved for each of the major banks could be material and thus could be expected to weigh on the earnings of the sector.
The banks for some time screened as good relative value in an expensive market. The counter argument is that the discount that the sector trades on to the broader industrials is warranted, given a soft earnings outlook (and thus capacity for dividend growth), a structurally lower return on equity following regulatory changes, sustained cost pressure from the areas of technology and compliance, and cyclically low bad debt charges.
Any discount to the market may persist in the medium term given that the outcome of the Royal Commission will likely not be finalised until 2019. We note that our Investors Mutual and Martin Currie SMAs are underweight the sector.
Banks P/E Relative to Industrials
Aristocrat Leisure (ALL) has been one of the market darlings in the last few years and reported a solid full year result, with a 36% increase in profit. This was ahead of its own guidance of 20-30% growth and was matched by a similar increase in dividends. High expectations were clearly built into the stock, however, which was softer following the announcement.
This may have been attributed to the recently acquisitive nature of the company, which announced further expansion into the social gaming and casino space through a US$1bn purchase of Big Fish Games, a US-based developer of games for desktop and mobile devices. It has followed has similarly large acquisition of social gaming company, Plarium, just two months ago. While the price paid looks on the high side, the social and mobile gaming market is going through a period of strong underlying demand growth, helped by the increasing adoption of smartphones worldwide.
Social Casino and Mobile Gaming Market Forecasts (US$bn)
The rationale of ALL’s strategy is to diversify its earnings base into sources that are recurring in nature and help to support a higher multiple for the stock. This makes sense given the cyclicality that has previously been evident in its poker machine sales, with demand driven by how often casinos are updating their machines and the shifts in market share. The latter has been a core driver of ALL’s success over the last few years on the back of market-leading products and innovation, with significant operating leverage in the business leading to a high level of earnings growth. Identifying when the next inflection point occurs in its market share is likely to be a key challenge for growth-style managers that have benefited from the stock’s significant rise.
BHP’s investor update this week on its Australian operations reiterated the view that there remains untapped latent capacity and brownfield expansion opportunities in its portfolio that can support production growth without the requirement to undertake big-budget, large-scale greenfield projects. The key focus was on its Olympic Dam copper operations in South Australia, which is the third largest copper deposit in the world. Olympic Dam has been a relatively poor-performing asset for BHP, particularly in recent years largely on the back of poor operational results, while a sharp drop in the copper price from FY11/12 has compounded its disappointing profit.
The initial investment is focused on improving productivity and stabilising its production profile. The expected IRR on its spend is in excess of 50%, which would appear to indicate that there are relatively easy gains to be made, but also that investment has been lacking over the last several years. Any potential brownfield expansion won’t be considered until the next decade when market conditions may well be different, although copper does remain one of BHP’s preferred long-term exposures, with the outlook supported by ongoing grade decline and the expected consumption uplift from emerging economies.
Olympic Dam Development Plan
Moderating Chinese economic growth poses a challenge for the mining sector, but we believe some exposure is worthwhile at present on the back of a better global growth environment, the current significant earnings uplift that spot prices would imply, reasonable valuations and the more shareholder-friendly capital management policies adopted by the majors.