At the following link readers may download a PDF file of the May 15th Joint Committee on Taxation analysis of federal receipts attributable to the latest stimulus bill passed by the House: https://www.jct.gov/publications.html?func=startdown&id=5260.
The pressure for the Senate to act is growing daily and will only intensify. We expect something to come in the way of a new stimulus package. We think of it as $1 trillion low (the Republican bid) and $3 trillion high (the Democrat ask). Neither political party can be seen as “We won’t spend any more to help those who are in dire straits” politicians. Stay tuned. We believe the final tally for this one ends up closer to $3 trillion than to $1 trillion.
Note that the national balance sheet of the United States allows us to finance these multi-trillion-dollar deficits. We cannot do that forever, but we can do it in 2020, because we are in severe recession with nearly 40 million unemployed or furloughed and national GDP shrinking at double digits. As a result, consumption demand has collapsed, and non-government-related borrowing is down.
We shall see what “opening up” versus COVID-19 resurgence reveals in the national economy. As this is written the number of states with an R factor above 1 is rising which means virus contagion is expanding in those states. Worsening contagion is visible in other states where a fractional R factor is approaching 1. Please remember that zero is best and above 1 is increasing danger for every person in the jurisdiction.
Meanwhile, the Federal Reserve is “all in” assisting the country, as it should be.
Side note: The Fed Board of Governors and the Regional Bank presidents and especially Chairman Jay Powell deserve the highest marks for doing their patriotic duty in conceiving and carrying out the necessary programs during this time of extreme national duress. That is my opinion. Others may disagree, and I would refer them to the WW2 model.
The Fed has more work to do. It has to reach sectors like nonprofits (they’re working on it) and go deeper into the muni space (they’re working on it). In addition, I expect the Fed to soon get to yield curve control and management so as to stabilize the forward rates in all maturities of the US Treasury securities term structure, just as it did in WW2. This is a critical next step.
When the Fed does that, it will also help stabilize the international financial system, as the total of, cross-currency, and interest rate swap, notional derivatives is now over $700 trillion and growing. The US dollar is the lynchpin for all this international financial response. And the Fed holds the power and prestige to sustain the dollar’s global role.
The Fed will avoid the trap of negative interest rates, as it should do. Negative rates are the stage 4 cancer of finance. They metastasize, developing financial tumors that worsen, and they are not easily defeated. They create finance under a failing and deflationary penalty system instead of an incentive system. Today, we continue to witness the damage from negative rates in the European and Japanese currencies. Europe cannot extract itself and has limited resilience to handle the COVID-19 shock.
At Cumberland, we have updated our five-currency comparison of negative rates and yield curves. We will send it to anyone who asks. Just email me.
My Cumberland colleague Andrew Crawford has raised the tax issue during our Cumberland morning strategy calls. He is correct to look “down the road” at what is coming. So we have developed a few bullets to summarize our thinking about taxes.
We believe that 2020 will see the lowest aggregate taxation in the US for decades. The changes in the law have already lowered many forms of taxation. They range from deferrals to lower excise taxes to changes in net operating loss carry-back to alteration in required minimum distributions, along with lots of other forms of tax relief.
Tax cuts are not just about the marginal rate. Here’s an example that may be obscure for many. I can make a section 7520 loan to my family heirs. The rate for a 20-year loan is a little over 1%; the rate is under 1% for shorter terms. The family member who borrows doesn’t have to pay back principal; just interest is required. The money can be invested by my family member, who gets to keep the benefit from the investment. The result is a transfer of value from me to my heirs without taxation until my death. Readers: Do NOT do this without advice from your accountants and tax specialists.
So what does this example mean for strategic thinking about asset classes?
Clearly, the smart investor wants to be in front of the wave of tax-sensitive strategies that are likely to be rapidly evolving. And the investor wants to be deployed in the sectors that have liquidity support from the Fed and have price discovery in functioning markets. Avoid the dysfunctional market sectors unless you are a gambler. And avoid complex or opaque or merely translucent structures unless you are certain that you truly understand the risk.
We expect tax rates in the United States to be raised in the future. The deficit structures currently evolving are not permanently sustainable. They are temporary and needed because of the COVID-19 crisis. But they cannot last indefinitely.
Political fights over taxation are in our future, and the shape of higher taxation will evolve out of this year’s and the 2022 and 2024 election cycles. It is difficult to conceive of any path that takes tax rates lower than they are now in 2020 calendar year.
Today the highest-grade, AAA-rated, tax-free sovereign state bond is sometimes paying more than 100 basis points over its equivalent longer-term US Treasury counterpart. In the US we don’t examine the total “public sector borrowing requirement”, as is done elsewhere in the world. Thus the $4 trillion state and local government bond market has about 90,000 distinct issuers of all sizes and types. It is a fragmented market, which is why it can offer huge incentives and opportunities to those who understand it.
Today the range of investment-grade longer-term munis runs from about 2.5% yield on the highest credit end to about 5% on the lowest side of the investment grade scale. We would not touch the below investment grade, junk-level credits. It is very important to understand that the Federal Reserve is focused on keeping investment-grade markets functional. The Fed is using a pre-COVID-19 investment-grade framework that includes BBB or Baa ratings or higher.
But we do not expect the Fed to bail out market agents or market segments that were composed of junk credits before the crisis hit. That is not their job.
In our view the deployment of money in the tax-free sector is a huge bargain for investors who agree with our outlook. If you think taxes will go lower, then the case for use of a tax-free instrument is weakened. But if you think that tax rates will be higher in the future, then any current tax-free bond yield will only be even more attractive when the tax hikes occur. And history shows that any time you could buy a very high-grade tax-free instrument at a yield higher than its taxable counterpart, that was a good time to buy it and not to sell it. No one expects the tax code to be repealed.
In sum, taxes will probably go up in the future and may go up a lot. Politics will determine how much and when. Federal deficits will be huge in 2020 and 2021, but they are not sustainable indefinitely. The Fed will accommodate financial needs in the investment grades by keeping markets functioning. The Fed will not bail out junk.
Please note that this prognosis is our opinion and that nothing in the future is guaranteed. If you were Rip Van Winkle and had fallen asleep on Halloween last year, only to wake up and look around today, you would see rampant disease and death and think you were still asleep and having a nightmare. If you looked at the bond market, you would conclude that we were in a severe recession. We are. If you looked at the stock market, on the other hand, you might think nothing had happened. But it has. And if you looked at the spread between tax-free and taxable investment-grade government bonds, you would think there was a misprint, because the higher scale of tax-free makes no sense unless the tax code is going to be repealed. It won’t be.
Thank you to Andrew Crawford, who raised these matters in our discussions.
Again, to readers, email me if you want the historical charts on negative interest rates versus the US dollar.
David R. Kotok
Chairman of the Board & Chief Investment Officer
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