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Observation Deck: A rocky ride to tax reform

 |  November 02, 2017

SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.

A rocky ride to tax reform

Daeyoung Choi, CFA, Credit Research Analyst

After months of speculation and behind-the-scenes negotiations, the White House finally unveiled a general framework for its long-touted tax reform. Negotiated by the so-called Big Six Republicans—Treasury Secretary Steven Mnuchin, Director of National Economic Council Gary Cohn, House Speaker Paul Ryan, House Ways and Means Committee Chairman Kevin Brady, Senate Majority Leader Mitch McConnell, and Senate Finance Committee Chairman Orrin Hatch—the plan incorporates many elements previously floated. These include:

For Individuals

  • Reduction of the number of tax brackets from seven to three
  • Reduction of top tax rate from 39.6 percent to 35 percent
  • Elimination of most itemized deductions (except for mortgage interest and charitable contributions), while doubling the standard deduction from $6,000 to $12,000
  • Repeal of alternative minimum tax and estate tax

For Corporations

  • Reduction of corporate tax rate from 35 percent to 20 percent (25 percent for small businesses)
  • Immediate expensing of certain capital investments
  • Limitation on interest expense deduction
  • Territorial taxation of U.S.-based multinational companies, including a repatriation holiday of overseas cash

The Republicans in Congress are hoping to have a bill by year-end. As with most plans whose broad frameworks involve cutting rates while eliminating special interest tax breaks, the key imperative for a successful legislative outcome will be the negotiations with these various interest groups. Lobbying efforts are likely to be intense, especially since the current preliminary plan is vague and lacks details. Already there has been a back-and-forth between the congressional leaders and the president on reducing the maximum contribution allowed to 401(k) retirement plans. This will be fiercely opposed by both AARP and the financial industry, and while the ultimate fate of this proposal is unknown, it serves as an emblem of what is likely to come.

Given the overwhelming sense of urgency for a significant legislative achievement, we expect that tax reform will pass in some form. But if many of these proposed elements make their way into the final bill, what will be the consequences for corporate America? Surely the lowered corporate tax rate would help, as will the full deductibility of capital investments, though the actual extent will depend on the details.

New rules that would eliminate the tax burden on repatriated overseas earnings will be a positive. Limiting the deduction of interest expenses will hurt some companies, especially those in the high-yield space, but for most investment-grade companies (still enjoying historically low borrowing costs) and banks (widely assumed to retain the ability to net interest expense against interest income) the negative impact will be muted. In addition, lower tax rates and the elimination of estate and alternative minimum taxes could stimulate spending to provide a near-term boost to the economy.

These potential benefits notwithstanding, there is no question that the tax plan as proposed will reduce the total tax revenue for the federal government. Without a clear plan to reduce fiscal spending proportionately, it likely will worsen the budget deficit and long-term debt problem. Republicans are banking on the stimulative effects of tax cuts to offset some lower projected revenues, though not everyone is convinced this is the best way forward. So the road to tax reform will be rocky and contentious. We continue to watch closely to see how it impacts various industries and the broader markets.

Markets
Treasury Rates  
 
Total Returns:  
3-Month 1.13%
 
ML 3-Month Treasury 0.09%
6-Month 1.28%
 
ML 6-Month Treasury 0.09%
1-Year 1.42%
 
ML 12-Month Treasury 0.03%
2-Year 1.60%
 
S&P 500 2.33%
3-Year 1.73%
 
Nasdaq 3.62%
5-Year 2.02%
 

 

 
7-Year 2.23%
 

 

 
10-Year 2.38%
 

 

 

Source: Bloomberg, Silicon Valley Bank as of 10/31/17 

Credit Vista: Simply the best…

Tim Lee, CFA, Senior Credit Risk & Research Officer

With all due respect to Tina Turner, when it comes to corporate credit, simply the best isn’t always better than the rest. Consider the current environment where corporate credit is poised to end 2017 with the highest rated industrial companies exhibiting weaker leverage metrics among those rated A3 or better by Moody’s Investor Service. Low interest rates and favorable credit conditions over the past five years have made it inexpensive to add debt, particularly to help juice equity returns in a subpar growth environment. Moody’s data compiled by SVB Asset Management reveals that, on average, EBITDA has marginally declined from 2011 through the first half of 2017 for this group of industrials rated A3 or better. At the same time, the average net debt carried by this group rose by 65 percent. The resulting average net leverage rose by a relatively modest 0.3 turns. However, the leverage degradation was more pronounced for companies with better ratings.

At the top of credit rating food chain, industrial companies holding the top two quality ratings, Aaa and Aa1, went from a positive net cash position in 2011 to now having an average net leverage of 1.2x. Industrials with the third best rating, Aa2, had a less dramatic jump of 0.6 turns, while industrials assigned the fifth best rating, A1, had a 0.5 turn increase. The most stable creditors were those rated Aa3 and A2, both of which experienced less than a 0.2 turn increase.

As industrials with the top three ratings took full advantage of their creditworthiness to borrow cheaply, they are now positioned with net leverage that is inferior to their lower-rated counterparts. The best positioned industrials on a net leverage basis appear to be in the sweet spot with ratings of Aa3, A1, and A2. While there are many metrics and factors we can use to measure and determine future credit performance, it’s important to remember that the best rating may not tell the full story.

Industrial Leverage Trending Up

Caption: Leverage has moved higher on average for industrial companies rated A3 or better by Moody’s since 2011. The rise has been pronounced in the top three ratings categories.

Economic Vista: Weathering the storm

Steve Johnson, Senior Portfolio Manager

The U.S. economy continued chugging along this fall, seemingly immune from the destructive hurricanes that wreaked havoc throughout the Continental U.S. and Puerto Rico. October data confirmed the positive economic momentum as jobless claims hovered near historic lows, consumer sentiment was high, and general economic activity remained robust. This was evidenced by multi-year highs on ISM manufacturing and non-manufacturing indices, and elevated new home sales. Hiring, however, hit an air pocket as September non-farm payrolls declined by 33,000, which was worse than expected and a stark reversal from the 156,000 of new jobs created during the prior month. This was the first negative print in seven years, though it was distorted by the recent hurricanes as an estimated 1.5 million workers were displaced during September. On the positive side, the unemployment rate ticked down to 4.2 percent despite a healthy 0.2 percent rise in the participation rate to 63.1 percent, the highest reading since March 2014. Jobless claims remained below the 300,000 mark throughout October and continued to suggest underlying strength in the overall job market despite the weather—related disruptions.

Wage gains were another welcome sign as average hourly earnings rose 0.5 percent in September, bringing the year-over-year increase to 2.9 percent. It is important to note, however, that this data was skewed by some lower-paying sectors that were affected by the hurricanes, shifting the mix of wage gains towards higher paying industries. This trend may only be temporary and could reverse in the coming months.

Inflation remained soft as core PCE, the Fed’s preferred measure of inflation, remained well below the central bank’s two percent goal, coming in at 0.1 percent month-over-month, good for a 1.3 percent year-over-year rate. The lack of pricing appreciation continues to remain top of mind for Federal Open Market Committee (FOMC) members as a tightening labor market has yet to induce target-level inflation.

In terms of overall growth, the first reading of third quarter GDP came in at three percent versus expectations of 2.6 percent. This is less than the 3.1 percent recorded during the second quarter but ahead of the first quarter’s lackluster 1.2 percent rate of growth. Similarly, consumer sentiment surged in October, with the University of Michigan consumer sentiment index rising to 100.7. This is the highest level since the start of 2004. The October gain occurred among all age and income subgroups and across all partisan viewpoints.

In addition to the mostly positive economic data, we continue monitoring the Fed’s actions and comments for unwinding its balance sheet. In October, the Fed allowed $6 billion in Treasuries and $4 billion in mortgage-backed securities to mature, rather than reinvesting the proceeds. This was widely expected, and markets digested the beginning of the Fed’s balance sheet wind-down without incident as the Fed has communicated its intentions in advance so as to avoid any disruption to U.S. fixed income markets.

Trading Vista: Risk on

Hiroshi Ikemoto, Fixed Income Trader

The Fed completed its first scheduled runoff of Treasuries from its balance sheet in October, where they allowed the first tranche of a total of $6 billion of holdings to mature without reinvesting the proceeds. This action, along with an approximate 83 percent chance of a rate hike during the December FOMC meeting, has put downward price pressure on Treasury securities across the curve. The benchmark 2-year Treasury note yielded above 1.6 percent, the highest level since October 2008, while the 10-year note is now hovering near 2.4 percent.

Even with this backup, we are still seeing strong demand for corporate debt in the short-end with spreads continuing to compress against their benchmarks. With healthy earning thus far in the banking sector, high-quality financials are leading performance with spreads tightening into single-digit basis points on bonds maturing inside of 18 months. The same can be said for commercial paper where discount rates are on par with the likes of maturing LIBOR rates.

Even with the very strong likelihood of a rate hike in December, we are not seeing dealers pricing in and repositioning ahead of this move. For now, demand for high-quality bonds remains strong with supply relatively constrained. As a result, we continue to invest throughout the curve, buying shorter bonds for their attractive yields and keeping reinvestment opportunities open, while buying longer bonds to maintain duration.



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The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.

SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. 

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