Commentary: Trades for 2018

Some quick investment ideas as we ring in the new year. 

1. Long US equities, with focus on names which received a windfall from tax reform. 

I hate Donald Trump, but that doesn't change the fact that many big companies are about to receive a windfall of cash. The US corporate tax code is Swiss cheese. Some companies like GE and Apple can structure themselves in ways to pay virtually no tax or defer taxes indefinitely. Financial firms, and companies like General Mills, have until 2018 paid virtually the full 35 percent corporate rate.  That means many of these firms are about to see a big increase in their after tax earnings. 

For example, after tax earnings for Wells Fargo will be 3-4 billion dollars higher per year because of the tax cut. That's worth at least a 10-15 bump in its share price. Some of that has been priced already, but markets still haven't fully grasped how much this means for the bottom line of many companies going forward.

As such, I expect a 'normal' return year for stocks, with equities returning 7-10 percent in 2018, and with companies receiving the biggest tax cuts outperforming.

2. Long Mexican 10 Year Government Bond 

Mexican presidential elections will happen this July, with Andres Lopez Manuel Obrador being a slight favorite.  The uncertainty of the electoral process will weigh on the Peso and Mexican stocks. Thus, the 7.6 percent guaranteed yield on the Mexican 10 year is attractive in peso asset space. Although the Bank of Mexico will likely raise rates 2-3 times more early this year, it will begin cutting rates in early 2019 once the effect of the removal of gas subsidies fully works its way through the economy.  Overnight rates in Mexico will probably be in the 5-6 range by 2020, which will be supportive of bond prices.  

Non-Mexican investors should wait until after the presidential elections to make this trade, because I believe the Peso will depreciate during the first half of the year before recovering after the outcome of the election is known. 

3. Long ARS/TRY 

Turkey's politics are a mess. Argentina's aren't much better. Inflation in both countries is still in double digits. That said, Argentina is slowly but surely bringing down inflation from nosebleed levels. Turkey's central bank on the other hand is under intense political to keep rates low despite high inflation. 

Given the large interest rate differential between the Peso and Lira, a weird opportunity has arisen. The 28 percent paid on Pesos more than makes up for the 8 percent is costs to borrow Lira. Meanwhile, the exchange rate between the Peso and Lira has been remarkably stable since Argentina floated the Peso in late 2015. This is largely the result of the fact that both countries are highly vulnerable to shifts in over all risk sentiment. This means the two currencies tend to move in the same direction.

Given the 20 percent net carry, a low leverage 2-3x long ARS position looks very attractive indeed.

 

 

  

  

Commentary: My fun but ultimately disappointing foray into cryptoland

Okay, so despite being a crypto skeptic, I don't live under a rock.  With bitcoin's insane surge this week, and the launch of a futures market later today, I finally fell into the rabbit hole and studied the economics and market structure of cryptocurrencies.

First, there is nothing novel nor particularly innovative about bitcoin itself. A distributed ledger (the block chain) is a horribly inefficient way to record and process payments. The main advantage bitcoin has over traditional digital money is that it is not a liability of a financial institution, so in theory it carries no counter-party risk. However, the downside is that it relies on a brute force method to keep track of payments which uses a tremendous amount of electricity and computational resources.  The block chain completely unscalable. And to be frank, except inside the dark musings of libertarian fantasy, with modern deposit insurance, the counter-party risk of holding deposits denominated in major currencies issued by governments with stable politics is essentially zero.  Bitcoin proper is a solution in search of a problem. Speculators might run the price up some more, but it has no staying power.  Bitcoin is nothing more than a digital beanie baby. 

But let's explore two very popular platforms which attempt to solve the scalability problem, Bitshares and Ripple. Both of these systems reintroduce some counter-party risk in order to make block chain technology more practical for widespread use. 

Ripple processes payments between gateways, essentially digital transfer hubs. Block chain technology processes payments between gateways, rather than everyone having to keep an updated copy of the ledger. Gateways themselves are de facto financial institutions. They issue liabilities which are used to settle payments. These liabilities (called issuances or deposits) can be denominated in anything, but for the most part in are denominated in national currencies or crypto-currencies. Liabilities can be redeemed on demand at gateways. 

The result is that end users of the Ripple network must take on a non-negligible amount of counter party risk. Any balance that one holds on the Ripple network is by definition the liability of a gateway. (Except for XRP, Ripple Lab's own crypto-currency which is the only token which exists natively on Ripple) 

Technically speaking, traditional digital money (aka bank deposits) also has this 'flaw.' However, in most countries depositories have the backing of deposit insurance combined with a theoretically unlimited liquidity backstop from their respective central banks. The system of gateways is essentially a banking system operating with no liquidity backstop, limited regulation, and no government guarantees.  Nothing stops gateways from investing in dubious assets and sticking it to their depositors when things go south.  Again, this might tickle the fancy of readers of Reason magazine, but it's a system which has failed spectacularly over the course of history. One only needs to study the free banking era in the United States. When banks operate with no liquidity backstop, the failure of one prominent institution can set off a wave of panic which leads to system wide collapse. This happened time and time again during the 19th century, and I have no doubt that failure of a popular Ripple gateway would bring the whole system down. 

 Finally, forcing depositors to impose market discipline on banks has its own cost.  It means that while there may be a common unit of account, there is no common currency. Because a US dollar held on the Ripple network is not really a dollar, but a promise by a gateway to pay a dollar, these assets do not trade at par. In other words a dollar denominated deposit at one gateway won't be worth the same as a dollar denominated deposit at another. This was how banking worked in the United States until the 1860s, when Congress passed the National Bank Act. It regulated banks on the asset side of their balance sheets, while simultaneously requiring nationally chartered banks to accept each other's notes at par value. Imagine if Wells Fargo dollars were not worth the same as Capital One dollars.  That was the reality of free banking and it's the current state of affairs on Ripple. 

At first, I was intrigued by Ripple. (I even applied for a job there, one I am now very unlikely to get!) It claims to be a real time payments system which uses actually currencies.  Then I realized it was essentially a resurrection of a deeply flawed system which has rightly been relegated to the dustbin of history. 

Government guarantees are one way to address counter-party risk. Collateral is another. Bitshares attempts to use the latter to solve the counter party risk issue. In theory, so long as one's collateral is good enough, any debt could be considered safe. I might willingly lend a homeless man one million dollars if he pledges 1.2 million in Treasurys. This means that unlike on Ripple, any user can issue liabilities on the Bitshares network.  But unlike shadow banking system, the form of collateral is not US Treasurys or Agencies, but BTS, a token native to the Bitshares network.  Current margin rules require 175 percent collateralization. That is, to short one US dollar, one must pledge USD 1.75 BTS equivalent of collateral. This may seem conservative, but consider the extreme volatility realized this year in virtually all crypto currencies. The Bitshares platform pledges to close out positions which don't meet collateral requirements, closing out the least collateralized positions first.  The claim is that this means collateral would be automatically liquidated before default could occur. However, its unclear if the platform could handle a daily swing of say fifty percent in the price of BTS, something which is hardly hypothetical given historical realized volatility in all crypto-currencies including BTS.

Bitshares is just the crypto equivalent of shadow banking. But unlike shadow banking in the real world which uses rock solid collateral (US Treasurys, Agency MBS) combined with over-collateralization, Bitshares relies on shaky collateral which is almost guaranteed to experience high levels of volatility. (Can positions really be closed out fast enough? What happens when a big price decline occurs and BTS liquidity dries up?)  For all its flaws, shadow banking is at least backed by government issued collateral. Bitshares uses untested collateral whose volatility can and will put enormous strain on the platform's systems.  Again, this is not hypothetical. Many currencies brokers went bust when Swiss Franc soared in value after the SNB ended its exchange rate floor for EUR/CHF. The CHF surged in price, liquidity all but evaporated, and lots of big players couldn't close out their clients' short CHF positions fast enough and got caught holding the bag.  One silver lining may be the platform's rather strict margin requirements. But again, given the level of price swings seen in the crypto-space, putting faith in that alone seems foolishly optimistic. 

There's nothing new under the sun. Both Ripple and Bitshares are based on flawed systems. Ripple is free banking 2.0 dressed up with fancy technology. Bitshares is shadow banking based on questionable collateral. Both systems have existed at various points in history and at times have failed spectacularly. Far from being a financial paradigm shift, cryptoland is just a collective of bright eyed neophytes eager to repeat the financial follies of the past. 

    

Commentary: The tax bill is a joke, but so is most punditry on it.

The Senate might pass the tax bill. Whoopee doo. Its a tiny package. The US economy is 18.5 trillion dollars. The tax bill increases the deficit by 1.5 trillion dollars over ten years. That's a tiny amount considering the cumulative GDP of the United States will be close to 200 trillion dollars over that same time period. (202.56 trillion exactly assuming a 2 percent growth rate) So putting 1.5 trillion into the economy ought to increase total GDP over the same period by somewhere around 1.5 trillion dollars. OK. Its a tad more complicated. Fiscal multipliers seen in the wild are usually between 1.2-1.5. So we are looking at a bill that at most ought to increase total GDP over ten years by about 2.25 trillion. That's a little more than one percent cumulatively. And guess what, that's what the rosiest estimates which are serious are predicting. 

Again, whoopee doo. No, the increased debt will not bury our children.(But again, I've debunked the debt nonsense a million times before) No this tiny package won't set off an era of robust growth. Its not a macro economic package at all. It's a Donald Trump ego package. 

A serious macro package would be bigger, and would be targeted like a laser on raising wages. That would attract more people back into the labor force, one of the few macro variables still out of whack from the great recession and definitely something that's holding back growth. Higher wages would also help the Fed get stubbornly low inflation back on target.

This bill might keep the stock market rally going. It's probably worth a couple trillion of increased market cap for America's largest companies, because stock prices are tightly tied to expect future after tax earnings. But this isn't rocket fuel for the economy. Its not even an M80. Its a burned out sparkler on July 5th. 

Commentary: The Bank of England's Mind Boggling Rate Hike

A very quick note on the Bank of England's actions today. (A very busy news day)

The UK's central bank has displayed stunning incompetence. The rate hike today was more or less largely priced in for over a month.  Indeed, the forward curve for Sterling OIS has shifted up markedly. In short, forty-five days ago, the markets were expecting 1-2 rate hikes over the next 12 months. As of yesterday, markets were penciling in about 2-3.  

 

As a result, Gilt yields rose, and the GBP appreciated. 

Today, the Bank of England followed through on its expected rate hike, while inexplicably take future rate hikes off the table. In other words, the bank has issued dovish forward guidance while simultaneously hiking rates. 

So now, the market is pricing in no more hikes. This a much more shallow path for rates than the previous consensus view.  So UK yields have plummeted, with both the 10 and 2 year notes shedding seven basis points.  And Sterling got whacked, down about 1.5 percent against the US dollar. 

Today's move makes no sense whatsoever.  The Bank of England has shifted from a tightening bias to a neutral-easing bias, and the markets have responded exactly how one would expect.  Basic financial theory says that long rates are determined by the expected geometric average of short rates, and the Bank just caused markets shift down their expectation for future UK policy rates. And the same time, the Bank of England said in its statement it was hiking to help control inflation caused by the fall in sterling.  Instead, it managed to tank the GBP and gilt yields. It is not at all clear to me if this was on purpose or not.  It would certainly contradict the tone of the MPC's statement, but at the same time committee members must surely understand basic theories of the term structure.  It makes no sense, I don't get it. I have no idea what the MPC was trying to accomplish.  Maybe I should send my resume to Theresa May.     

Commentary: I'm a Staunch Democrat, and I Think Corporate Taxes Should be Zero

The very serious people will be aghast to hear it, but today, as in 1946, taxes for revenue are obsolete. The facts speak for themselves.  The US government (as well as national governments in the UK, Japan, Canada and many other nations) has been running a perennial budget deficit for roughly 80 years. Markets happily gobble up new bond issues.  Some have called US Treasurys America's greatest export. 

With the removal of the link between gold and the dollar in various steps between 1933 and 1971, the last vestiges of the old system are gone.  When domestic currency is linked to gold or any other commodity, financing the government with domestic currency issues will inevitably destroy the monetary standard.  In order to run deficits without compromising its own gold standard, the government must issue bonds which are only convertible to gold upon maturity.  

Under the fiat money system which exists in nearly all the advanced economies today, no such constraint exists. A government could theoretically issue no bonds under a free floating fiat money system. Inflation is supposedly the reason why governments must issue bonds.  "Printing money" would caused runaway inflation.  People like to bring up Germany in the 1920s, or Argentina and Zimbabwe today.  However, with modern finance, I contend that deficits financed with money printing are only marginally more inflationary that deficits financed with bond issues. 

Fundamentally, inflation is caused by an increase in nominal spending relative to the economy's capacity to produce.  That spending can come from anywhere.  It can come from the government or private sector. In general, two policy levers exist to affect economy wide spending. The budget balance and interest rates. Government spending directly raises economy wide spending. When the government finances some of its spending via debt rather than taxation, its spending not only increases economy wide spending, but it increases the net worth of the private sector. This leads to higher private sector spending as well.   This has been called many things, the Keynesian multiplier, or a "wealth effect."

Some mistakenly believe that the funds used to purchase government bonds cannot be used to command real resources. Thus, bondholders forgo consumption until the bonds mature. Or in other worlds, the US Treasury cannot sell $10 billion in T-Bills until somebody has saved $10 billion dollars. Thinking along these lines, it is reasonable to conclude that bond financed deficits are not inflationary, because any government borrowing necessarily reduces private sector spending by a corresponding amount. Unfortunately, this is simply not how modern bond markets work. 

Bond markets have come to be dominated by large financial institutions who themselves issue short term liabilities to fund their activities. These firms arose largely because of the desire of some investors to hold ultra-safe short term instruments. In effect, some firms borrow funds on the wholesale funding market, and purchase government securities which are then pledged as collateral. Thus, any increase in the supply of government debt necessarily increases the demand for reserve balances, which the Fed must accommodate or allow short term interest rates to rise.   (Eg, abandon its target for the Fed Funds rate)

Thus, the notion that savings is required for bond issuing is of a bygone era. Because the Fed (or any central bank) takes a fundamentally passive role in supplying reserve balances, the ability of the financial sector to engage in maturity transformation in the bond markets is never reserve constrained. This closely parallels the reality that bank lending is also never reserve constrained either. 

Via a complex chain of intermediaries, government bond issues create reserve balances. The same balances which would have been created if the government had just printed money. So what's the point of bonds anyway? While investment banks are not limited in their capacity to engage in maturity transformation by the quantity of reserves they hold, they are constrained by their ability to take interest rate risk. Because it's inherently risky to borrow short and lend long, investment banks face margin requirements when they pledge their securities. All else being equal, an increase in the supply of longer dated securities increases term premiums. Therefore, government bonds are really instruments of monetary policy, not fiscal policy per se.  

Why did 'money printing' cause runaway inflation in Germany but not the USA or Japan? It all has to do with scale. From 1920-23, the German government was running deficits of close to 60 percent of GDP. The US deficit peak at around 10 percent of GDP in 2009. Japanese deficits have hovered around six percent of GDP in recent years. In both Japan and the US, large deficits came at a time when the economy was running well below peak capacity. By contrast, Germany's industrial base had been ravaged by the war. In other words, German deficits sent spending through the roof at a time when the economy was struggling to produce.

Since the 2008 financial crisis, and even before, a rich literature has developed as to whether its desirable to use the supply of government debt to control longer term interest rates, or if central banks should just be more transparent with their forecasts of the path of short term rates. The very existence of this debate lends credence to the idea that the management of the supply of long term government debt is crucial to the conductance of monetary policy

Finally, this has been known by central bankers for decades, but the cat was finally let out of the bag after the Great Financial Crisis and the implementation of QE.  Ben Bernanke himself stated on numerous occasions that QE operates by changing the mix of assets available to private investors, and ultimately lowers longer term interest rates by making bonds scarcer. There was never the expectation that the reserve balances created would by QE would be 'lent out.' If that were the case, QE would have caused hyper-inflation. Again, bank lending is price constrained, not reserve constrained.

But what are taxes for? If the Federal government finances itself by creating reserve balances, why tax at all?  The answer is to control inflation and to influence economic incentives faced by firms. On the inflation front, the price level is determined by the level of autonomous spending, the government's budget balance, the interest rate/credit policies, and the economy's capacity to produce. Taxes are therefore a key policy lever to target the price level, along with interest rates. This is because any deficit spending, financed with bonds or money printing, adds to the stock of money.  Interest rates influence the rate of private sector credit creation, which also is a key determinant of the price level. Again, the sole purpose of government bonds is to take advantage of capital market frictions which result in the supply of long term debt's ability to influence longer term yields. (Which again is what QE was all about.)

Given the above, we can postulate some first principles for tax design and fiscal policy, namely: 

1. The budget deficit should be set solely with regard to achieving price stability and full employment. Budget outcomes (eg, achieving a 'balanced budget') are never ends into themselves.  Doing so is akin to judging the success or failure of monetary policy on the level of the Fed Funds Rate, rather than the achievement of the objectives of full employment and price stability.    

2.Thus, revenue is never and should never be the primary concern  

3.The distortions should be minimized unless purpose of the tax is penalize a specific activity. (Tobacco Consumption, Carbon Emissions, Puppy Kicking, ect.)

4. Like Beardsley Ruml stated, it may be desirable to use taxes to change the distribution of income within an economy.  However, this should be done sparingly. 

So where does this leave us on the corporate tax?  Fundamentally, corporations are money transfer machines. They take in money from customers, and then transfer it to various stakeholders such as workers, investors, and vendor firms. From the principles above we can conclude that: 

1. We are close to full employment, and there's no evidence of inflation. A neutral fiscal policy is called for. We shouldn't increase or decrease the deficit now. 

2. The revenue raised by corporate taxes is quite small in terms of total receipts. In FY 2015 corporate tax collections were only $344 B, compared to 1.54 T and 1.06 T for indindividual income and payroll taxes respectively.   

3. The corporation is a useful piece of social technology which helps people to organize themselves into productive economic units. There is no reason to penalize corporations specifically. (It would not be desirable for all corporations to become sole proprietorships)  

4. Finally, any corporate tax collection by definition reduces the income of corporate stakeholders, (either shareholders get lower payouts or workers get lower salaries) thereby reducing tax revenues on the individual side of the tax code. 

One fair argument may be that the corporate income tax discourages firms from accruing large amounts of cash on their balance sheets. Both theory and practice discredit this idea. 

First, the existing corporate tax has not stopped US corporations from accruing over 2 trillion dollars of cash, much of it in overseas tax shelters. 

Secondly, if the corporate tax were eliminated and all income derived from corporations (shareholder payouts and wages) were taxed at normal individual rates, the accrual of cash would only defer the tax liability of company stakeholders, but would not increase after tax income. For what its worth, the same is true for 401K accounts.  The tax deferral is only useful because most people are in a lower tax bracket when they draw on their accounts than when they are working. 

Finally, the advantages of allowing firms to accrue cash without tax would:

1. Eliminate tax competition and end the economically wasteful practice of committing real resources to tax avoidance schemes. 

2. Make it easy for firms to finance themselves with retained earnings and build stronger equity cushions. Congress is rightfully concerned that under the current tax system, equity financing is penalized while debt is encouraged. This is not only because dividends are not tax deductible while interest payments are, but also because retained earnings get whacked by a 35 percent tax!

In the end, any corporate tax just reduces shareholder or worker incomes. Revenue is not a primary concern, but it could be easily made up by taxing all corporate payouts at applicable marginal rates. The corporation itself is not an undesirable legal structure, so it makes no sense to tax corporate income before it is paid to stakeholders. The answer is clear. Cut corporate taxes to zero.