tariffs and the stock market

The Trump administration has just triggered the latest round of tit-for-tat tariffs with China, declaring 10% duties on $200 billion of imports (the rate to be raised to 25% after the holiday shopping season).  China has responded with tariffs on $60 billion of its imports from the US.  Domestic firms affected by the Trump tariffs are already announcing price increases intended to pass on to consumers all of the new government levy.

It isn’t necessarily that simple, though.  The open question is about market power. Theory–and practical experience–show that if a manufacturer/supplier has all the market power, then it can pass along the entire cost increase.  To the degree that the customer has muscles to flex, however, the manufacturer will find it hard to increase prices without a significant loss of sales.  If so (and this is the usual case), the company will be forced to absorb some of the tariff cost, lowering profits.

From an analyst’s point of view, the worst case is the one where a company’s customers are especially price-sensitive and where substitutes are readily available–or where postponing a purchase is a realistic option.

 

Looking at the US stock market in general, as I see it, investors factored into stock prices in a substantial way last year the corporate tax cut that came into effect in January.  They seem to me to be discounting this development again (very unusual) as strong, tax reduction-fueled earnings are reported this year.  However, the tax cut is going to be “anniversaried” in short order–meaning that reported earnings gains in 2019 are likely going to be far smaller than this year’s.  The Fed will also presumably be continuing to raise short-term interest rates.  Tariffs will be at least another tap on the brakes, perhaps more than that.

Because of this, I find it hard to imagine big gains for the S&P 500 next year.  In fact, I’m imagining the market as kind of flattish.  Globally-oriented firms that deal in services rather than goods will be the most insulated from potential harm.  There will also be beneficiaries of Washington’s tariff actions, although the overall effect of the levies will doubtless be negative.  For suppliers to China or users of imported Chinese components, the key issues will be the extent of Chinese exposure and the market power they wield.

PS   Hong Kong-based China stocks have sold off very sharply over the past few months.  I’m beginning to make small buys.

 

 

Snap (SNAP) non-voting shares (iii)

forms of capital

Traditional financial theory separates a company’s long-term capital into two types:

–debt capital.  This is money the firm has borrowed, either through bank loans or company-issued bonds.  Creditors may have influence over company operations through restrictions spelled out in the loan documents, called covenants.  They generally specify measures to accelerate loan repayment that the company must take if it fails to meet stipulated profit or cash flow measures.  (An example:  the firm may be forced to devote all cash flow to loan repayment if profits decline sharply.  Money can’t be spent on things like capital improvements or dividends unless creditors give the ok.)

–equity capital.  Equity means ownership.  Common stock ownership is typically established by the means equity owners have to assert/protect their interests–usually the ability to vote on appointment of members of the firm’s board of directors.  The board, in turn, hires and evaluates management.

Some companies may also issue preferred stock.   Preferreds qualify for their name because they have some advantage, or preference, over common.  The typical preferences are: higher/more secured dividend payment; and/or priority over common equity in liquidation proceedings.  On the other hand, preferreds typically either have restricted/no voting rights.  In the US, preferreds, despite the equity in their name, typically trade as if they were a form of corporate debt.

SNAP non-voting shares

Where do the SNAP shares fit in this scheme?

They’re clearly not debt    …but are they equity?

They are certainly not traditional equity.  They have no ability to exercise any influence on company operations, and certainly no way to replace an underperforming board of directors.  On the other hand, they don’t appear to have any of the greater security of preferreds.  In fact, they seem to be a hybrid that combines the riskier features of both.

The closest I can come, in my past experience, to US non-voting shares like SNAP’s (or Google’s for that matter) are Korean preferreds and Italian certificates of participation.  In both cases, they traded well in up markets but underperformed very signficantly during market declines.

 

“hard” Brexit, not “soft”

Ever since the Leavers overwhelmed the Remain faction in the UK’s Brexit vote, observers have been wondering how the UK is going to effect its break with the EU   …and how complete the breach with continental Europe will be.

The two main approaches were dubbed soft, meaning that negotiations would be held at a leisurely pace, the break would come eventually–but not soon–and that the UK would retain as many of the privileges of EU membership will shedding as many obligations as possible.

Article 50 of the Lisbon Treaty lays out the process for a country to withdraw from the EU.  It provides that a state that wishes to leave sets the process in motion by invoking Article 50. That starts a two-year clock running, at the end of which the separation occurs.  Since two years is a relatively short period in diplomatic time, especially to arrange complex future trade agreements, conventional wisdom has been that a country like the UK would begin negotiations first and only trigger Article 50 when the negotiating finish line was in sight. Taking this path would be the more economically sensible.  It would also be a clear sign that soft is the ultimate goal.

The alternative would be “hard,” meaning basically getting out of Dodge as fast as possible.  Why do so when collateral economic damage would result?    …because other political considerations, like halting immigration from the rest of the EU, have a higher priority.

 

Over the past week or so, Prime Minister Theresa May has been signalling that Brexit will not be put on the back burner, and that, in consequence, the UK government is opting for the “hard” road.  She will invoke Article 50 by next March, at the latest.  And she has packed her negotiating committee with the most anti-EU people she can find.

This decision has a number of consequences:

–Scotland, where two-thirds of voters cast their ballots to Remain in the EU, is reviving its own referendum to withdraw from the UK and enter the EU as a sovereign country itself

–putting itself under time pressure by effectively starting a two-and-a-half-year clock running, the UK has revealed its sense of urgency.  That may have lost it negotiating leverage

–half of the UK’s exports go to the rest of the EU.  Time constraints may see it leaving the EU in early 2019 without trading agreements with countries where its major customers reside–meaning export sales may fall off a cliff

–similarly, it becomes less likely that bankers based in London can retain their current unfettered access to clients in other EU countries.  This suggests that banks may begin to shift operations to the Continent

–sterling will continue to slide.  For portfolio investors like you and me, this has perhaps the most important near-term implications.  There’s no need now, nor in the near future, to change from favoring London-traded stocks whose assets and earnings are outside the UK.  Better still if the firms’ borrowings and SG&A expenses are in sterling.

 

 

 

Trump’s taxes

Over the weekend, the New York Times published an article that contains copies of parts of Donald and Marla Trump’s 1995 income tax filings.  The pages, mailed to a Times reporter in September and verified as genuine by the accountant who prepared them, contain two items of note:

 

–during that year, the Trumps had income of about $9 million.  That was more than offset by a loss of $15.8 million generated from “rental real estate, royalties, partnerships, S corporations, trusts…”–which I take as being tax loopholes designed for the real estate industry.  If we assume that this is par for the course, it would mean that the Trumps typically pay no federal or state income tax.

 

–the Trumps also show that as of that year they had accumulated other losses totaling a stunning $909 million.   This figure is presumably the cumulative result of Donald Trump’s efforts as an investor.  Two points:

—tax losses have a current economic value, which deteriorates as time passes.  In this case, the value in 1995 of the Trump’s loss was about $350 million, and was shrinking in economic worth by, let’s say, $30 million per year.  Logically, the best course of action would have been for the Trumps to use the loss by selling, the sooner the better, something they owned and had a profit on.  The fact that they did not suggests they didn’t have any investment gains at that time–or that they used what gains they had to whittle the loss figure down to $909 million.

—Donald Trump was born into a wealthy real estate family.  He entered the family business with the advice and support of his successful father.  Falling interest rates + the development of New York City as a world financial center made the 1980s a golden age for real estate investing in the region the Trump family had expertise.  Yet the Trump 1995 tax returns suggest that on a net basis Donald not only made no profit during a time when real estate was like a license to print money; instead, he lost nearly a billion dollars.

In a recent Forbes article, John Griffin, a finance professor at the University of Texas/Austin examines Donald Trump’s investing career using publicly available data, both independent estimates and figures self-reported by Trump.  Prof. Griffin concludes that Mr. Trump has made only about half the profits of a typical real estate investor (about 40%, taking the self-reported figures), while taking on a higher than average level of risk.  Mr. Griffin concludes, ” Donald Trump is obviously a skillful presenter and a talented entertainer, but in terms of his investment skills, he is a clear underperformer.”  To my mind, the mammoth loss shown in the 1995 Trump tax return suggests that a less favorable assessment may be warranted.

 

 

 

will OPEC cap its oil output?

…maybe, for a short while anyway.   Ultimately, no.

Will this move shore up oil prices?

…probably not.

Yesterday OPEC announced a provisionary agreement according to which the oil cartel’s members will limit aggregate output to between 32.5 million barrels per day and 33.0 million.  At the lower end, that would remove 750,000 daily barrels (or 2.3%) from OPEC production.  According to the Financial Timesvirtually all of the reduction would be by Saudi Arabia; other OPEC members promise only not to increase theirs.

Saudi Arabia has previously been dead set against any agreement of this type.  Why?   During the early 1980s oil glut, the Saudis sliced oil liftings from 13 million barrels daily to 3 million in a vain attempt to stabilize prices.  That effort failed because everyone else in OPEC cheated, boosting their output to fill the void.

That such cheating happens shouldn’t come as a shock.  It’s standard cartel behavior–and the reason most cartels fail.  The truly startling development in the modern history of commodity-producing cartels was the solidarity of OPEC in its formative years, when it was a political cartel opposing exploitation of third world countries.  It has lost its power as it evolved into the current economic one.

So, as I see it, there’s no reason not to expect widespread cheating again.

Another factor arguing against this agreement actually stabilizing crude oil prices is that OPEC doesn’t dominate world oil production as it did in the 1980s.  Four of today’s top six oil-producing countries (Russia, US, China, Canada) are not members of OPEC.  There’s every reason to expect that all of the four would boost output as/when prices start to rise.

 

To my mind, the real news the OPEC accord signals is the changed attitude of Saudi Arabia.  I think this must mean that Riyadh is in worse financial shape than is commonly believed.

Certainly, the country is radially dependent on oil   …and has become accustomed to the revenue from  $100+ per barrel prices.  So it is now running a large government budget deficit.  My guess is that it is also having a much harder time than expected in borrowing to bridge the gap between revenue and spending, and that efforts to develop other facets of the economy are not moving forward smoothly.  Saudi Arabia has just announced a salary cut for government workers, which can’t imply greater political stability.

If there is a valid reason for oil to have risen on the OPEC announcement–and I don’t think there is–it would be worries of political developments in Saudia Arabia that disrupt oil production there.

Personally, not owning any oil stocks at present, I’m thinking that the seasonal low point for demand, that is, January/February, would be a better entry time than right now.

interest rates and economic growth

Over the past few days, I’ve written about two approaches to the question of the appropriate level for interest rates.

fixed income as an investment on its own

The first considers fixed income as an investment, with no reference to current economic conditions or to use of rates as a government policy tool.  According to it, holders of short-term fixed income instruments receive protection against inflation + a small real return; holders of long-term instruments receive inflation + a real return of 3% or so + an extra return if the instrument carries higher risk.

rates and economic policy

The second looks at short-term interest rates as a tool of economic that aims at steering growth along the preferred path of a given nation’s government.  The monetary authority slows the economy down and speeds it up by raising/lowering rates as circumstances dictate.  In the US, the recent preferred metric for judging success has been the employment figures.

quantity of money

There is a third, admittedly subjective, approach to this topic, one that many professional investors have traditionally used to gauge the tone of financial markets.  The idea is that the economy requires a certain amount of liquidity (i.e., money) in order to operate efficiently.  This is to maintain inventories, pay salaries and fund new investments.   It operates best when it has precisely that amount.

In a period like the current one of continuous radical supply chain and financial innovation, it may be hard to judge when too little money is available, and therefore activity is constrained and rates are too high.

On the other hand, adherents to this idea think that when money is too abundant, the excess inevitably finds its way into economically destructive financial speculation.  The signs that rates are too low are easier to spot:  soaring housing prices, bubble-level stock PEs and high-risk, nevertheless covenantless, junk bonds.

recent financial market worries

This third idea is the basis for the recent conversation in financial markets that ultra-low interest rates have passed their best-by date and are now doing more harm than good.  The strongest evidence that this is the case is in the junk bond market, I think.  However,  if there’s speculation in one corner of the financial markets, it must also be at work in the others.