By Barb Shegog and Ted Howard, with additional reporting by Craig Martin
A look ahead to some of the top issues as 2018 gets underway; they’ll sound familiar.
“Tomorrow was created yesterday, and by the day before yesterday, too,” goes the quote. And while this can said of any year, it seems truer than ever that 2018 was surely created by last year and the year before. Tax reform impact, the yield curve, and FX volatility and Brexit are just a few of the items that will feature in the new year that were products of last year and the year before.
One of the larger issues wrapped inside the coming tax reform bill is repatriation. Currently, a sizeable number of NeuGroup members, many with a lot of cash parked overseas, are sitting on the sidelines waiting for news regarding repatriation before making future investment decisions.
But the wait might not be too long as Congress seemingly is on the cusp of finally getting a tax deal done. Although the world is hearing more about tax reform today, the current legislation being negotiated was first released by the House GOP as a “Blueprint” in June of 2016, and then used by the GOP as a campaign document.
The bill has taken the proverbial long and winding road with the House finally passing a bill in November of 2017 followed by the Senate in December of 2017. Now it is being tossed back and forth in conference negotiations and pressure is mounting to get something done by the holiday recess.
What’s the GOP Trying to Achieve?
Every 25 years there tends to be a tax overhaul, according to a panel on a recent webinar jointly hosted by the NeuGroup and Franklin Templeton Investments. The last major tax legislation was in 1986. At that point, the corporate tax rate was at 46%, which was then lowered to 34% to make the US more competitive globally.
Over the years other countries have reduced their corporate tax rate, leaving the US with one of the highest marginal rates of all developed countries. Thus the real driver for the current tax reform is bringing the US in line with the international tax system. Reform’s broader objectives include boosting economic growth, US MNC competitiveness, and preventing corporate tax base erosion through inversions and other tax avoidance schemes. To accomplish these objectives the legislation will cut the corporate (and pass-through business) tax rate, enact international tax reform and add domestic investment incentives. All of this will have to fit within budget parameters so legislators are going to have to find revenue offsets.
Fixed Income and Rates
Tax reform and tax cuts combined with increased deregulation should provide cyclical and sector stimulation to the economy.
Franklin Templeton’s Michael Materasso noted on the webinar that the US economy “remains healthy and stable, and … is not by itself in above-trend growth; we are currently experiencing global cyclical growth.” Currently market conditions do not warrant a big move higher in short-term rates, he said, adding that investors are now witnessing a Goldilocks’ economy. The past two quarters’ growth has been above trend and next quarter growth could be over 3%. The economy is currently at full employment at a 4.1% unemployment rate and could possibly dip to 3.5%.
Meanwhile the Federal Reserve reinforced at its last 2017 meeting (where it raised rates) a continued gradual approach to monetary policy, with three rate hikes in store for 2018. The big question for investors is what does all this mean for fed funds? If one believes the Fed “Dot Plot” chart, the median for fed fund rates in 2020 would be roughly 2.75 percent; and there is a bit of a disconnect between the market and the Fed’s view on fed fund futures. However, the 2-year appears to be priced correctly.
One risk to this assessment is inflation is showing some signs of bottoming with the core PCE and core CPI showing signs of an uptick. The yield curve will continue to flatten and “if you are comfortable with a 2¾ to 3% terminal rate of fed funds, then it is quite possible the treasury yield should pick below that.” This would result in rates not moving significantly higher.
Mr. Materasso said there is “nothing cheap in the credit market.” Despite credit spreads being at all-time highs, “the 1–5-year credit spreads should remain narrow.” Based on their economic and interest rate outlook as well as past cycles, spreads can remain at relatively narrow levels for an extended period of time. The sector should be owned more for carry than total return.
One attractive investment area noted by Franklin Templeton is the shorter maturity TIPS. Mr. Materasso said that despite his firm’s fairly benign outlook on inflation, Treasury Inflation Protected Securities or TIPS, could cheapen in 2018 and offer opportunity.
Meanwhile, the flattening 2–10-year yield curve in 2017 could continue, with some wondering if that will push the US into recession. The curve has flattened from about 135 basis points at the start of the year to 57 basis points currently. The flattening was primarily the result of the 2-year yield rising, driven in greater measure by Fed tightening, and a 10-year yield that is little changed, says Brown Brothers Harriman. Also importantly, the bank notes, while the Fed acknowledged that the resulting fiscal stimulus may boost short-term growth, “it does not appear to be the ‘economic miracle’ that will boost growth potential, or trend growth.”
“It’s worth noting that the flattening yield curve has had a tremendous impact on the cost of longer-term funding as most companies have skewed significantly to fixed rate debt (either via bond markets or swaps on term loan debt),” said Amol Dhargalkar, Managing Director, Global Corporates Sector at Chatham Financial. “Is there such a thing as too much fixed rate debt? And for those looking to issue fixed rate debt, the cost of forward hedging has never been cheaper due to the flat yield curve—consider this proactive strategy especially for large issuances.”
Brexit and FX
Brexit will also be a feature of the new year; treasurers will need to make certain their hedge strategies and policies are up to date. The constructs of Brexit are now taking shape and will have a big impact on the pound and the FX markets overall. How fast the ECB exits its quantitative easing program versus how fast the Fed raises rates in the US will also have quite an effect on the euro-dollar exchange rate. The ECB recently announced that its asset purchases would be halved starting in January to 30bln euros a month through September 2018.
“Not only is there the potential for increased volatility from major currencies like GBP and EUR, but also we’ve been on a run of dollar weakening for much of the past year,” says Mr. Dhargalkar. “What happens when that turns around, as it always does? Volatility when currencies move sideways isn’t necessarily troublesome for treasurers—it’s when your reporting currency makes big, persistent moves in a single direction that really can be painful.”
Terms of Repatriation
Under the terms of the new tax law and regardless of whether they actually do repatriate cash, MNCs will owe a 15.5% tax on unremitted foreign earnings held as cash and cash equivalents and an 8% tax on foreign earnings backed by other assets. According to Morgan Stanley research, this can result in “an implied tax rate above 15.5% for the liquid earnings that firms can actually bring back to the US.” The taxes are payable over an 8-year period. This means only the first tax payment would be due immediately whereas firms could repatriate all their foreign cash immediately.
All the Other Pieces
There are many other issues that could steal the show in 2018. Cryptocurrencies are gathering momentum and adherents as the new year dawns. Bitcoin is nearing $18,000, and there is belief that central banks will launch their own distributed ledger-based currencies in 2018.
Regulations will continue to be slashed, with President Trump on an ambitious plan to pare federal regs down to 1960s levels. That means going from currently close to 185,000 pages of federal regs to about 20,000 pages. And while the big reg for finance, Dodd-Frank hasn’t been and likely will not be repealed outright; a Republican-led Congress will continue to repeal pieces of it.
Cyber crime is expected to keep getting worse. Most members of the NeuGroup peer group universe think so, but most feel they have adequate safeguards in place. However, what most are lacking are third-party suppliers. For many this will be the focus in 2018.
Another growing area to watch for in the new year is robotic process automation. While many are skeptical of its application at the moment, or more accurately, skeptical of the ROI, that won’t last forever. RPA is already at low-level repetitive tasks; in 2018 this will likely pick up as artificial intelligence starts to creep further into the mix.
Activism and money market funds will also feature in the new year, although both of these have been brewing for a while. There’s money in activism and money is coming back to prime institutional money funds.