Howard Marks’ Latest Thinking: Markets and New Tax Law


Howard Marks Memo: Latest Thinking, January 23, 2018

More on the Markets

  • Positives:
    • US economy is chugging along, and the recovery that started in 2009 has become one of the longest in history. The rest of the world’s economies are joining in for that rare thing, worldwide growth. Most economies seem to be gaining rather than losing steam and they don’t appear likely to run out of it anytime soon
    • One of the reasons for sluggish recovery during the Obama administration was the low level of capital investment. No one wants to make long-term investments in an inhospitable environment for business. In contrast, it’s very clear that Trump is committed to being a pro-business president and a deregulator. In the first three quarters of 2017, capital spending rose at an annualized rate of 6.2%
    • Recent tax law will put money into the pockets of corporations that pay US taxes by reducing their tax rate, and it will result in the repatriation of large amounts of foreign profits that US companies have been holding abroad
    • Unemployment rate is down to 4.1%, nearly the lowest in 60 years, meaning we’re nearing “full employment”. With so little employment slack remaining, it seems reasonable to think near-term GDP growth will translate into wage gains, and thus back into further increases in demand
    • Low levels of inflation worldwide mean central bankers need not rush to raise interest rates to restrain it. There’s no obvious reason to predict hyperinflation
    • Except in pockets, investor psychology can’t be described as euphoric and imprudent. For years the markets have been “climbing a wall of worry,” an old-fashioned phrase used to describe a healthy ascent that’s occurring not because of euphoria and risk-obliviousness, but rather despite a catalog of perceived ills
    • Known catalysts for a market downturn – recession, ballooning inflation, much-higher interest rates, major central bank missteps, a governmental breakdown in Washington, and war – can’t be assigned probabilities that are more than modest
  • Negatives:
    • Possibility of slow long-term economic growth, the potential for rising interest rates and inflation, the impact of reversing stimulative monetary policy and the Fed switching to being a net seller of securities, the implications for employment as automation increases, the world’s dependence on China’s growth, and political and geopolitical tail risks
      • As the markets have risen, talk of all these things seems to have gone quiet
    • Interest rates are likely to rise
    • Most valuation parameters are either the richest ever or among the highest in history. In the past, levels like these were followed by downturns. Thus a decision to invest today has to rely on the belief that “it’s different this time”
    • Prospective returns in the vast majority of asset classes are some of the lowest in history
    • The need of investors to wring out good returns in this “low-return world” is causing them to engage in what I call pro-risk behavior. They’re paying high prices for assets and accepting risky and poorly structured propositions
    • Market behavior implies a level of equanimity on investors’ part that could prove unrealistic (2017 was the first year in history in which S&P 500 didn’t decline from high to low by more than 3% at least once)
    • Many investment decisions are being made today on the basis of relative return, the unacceptability of the returns on cash and Treasuries, the belief that the overpriced market may have further to go, and FOMO. That is, they’re not being based on absolute returns on the fairness of price relative to intrinsic value
  • Some people are excited about the fundamentals, and others are wary of asset prices. Both positions have merit, but as is often the case, the hard part is figuring out which one to weight more heavily
  • I’m convinced the easy money has been made. Prospective returns are well below normal for virtually every asset class. I don’t see a reason to be aggressive
  • You could have said this a year ago, and two years ago, and three years ago – and in general, I did. However, going meaningfully to cash would have been a big mistake – certainly based on how markets performed, but also on the merits
  • Basic themes supporting the “melt-up” theory include (a) the existence of the fundamental positives listed above and (b) the arrival of euphoric psychology, which has been absent to date

Reactions to the New Tax Law

  • With respect to the taxation of individuals, it’s not much of a reform. It doesn’t fundamentally change what income is taxed, how it is taxed, or the structure of the tax process. It reduces or eliminates some write-offs or loopholes, but not a great many
  • What matters the most is that it’s primarily a tax cut for the majority of Americans, and tax cuts are stimulative
    • It doesn’t make sense to try to artificially prolong an already-long recovery
    • And doesn’t it seem odd that the government is implementing a stimulative tax cut just as the Fed is raising interest rates and reversing its purchases of securities?
    • Unanimous willingness of former “deficit hawks” to pass a bill that adds more than $1 trillion to deficits and debt is indicative of “ideological pliability.” That bodes ill for fiscal discipline in the future
  • Centerpiece of the tax law is the reduction of the stated tax rate on corporate profits from 35% to 21%. What are its merits?
    • Our corporate tax rates shouldn’t be higher than the rates in other countries, as it has been to date
    • Lower rates will be good for our companies, and now our tax rate on corporate profits is one of the lowest in the developed world
    • Because of our previous tax system, US companies have $2.8 trillion of cash from foreign profits stranded overseas (now, that will be brought back at rates as low as 8%)
    • There’s every reason to believe the rate cut and repatriation will put money in corporate coffers, enhance credit ratings, fatten dividend payments and finance stock buybacks
  • All else equal, the tax law is likely to result over time in higher deficits, higher national debt, higher economic growth, higher inflation, higher interest rates, higher federal debt service requirements, and thus still-higher deficits and debt. These things tend to go together, and together they constitute the fiscal path Dudley describes as unsustainable. The outlook was troubling before; the tax cuts will make it worse

SALT (State and Local Taxes)

  • People who live in states with low or no income taxes may not have paid particular attention to the aspects of the new law relating to SALT, but it’s a big topic in NY
  • Up until now, to limit the impact of double taxation, itemizers have been able to deduct all state and local taxes paid from the income that was taxed at the federal level, the principle being that one should pay federal income tax only on what’s left after state and local taxes have taken their cut
    • House bill eliminated this deduction completely, but the final law permitted deductibility up to $10,000 (this avoided harming people with incomes below $100,000 or so)
  • On the higher earner’s marginal dollar of income (using rounded numbers):
    • Before the new tax law, a top-bracket earner in NYC, for example, took home about $53 from $100 of marginal earnings (after federal income tax at 40% and state/city income taxes at 12%, less the benefit from recouping 40% of that 12% on the federal return because of its deductibility)
    • Under the new law, take-home pay will be about $51 (after federal tax at 37% and state/city tax at 12%)
    • Thus take-home pay per incremental dollar of earnings will decline by about 4%
  • Important conclusions:
    • Reduction in take-home pay increases the penalty for living in high-tax states
    • Especially when added to high property taxes, this can give top-bracket earners a significant incentive to move to no-tax states such as Florida, Texas, Nevada, and Washington
    • I estimate for someone with a given large income, marginal take-home pay will be about 20% higher in a no-tax state than it is in NY, and that’s a lot
    • Top 1% of New York taxpayers pay 50% of the state income taxes. If and when their emigration accelerates, states like NY may get into a negative spiral
  • Bottom line on the new tax law is as follows:
    • Our tax system is not fundamentally reformed. Such changes will be feasible only in the unlikely event that bipartisan cooperation returns to Washington
    • Net income of corporations that pay US taxes will be enhanced, but the impact of the corporate tax reduction on other segments of the economy will be limited
    • Outlook is enhanced for no-tax and low-tax states and impaired for high-tax states
    • The tax law is likely a short-term positive and a long-term negative in a variety of ways

Image Source: Observer