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DO Fight The Fed
Wednesday, September 21 2011 | 11:07 AM
Vinny Catalano CFA
President & Global Investment Strategist,
BLUE MARBLE RESEARCH
|Today, Wall Street's Professional Investor Class (PIC) waits with bated breath for the Fed to provide words of comfort so that one of Wall Street's revered axioms, "don't fight the Fed", will deliver much needed relief to the beleaguered warriors of finance.
One of characteristic of the PICs that is useful to remember is that they are highly reliant on heuristics - rules of thumb that help frame the world into bite-sized analytical pieces. One of the heuristics that has worked from time immemorial is 'don't fight the Fed". For example, last year, around this time, a well-known hedge fund manager advised investors and traders of this well-worn axiom to great effect and result (stocks rose from the fall of 2010 into the summer of 2011). Unfortunately, while the monetary elixir did work its magic on the PICs (they bought stocks), it had little effect on the real economy.
Never sated, the ever-thirsty PICs are back at the don't-fight-the-Fed troff for another hearty slurp of monetary ease = higher risk asset values. From the PICs and Fed's perspectives, the economic rationale for this view is rather simple: Easy money = an increase in the value of risky assets = a positive wealth effect = increase demand = higher GDP (which then = higher wages, increased hiring, etc, etc). Hence, don't fight the Fed ALWAYS delivers. Or does it? And when it does, is the effect always the same under all conditions? Or are the results a product of the economic and financial times?
It may be a risky thing to go against such a dogma. After all, the four most dangerous words in the investment language is "this time is different". And to assume that more easy money will not produce the above listed outcomes is the speak those very dangerous words. Yet, if one believes we are in times that are truly different, particularly in the post WW II era, then perhaps it's time from some fresh perspectives.
Going against such a well-established dogma of day is also especially dangerous given the changed structure of the market. For, when the momo lemmings (who could care less what the drivers are or what direction the markets are headed, just along as stock prices move) jump on the market trend du jour bandwagon, the wheels get turning rather quickly.
Investment Strategy Implications
If you are going to go against a revered heuristic it is useful to have your own heuristic to counter the revered one. My heuristic is this: in a liquidity trap, the effectiveness of monetary policy is limited, at best. Moreover, monetary ease becomes even more limited when fiscal policy is contradtionary (i.e., expansionary austerity). These global macro forces are strong, pervasive, and global in scope.
So, the PICs may rejoice in what they hear today. And risk assets may rise - for a while. But the global macro forces at work can, and I believe will, overwhelm the monetary elixir the Fed will provide. And the PICs don't do global macro very well. (More on this point in a future blog posting.)
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Monday, February 14 2011 | 01:10 PM
SNR DENTON US LLP
|On February 8, 2011, the Board of Governors of the Federal Reserve (the “Board”) issued a notice of proposed rule making under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The proposed rules establish criteria for determining whether a nonbank entity (1) is nonbank company that is “predominantly engaged in financial activities”, and (2) is a “significant nonbank financial company”. Both of these rules are important, because the Dodd-Frank Act gives the Financial Stability Oversight Council (the “FSOC”) the authority to determine whether a nonbank financial company shall be subject to the Board’s supervision, because it could pose a threat to the financial stability of the United States.
One of the necessary criteria for a company to be a “nonbank financial company” is that it be engaged “predominantly in financial activities”. Under the first proposed rule, a company would be “predominantly engaged in financial activities” if in either of its past two fiscal years, eighty-five percent of its consolidated annual gross revenues or consolidated total assets in that year were derived from or related to, respectively, “activities of a financial nature” or the ownership, control, or activities of an insured depository institution or any of subsidiary thereof. Additionally, the Board would have discretion to determine “based on all the facts and circumstances” that at least eighty-five percent of a nonbank company’s consolidated annual gross revenues or consolidated total assets are derived from or related to the aforesaid activities.
One factor, in determining whether a “nonbank financial company” is to be subject to the Board’s supervision, is the degree and nature of its connections with other significant nonbank financial companies and significant bank holding companies. In this regard, the second proposed rule defines a “significant nonbank financial company” as a nonbank financial company that is already supervised by the Board, or that had at least $50 billion of total consolidated assets as of the end of its most recently ended fiscal year. Furthermore, the FSOC may recommend to the Board that nonbank financial companies supervised by the Board report to the FSOC, the Board, and the FDIC on their credit exposure to other significant nonbank financial companies and significant bank holding companies. (A “significant bank holding company” is a bank holding company or foreign bank treated as a bank holding company that had at least $50 billion of total consolidated assets as of the end of its most recently ended fiscal year.)
These proposed rules are important to several companies in the equipment finance arena, because if any of those companies qualify as nonbank financial companies, then they could be subjected to supervision by the Board, similar to that imposed on bank holding companies, and could be required to report on their credit exposure to other significant nonbank financial companies and significant bank holding companies. It is as yet unclear how burdensome the increased regulatory oversight would be.
The deadline for comment is March 30, 2011.
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Tackling the US Unemployment Problem-Infrastructure Investments Without Increasing Taxes or Deficit
Friday, February 11 2011 | 09:44 AM
|High unemployment is one of the most important issues the US economy is facing, and one of the most effective ways to tackle this problem is investments in productive infrastructure. Here is an idea that will encourage private investment in infrastructure without requiring increases in deficit or taxes, along with steps needed to ensure that the program will be effective.
High level of unemployment at 10%, or 17% if you also count the under-employed, is one of the biggest challenges the US economy faces today. Consumers are about 70% of the economy. People without jobs can’t spend as much on goods and services, and can’t buy houses, which does not help housing situation, another significant issue. US companies have managed to increase profits but partly by reducing costs and spending, which also does not help the economy grow. The QE2 program undertaken by the Federal Reserve is meant to help unemployment indirectly by driving interest rates lower, but its effectiveness is far from certain, and is being questioned by many.
Why Infrastructure Investments?
One generally agreed approach to increasing employment is investment in infrastructure projects. The jobs created are local and cannot be exported, and the jobs will be created in sectors like construction that are facing higher unemployment (about 21% of the eight million jobs lost in 2008 & 2009 were in the construction sector, which still has unemployment at 17% level). Also, spending on infrastructure generates demand for products and services from a variety of industries, creating more jobs.1
Another consideration in favor of infrastructure investments is that deteriorating US infrastructure is sorely in need of maintenance. American Society of Civil engineers estimates that US needs $2.2 trillion in infrastructure spending over next five years2. The collapse of the I-35W bridge over Mississippi River in Minneapolis in Aug 2007 was a vivid example of this need. Increased spending also makes sense comparatively - US spends 2% of GDP on infrastructure, while China and Europe spend 9% and 5% respectively.
Also, several factors make this a good time to make investments in infrastructure – raw materials and labor are cheap, as is cost of financing. The maintenance is necessary and overdue. Not doing it now just means that it will have to be done at a later time when it will likely cost more.
Issues in Investing in Infrastructure
The biggest issue is finding funds without increasing deficit or taxes. US National debt for the $14.5 trillion economy has already ballooned to more than $13 Trillion. In Sep 2010, the Obama administration proposed a plan to spend $50 billion on infrastructure investments. However, the congress has not approved the plan, and the increased focus on reducing deficit and spending in the newly elected congress will constrain spending by the federal government. The state and local governments have lower tax revenues due to weaker economy and lower real estate values, and are constrained in their ability to spend.
Need for funds is one problem. Another problem is picking projects that are productive and not just a waste of money. Government may not be the best judge for picking the best projects. Solution to both problems is increased involvement of private sector.
Investment in Infrastructure without Increasing Deficits or Taxes
To get the private sector to invest in infrastructure projects, the government has to provide incentives, but in a way that does not increase deficit or taxes. One possibility for doing this may be by using the estimated $1 trillion of unrepatriated profits US companies hold in foreign subsidiaries. American companies can generally defer paying taxes on foreign profits as long as they keep the money outside US. When they bring the money back to US, they have to pay the top corporate tax rate of 35%. To defer taxes, US companies generally have left large sums of profits in their foreign subsidiaries.
These untaxed profits are part of the reason large multinationals have lower overall tax rates for which they have been criticized at times. Earlier this year, the administration proposed restricting companies from deferring taxes on profits earned oversees (estimated to raise $210 billion in revenues over next 10 years), but faced strong opposition since that would put the US companies at a competitive disadvantage.
On the other end, US companies are arguing that they could bring back the earnings in their foreign operations if the US government offered a tax amnesty and permitted them to repatriate foreign earnings at a low rate of around 5% instead of the 35% federal tax they face at present (see editorial in Wall Street Journal on Oct 20, 2010 by John Chambers, the CEO of Cisco, and Safra Catz, the President of Oracle). They argue that 5% tax could bring $1 trillion back to US for increased economic activity and could generate $50 billion in federal tax revenue.
The tax amnesty does not cause an increase in deficit or taxes, as government is giving up what it is not getting anyway - without it, these funds will not come back into the US economy, and the Treasury will not get the additional tax revenue. However, the funds brought back will not necessarily generate jobs. The companies could use the money for M&A activity, stock buybacks, and paying out dividends. A better idea will be to offer the tax amnesty only to the funds brought back that are invested in infrastructure and clean energy projects in the US. A limited time tax amnesty will encourage US companies to repatriate earnings back to US. A requirement to invest in infrastructure projects for a minimum fixed number of years (say something between 3 to 5 years) will ensure that the funds brought back create jobs. Companies will be allowed to invest in either debt or equity depending on their risk-reward preferences. All investments will be chosen and managed by private fund managers, who will pick projects and investments based on sound economic calculations of cost-benefit and expected returns. The companies will be able to pick any fund manager based on their judgment of manager’s capabilities.
This basic framework could be enhanced in several ways. Companies could be encouraged to invest for a longer period by offering to reduce any taxes on the earnings from the infrastructure investments, if the investments are held for say 7 to 10 years or more. Also, companies could be allowed to use part of funds brought back to build new plants for their own use.
Will Private Investors Invest In Infrastructure?
If the government did allow repatriation at low tax rates for money to be invested in infrastructure, would there be demand for it? Can these projects generate returns that investors will find attractive? The answer to both is affirmative. Prequin reported recently that 28 US Infrastructure debt funds were on the road trying to raise $26.4 billion. Europe, smaller in size, but with better developed Public Private Partnership programs in the sector, had 38 funds trying to raise $29.3 billion. Large investors have expressed willingness to invest in these projects. Zhou Yuan, head of asset allocation at China Investment Corporation (CIC), said in November that CIC would be willing to invest in large projects like high speed links between US cities, and super high-voltage transmission lines that provide a good risk-return profile, and suggested US should invest $1 trillion over next 5 years in form of public and private equity partnerships to create jobs (instead of QE2) and improve competitiveness.
Ensuring the Program is Effective
An editorial in New York Times on Oct 23 opposes the idea of tax holiday for repatriating foreign investments citing the experience of 2004. In 2004, after strong lobbying by the US multinationals, the Congress passed the American Jobs Creation Act in which the Homeland Reinvestment provision gave US companies a one-time break to pay 5.25% rather than 35% in taxes on the repatriated foreign profits, with the intention that the repatriated money would prompt investment in the United States economy and spur job growth. To qualify for the one-time tax break, companies had to promise to use the money to invest in their domestic operations. They could not use it to pay dividends, or compensate executives.
The program was heavily used by large corporations – many in the pharmaceutical and technology industries. For example, Pfizer brought back $37 billion, and Hewlett-Packard repatriated $14.5 billion. The amount of repatriation exceeded expectations. In all, 843 corporations took advantage of the offer, bringing back $362 billion in foreign profits. Of that amount, $312 billion qualified for the tax break, giving those companies total tax deductions of $265 billion claimed from 2004 through 2006.
According to analysis later, of the $299 billion companies brought back from foreign subsidiaries, between 60 and 92 percent of it went to shareholders, through increased share buybacks or increased dividends. Repatriations did not lead to an increase in domestic investment, employment or R&D, even for the firms that lobbied for the tax holiday stating these intentions. For example, Dell, which repatriated $4 billion, spent $100 million on a plant in Winston-Salem, N.C, which they said they would have built anyway, and used $2 billion two months later for a share buyback. Also $100 billion was estimated to go right back to foreign subsidiaries.
The provision requiring domestic investment had wide definitions of the term investment and allowed corporations to use repatriated profits to shore up their domestic finances, pay legal bills and even bankroll advertising. While companies did make investments in their domestic operations, the repatriated money also freed up a corresponding amount of cash to pay out to shareholders or buy back stock.
Money is fungible. It can be easily moved from one bucket to another. Hence, to ensure that the tax break really results in investments that create jobs, that money has to be separated. Hence, for this idea to be effective, the funds brought back must be invested with third-party private fund managers for a minimum number of years to qualify for the tax break.
Longer term, the US needs to develop regulations that clarify and encourage private sector investment and involvement in the infrastructure sector. Public-Private Partnerships and securitization of infrastructure financing can play a very useful role in developing this sector which is essential for the growth and competitiveness of the US economy in the longer term.
1An Oct 2010 report from the Council of Economic Advisors & the US Treasury (An Economic Analysis of Infrastructure Investment) discusses the benefits of infrastructure investments in detail. Also, see Jan 2009 article How Infrastructure Investments Support the U.S. Economy: Employment, Productivity and Growth from PERI & AAM.
2Also see CBO Testimony on Current and Future Investment in Infrastructure.
Note: This idea was originally published at http://marketsandeconomy.wordpress.com/2010/11/23/tackling-the-us-unemployment-problem/
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