The Dividend Cafe - (Not) Our First Ever Piece on Tax Reform and Markets

Episode Date: December 7, 2017

(Not) Our First Ever Piece on Tax Reform and Markets by The Bahnsen Group

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to the Dividend Cafe podcast. This is David Bonson, Chief Investment Officer, Managing Partner at the Bonson Group. And we want to go through a couple of things related to the market for you this week. But first, I want to mention that going into 2018, we plan to completely, totally overhaul this podcast. We do not know exactly what we want to do with it, other than that we do not want to continue using it just as a sort of repeat regurgitation of the written Dividend Cafe. We want to have more fresh content, more unique content, even unrelated to the weekly writing,

perhaps more ad hoc content throughout the market week. So we're working with our communications team to kind of figure out what is the most useful way to communicate to clients and guests who want to hear our podcast content, but we want to know what they want to hear, how they want to receive it, and just generally what the best way to approach our podcast medium is. So we welcome any feedback you have on that topic as we kind of strategize these things going into next year. In the meantime, certainly tax reform continues to be kind of the front and center item in the markets. As we've been writing for quite

some time, a signed tax reform bill is going to be a reality very soon. There's still open questions, but from our vantage point, one of them is not whether or not the president will sign the bill put before him. He's going to sign whatever is put before him, in our opinion. The question is what the bill will look like after conference, which they've now officially gone into. Conference meaning where the House and the Senate go to reconcile their two bills. I lean towards the view that says the Senate bill will serve as the foundation of what comes out of conference, not the House bill. But I do not believe that the House will sign the exact Senate bill. I think there will be some modest tweaks making the conference somewhat worthwhile, but I

don't think they'll be significant. But there's still some areas that we're really interested in, some of these sort of modest tweaks that we expect. So the new corporate tax rate, will it kick in in 2018 or 2019? Will the final corporate tax rate be 20% or 22%? We're also hearing a little bit of ideas about the corporate tax rate going to 25% next year and then going to 20% the year after. So sort of a creative way to tether into the rate and save a little bit of revenue. It doesn't save a lot. Still trying to find out if some of the income, the individual income rates will be reduced.

Particularly important to taxpayers in high-tax states looking to offset the impact of their lost state and local tax deductions. There's now ambiguity, there wasn't a few weeks ago, about the fate of alternative minimum tax. It was going to be repealed. Now it's kind of still on the table, so we're waiting to figure out what goes on there. And I'm assuming at this point that the estate tax is not going to be fully repealed, but the House plan doubled the exclusion and then six years later repealed the state tax altogether. The Senate plan did not repeal a state tax, but it did double the exclusion.

So they're definitely issues of interest and significance. They're just not what we'd call cliffhanging suspenseful. They're mostly, you know, on the margin tweaks to the plan that we care about, but more or less the fundamental basics of the plan are at this point well known. The markets obviously responded very favorably. in recent days because the one-time repatriation cost has increased, making the move to bring cash back from offshore to onshore marginally less appealing. But I will say this, those small and mid-cap domestic companies with high effective corporate tax rates, they previously were not big beneficiaries of the loopholes and deductions, their cash flow and earnings stand to benefit tremendously. And we don't think that's been fully appreciated yet by the market. We believe the bill

will result in higher interest rates, more government debt to finance deficits before the economic growth kicks in. Yet we don't believe it'll create more corporate credit because the bill limits tax deductibility of debt interest. So really when you look at the impact of the equity markets and bond markets, interest rates and so forth, it kind of calls for more selectivity in equities and more selectivity in bonds. Within that selectivity, we'd suggest small and mid-caps are going to be bigger advantages out of the tax reform bill, the financial sector and energy sector. The financial sector has definitely been going up already in anticipation,

but we also think it benefits if, indeed, interest rates do go higher as a result of the growth created by the package and deficit spending. The lower tax rate will be one benefit, but then the higher interest rates will mean higher net interest margin and a more robust earnings environment for the financial sector from the steeper yield curve. for the financial sector from the steeper yield curve. In energy, you not only have the instant expensing in the corporate sector, but you also get the really big delta from their previous effective tax rate down to the new one because they also were not huge beneficiaries of the loopholes and deductions. So it's a really, they're the second highest paying corporate tax sector, by the way, the

energy sector. So as far as the negatives, what areas do we think have on the margin maybe a slight disadvantage out of the new tax plan? The high yield bond market, we mentioned some tax deductibility ceilings on the debt interest for corporate borrowing. And then definitely companies that have done a lot of inversions and other kind of tax avoidance techniques in the past, those things now become very disadvantaged. And I suppose with interest rates rising, you have to look at your treasury bonds and more traditional interest rate exposures. Certainly certain maturities there could struggle.

How are companies going to use the new cash? Whether we're talking about increased cash flow due to a lower tax liability or large cash balances that are repatriated to the states or large cash balances that are repatriated to the states under the tax holiday provisions of the bill. Many companies, one way or the other, are going to have more cash on hand because of this tax reform bill, period. The big question for markets will be how that cash gets deployed. Economically, the desire of policymakers is that companies use it stimulatively to generate growth, build factories, hire laborers, increase wages, etc. Indeed, I fully expect all of that will happen, and then some. Politically, there's some fear that companies may instead just buy back stock and pay out dividends.

And I would point out that while I wholeheartedly disagree that even that would be counterproductive economically, I think wealth creation and shareholder value are net positives versus redistribution confiscation in a free enterprise economy. The fact of the matter is that from an investment standpoint, if that negative were to happen, it would be extraordinarily positive. Regret as primary. I'm borrowing heavily here from one of my mentors, Nick Murray, but it does warrant sharing. The primary driver of investor mistakes is not fear and it is not greed, though both are up there, both are connected. Rather, I believe it is regret. When one does not pare down risk and then markets make them wish they had, their regret often leads to incredibly bad decisions. More commonly, more relevant, when one exits markets prematurely or delays entry,

and then markets punish their decision, the consequent regret is generally catastrophic. The only solution is to seek the best decisions at all times, disciplined, balanced, sensible decisions that are divorced from emotions, especially the emotion of regret. Got some great things at DividendCafe.com this week talking about the conventional wisdom around tax loss selling in December, some of the flawed understanding of that subject. We look at currency and stocks and why the different reasons for currency movement

matter to stocks much more than just the direction of the currency itself. Household debt versus government debt, it's fascinating to me. Household debt now basically is even with government debt across the economy, yet it was more than double the percentage of government debt in pretty recent years. So it would seem like really good news. The household debt has, yeah, delevered a little bit, more importantly not grown in its leverage. But the real reason that delta has gone away is government deficit spending

has just been in hockey stick growth since 2007. been in hockey stick growth since 2007. So it's an interesting dichotomy between the household sector deleveraging and the government sector releveraging. Disappointment in 2017. I mean, how could anyone be disappointed as an investor? Stocks are up, bonds are up, real estate is up, emerging markets is up, Even alternatives are up. We celebrate positive returns, don't we? Well, I guess. I mean, I get that, of course. But this is crucial to understand for long-term investors. In periods of high volatility, expected returns into the future go higher because of the basic economic laws of volatility. The low volatility of 2017 has not created some of the buying opportunities that most

years create. Is it disappointing? Well, probably not psychologically, but it is mathematically. Great chart of the week at DividendCafe.com this week showing you how crucial it is that the United States get their statutory corporate tax rate more in line with foreign competitors. We're going to leave it there. We encourage you to please reach out with any suggestions for what you'd like to see out of the podcast in 2018. We're going to keep plugging away what we're doing the next few weeks. And then going into the new year, look forward to having a whole new plan, vision, and growth around the podcast property. We want it to be a real value add in terms of the content creation and thought leadership that we produce here from the Bonson Group. Thank you for listening to The Dividend Cafe, financial food for thought. and with Hightower Advisors LLC, a registered investment advisor of the SEC. Securities are offered through Hightower Securities LLC.

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