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Commentary – 2019 3rd Quarter


Summer is officially in full swing, which has young boogieboarders, college partygoers, and the rest of us relaxation-seekers flocking to the shore. Maybe we’ve been reading too many economic updates, but capital markets share striking resemblances with the beach. A month ago, for the first time in over a decade, the Federal Reserve announced its plans to potentially reduce interest rates. But unlike ocean tides, what happens next is unpredictable. Also, this past quarter the IRS finally received complete data relating to the new tax law. We looked at the significance of this from a planning perspective after many taxpayers were surprised this past April. Lastly, as business, finance, and economics become increasingly global, we share a story of how a trade dispute in the 1960s has an ongoing impact to this day.

The Man on the Moon

A beach full of vacationers is very close to a market full of investors. Both will start with research, whether it is on rental rates of different properties or price/earnings ratios of different stocks. They will each have an objective—the investor may want to retire while the beachgoer just wants to build a sand castle. There are risks involved, from terrible sunburn to terrible returns.

Investors and vacationers also change their behavior based on conditions with reactions which aren’t always pre-prescribed—some will move their chairs back when the water gets too close, others will try to bodysurf the biggest wave. One thing is for certain: the tide of the ocean influences every beach activity. And in global financial markets, central banking is the moon.

Economic cycles are very much like ocean tides; no two are the same but take a step back and patterns start to reveal themselves. Periods of rapid expansion are typically followed by periods of stagnation that culminate in recession. Today’s environment feels a lot like a late-cycle economy; growth and employment are above trend, inflation is near its target, and financial conditions—interest rates and monetary policy—have tightened from highly accommodative positions in recent years. In the past, similar conditions often ended in recession or, at least, a more challenging investment environment.

Central bankers have other ideas. Officials have made it clear their priority is to “sustain the expansion,” and that this requires keeping financial markets on a reasonably even keel. Surprises, especially the kind that lead to higher borrowing costs and lower asset valuations, are not part of the plan. The problem with this attitude was perfectly captured in the title of a recent Barron’s article: “Does the Federal Reserve Rule the Markets, or Is It the Other Way Around?”

At an interview at Wharton this past quarter, former Federal Reserve Chairman Alan Greenspan was able to shed some light on this question. He discussed the current 12-month consumer-price index measure of 2% (precisely the target rate) and why it’s wrong.

From the Wall Street Journal –
Mr. Greenspan noted, “we have a problem with measuring inflation. Because products are continuously changing, when new products go on the market, they come in at relatively high prices. Henry Ford’s Model T came in at a very high price, and the price went down as technology improved. You didn’t start to pick up the price level until well into that declining phase. So, there is a bias in the statistic. You’re getting statistics which are not correct. If you had a 2% inflation rate as currently measured, it’s the equivalent of zero for actually what consumers are buying.”

Getting inflation right is vital—it’s used for cost-of-living adjustments for wages, the Fed’s interest-rate decisions, and income tax policy changes. If we are to believe Mr. Greenspan, then central bankers are basing these decisions on flawed information. This is scary because the Federal Reserve has more tools available and more influence than ever before in history. Whether it’s changing the federal funds rate, buying or selling bonds on the open market, executing a reverse repurchase agreement, or any of the several other functions at their disposal, the economic effect of central bank policy has significantly increased since quantitative easing.

The 10-year Treasury note continues to trade at a lower yield than the three-month bill. Otherwise known as an inverted yield curve, this has historically been a reliable predictor of imminent recession. Central banks are moving in lockstep to combat the trend—five countries in the Asia-Pacific region have lowered interest rates over the past 3 months with the U.S. soon to follow . Since businesses and markets are now globally interconnected, monetary policy is becoming intertwined with trade policy.

America’s economy accounts for a quarter of global output, so if it stumbles the world will, too. In June, the U.S. economy created a whopping 224,000 new jobs, more than twice as many as needed to keep up with the growth of the workforce . Two weeks ago, U.S. President Donald Trump and Chinese President Xi Jinping reached a trade truce with no new tariffs, an agreement to restart negotiations, and a reprieve for Huawei Technologies . The market jumped up on the news.

It may be time to rewrite the rules for how all rich economies behave. An unusually sluggish and stretched expansion may be expected after the worst financial crisis in 80 years, but it also points to an economic transformation. Growth is slow and stable as activity has shifted to services and intangible assets. There are few signs of wild mortgage lending and reckless financial firms. Inflation is remarkably subdued. Recessions used to be triggered by housing bubbles, price surges, or industrial busts. Today, there are global firms, a financial system addicted to cheap money, and a political system that is toying with extreme policies because living standards are not rising fast enough. The current expansion can continue well beyond historical norms, but the way it will eventually end will be different.

A Day Late, A Dollar Short

Changes to the tax law are about as American as apple pie. The country was essentially built on them, as the Revolutionary War was incepted by a series of tariff disputes. It wasn’t until the Revenue Act of 1861 that the tax system as we know it today started taking form. Together with the 16th constitutional amendment in 1913, these pieces of legislation effectively made income and investment gains taxable. The last major change was when Social Security and Medicare taxes started to be withheld from paychecks in the mid-1900s.

Since then, most of what we’ve seen is policymakers tinkering with the current law, in effect making it ever more complex. There is one thing which has stayed the same—Americans have an undying political and moral fury when it comes to Uncle Sam taking a piece of the pie. The 2018 tax year renewed the hatred as many Americans were surprised when filing their tax returns.

Tax changes make it difficult to plan, but this is especially true in the initial implementation year. Consider this simple timeline –

• Tax Cuts and Jobs Act goes into effect in January 2018
• The IRS releases new tax withholding tables in May 2018
• The IRS releases initial findings from new tax law in June 2019

Here’s the upshot: your employer could not have known how much to withhold from your paycheck for at least 5 months from the new tax law going into effect and the IRS could not issue any guidance on the effectiveness of the new law for almost 18 months. Even though about two-thirds of households received tax cuts, an April Gallup poll found that just 14% of Americans thought their taxes went down. In many cases, the cut showed up in the paycheck instead of in refunds, likely skewing their perception.

Taxes were cut for low and middle-income workers, but refund statistics remained the same. However, real movement occurred toward the upper end of the income distribution for refunds. Average refunds for households making between $100,000 and $250,000 dropped 10% (many of them owed), while average refunds for those between $250,000 and $500,000 rose by 11%.

That is a recipe for divisiveness, but the good news is that there was a simplification to the law. So far, 90% of tax returns have claimed the standard deduction for 2018, up from 70% the year before. This means that tax planning should be made easier for most Americans, at least going forward. The best action is to compare year-to-date paycheck withholding with your 2018 tax return. If there is a discrepancy, the employer can be told to withhold more tax.

Or, at least throw some tea in the harbor in protest.

The Chicken or The Full-Sized Pickup Truck

Tariffs seem to be the topic du jour, so let’s dive a little deeper. Have you ever asked yourself, in a time of quiet reflection, how a small, flightless bird has influenced the American auto industry for decades?

After World War II, the development of factory farming turned chicken into a mass-produced commodity. By the 1960s, German families loved cheap American-raised chicken that was suddenly being imported after the war. German chicken farmers weren’t too happy with American chickens flooding their market. The farmers pressured the German government and the German government started taxing frozen chicken imports.

Not to be outdone, the U.S. did what countries often do in situations like this; they retaliated with trade protections of their own. In 1963, President Lyndon Johnson imposed a 25 percent tariff on potato starch, dextrin, brandy and light trucks. Not because they had anything to do with chicken, but simply because they were all imported from Europe in large quantities.

The tariffs imposed on light trucks were aimed squarely at the German automobile industry, which was making big inroads into the U.S. market with an array of innovative and economical small vans and pickups. The American strategy worked. Volkswagen’s pickup and van business collapsed in the United States, but the Europeans were not the only ones who suffered. Japanese automakers were also hit hard by the tariffs on light trucks, even though their nation’s roosters were not party to this cockfight. Trucks produced by the likes of Toyota and Isuzu were rendered uncompetitive versus those produced by U.S. manufacturers, and that prompted the American automobile industry to lobby successfully for the continuation of the so-called chicken tax long after the poultry battle was over.

And as such, the groundwork was laid for Ford and General Motors to own the U.S. pickup truck market. The Ford F-150 has been the best-selling vehicle in the country for the past 36 years and the best-selling pickup truck for the past 41 years . It took until this year for it to be unseated by, you guessed it, the Chevrolet Silverado.

The Japanese eventually found ways around the chicken tax. They began importing the truck chassis and adding the bed after it was offloaded in the United States. As demand grew, they decided it was more cost-effective to build the pickups in America and constructed their own U.S. factories.

GM and Ford went the opposite direction as production costs overseas changed. General Motors began importing small trucks from Mexico and Canada, which were exempted from the chicken tax by the North American Free Trade Agreement. Ford started importing small commercial vans from Turkey as passenger vehicles, equipping them with rear seats, seatbelts, and windows, then removing this equipment after the vehicles landed in the U.S. and reconverting them to commercial vehicles. Both were costly, but still cheaper than paying the chicken tax.

The bottom line: tariffs change the way business is conducted across the globe and, ultimately, consumers foot the bill. Americans pay more for pickup trucks than any other vehicle specifically because 1960 Germany liked inexpensive chicken.

We hope you enjoyed our comments. If you have any questions, please do not hesitate to contact us. We welcome the opportunity to discuss our thoughts in greater detail. Thank you for your continued confidence in Planning Capital Management.

[1] Matthew Klein, “Does the Federal Reserve Rule the Markets, or Is It the Other Way Around”, Barron’s, July 5 2019

[2] Andy Kessler, “The Federal Reserve is Flying Blind on Inflation”, The Wall Street Journal, May 12 2019

[3] Brian Blackstone, “Monetary Easing Looks Different This Time Around”, The Wall Street Journal, June 10 2019

[4] Leader’s Briefing, “America’s Expansion is Now The Longest on Record”, The Economist, June 11 2019

[5] Ben Levisohn, “The S&P 500 Soared Last Week Because a Trade Truce Conquers All”, Barron’s, July 5 2019

[6] Richard Rubin, “Here’s How the New Tax Law Is Working”, The Wall Street Journal, July 2 2019

[7] Benjamin Zhang, “The glorious history of the Ford F-Series truck”, Business Insider, November 27 2018