“After many years of discussions and building on the progress made last year, we have achieved a historic agreement on a more stable and fairer international tax architecture,” financial leaders from the G20 said in a communique on Saturday. The group was meeting in Venice, Italy, with Treasury Secretary Janet Yellen representing the U.S. Next steps include work on key details at the OECD and then a final decision at the G20 gathering of presidents and prime ministers scheduled for Oct. 30-31 in Rome.
The latest pact would establish a global minimum corporate tax of at least 15%. It would also mean companies like Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB) and Google (GOOG, GOOGL) would partly pay taxes on where they sell their services, instead of the location of their headquarters. Implementation could happen as early as 2023, but would depend on action at the national level.
Several European countries continue to object to the minimum tax rate, saying it would remove a tool for encouraging foreign investment. Among them are Ireland, Hungary and Estonia, which will all need to be encouraged to sign up to the deal by October. Resistance from any EU nation could prevent the 27-member bloc from going ahead with the plan or at least force the bloc to resort to novel legal maneuvers that have yet to be tested.
The new tax approach could also run into opposition in the U.S., where Yellen needs to sell the deal to Congress. The changes could require the U.S. Senate to alter existing tax treaties, which would take a two-thirds vote and at least some GOP support. Republicans have already expressed opposition to any rise in taxes, while some lawmakers have condemned the idea of ceding taxing authority to other governments. Business groups have additionally complained that higher taxes could threaten the economic recovery as American companies navigate their way out of the coronavirus pandemic.
Corporate tax rates in select economies:
Countries with the lowest corporate tax rates:
The Fed and Our Debt Levels (By Stansberry)
COVID has left us with massive debt. And this problem isn’t something the Fed can simply brush aside as “transitory” – like it’s trying to do with the recent uptick in inflation.
Specifically, this problem is our country’s collective debt load, which keeps growing higher.
I know debt isn’t a sexy subject, but if you want to become wealthy, it’s important to know about debt, when it can be beneficial, and most important, when it’s dangerous.
The first thing to understand is that not all debt is bad. Debt can be a good thing.
In fact, debt can be used to increase a company’s earnings per share and return on equity. By using leverage, companies can cause their stock prices to go higher, much faster.
The problem, of course – as with most things in life – is excess.
Too much of a good thing becomes dangerous. The extra leverage brings added risk. When the sun stops shining, the debt doesn’t go away. It still must be repaid.
That’s exactly what has happened with debt in our country and the biggest offender isn’t who you might first expect. The American consumer has always been the posterchild for our country’s long-lasting debt problem. But that isn’t the case these days.
Households are actually the most responsible borrowers in the US today. Americans didn’t just use their stimulus checks and unemployment benefits to bid up “meme stocks” like GameStop (GME) and AMC Entertainment (AMC). Some folks acted responsibly and used the money to pay down their credit-card debt and home-equity lines.
Credit-card debt has fallen by 17% since the beginning of 2020. Credit-card delinquencies are now at their lowest level in a decade, and home-equity debt is down 14% since the start of 2020.
This deleveraging has left the average U.S. consumer in much better financial shape than before the pandemic. Total household debt – excluding mortgage debt – is down 2% since the pandemic started, despite tens of millions of people being out of work.
The biggest abusers of debt is the US Government. The U.S. now owes more than $28 trillion. This pile of debt represents 129% of our country’s gross domestic product. It’s the highest this ratio has ever been. It’s even higher than it was at the end of World War II.
Since the last financial crisis, the U.S. government’s debt has more than doubled, increasing by $17 trillion in that span, and around $5 trillion of this increase has been added since the start of the pandemic.
The U.S. government runs up debt like it doesn’t have to pay it back… Last year, it spent nearly twice the amount it collected in taxes, running a $3.2 trillion budget deficit.
Imagine if the average American household behaved like the government.
The median family income in the U.S. is around $69,000. According to the website Federal Budget in Pictures, if the median family managed its budget like the government, it would’ve spent $132,000 last year and racked up the $63,000 difference in credit-card debt. And that’s on top of the $541,000 in debt that the family would’ve already owed.
Of course, individual Americans don’t have the government’s luxury of being able to pay back debt by simply printing more money. And neither do corporations. That’s why.
U.S. companies have simply gorged on debt since the last financial crisis. Corporate debt is up 70% since the end of 2008. It now tops $11 trillion.
This is just an acceleration of a trend that goes back four decades. Corporate debt has increased nearly 1,200% over this period. The reason for this soaring debt is simple.
The Fed has lowered interest rates over and over again during this time period.
Take a look at the chart below, which shows corporate debt and interest rates – measured by the 10-year U.S. Treasury yield – over the past 40 years. As you might know, the 10-year Treasury yield is the most important rate for corporate borrowers. The interest rates they have to pay are based on this rate. That’s why I’m using it in this example.
You’d think the Fed was playing a game of limbo… How low can rates go?
Interest rates have steadily descended to zero over the past four decades, and it’s pretty easy to see the effects of these changes. Corporations have acted like a bunch of 5-year-old kids set free in a candy store and told to eat as much as they want until they’re full.
The pandemic only accelerated this trend.
You’ll remember, at the onset of the pandemic last March, the Fed lowered the federal funds rate – the interest rate it directly controls – to essentially zero (to 0.05%). All other interest rates in the economy are based on this rate. The 10-year Treasury yield hit its lowest point ever (0.51%) last August.
On top of having to pay next to nothing on borrowed money, corporations got another gift from the Fed during the pandemic.
Last spring the Fed started buying corporate debt for the first time. This unprecedented move gave the bond market a needed boost of confidence in the middle of the pandemic. More important, it prevented credit from drying up – averting a crisis.
U.S. companies used the Fed’s generosity to issue record numbers of bonds last year. Collectively, they issued $2.3 trillion worth of bonds, crushing the full-year record of $1.7 trillion set in 2017. And so far this year, we’re on pace to break that record once again.
So-called “investment grade” companies are responsible for around 80% of this borrowing. They’re the most credit-worthy borrowers. They can borrow money at lower rates than their less-credit-worthy peers – the so-called “high yield” (or “junk”) borrowers – because they are much more likely to pay back their debt.
But investors are even throwing massive piles of money at risky, junk-rated borrowers these days.
For example, junk-rated health care company Centene (CNC) recently sold $1.8 trillion in bonds for a record-low interest coupon of 2.45%. That’s the type of rate only companies with clean credit used to be able to get. For example, back in 2016, health care giant Johnson & Johnson (JNJ) – which is one of only two companies with a perfect “AAA” credit rating – issued a bond with a 2.45% coupon.
But that’s where we are today, the worst abusers of debt are being treated like royalty. Junk bonds yield an average of just 4%. That’s the lowest they’ve ever yielded. It’s even less than inflation today.
And yet, the risk in buying these junk bonds has never been greater.
If you buy a basket of junk bonds today, more than 4% will almost certainly default. That would turn a 4% return into a guaranteed negative return after factoring in credit losses.
Remember, corporate debt can only go down in one of two ways.
- It gets paid back.
- It gets wiped out in bankruptcy.
In a normal credit cycle, all of the bad debt from the excesses of the cycle gets wiped away leaving corporations with less leverage. We saw deleveraging after the last financial crisis. But not this time.
The pandemic caused 146 U.S. companies to default on their debt last year, according to credit-ratings agency Standard & Poor’s. But that wasn’t nearly enough to wipe away all of the bad debt.
Corporate debt hasn’t fallen. It has done the opposite, growing faster and higher than ever before.
And much of this debt will never be paid back.
How do I know? Just look beneath the surface and you see all sorts of risks.For example, the credit quality of corporate debt is much worse than ever before.
The percentage of corporate borrowers with junk credit ratings is now at an all-time high (58%). In other words, nearly six out of every 10 borrowers in the U.S. have dubious credit ratings. These are the borrowers who are much more likely to default.
The same deterioration is evident in the highest-rated borrowers, too… Today, 55% of all investment-grade borrowers are on the lowest rung of the ladder before dropping into junk territory (credit rating of “BBB”). These borrowers are one downgrade away from becoming junk credits.
Before the pandemic, that percentage was less than 50%. And before the last financial crisis, it was less than 30%. So as you can see, the problem is getting worse across the entire credit spectrum.
The truth is, even with record-low interest rates, many companies these days can’t even afford to pay the interest on their debt.
The Fed has created Zombie companies. Zombies are companies that don’t earn enough profits to cover their interest – let alone repay their debt. They’re the walking dead, only kept alive by creditors willing to lend them more money to pay off their debt as it comes due.
Zombie companies are now at an all-time high. The current mark of 24% far eclipses the previous record of 16%. Take a look at how much it has surged in recent years…
Think about that; one out of every four companies is a zombie. They’re only alive today because the Fed has consistently lowered interest rates, allowing them to keep kicking the can down the road.
Now the Fed has painted itself into a corner. With interest rates near zero, the Fed can’t lower them any further. And with inflation rising, it can’t afford to keep them low much longer. Soon, it will be forced to raise them.
The problem is that it can’t afford to raise them very far either. If it does, the cost of the debt will be too much for many borrowers to handle. Higher rates will set off a wave of bankruptcies like we’ve never seen before.
Edward Altman believes we’re on the cusp of that happening. And if anyone would be qualified to know, it would be him.
The New York University professor invented the best predictor of corporate bankruptcies in 1968 – the famous “Altman Z-score.” He believes we’re headed for a second wave of bankruptcies beginning this year.
Extreme debt suppresses money velocity and reduces economic growth.
- Higher debt levels cause the risk premium to rise, which leads banks to cut their loan to deposit ratio. This, combined with falling debt productivity, reduces the velocity of money.
- Bank deposits then flow into government securities instead of private sector loans, diverting capital from high-multiplier sectors to less productive ones.
- GDP is simply money times velocity, so economic growth finds a lower equilibrium as velocity falls.
- Debt-financed government spending has only a limited and temporary stimulative effect.
- In this environment, central bank tools can restrain growth but are less able to stimulate it.
- Sustained fiscal restraint would work off the debt overhang and let the economy recover, but this is politically unlikely.
This year’s growth and inflation rates will be “the highest for a long time to come… No pathway out of this trap exists as long as overreliance on debt remains the only tool of fiscal and monetary policy.” Long-term Treasury yields can increase over the short run but the major trend remains downward.
Market Data
- Technicals show that the Nasdaq 100 rally is stretched
- Meme stocks, Cryptos and Small Caps are underperforming the benchmark S&P 500.
- Fund managers put more money into tech recently.
- But they remain positioned for reflation.
- Inflation/taper tantrum remains the largest tail risk, according to BofA’s fund manager survey.
- State Street’s Global Allocation ETF reduced its overweight to equities and high yield bonds, citing investor complacency and potential for greater downside risk.
- The correlation between Small-Cap stocks and Growth stocks has plunged to an 80-year low. This is primarily due to the Technology sector, which is also showing an extremely low correlation to Small-Cap stocks.
- Based on the headline CPI, the real S&P 500 earnings yield doesn’t look very attractive.
- The risk-adjusted rally in the S&P 500 over the past year is starting to roll over now. That has usually preceded weak returns, with defensive sectors showing the best relative performance.
- Stocks that perform well in a rising inflation environment have underperformed substantially in recent weeks – despite the upside CPI surprises.
- Related to the above, companies with weak balance sheets had a rough 30 days.
- Small caps continue to struggle.
- Growth stocks appear overbought over the short term.
- Cyclicals are not yet overbought relative to defensives.
- This week saw some wobble in what has been a historically positive risk-adjusted rally in the S&P 500. There is a lot of rotation under the surface, with too-few stocks above their 50-day averages, and low correlations among sectors. Several of them have given recent reversal signals. Some commodities still look vulernable especially if low exposure to the dollar continues to reverse.
- In spite of the market making new, all-time highs this week, participation continued to deteriorate. Our focus is usually on the S&P 500 Large-Cap Index, so we’ll begin with that, but mid- and small-cap stocks are really looking bad as well. The Silver Cross Index for the S&P 500 has dropped to 60%, meaning that 60% of SPX stocks have the 20EMA above the 50EMA. Obviously, the largest component stocks are holding the index aloft. This is entirely possible because there are some giant stocks in the index; however, 60% is really starting to push the envelope. To make matters worse, only 50% of SPX stocks are above their 50EMA, meaning that there is the potential for an additional 10% of stocks to lose their Silver Cross status, which would leave only 50% of stocks supporting the index.
- &P 400 Mid-Cap stocks are much worse than the large-caps. Only 43% of them have the 20/50EMA Silver Cross, and only 29% are above their 50EMAs. That leaves an additional 16% of mid-cap stocks with the potential for 20/50EMA negative crossovers. We will assert that there is no way for this index to avoid a bear market under those circumstances.
- Market participation continued to deteriorate. Our focus is usually on the S&P 500 Large-Cap Index, so we’ll begin with that, but mid- and small-cap stocks are really looking bad as well. The Silver Cross Index for the S&P 500 has dropped to 60%, meaning that 60% of SPX stocks have the 20EMA above the 50EMA. Obviously, the largest component stocks are holding the index aloft. This is entirely possible because there are some giant stocks in the index; however, 60% is really starting to push the envelope. To make matters worse, only 50% of SPX stocks are above their 50EMA, meaning that there is the potential for an additional 10% of stocks to lose their Silver Cross status, which would leave only 50% of stocks supporting the index.
- The S&P 600 Small-Cap Index is in the worst shape of the market indexes. Only 41% have a Silver Cross, and only 21% are above their 50EMA, meaning that the Silver Cross percentage could drop to 21% or lower. We think it is safe to say that this index may already be in a bear market, it just doesn’t know it yet. It’s down over 7% this month.
- This year’s M&A activity has been unprecedented.
- The S&P 500 dividend yield is increasingly unattractive when adjusted for inflation.
US Economy
- The durable goods inventories-to-sales ratio (at the wholesale level) continues to move lower amid supply constraints.
- Automobile inventories have been exceptionally tight.
- The recovery in retail sales has been faster than in previous post-recession environments.
- The recovery has been uneven, with industrial equipment lagging.
- The ratio of home prices to household income is nearing the housing bubble peak.
- The percentage of Americans working from home is down by half since the 2020 peak. Employment in sectors with high work-from-home ratios has almost fully recovered.
- Will we see a sharp rise in rent inflation once the eviction moratorium ends?
- Economies of countries with low vaccination rates are underperforming this year.
- Job postings on Indeed are now substantially higher than the levels we saw before the pandemic.
- Consumer and business survey data suggest that the unemployment rate should be below 4%.
- The Citi Economic Surprise index is back below zero, pointing to some loss of economic momentum.
- Air travel continues to recover but is still about half a million (per day) below the July of 2019 throughput.
- Increases in US freight rates accelerated last month.
- According to the NFIB small business data, the core CPI should moderate soon.
- The capital efficiency ratio has risen since 1985, which implies that less capital investment is required to generate the same amount of output.
- Established large firms increasingly dominate hiring in the US.
- The CPI report surprised to the upside – again. Both the headline and the core inflation measures easily topped forecasts.
- However, the Fed’s “transitory” thesis still holds. The “reopening” and chip-shortage components of the CPI continue to dominate.
- Gains in automobile prices have been unusually sharp.
- But it’s not just about shortages. The used-car industry’s price gouging is hitting extreme levels.
- The “job openings hard to fill” indicator is off the highs. It suggests that more workers are re-entering the labor force as businesses boost compensation
- Hiring plans continue to surge.
- But CapEx plans are trending down.
- What is the single most important problem for small businesses?
- The June producer price report topped forecasts, with the core PPI monthly gain hitting a multi-year high.
- Without the vehicle (chip-related) and reopening-related CPI components, inflation is still below the pre-COVID trend.
- There are signs that rent inflation could accelerate
- Last month’s industrial production report was weaker than expected as factory output declined.
- Manufacturing production remains below pre-COVID levels.
- Much of the weakness was due to slowing motor vehicle production
- Supply-chain constraints remain severe, but fewer companies see rising delivery times.
- Price pressures persist, but manufacturers have gained pricing power and plan to use it
- As states canceled the emergency unemployment benefits, consumer confidence took a hit (as households worry about personal finances).
- The U. Michigan consumer sentiment report showed confidence deteriorating this month. Analysts have attributed this decline to higher prices and the loss of emergency unemployment benefits
- Buying conditions for durables and vehicles declined.
- Rising inflation expectations pushed households’ real income projections sharply lower.
- Retail sales remain well above the pre-COVID trend.
- Despite all the complaints about high automobile prices, spending on vehicles remains highly elevated for this time of the year.
- Online spending slowed but is still above last year’s levels.
- Credit card spending has been robust.
- Three million adults expect to re-enter the labor force within twelve months as unemployment benefits end.
Thought of the Week
“The way I see it, if you want the rainbow, you gotta put up with the rain.” – Dolly Parton
2 Pictures of the Week
All content is the opinion of Brian J. Decker
