THE END OF THE INCESSANT U.S. BID?
2018-09-18 2pm EDT | #USD #pension funds #tax bill
It’s not getting much airplay, but on Friday, a rather important factor to the incessant U.S. financial asset bid expired.
According to Bloomberg’s Brian Chappatta, Friday was the last day U.S. corporations could deduct pension contributions at the 2017 corporate tax rate of 35 percent and will now only be eligible for the new 21 percent rate.
There has been considerable debate amongst the fixed-income community regarding the amount of curve flattening that has been the direct result of corporations accelerating their pension contributions. In fact, Brian’s article is named, “The Yield Curve’s Day of Reckoning is Overblown” and is mostly a rebuke of the idea that this factor has been the driving force to the recent flattening.
I don’t agree with all of Brian’s conclusions - but hey - that’s what makes a market!
The U.S. has been flattening at a vicious pace, while most other major bond market curves have been treading water.
And as Brian points out, there has been a tremendous demand for U.S. fixed-income from pension funds:
I love the steepener trade for a variety of reasons so I need little excuse to be bullish on the yield curve, but I wonder why bond traders are the only ones talking about the pension contribution deadline. Last I checked, most pension funds hold bonds and equities in their portfolio. Surely if corporations are accelerating their pension fund contributions, then this will also affect U.S. equities.
Now there is absolutely no way this pension contribution acceleration has been solely responsible for the unbelievable U.S. equity performance over the past six months, but can we be sure it hasn’t at least contributed to the amazing run from U.S. financial assets? And now that it is ending, what does that mean going forward?
Not just the pension contribution acceleration that has pushed U.S. assets higher.
Let’s take a moment to think about what last year’s tax cut has meant to the markets.
First of all, all else being equal, the corporate tax cut should have resulted in U.S. equities outperforming other markets. Check.
Secondly, this relative attractiveness would most likely attract capital from around the world, sending the U.S. dollar higher. Check.
Thirdly, the tax bill encouraged overseas earnings repatriation which has happened in spades.
Although we all would hope this capital be allocated towards plants and equipment or worker wages, we know the vast majority went into stock buy backs, with maybe a little pension fund top-up thrown in for good measure (after all it could still be deducted at the higher rate until September).
Again - what is the result of this repatriation? U.S. financial assets outperforming the rest of the world.
Then, let’s take it one step further and examine what U.S. financial asset outperformance has meant for Central Bank policy. At the margin, the fact that the Fed also tunes to financial condition has caused the Federal Reserve to be marginally more hawkish than would otherwise been the case, This has caused even more capital to be attracted to the U.S., meaning the U.S. dollar has been bid even higher.
So the end result of the tax reform bill has been a massive bid to U.S. financial assets as money has ploughed in from all over the world.
I know U.S. dollar bulls will tell you the rise has just started. But to me, it seems like an extraordinary amount of buying has already occurred.
And as for the U.S. equity bulls, who are you counting on being the marginal buyer? The self-reinforcing feedback loop since the tax bill’s passing has forced a lot of managers into U.S. equities, but eventually the repatriation buybacks slow down. Eventually the pension fund deadline scramble subsides. And then who is left to buy?
Don’t misconstrue my remarks as some sort of apocalyptic proclamation of an upcoming 1987-style equity crash - I am not suggesting anything of that nature. On the whole, money throughout the world is still extraordinarily cheap and credit is still flowing.
Yet I will take the other side to all the U.S. bulls who believe American financial assets will continue to outperform at this rate. The run has been terrific but my twitter feed is filled with overly enthusiastic traders hooting about the U.S. outperformance versus China (or the rest of the world), with a comment about how trade wars are in fact, actually easy to win. I have been waiting patiently for them to take it too far, and I think we have hit that point.
The U.S. is indeed the cleanest white shirt in the laundry pile, but it is nowhere as pristine as the market believes. My bet is that on a relative basis, there are other shirts to buy.
I am a seller of US dollars, with a stop at 96 on the US dollar index. I would also err on selling U.S. equities and buying pretty much any other stock index against it.
I know, I know - the rest of the world is a basket case versus America. Not disputing that one bit, but the real question is whether that is already in the price.
We might well look back to the September 15th date and realize the pension fund contribution deadline marked the peak in U.S. outperformance for some time.
Thanks for reading,
East West Investment Management
Global Select Opportunities Fund