And The Dividend Flow Turned Into A Flood

Jan. 04, 2018 1:38 PM ETAMZN, ANF, PHG, BKH, BP, LUMN, DHI, EXC, FITB, HD, JHG, KBH, KSS, M, MCO, OZK, PACW, PHM, SO, SYF, T, TTM, VZ64 Comments
Douglas Adams profile picture
Douglas Adams


  • The impact of the Republican tax cut program on corporate balance sheets will be short-term and singular but likely not along the lines government policy makers are expecting.
  • US taxpayers will take an average equity equivalency stake of over 6% in 19 companies I have sampled with the expectation that jobs and economic growth will result.
  • Many of these companies across the sample are heavily indebted and the windfall tax savings will more likely go toward debt reduction and shareholders.
  • What is good for GM turns out to be a rather poor use of capital to promote economic growth and jobs creation in the greater economy.

The following is a sampling of domestic companies with current tax rates close to the current statutory tax rate of 35% across a representative array of market sectors. The sectors include retail, telecom, utilities, regional banks and financial companies. The list is by no means exhaustive and many other largely domestic companies could have been included. Rather, the goal here is to offer a taste of just how the recently passed tax cut program will impact corporate balance sheets and offer up the most likely path on just how the tax largess might be spent.

The determining methodology is not complex: I have screened companies for current tax rate, number of outstanding shares, current earnings per share (TTM), current yield and outstanding debt. I have estimated size of the tax savings in terms of increase earnings per share in the range of $0.07 to $0.08 on an annualized basis. Multiplying the range by the percentage point reduction in tax liability provides a rough estimate of total savings for each of the following companies from the tax package for tax year 2018. Another interesting statistic is to divide the market capitalization of each of the companies by the low-range annual tax savings from the tax cut program which provides a rough estimate in the equity stake equivalent US taxpayers are taking in each of these companies. The results by sector are as follows.

Figure 1: Selected Retail Stocks

Current Tax Rate %

% Point Reduced Shares (M) Current EPS (TTM) Projected EPS (TTM)

Annual Range(M)

US Equity Stake % Current Yield % Debt (M)
ANF 35.7 15 68 $0.20 $0.28 $5-$6 2.0 5.30 $309
M 27.7 7 304 $2,28 $2.83 $143-$163 5.5 5.89 $6,535
KSS 36.1 15 168 $3.79 $5.38 $178-$203 5.3 5.2 2,795

Abercrombie & Fitch (ANF) will receive a 15-percentage point reduction in its 2018 tax liability, a decrease of 41% on its 2017 tax outlay for a projected savings of between $70 million to $80 million. The equity stake equivalency for US taxpayers is roughly 2%. The company already has an established record of above-average dividend yield with debt levels at a fraction of those of its department store peers. This would likely signal that ANF is in the position to place even greater emphasis on enhanced shareholder programs as debt management appears to be under control. Increasing market share through a strategic acquisition is another possibility. Even committing some of the tax largess to one-off bonuses to management and even headline workers appears doable.

Macy's (M) will receive a 7-percentage point reduction on its 2018 tax liability over its 2017 filing. Its projected EPS is slated to jump by 24% with projected savings in the neighborhood of between $143 million to $163 million for an equity equivalency stake of about 5.5%. Macy's has a good record of dividend yield at 5.89%, but its debt load of $6.5 billion will likely be the company's most prudent option in disbursing its tax cut largess. Macy's long-suffering shareholders will no doubt be rewarded, but wage and salary growth will likely rank low on the priority list. Simply stated, debt relief and shareholder payouts will command more attention for the foreseeable future as management figures out how to dig out of a 28% market hole for the year, despite a promising finish since Black Friday.

Kohl's (KSS) reduction of its 2018 tax liability will be the most of the sample at 42%. The company's EPS range projects out to $178 million to $203 million-an equity equivalency stake of roughly 5.3%. Kohl's debt load is 135% less than that of Macy' or about half of Macy's debt to equity ratio with Kohl's being about 19% larger than its peer by market capitalization. The company will likely be presented with a relatively full range of options to ponder, including M&A, share buybacks and other shareholder programs as well as debt reduction. Workers could likely see one-off bonuses and even ongoing upticks to current salary and wage packets.

The National Retail Federation forecast retail sales in a range of between $678 billion and $682 billion, up from $655 billion YOY. Current estimates of the recently concluded holiday shopping period project the actual number to be in the upper part of that range. US retail sales since Black Friday rose at their fastest pace since 2011, according to MasterCard Spending Pulse data that tracks both on-line and in-store spending. Total sales increased 4.9% during the holiday buying period, up from 3.7% in 2016. On-line sales soared just over 18%, driven by a robust jobs market and rising consumer sentiment, both measures hitting 17-year lows and 17-year highs in November, respectively. With little surprise, Amazon (AMZN) was responsible for most of the on-line surge, according to data from Adobe Digital Insights as shopping trends continue to shift away from bricks and mortar shopping outlets.

One example of reverse engineering the flood-like move toward on-line shopping comes to light in the after-holiday market where brick-and-mortar stores like Kohl's have begun accepting certain Amazon returns in exchange for store credit. Long a drawback to on-line shopping in many shopping categories, particularly in clothing, customers gain convenience while stores gain sales that might otherwise have not happened without store credit being on offer. Store credit and gift cards translated into an average of $38 in further spending, according to the payment technology company First Data. And with consumer confidence at close to 17-year highs in November, Kohl's return strategy offers up a silver lining of sorts to the continuing struggle between physical and virtual stores. Meanwhile, consumer credit purchases are at their highest level since the end of 2008 at $757 billion through the end of the 3rd quarter according to Experian data.

Figure 2: Selected Home Builders and Remodeling

Current Tax Rate % % Point Reduction Shares (M) Current EPS (TTM) Projected EPS Increase % Annual Range (M) US Equity Stake Current Yield % Debt (M)
KBH 29.27 8 87 $1.40-$1.80 28 $50-$57 5.2 0.31 $2,376
PHM 35.5 15 293 $2.02-$2.85 41 $297-$340 3.3 1.08 $3,356
DHI 35.2 14 375 $2.74-$3.85 40 $373-$426 5.1 0.98 $2,052
HD 36.3 15 1,167 $720-$10.23 42 $1,250-$1,498 18 1.89 $1,

Among the home builders, PulteGroup (PHM) pulls the slightly higher decrease in tax liability for 2018 with a 41% drop over its 2017 filing. That translates into a EPS range of $297 million to $340 million through tax year 2018, or an equity equivalence stake of about 5.2%. PHM is the second biggest home builder of the group at $9.7 billion in market capitalization and carries the largest yield at 1.08%. The company's debt to equity ratio is twice that of DH Horton (DHI) at 74 and shoulders the biggest debt load at $3.4 billion for a company that is a shade under half the size of DHI by market capitalization. KB Homes (KBH) is the smallest homebuilder of the group at $2.7 billion in market capitalization, but with a debt to equity ratio of 158 is five times that of DHI with almost 8-times less market heft. Realistically, the company's debt load leaves it with few viable options beyond debt reduction. DHI appears to have the strongest balance sheet of the group and with $373 to $426 million in tax savings in 2018 for an equity stake equivalency of roughly 5.1%. DHI has the best prospects for wide-ranging options in deploying the funds amongst debt retirement, shareholders and either one-off bonuses or even on-going salary/wage increases for workers. PHM has few options given its debt to equity ratio with debt reduction being the most prudent option of pursuit, followed by sharing much of what remains with shareholders. Salary and wage enhancements appear less likely.

Home Depot (HD) is a big company with an outsized debt to equity ratio of 545. Its share of the tax cut windfall will reduce its 2018 liability by an estimated 42%, amassing a savings of $1.25 billion to $1.5 billion, for an equity equivalency stake of almost 18%. Yet against a debt load of $24.3 billion, HD will most likely concentrate on debt reduction as its top priority with shareholder payouts a distant second on the priority list. Look for one-off bonuses for wage and salary earners at best.

HD has done well throughout the course of the year, tying into the logjam in the housing market where 1st time home buyers are being increasingly thwarted by high home prices across many markets and higher lending standards that keep them on the sidelines in larger and larger numbers. The difficulty of 1st time home buyers in entering the market means 1st time homeowners are finding it difficult to move up-market due to the falloff of 1st time buyers that would have in the past provided the liquidity for just such an up-market move. Already tied into historically low rates if carrying a mortgage, homeowners are staying put and renovating rather than buying new.

HD will benefit all the more with the new tax provision that caps deduction for state and local/property taxes at $10K, particularly in high-tax states like New York, California and New Jersey. While home prices could slide up to 14% in many markets in high-tax states to adjust for the loss of mortgage deductibility above the 10K cap, the demand for debt by governments at all levels to fill revenue gaps caused by the tax cut program will begin the process of crowding out private sector borrowers. The result-mortgage rates will likely rise faster than otherwise would have been the case given the high demand for debt from government. An estimated 23 million fewer US homeowners will enter the housing market as a result-with particular concentration in high-tax states, according to Zillow data. Economists have long held the mortgage deduction suspect. The mortgage deduction represents a classic example of the misappropriation of capital which favors rich over the poor, homeowner over renter while at the same time furthering income inequality in the greater economy. The new tax program walks down a path surprisingly close to this sentiment both tone and spirit. By doubling the standard deduction for both individual and joint tax filers, the new tax program now goes a long way toward blurring the tax distinction between owning and renting. While not eliminating the deduction entirely, the share of taxpayers that will claim the deduction in the future is expected to fall to roughly 4% of all taxpayers from about 21% under current law, according to data from the National Association of Home Builders. Not good news for the housing market.

One big blemish on HD comes from its high debt level. Companies now face a new limit on their interest deductions which will be capped at 30% of EBIT on an annual basis. Further, in 2022 companies will no longer be able to strip out depreciation and amortization costs from earnings benchmark that is allowed to determine the 30% threshold. Debt exceeding the 30% threshold can be carried forward for up to five years. This likely means the windfall drop in tax liability for HD will largely be used for the reduction of debt.

The capping of property/state and local taxes to $10K drives another spike into future sales of new and existing homes, particularly at the highly lucrative upper end of the market. While the revised $750K limit on mortgage interest, down from $1M under current law but up from the House version of $500K, impacts about 4% of all mortgages originated last year, according to Attom Data Solutions. By region, New York City and its immediate environs will be hit hard by the limit where about 64% of all mortgages this year were in excess of the new limit. In San Francisco, that proportion was 58% and the surrounding bay area counties of San Mateo, Marin and Santa Clara counties the figures were between 44% and 55% of the total mortgage originations YTD. While the new limits include all mortgage origination activity since the 2nd of November thus grandfathering existing homeowners with above threshold mortgages, the continued tightening of the federal funds rate and increased government borrowing literally guarantees to put upward pressure on mortgage rates-offering a powerful financial incentive to homeowners to simply stay put. None of this is good news for the housing market.

Figure 3: Select Telecom

Current Tax Rate % Point Reduction Shares (M) Current EPS (TTM) Projected EPS (TTM) Projected EPS Increase Annual Range (M) US Equity Stake Current Yield % Debt (M)
T 37.2 12 6,139 $2.08 $2.82 36 $5,028-$5746 4.8 5.14 $76,011
VZ 35.2 14 4,079 $3.90 $5.47 40 $4,055-$4,634 5.3 4.86 $115,320
CTL 36.6 16 1,069 $1.90 $2.71 43 $1,167-$1,314 2.0 12.53 $24,854

AT&T (T) is the biggest company of the group by market capitalization at $239 billion and has the lowest but still outsized debt to equity ratio of the sample at just over 100. The company will save an estimated $5.03 billion to $5.75 billion as a result of the tax cuts. For taxpayers, this is the equivalent to an equity stake of about 4.8%. At the other extreme, Verizon (VZ) is the second largest telecom company of the sample, but is in the unenviable position of being in the possession of the largest debt to equity ratio at 479. Century Link (CTL) is the smallest company by market capitalization at $17.8 billion with a proportionally high debt to equity ratio of 147. The company is also the biggest fan of shareholders, fielding a whopping 12.53% yield. While debt reduction is the most prudent move for CTL, its dividend history signals strongly that shareholders will not be forgotten as management earmarks the company's tax windfall in the coming year. Both T and VZ also have long-standing commitments to shareholders with utility-sized yields so there is little to leave to chance regarding the disposition any one of these companies' take in the coming tax giveaway. T has already announced a token bonus to its 200,000 domestic workers as the company strives to convince regulators on the efficacy of its Time-Warner takeover. Shareholder cash payouts will likely be curbed as a consequence.

Not only do telecoms pay one of the highest rates in the country among large S&P 500 companies, but they will also benefit from the additional bonus of deducting capital expenses for new equipment for the next five years. This means the government shares in the cost of investments while having to borrow for the privilege to make up the lost revenue in its current account. The depreciation write-off comes a very strategic time for telecom companies which are about to roll-out their respective, and capital intensive, 5G networks at an estimated cost to each of close to $1.5 billion, according to Wells Fargo estimates. While AT&T humored the administration with a very public announcement of $1,000 bonuses to about 200,000 domestic employees in the New Year, both companies' new tax rate, yield and outsized debt load signal strongly that most of the sector's tax savings will trickle down not to employees but to debt reduction, a perfunctory enhancement to already rich shareholder dividend program and the cost of its 5G equipment rollout across the country. Debt remediation will be critical moving forward given the new debt ceiling caps on interest deductibility which will require laser-like focus for all three of these companies given the size of their respective debt loads to date. How all of these tasks will be juggled in the near- and intermediate term will be an interesting spectacle to behold.

Figure 4: Select Utilities

Current Tax Rate % % Point Reduction Shares (M) Current EPS (TTM) Projected EPS (TTM) Projected EPS Increase Annual Range (M) US Equity Stake % Current Yield % Debt (M)
EXC 34.1 13 962 $2.24 $3.10 38 $882-$1,008 4.3 3.36 $31,701
BKH 30 9 53 $2.63 $3.42 30 $34-$38 9.4 3.22 $2,251
SO 34.7 14 1,000 $2.98 $4.16 39 $70-$80 5.0 4.78 $8,150

Utilities also post some of the highest effective tax rates among US companies. The smallest company of the mix is Black Hills (BKH) at $3.21 billion in market capitalization. The company also has the distinction of fielding the largest debt to equity ratio of the group at 205. While in the making for a $34 million to a $38 million savings in tax liabilities for 2018, the company faces $2.3 billion in outstanding long-term debt. For taxpayers, this is an equity stake of about 9.4%. Debt reduction will likely be the priority for any savings accrued by the tax windfall. Even shareholders could play second fiddle in the process. Wages and salaries will likely be well down the priority list. Southern Company (SO) is the largest of the group with the second largest debt load in proportion to current equity levels with $956 million to $1.1 billion about to be realized by the tax windfall, an equity equivalency stake of about 5%. That leaves Exelon (EXC) as the second biggest company of the group at $37.84 billion in market capitalization and the lowest debt to equity ratio of the group at 139. All three companies have well-established and generous yields well above that of the 10-year Treasury note at 2.41% at Friday's market close (29 Dec).

The deductibility of capital expenses for equipment, like telecoms, is an added bonus for all highly capital-intensive production facilities, which will make tax savings all the more beneficial to both operations and shareholders alike. Lower statutory rates and new depreciation schedules should free up capital to invest in infrastructure and refurbish existing equipment while rewarding shareholders at the same time, minimizing the issue of new debt to accomplish either program. Profit margins and consumer rates are set by public regulatory commissions, variously named according to state. These rates are currently based on the 35% statutory rate. Those calculations will now be recalibrated at the new 21% statutory rate in the New Year.

The glut of gas in the market has applied significant downward price pressure on gas and an equally significant increase in competition for the supply of electricity across large swaths of the mid-west, the mid-Atlantic and New England regions of the country. At the same time, the abundance of cheap gas at a fraction of world prices has made the economics of building gas-fired power plants all the more compelling as nearly 9.3 gigawatts of coal-fired electric power generation have been replaced by nearly 8.7 gigawatts of gas fired in the last three years. An additional 12 gigawatts of gas-fired power are scheduled to go on-line by 2020. These facilities are being located in close proximity to sources of gas, thus minimizing the cost of transportation.

Figure 5: Select Regional Banks and Financial Institutions

Current Tax Rate % % Point Reduction Shares (M) Current EPS (TTM) Projected EPS (TTM) Projected EPS Increase % Annual Range (M) US Equity State Current Yield % Debt (M)
PACW 27.2 6.2 120 $2.90 $3.56 23 $52-$60 12.5 3.97 $338
OZRK 34.7 14 122 $2.71 $3.78 39 $117-$133 5.4 1.5 $2,558
FITB 31.9 11 705 $2.65 $3.78 34 $538-$615 4.0 2.08 $1,491
SYF 36.9 16 782 $2.63 $3.76 43 $868-$992 3.5 1.55 $19,900
MCO 31.4 10 191 $2.81 $3.70 32 $134-$153 21 1.03 $2,979
JHG 31.1 10 197 $1.28 $1.70 32 $139-$159 5.5 3.33 $324

Regional, mid- and small-bank along with similarly sized financial institutions have long been targeted by investors as beneficiaries of any tax cut legislation, and the above calculations do not disappoint. PacWest (PACW) locks in an estimated $52 million to $60 million in tax savings through 2018. This computes to an equity stake of about 12.5%. Its debt to equity ratio is just over 30. The company's current yield is high for the group. The Bank of the Ozarks (OZRK) carries a higher marginal tax rate which gives the bank a bigger savings in the tax program with an estimated range of $117 million to $133 million over its 2017 filing, or about a 5.4% equity stake on behalf of US taxpayers. OZRK's current yield is almost 165% less than PACW while its debt load is almost five times higher. Otherwise, the two banks are roughly equal in market size. PACW's lower debt load and higher dividend yield makes the bank a better choice in the upcoming shareholder payout sweepstakes.

Fifth Third (FITB) is a much bigger bank with a market capitalization of $21.4 billion, the better part of four times the size of either PACW or OZRK. FITB has the lowest debt to equity ratio of the group at 11.70 while looking to save an estimated $538 million to $615 million in taxes in 2018, for an equity equivalency stake of roughly 4%. FITB recently made news with a very public announcement of its intention to pay its lowest hourly staff at the $15/hour to curry favor with administration officials while the Federal Reserve ponders releasing the bank from its too-big-to-fail supervisory regime which would create further windfall savings on compliance. The tax and compliance savings make FITB a good candidate for further investor attention as the bank devises a regime of returning much of its newfound capital to shareholders.

The financial companies of Synchrony (SYF) and Moody's (MCO) are fairly evenly matched in market size ($30.22 billion and $28.21 billion respectively) and debt to equity ratios (141 and 131, respectively). SYF has a higher effective tax rate to date and a much higher level of shares outstanding, producing a tax savings in 2018 in the range of $868 million to $992 million, for an equity stake equivalent to about 3.5%. Moody's has a much lower current tax rate which estimates out at $134 million to $153 million in savings over its 2017 filing. This computes to an equity stake of just over 21% for US taxpayers. SYF's higher debt load will likely mean more of its tax largess will be devoted to debt reduction than the more moderately leveraged MCO. Still, the tax savings incurred by both companies should provide ample opportunities to both reduce debt as well as reward shareholders with enough left over to provide some one-off bonuses to staff.

Janus Henderson (JHG) is a much smaller financial investment company with a market capitalization of $7.67 billion. The company's debt load is modest, the estimated $139 million to $159 million in tax savings, or an equity equivalency of about 5.5%. The company's already generous 3.33% yield will likely provide a good deal of shareholder cheer on top of giving the company a host of options to employ its newly found capital to expand market share or further enhance shareholder value.

Small and regional banks and financial companies will also benefit from the lack of foreign exposure on its balance sheet as earnings shifted abroad from US-based operations now face a 20% excise tax. Shifted earnings have amounted to as much as 30% to 40% of earnings in the past, according to data from the Joint Committee on Taxation which estimates the provision would capture about $154.5 billion over the ten-year life of the tax program. In a last-minute change, the bill excludes derivative payments made to offshore subsidiaries-a big source of income for many large banks and financial institutions. Small and regional banks below the $50 billion in assets threshold will retain the deduction of certain payments to the FDIC, a deduction that will disappear for banks above the threshold.

Internationally, Royal Dutch Shell expected to take charges of $2 billion to $2.5 billion against the accounting value of its deferred tax assets held on losses incurred by US subsidiaries. Barclays projected a record £1 billion charge in the 4th quarter for 2017 which could squelch shareholder hopes of a sizable increase in dividend payouts by the company. And last week, Credit Suisse announced a SFr2.3 billion write down on deferred tax credits in its 4th quarter results due to the tax changes in the US. Most recently, British Petroleum (BP) announced that the US tax reform will cause a one-off charge of some $1.5 billion in its 4th quarter results. The impact of the new base erosion and anti-abuse tax (BEAT) provision of the US tax program, where US-based subsidiaries of foreign companies face a 20% excise tax on any earnings payments/transfers out of the US will significantly reduce the benefit of the statutory tax rate decrease for American subsidiaries of foreign owned companies. Designed to discourage tax avoidance by companies seeking to move earnings to lower tax jurisdictions, the provision has caused a good deal of international uncertainty-not to mention consternation-as to if and how BEAT provisions will apply. The provision could be the target of a legal challenge in the World Trade Organization.

What is good for GM is not, necessarily, good for the greater economy. The reasoning behind borrowing from future growth to finance a $1.5 trillion corporate tax cut at a time when the unemployment rate is at a 17-year low or at a time when the S&P 500 has sketched out 14 consecutive months of positive growth while ringing the bell on 70+ new highs on the year or at a time when corporate profits are approaching historic highs, or at a time when consumer sentiment is at a 17-year high-is difficult to grasp. Equally curious is the decided shift toward higher budget deficits during a period of relative economic expansion. The more typical pattern is the reverse: deficits rise in periods of economic contraction as economic safety net spending at all levels of government soars in the face of outsized unemployment. Moreover, few economists expect a short-term stimulus package outlined above to leave any lasting imprint on long-term economic growth. The Federal Reserve in its December projections sees long-term economic growth reaching 2.5% in 2018 and pulling back both in 2019 and 2020 to 2.1% and 2.0%, respectively. The Fed still projects three hikes in the federal funds rate for 2018 while the interest rate sensitive yield on the 2-year note at 1.90% pushes a nine-year anticipatory high. The Fed's balance sheet unwind continues apace, bumping the pull-rate of liquidity from the financial system to $20 billion/month in January. The Joint Committee on Taxation (JCT) sees almost no increase in growth after the 10-year tax program.

The national debt, which just recently pushed over $20.5 trillion looms particularly large in a rising interest rate environment. Government debt stood at 108.1% of GDP, according to estimates by the International Monetary Fund (IMF). The potential for crowding out legitimate spending priorities from defense to infrastructure to security to safety-net-this at a time when the biggest demographic slice of the post-WWII era continues to exit the labor force in numbers that vastly outstrip new entrants to the workplace is foolhardy to ignore. The addition of an estimated $1 trillion to the federal deficit means more demand in the debt market, pushing mortgage rates up at a faster rate than would otherwise be the case, adding more pain to the housing market. And more curiously still, in the 2008-09 time frame when the US unemployment rate had just breached 10% and the labor force was shedding jobs at a monthly rate of 422,000 at the same time an imploding US housing market was pushing the global financial system to the brink, reining in a runaway deficit was deemed the quintessential legislative priority of the moment.

Figure 6: National and Adjusted Financial Conditions Indices

Meanwhile, the rate of 12-month loan growth hit a four-year low through the end of the 3rd quarter according to FDIC data, marking the sixth consecutive quarter of decline. Through the last week in December, bank loans to companies grew 1.1% YOY, up slightly from a 9.8% rate in the prior week. Business lending fell to its lowest level since the 1st quarter of 2011. The average weekly loan growth for the entirety of 2017 came to 2.7%. By way of comparison, loan growth in 2016 was 9.3% and in double digits in 2015, according to Federal Reserve data. The decline in corporate lending is even more curious given the level of liquidity that remains in the US financial system. The current measure of financial conditions through December is -0.92, the lowest post since January 1994 (see Figure 6, above). Forget the punch bowl, the economy has a literal lake of liquidity and there are few companies being denied access to funding for investment. The question appears to be more of a demand side issue-an economic condition that will not be remedied by corporate tax cuts.

For deposit-taking banks, borrowing at the short end of the yield curve and lending at the long end of the yield curve is a critical bank profit center. Much of the decline in lending stems from an ever-flattening yield curve. The yield spread of the 2-year and 10-year Treasury note came to 52 basis points at Friday's market close (29 Dec) for the lowest post since September 2007-a troubling signal by any measure. The 10-year Treasury closed the year with a 1.43% loss. By way of contrast the market performance of the 2-year note closed out the year with a gain of just under 58%. While a flattening yield curve and its ultimate inversion has presaged every US recession since WWII, the threat of a recession given current US economic conditions is deemed by most economists as unlikely. That said, the Fed will have to be extremely careful as it continues to remove monetary accommodation from the financial system. The Fed ended its asset purchase program in December 2015 but the European Central Bank (ECB) and the Bank of Japan (BOJ) continue their respective asset purchase programs as economic conditions in both Europe and Japan still warrant central bank intervention. With the passage of the tax cut program here in the US, a real conundrum is created: Upward pressure on long-term yields by the removal of monetary accommodation by the Fed is at the same time being countermanded by downward pressure on long-term yields by increased foreign investor demand. In the meantime, short-term yields will likely continue to creep upward as accommodative monetary policy is squeezed from the financial system. Increased foreign interest in higher yielding US assets will likely mean long-term yields will continue to bump about in a narrow trading range. The result is an ever-flattening yield curve. US deposit taking banks are unceremoniously caught in the middle of this play.

Recent market activity appears oblivious to any lurking perils on the financial horizon, real or imagined. The global stock market gauge breached the threshold of 14 consecutive months of gains for the longest run on record. The economies of all 45 countries tracked by the Organization of Economic Cooperation and Development (OECD) expanded-a rare synchronous occurrence. The S&P was up almost 20% for the year with dividends yet to be included-its sixth best annual performance of the past two decades. European factories in December reported their strongest month since 1997. Meanwhile, the dollar has moved in the opposite direction testing a three-month low. A sharp drop in US Treasury yields have delineated recent market activity in the bond market as demand for either safe-harbor vehicles and/or arbitrage plays continues apace. The yield on the 10-year note lost 1.43% on the year while the 10-year German Bund rose 0.24% and the 10-year Japanese note rose 0.009% over the same period. Both the euro and the price of gold notched zero-sum gains largely at the dollar's expense but also on reports of German consumer prices in December rising 1.6% YOY, while the price of Brent crude slumped only slightly on the news of a Libyan pipeline explosion that is already squeezing the country's supply to world markets while causing angst among investors. Commodities were in boon mode in local currency terms for much of 2017 given the dollar's weakness for much of the year. Volatility remains at historic lows. All of these price moves are happening against a backdrop of strong economic data releases of the past several weeks-in addition to the pending fiscal impact on US assets from ill-timed tax cuts and the promise of even looser financial conditions here in the US-despite the Fed's tightening efforts to the contrary and stubborn, below target inflation.

One final note. Presidents Kennedy and Johnson reduced taxes in 1962 and 1964 with the support of 21 Republicans in the Senate. President Reagan's tax reform package of 1981 attracted the support of 26 Democrats in the Senate while his 1986 tax program was not only revenue neutral but got the nod of 33 Democrats in the Senate. GW Bush's tax cuts in 2001 and again in 2003 were also passed with the support of 12 Democrats in the Senate. That the current tax package got no Democratic support in either the House or the Senate paints the current program with a decidedly temporary brush which lends a good deal of credence to the windfall characterization where the bill's longevity is politically uncertain-despite the program's "permanent" tax features. That uncertainty over duration plays against the tenets of long-term investment planning-irrespective of the fact that tax rates aren't that important a factor in most corporate investment decisions. At the same time, short-term gratification measures such as shareholder enhancement programs or one-off special payouts and boosted dividend distributions fit well into the windfall motif. In most industries, low profits, languishing share prices and uber-competition usually signals heightened M&A activity and/or enhanced stock buyback programs-or both. In today's market, with both high corporate profits and matching valuations, M&A and stock buyback programs become more problematic-but certainly cannot be ruled out. The theory will be put to the test once the tax windfall begins to flow.

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

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.

Recommended For You

Comments (64)

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.