• "Kee Points" with Jim Kee, Ph.D.

    US market indices are at all-time highs in anticipation of tax and regulatory reform. Corporate income taxes and regulations affect the current and future earnings or cash flows (earnings after accounting distortions are removed) of companies, while investor taxes (i.e. dividends and capital gains) affect how much investors are willing to pay for those cash flows. With respect to the first part of this statement, taxes and regulatory compliance costs are expenses, so reducing them results in a direct increase in cash flows. As for investor taxes, it is helpful to consider that investors discount these cash flows. Future dollars aren’t worth as much as current dollars, so they are discounted. The rate at which they are discounted is sometimes referred to as investors’ required rate of return. This required rate of return encompasses the fact that investors want to be compensated for (1) the taxes they will have to pay, which are primarily dividend and/or capital gains taxes, (2) inflation (if they are paid back in dollars that are worth less, they will require more of them), and (3) risk. With President Trump elected with a platform of lower corporate taxes and less regulation, and a Republican congress making that more likely, it makes sense that investors would bid up stock prices in anticipation of lower corporate taxes and less regulation. And since markets were probably expecting Hillary Clinton to win, and Clinton’s platform contained slightly higher investor taxes (dividend and capital gains), it makes sense that the market would be re-pricing that (i.e. incorporating lower dividend/capital gains taxes) as well.

    There are risks out there, which the market sees as well as you and I, but right now it looks like the market is not weighing those risk too heavily. Another way of saying that is that right now the markets aren’t expecting (and pricing) that the risks will disrupt production and exchange, upon which wealth creation depends. Chief among these risks, I would say, include (1) the risk of a global trade war, (2) the risks of further disunity in Europe (i.e. French presidential elections in April, Brexit fallout, resurgent debt problems, etc.), (3) the risks of increased belligerence from countries such as North Korea and Iran (as accurately predicted by former US Secretary of State Condoleezza Rice here in San Antonio a few months ago). I think a lot of people would put the potential for impetuous actions on the part of President Trump as a fourth risk.

    Market Update Questions: Answers to Specific Questions From Our Clients

    Each year we give market updates in San Antonio, Austin, Houston, and Corpus Christi, and we take as many written questions as we can to answer for the audience at the end. Here’s a few that I thought might be of interest to Kee Points readers:

    What about the economy keeps you up at night? To be honest, tax and regulatory ambiguity are highest on my list, because I think the best way to achieve a dynamic and innovative economic environment is through a relatively clear and stable tax and regulatory environment. External “shocks” are always a concern (North Korea/Russia/Iran events, China economic/financial shocks, European election/debt events), but overall I think economies can deal with those uncertainties if policy (tax and regulatory) uncertainty isn’t thrown into the mix. That doesn’t mean we won’t have recessions, which are caused by unforeseen shocks, it just means that recessions shouldn’t turn into prolonged depressions if policy “churning” is limited. And prolonged depression is what would keep me up at night.

    What will be the economic impact on Texas with border wall construction? I would say it will be similar to any other large public works project, i.e. a positive for the state/region where the project takes place, negative (or at the expense of) for the other states paying for it. So I look at it as a zero-sum affair in which Texas gains what the other 49 states lose in payments. Economic benefits would likely be highest for border towns and materials/engineering firms in Texas in general and south Texas in particular. Like most public spending projects, I think the impact will be positive but transient. That’s over-simplifying a bit, as there are positive and negative spillover effects (the negatives of reduced cross-border flow of goods and services, but also the positive of perhaps more property rights security, etc.), but that’s how I look at it.

    How long after implementation will it take for trade protection to be felt in the system? Think about it like this: prices lead quantities. All trade restrictions have winners and losers, so I expect the winners (companies that compete with imports) will see stock price movements fairly quickly, as will losers (i.e. companies that source goods and services from overseas). But it really depends upon what legislation is actually passed and implemented, and that should take a while. As for the impact on the actual flow of goods and services (i.e. quantities), that depends upon markets (i.e. supply and demand responsiveness or “elasticities”) in the sectors affected. Sometimes companies can pass on higher import prices to customers; other times they can negotiate with foreign sellers who push the burden backward to their own workers and suppliers through lower wages/prices. Believe it or not, economists don’t know this in advance…it reveals itself over time, sometimes over a year or two depending upon the nature of the industry (i.e. the amount of fixed costs, asset specificity and mobility…things that take as too far afield!).

    Are you expecting higher inflation in the future? As far as inflation goes, the concern is that, as the economy expands, the excess reserves in the banking system (created “out of thin air” through the fed’s asset purchase or quantitative easing programs) will get loaned out too quickly. That is, the money supply will expand because each dollar loaned out increases the money supply by a multiple of that dollar due to the nature of fractional reserve banking (you borrow $100 to purchase something, the seller deposits that $100 in her bank, which then holds some on reserve and loans the rest out, say $90, to someone else who then buys something else, the seller of which deposits that into his bank, which holds some on reserve and loans the rest out, etc.). So whether or not we get too much inflation (above 2 or 3 percent core inflation for a sustained period) depends upon the ability of the Federal Reserve to control or hold in place those excess reserves (which are held on account at the fed). Ben Bernanke asked Congress for and received in 2008 the ability for the Federal Reserve to pay interest on bank reserves held at the fed for just that reason, i.e. so the fed could control the excess reserves and the rate at which they are loaned out. Specifically, banks won’t loan out excess reserves if they can receive the same interest payments risk-free from the fed. That’s a degree of control over the money supply that the fed didn’t always have, and that’s why I have above-average confidence that the fed can keep inflation from breaking out in a damaging way. However, it is true that we have never been in a situation quite like this (with $trillions in excess reserves due to asset purchases), so no one can say that they know for sure what the outcome will be. But my confidence is supported by experience thus far - inflation has been below target for 8 years, and many economists had forecasted hyperinflation during that period which never materialized. They didn’t get the “interest on reserves” part.

    What about the national debt? I think the better research (including research I was involved with in the 1990s) indicates that government debt itself is a poor predictor of economic performance. It is the incentives in the economy that matter the most. That’s why you’ve had countries in trouble and debt default with varying debt burdens. Demographics will push our unfunded liabilities (debt burden) up substantially in 5 years or so due to Medicaid and Social Security obligations. But I expect that it will be worked out through things like means testing, (the more you have the less you get, regardless of how much you have paid in), alternative inflation adjustment mechanisms for future obligations, and adjustments to age and other eligibility requirements.

  • "Kee Points" with Jim Kee, Ph.D.

    According to the Bureau of Labor Statistics, 227,000 jobs were created in the month of January 2017,which was far better than the 175,000 new jobs expected by consensus surveys. Wage growth (average hourly earnings) was disappointing, which is consistent with a labor market that has more “slack” than you would expect given the 4.8%unemployment rate. As a basic concept, the labor force is defined as the members of the population that are either employed or unemployed but actively seeking employment; people who are neither employed nor seeking employment arenot in the labor force. The story here is that the labor force participation rate — the percentage of the population that is either employed or unemployed —has been declining since 2000, and this decline has been accelerating since the Great Recession. That would lead to a falling unemployment rate (the number of people looking for a job but unable to find one) even with no new job creation. Most economists expect the labor force participation rate to start moving back up as growth and hiring expands and more people re-enter the labor force. That increase in the participation rate could also keep the unemployment rates from moving lower, even if job creation stays strong. This is all based upon a cyclical view of unemployment, by the way. The structural view, in contrast, argues that fundamental transformations in the economy have driven the participation rate down (demographics, skill mismatches, etc.), so it is unlikely to materially rise back up any time soon. There is probably some truth to both the structuralist and cyclicalist views.  

    The jobs number matches the Institute for Supply Management (ISM) Manufacturing and Services Purchasing Managers’ Indices (PMIs) for January, which were also released last week. Both came in very strong (46% and 57.2% respectively),indicating GDP growth in the 3% to 4% range based upon historical relationships. Those estimates have been running a little high during this expansion, and I prefer the Atlanta Federal Reserve’s GDP Now estimate, which is currently measuring 3.4% GDP growth so far (the New York Fed’s model is at2.9%). That would be pretty good for a first quarter, because historically the first quarter of the year is the lowest on average. Stocks have responded positively, punctuated with declines driven by signals of policy uncertainty coming from Washington. 

    Interestingly,the Eurozone economy has also been exceeding expectations, with 14 consecutive quarters of growth, strong sentiment, and unemployment at least down to single digits (Financial Times). And speaking of Europe, European Central Bank President Mario Draghi expressed concerns Monday regarding the Trump administration’s plans to roll back the 2010 Dodd-Frank financial regulations. Nobody really knows what form such deregulation would take (as Draghi pointed out), but I can say that the legislation has far fewer advocates among economists than it did when it was first passed. Jeb Hensarling, chairman of the House Financial Services Committee, recently introduced the Financial CHOICE Act to reform Dodd-Frank. The idea is to increase bank capital, which would decrease the vulnerability of banks to runs that would threaten the entire banking system (“systemic risk”). In a nut-shell, the act would rather cleverly allow banks to voluntarily opt out of or be exempt from a lot of Dodd-Frank regulation by increasing their capital, which can be done by issuing equity shares (which could dilute the shares of existing shareholders) or cutting dividends for a while in order to retain cash and build capital. Economist John Cochrane points out that the cleverness in the act lies in the fact that it could lead to less regulation without entirely repealing and replacing Dodd-Frank: “Would you rather be free to do things as you see fit and not spend all week filling out forms? Then stop whining, issue some equity, or cut dividends for a while.” (Chicago Booth Review). I like any bank regulatory simplification that sounds less divisive than “repeal and replace”!

  • "Kee" Points with Jim Kee, PhD.

    In the US, fourth quarter 2016 GDP growth came in at 1.9%, resulting in 1.6% growth for the full year (Bureau of Economic Analysis). That’s respectable by other developed-market standards (i.e. Europe, Japan) but subpar by normal US standards. Expectations are that there will be stronger US growth in 2017, due mainly to (1) stronger consumer spending (end of deleveraging), (2) stronger government spending (e.g. some increase in infrastructure spending), and (3) stronger business investment spending (less taxes/regulation). Overall expectations are for stronger global growth as well in 2017, with Japan holding steady at low but positive growth and Europe accelerating slightly. Data from the UK continues to hold up better than many economists (like me) expected.

    In China, the world’s second largest economy, I would say the opposite seems likely. Fourth quarter GDP growth numbers in China showed a slight acceleration (6.7%), due largely to temporary stimulus efforts that are expected to phase out by mid-2017. China’s official growth target for 2017 is 6.5%, which is below last year’s 6.5%-7.0% growth target. China has a growing corporate/government debt problem to contend with, and a domestic dearth of consumption relative to income (i.e. high personal savings rate) which makes transitioning to a consumer economy from an export-led economy difficult. It is not surprising to see official growth targets there come down.

    I would be wary of investing in many Chinese companies. A former colleague of mine, Joel Litman of Valens Research (one of the brightest accounting minds I’ve ever met), has calculated the returns-on-investment (ROIs) for over 800 non-financial companies in China (listed on the Hong Kong, Shanghai, and Shenzhen stock exchanges). He found that 70% are generating negative economic profits when measured using the Uniform Adjusted Financial Reporting Standard (which Litman claims has fewer distortions than GAAP or IFRS-International Financial Reporting Standards).

    That has been one of Japan’s problems for over two decades: their companies were able to get access to capital from the government whether they were profitable or not, creating so-called zombie companies that destroy wealth rather than create it. I’ve been watching for that in China for over a decade now, and Litman’s work suggests it may be becoming a reality. Anyway, a trade-war with the US is something I would bet the Chinese will try very hard to avoid. By the way, a conservative view of China should moderate enthusiasm (currently running high) for emerging market investments, which tend to correlate with Chinese growth and with commodity prices (which themselves have correlated with Chinese growth for the past 15 years). Some of that enthusiasm is based upon relative valuation measures (i.e. emerging market stocks look “cheap” relative to other markets), but it may be that they are cheap because of slower expected growth in China.

    And speaking of trade, your guess is as good as mine as to why President Trump engaged Mexican President Enrique Peña Nieto last week in a manner that ensured a deepening rift. With regard to international trade in general, there has been a lot of discussion lately of “border tax adjustments,” which many Republicans favor but which Trump feels are too complicated. The idea of a border tax adjustment is to reduce taxes on exporters and raise taxes on importers - or at least on imported goods that companies here use to make their final products - all of this ostensibly to level the playing field relative to other countries whose international tax systems differ from ours. Legally, it is not clear what form a border tax adjustment could take that would keep the US in compliance with international law (i.e. the World Trade Organization and the General Agreement on Trade and Tariffs that it subsumed). Also, the economic incidence is difficult to determine, as taxing companies on imports from Mexico (or not allowing them to deduct them as a part of their cost-of-goods sold) could cause Mexican firms to pass the tax backwards by paying their workers less (which is why Mexican workers are upset). Or, US firms could pass it forward in the way of higher prices to US customers (in which case we’re paying for The Wall, as the press has noted). And if border taxes cause us to import less globally, then that puts upward pressure on the dollar (fewer dollars supplied globally to buy foreign goods). So does exporting more globally, because of stronger demand for US dollars by foreign buyers. A stronger dollar in turn would negate the negative impact on US importers (because their dollars now buy more) and it would hurt exporters because their goods would cost more in international markets. These points just really scratch the surface, but I hope they illustrate the complexities involved with border-tax adjustments.

    The US’ biggest trading partners, by the way, are Europe, Canada, China, and Mexico, in that order (but they’re all pretty close in dollar volume). For what it’s worth, I would rather, in the words of Canadian economist Reuven Brenner, see the government “get back to basics and negotiate an international agreement to stabilize currencies.” Brenner (following Nobel Laureate Robert Mundell, another Canadian economist) points out that currency fluctuations wreak havoc with contract values, and contracts are the “essence of commercial societies.” Trade agreements, renegotiations, and “updates” (as proposed NAFTA changes are often called) are important, but so are exchange rate policies, which deserve more attention than they are getting at the moment.

  • "Kee" Points with Jim Kee, PhD.

    The Trump Inauguration Speech:

    A big concern among analysts (e.g. Greg Valliere) following President Donald Trump’s inauguration speech was the sense that he intended to follow through on a lot of his agenda, which included trade restrictions. That seems to be the issue that most concerns economists (even among supporters). Many feel that trade restrictions would negate the more positive agenda items like tax and regulatory reform and increases in infrastructure spending.

    Wall Street Journal writer Jude Wanniski popularized the idea back in 1978 that the Smoot-Hawley Tariff of 1930 was a primary cause of the stock market crash of 1929 (the coalition to block it fell apart on the eve of the crash) and of the Great Depression. It was certainly not a good piece of legislation, as exports fell 30% from 1929 to 1933, and imports fell by 40%. But its importance has often been exaggerated. Even free-trader Milton Friedman, when asked if the Smoot-Hawley Tariff caused the Great Depression, argued “No. I think the Smoot-Hawley Tariff was a bad law. I think it did harm. But the Smoot-Hawley Tariff by itself would not have made one-quarter of the labor force unemployed.” As an aside, Robert Mundell’s 1999 Nobel Lecture, “A Reconsideration of the Twentieth Century,” is one of the better discussions of the Great Depression and its causes, and the one I most recommend.

    Trade theory: It doesn’t take a whole lot of training in trade theory to know that unskilled or expensive labor will suffer in a country that opens up trade to countries with a big surplus of unskilled labor or less expensive labor (like Mexico and China). Economists Wolfgang Stolper and Paul Samuelson formalized this in what is known as the “Stolper-Samuelson theorem” in 1941. Less skilled labor (really workers in general) in industries whose goods aren’t traded internationally, like a plumber’s assistant, are less threatened than those in industries whose goods are traded internationally, like autos and machinery. That’s pretty much what we’ve seen here in the US. There are three ways to mitigate this (2 positive and 1 negative), and I think we will see aspects of all three:

    • Reduce costs: The National Association of Manufacturers regularly points to excessive regulatory costs and compliance (e.g. labor, environmental, tax) as a reason for lack of competitiveness in US industries that compete globally. Some of these represent hard-fought gains for both workers and the environment, but there are probably some excesses as well. It is an area that is certainly worthy of review and is indeed under review.
    • Increase labor skills and mobility: A shortage of workers with the information technology (IT) related skill-sets that modern manufacturing requires, as well as the necessity of retraining workers for non-import competing jobs, are also cited as a prerequisite for mitigating the negative impacts of trade. That means spending more on education and job retraining programs. The track-record of federal “job corps” type educational programs isn’t exactly stellar, but IT advances in the field of education should lead to improvements here.
    • Restrict trade from other countries. One way to protect workers from the negative impacts of foreign competition is to keep foreign goods out, which is why it is called protectionism. This lessoning of competition tends to result in higher priced goods in the protected countries, and it leads to less efficient production by reducing the gains to specialization. That’s why economists tend to oppose trade restrictions.

    Businessmen and politics: Another topic of current interest is the strength of business experience but the dearth of political experience by members of Trump’s cabinet. Here’s how I think about it: Economics is about solving the “economic problem,” which Nobel Laureate Frederick von Hayek described as not how best to build a bridge, which is a technical or engineering problem, but whether or not to build a bridge at all given competing use for the resources (which could be used to build toys, an aspirin factory, etc.). Decentralized markets tend to solve this economic problem of what to do, as distinct from the technical problem of how to do it, through the signals of profit and loss. By contrast, in a non-market (i.e. communist) country you have, said, Hayek, “the spectacle of a socialist economic order floundering in the ocean of possible and conceivable economic combinations without the compass of economic calculation [of profit and loss].”

    That is important, because if enthusiasm for business experience in a political cabinet lies in the expectation of more intelligent centralized direction of economic activity, it is (based upon Hayek’s logic) misplaced enthusiasm. Even famed management theorist Peter Drucker talked about how a successful businessman can be “wrong about everything else in the future economy or society, but that does not matter as long as they are approximately right in respect to their own business focus.” But what I hear, largely, is excitement over cabinet members with business experience because they will “have a better idea of what to do.” That’s the wrong reason to be excited.

    The better case for business experience lies in the analogy of an elephant walking through the woods and stepping on ants without being aware of it. Here the elephant is the federal government, and the ants are individual businesses. The analogy has to do with the fact that government policy makers, rather than being part of some sinister plan to undermine capitalism, are really (or often) unaware of some of the burdens on business that might result from their policies. In this case appointing cabinet members with business experiences can indeed lead to more sensitivity regarding the impact of government policies on private businesses. It is in that sense that business experience can help to produce better policy.

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