Heightened market expectations around the incoming Trump administration include many of the themes that have been widely reported in the press - tax cuts, deregulation and fiscal spending. All of this could spur economic growth in the short term, though likely not over the longer term due to a variety of headwinds that will likely materialize rather quickly the further out the analysis goes. Economic benefit depends a good deal on just what form these tax cuts, deregulation and fiscal spending take, and none of these policy options to date are in any way clearly spelled out, let alone shovel-ready.
Any one of these areas of change could spur growth in the immediate term; taken together, such a package could become one of the biggest fiscal packages in recent memory. How well such a fiscal package would fit into an economy that, for all intents and purposes, is tantalizingly close to full employment, sports one of the lowest levels of inflation in the post-WWII era and currently carries a debt-to-GDP ratio of close to 105% is an interesting story to tell. Interest rates, while rising, remain historically low, which makes an infrastructural play possible - a play that most on either side of the political divide would agree has long been needed. Yet, the fear of government borrowing at full employment and in a low interest rate environment takes on the added risk of crowding out private capital investment, which has for years been anemic at best. Increasing interest rates will invariably put added pressure on burgeoning corporate debt that has, for years, gorged itself on the ever-cheaper cost of capital to fund patently non-productive exercises such as share buyback schemes and enhanced dividend payout programs.
One thing at a time: the beginnings of a policy statement on tax cuts are slowly emerging mostly from the Republican halls of Congress that could morph into a formal tax reform package. Destination-based cash flow tax (DBCFT) with a border adjustment is the latest tax fix that is beginning to cause quite a stir.
The basic idea around current corporate tax policy is to tax income that is generated in the US. Of course, there are countless ways to avoid such a defining scenario and still stay, loosely, within the intent of the law. Moving income generating sales, royalties, intellectual property and operations to lower taxing regimes abroad is a tried and true approach to lowering one's corporate income tax liabilities. Another is to take on inordinate levels of debt, which, short of rolling the dice on bankruptcy, is a fully deductible pursuit. In historically low interest rate environments, the debt approach is as close as you get to a no-brainer.
All of this distorts the economy, largely leaving others to pick up the resulting tax tab, including the government's current account balance. DBCFT does away with many such distortions with a plurality in Congress and a stroke of a presidential pen:
- As the name implies, DBCFT concentrates on cash flow - more specifically, domestic cash flow. Income derived from domestic sales less the cost of labor and materials is the new tax mantra;
- Debt is no longer favored over equity, which rescinds the tax advantages of holding debt. Interest payments throughout the economy will no longer be deductible which impacts bondholders, banks and other creditors holding debt;
- Invoking the concept of a border adjustment, income derived from exports and international sales under DBCFT is not taxed at all;
- Imports would be fully taxed, since the income derived by the importing company would be derived domestically. Further, importing companies will not be able to deduct payments to foreign suppliers or captured affiliates from their income liability;
- Statutory corporate tax rates would fall somewhere in the 15-20% range;
- Capital investments will be deductible in the tax year the investment was made rather than over the course of time via amortization - a proviso that was made permanent during the Obama administration that appears will be carried over into the DBCFT proposal.
While DBCFT rids the economy of many of the distortions currently present, it appears the regime would create a host of others that could be equally distorting, with known and unknown consequences. The biggest economic sector that will be hit is retailers, especially those whose business model depends on the importation of goods that are currently sold in the US market at razor-thin margins. The taxes on imports under DBCFT would likely wipe out current margins in their entirety. Of equal concern is the computation of tax liabilities for banks, partnerships, pass-through entities and financial institutions whose revenue base depends on fees for advice and services. The impact on food, clothing and energy costs - all disproportionate components of low-income budgets - is equally unknown.
Yet, beyond all of these issues is an even bigger international juggernaut, which is where I would like to turn for the rest of the piece.
A tax-free US export regime would cause the dollar and dollar-based assets to soar, likely proportional to the tax regime percentage on imported goods coming into the US market. Such a tax regime set into place by one of the biggest markets on the planet would act like a magnet in attracting international capital and export operations to US shores. The renewed strength of the dollar would presumably come on top of a dollar that is already expected to strengthen from an accelerated program of rate hikes by the Federal Reserve offsetting price inflation stemming from reflationary fiscal policies of the incoming Trump administration. Growth in the US economy is currently expected to expand by 2.2% in 2017, according to the latest estimates from the World Bank. Both Europe and Japan are expected to grow at a much weaker pace of 1.5% and 0.9%, respectively. Using the tax benefits of the regime, international export corporations would rack up year upon year of negative taxable income credits potentially on a perennial basis - as current account deficits balloon for lost revenue. Carry trade arbitrage between low and higher interest rate environments will further distort international capital flows.
Proponents of the idea argue that the strengthening of the dollar in international currency markets would largely offset the import tax as US goods and, potentially, services over time would become proportionately more expensive in world markets in dollar terms. Perhaps. Over time is the operative term here. In the meantime, however, the World Trade Organization could be fully expected to come down hard on such an export bias as a protectionist impediment to free international trade. While the WTO legal cogs slowly, but meticulously, grind out a solution to the issue, the ground-level response by adversely impacted countries would likely be less legally sublime but implemented with blinding speed as tax-based barriers to US imports would spring up like a wild fire in parched underbrush. The resulting havoc could grind the international distribution of goods and services to a virtual halt, sinking overall global economic growth in the process. Global trade this year will grow at the slowest pace since 2007, according to WTO data. MSCI estimates that if policies such as trade protectionism and government deficit spending increase significantly in the developed world in the next two years, US equities would shed more than 17%, while European equity markets would fall closer to 20%. With a DBCFT regime in place in the US, the hit to developed markets spans the unknown.
In the emerging market space, a 15-20% uptick in the dollar would be singular. The People's Bank of China (PBOC) has burned through an estimated $1 trillion in foreign reserves defending the renminbi since devaluing the currency by about 2% in August 2015. Shocked global markets hastened to price in the new reality as investors lost billions in the exercise. Since August 2015, the PBOC has managed the currency's decline with much more finesse. Global markets have been markedly less rattled, even though the renminbi has given up another 10% against the dollar through the end of 2016 and 7% against an expanded basket of currencies of its major world trading partners. The PBOC continues to intervene in currency markets, even though officials almost never affirm or deny their presence in managing the country's currency markets. Traders are left guessing whether the capital flows they see on their computer screens are coming directly from the central bank or the web of state-owned banks trading their own books or through manipulations of reserve requirements or merely through the instructions of the PBOC to banks that suddenly squeeze liquidity in the financial system by restricting bank-to-bank overnight lending. Last Friday (6 January), the cost of overnight funds in Hong Kong, by far the biggest offshore renminbi center, soared over 61% - the second highest level on record. A popular and particularly lucrative trade swaps renminbi for dollars as pressure on the Chinese currency peaks, allowing investors to pocket the difference when the PBOC's daily renminbi fix weakens. The one-way trade has been a consistent winner as the PBOC remains in a constant struggle to contain capital flight, which not only weakens the currency, but poses a direct threat to both financial and political stability of the country.
Fold DBCTF into the mix, and the dollar-to-renminbi ratio passes quickly into the unknown: A 15% premium on the renminbi at today's market close (12 January) of Rmb6.8915 would put the valuation at the historic low of Rmb7.925. A 20% premium would simply push the valuation beyond the pale at Rmb8.2698. As we have seen, the PBOC spent $1 trillion of its foreign reserves in a controlled decline of the renminbi since the August 2015 devaluation. Defending the currency's decline in the face of DBCTF would likely make short shrift of their remaining $3 trillion foreign reserves. The impact on the highly leveraged Chinese economy with its currency in free fall is more than difficult to fathom.
Closer to home, Mexico has indeed fared well under NAFTA (1994), bringing much-needed stability - both economic and political - to a country whose economic history is replete with boom and bust cycles. Through NAFTA, Mexico enjoys unprecedented access to US consumers to the extent of which is but a dream for other emerging market economies. Mexico has won nine of eleven new major automotive plants built in North America in the past six years, according to the Center for Automotive Research. The placement of these plants is an outward acknowledgement of the same economic and political stability that has attracted more than $17 billion in foreign direct investment (FDI) over the past five years, according to government data. It is the same FDI that has, in turn, created tens of thousands of jobs, transforming Mexico into an automobile and parts manufacturing powerhouse on the continent. Currently, Mexico ranks fourth in the world in automotive manufacturing behind the likes of Japan, Germany, South Korea and, of course, the US. Mexico produced 3.5 million light vehicles through the end of 2016 - a figure that has doubled in the past decade. Almost 30% of Mexican GDP derives from trade with the US, and 80% of that trade goes to US markets.
This foothold of economic and political stability has now begun to unravel at the edges in the wake of the surprise Trump victory in November's presidential polling. Throughout the campaign candidate Trump was vitriolic in his denouncement of NAFTA, placing the peso under constant and undeserved pressure in world currency markets. On the eve of the election, the peso was trading at 18.5908, just above its simple running average for the year of 18.41. By the market close on the 9th of November, with the Trump victory secured, the peso had jumped almost 7% to 19.8418 to the dollar. By the 11th of November, it had weakened to 20.9164 for an unprecedented 12.51% market move over roughly a 48-hour period. Through Thursday's market close (12 January), the peso had weakened to 21.7804 for a 17.16% market move since the election, setting two new market lows against the dollar in the process. Mexico's central bank has burned through $1.81 billion defending the peso in the last week alone, driving its foreign reserves to a dangerous low of about $175 billion, according to central bank data.
Inflation is now at a two-year high as a government move to end subsidies on gasoline, which began at the first of the year, has quickly migrated through the greater economy. With the protectionist bent of the incoming Trump administration now awaiting specific policy initiatives, the growing storm bodes ill for Mexican economic growth over the immediate and medium term. In December, Fitch cut its rating outlook for long-term Mexican debt from stable to negative, citing the depreciation of the peso as a serious headwind to the country's public finances. Add DBCFT to the equation with a 15-20% strengthening of the dollar, and the peso falls to a record low of 25.047. At 20%, the peso falls into a deeper hole at 26.1365 to the dollar.
The US Customs and Border Protection processed 1.048 million passengers and pedestrians on the southern tier on a typical day in 2015, up from 1.026 million in 2014. It is hard not to imagine those numbers rising geometrically if the Mexican economy begins to spin out of control. The interest of the US is well served in helping Mexico help itself by providing and securing an environment of economic and political stability to enable the country to attract foreign direct investment that will build factories and infrastructure to allow Mexico to compete in global markets. A strong and viable Mexican economy creates jobs in the country itself, which obviates the need for surplus labor to migrate north to supplement their household income.
According to IMF data, there are 43 countries that directly tie their currencies to the US dollar on data through the end of 2014. Each in their own way will be impacted by a significant change in the market value of the dollar in world currency markets. Sharp increases in the strength of the dollar in economies pegged to the dollar will mean sharp increases in the cost of goods and services at the local level, while fanning inflation and squeezing consumer purchasing power - all at the expense of economic growth. Countries not officially pegged to the dollar, particularly in the emerging market space, could see the exit of so-called "hot" institutional money as capital flows seek safer investment vehicles, such as dollar-based assets. Local interest rates and price inflation rise, while local currency valuations fall against the strength of the dollar. Economic growth suffers proportionately.
DBCFT will act as a magnet for capital inflows to the US as export-oriented corporations seize the opportunity to take advantage of the outsized benefits of a tax-advantaged export economy. The magnet for capital inflows will provide irresistible incentives for job seekers across the globe - and especially from Mexico and places further south - who will continue risk life and limb in seek of a better life, perhaps for themselves, but most certainly for their children. Throughout history, the building of walls - physically or figuratively - has proved time and time again to be little more than a myopic, populist "solution" to a highly complex social and/or political need of the moment. We need - and should expect - more creative thinking from the leaders we elect.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.