Morning Report: Corporate taxes and inflation

Vital Statistics:

	Last	Change
S&P Futures	2645.0	-3.0
Eurostoxx Index	386.0	-0.7
Oil (WTI)	57.8	0.4
US dollar index	86.8	0.1
10 Year Govt Bond Yield	2.39%
Current Coupon Fannie Mae TBA	102.625
Current Coupon Ginnie Mae TBA	103.625
30 Year Fixed Rate Mortgage	3.88

Stocks are falling victim to profit-taking (and possibly window-dressing) on the first day of the month. Bonds and MBS are up. 

Manufacturing slipped in November, according to the PMI Manufacturing Index. The ISM Manufacturing index moved slightly lower as well.

Construction spending rose 1.4% MOM and 2.9% YOY in October.

Negotiations continue on tax reform as Republican Senators made a lot of progress overnight. Issues about a financial trigger are separating fiscal hawks from conservatives. Probably the best summation of play:“We’re trying to get to a point where nobody is going to get exactly what they want but enough to get the bill passed,” Senator Thom Tillis of North Carolina said. Republicans need to have something to show in 2018, and this is something. At the end of the day, it will probably be more symbolic than substantial, at least on the individual income tax front. Cutting corporate taxes will almost certainly help the economy however.

Here is the thing to keep in mind about corporate taxes: Transfer pricing matters. Transfer pricing is how firms with international arms allocate revenues and expenses. For example, expenses like investor relations, legal, etc are used by the international arms as well and some of those costs should be allocated to them. If the company has operations in high tax and low-tax jurisdictions, they have the incentive to allocate all of their costs to the high tax jurisdiction and all of their revenues to the low tax jurisdiction. This minimizes US income and maximizes foreign income which results in companies making low payments to the IRS and high payments to foreign tax authorities. The US tax code effectively subsidizes foreign governments! It also locks up cash overseas, as companies have to pay US tax on that income once it is repatriated, which is even more of an incentive to shift earnings overseas. We have the highest corporate tax rate in the world, but the effective US tax rate is about what everyone else pays. If we equalize our corporate tax rate to the rest of the world, that incentive to play games with revenue and expense goes away. Which is why you could, at the margin, see revenues increase despite cutting corporate taxes. 

After tax reform, the focus in Washington turns to funding the government. Democrats are demanding action on immigration in exchange for yes votes on a continuing resolution. For all the posturing over these things, they invariably get resolved. 

Booms don't last forever, and neither do busts. After experiencing a generation of deflation, Japan is beginning to see the stirrings of inflation. Imported deflation from Asia has been a bit of a free lunch for the US as it allowed the Fed to be about as easy as it wanted without triggering inflation - at least inflation as measured by the Consumer Price Index. IMO, if Japan is recovering for real, and the Chinese economy maintains strength (i.e. their real estate bubble doesn't burst) then inflation is probably set to return. A Japanese recovery is a bit of a sea change for the Fed, and the return of the world's second biggest economy will gobble up the glut of capacity we currently have. This could force the Fed to act more quickly than it otherwise would. 

What does inflation mean for the US? First of all, more consumer comfort. An economy with low inflation and low wage growth is much more uncomfortable than an economy with moderate inflation and moderate wage growth. While this may seem counter-intuitive (if wages and prices are rising together, who cares what the rate is?) it matters because of debt. Rising wages and prices means that the relative size of a household's debt decreases over time. While this won't necessarily apply to floating rate debt like credit card debt, it will apply to things that are fixed, like car loans, student loans, and mortgages. Worries about 1970s style hyper-inflation in the US are also overblown. That phenomenon was largely due to the oil shocks and a host of other issues (capacity constraints) that are no longer applicable. 

Of course what is great for a borrower is necessarily bad for a lender (or people who own long-duration assets, like banks and insurance companies). I wouldn't rule out a hiccup in bank earnings or insurance company earnings, but I can't see anything systemic like we had in 2008. I do wonder how much this will affect the $4.5 trillion of assets owned by the Fed.

Overall, higher inflation will be good for the real estate market, as it means higher prices and higher employment. Higher inflation is most beneficial to the first time homebuyer.