Canadian Minister of Finance Jim Flaherty warned Canadians on Monday of the dangers associated with a contagion of a Greek sovereign debt collapse.  Canada is not an “island”; of course he is right, but are people aware of how truly widespread these linkages are?

Everyone by now has likely seen the infamous cartoon sketch of how a pension fund in a town in Norway ended up with AAA-rated subprime mortgage debt exposure. Fast forward the next 3 years and we have the reverse situation occurring with the Greek debt crisis.  The collapse of Greek debt has forced many European banks into a jam and perhaps none more so than Dexia SA, the Belgian/French banking concern.  They have roughly €5.4 billion of Greek credit risk (of which €3.5 billion is to the Greek government) against a Tier 1 Capital base of €17 billion – not pretty!!  

Source: The Wall Street Journal

Dexia, as reported in the WSJ this past weekend (http://online.wsj.com/article/SB10001424052702303635604576391882144021882.html?KEYWORDS=euro+jitters+ricochet), has $17 billion of municipal (“muni”) bonds it has backed in the U.S. – including a $72 million piece of debt associated with a local skating rink and arena in Everett, Washington - home of 104,000 proud Americans.  Investors in these bonds are now demanding higher yields as Dexia is under review for a possible two-notch downgrade by the likes of Moody’s (they know apparently a bad situation when they see it).  It gets better - if investors in the bonds do not rollover during the “remarketing process” (maturing), then Dexia has to buy the bonds back – and they have eaten $400 million so far.  But wait, it gets even better for Everett - Dexia has a pseudo ARM arrangement where they can push the interest rate up and shorten the duration on the issuer.  Nice.  Now the municipality can go out and shop for another “backer” (and many are), but costs will go up and further pressure will build on an already-stressed situation for local governments.  For Everett, rates go from 0.65% to 1.75% or over $24,000 per month – that is a lot of ice rental time!

Jim McGovern

As a follow-up to earlier posts, a couple of interesting items of interest yesterday.  The first is the Microsoft disclosure that of the $50.2 billion cash on its’ balance sheet, $42 billion is held offshore.  The disclosure came courtesy of the SEC who is sniffing around Microsoft’s taxation and specifically how it has managed to keep those liabilities relatively low.  Microsoft acknowledged that by channeling sales through low-tax countries (like Ireland) they were able to save a lot on taxes.  With so much of the cash “offshore” and subject to tax if it is repatriated back to the U.S., is it any wonder that Microsoft (along with other companies like Google) are taking advantage of the Fed’s low rate policy and the public’s ravenous appetite for anything with a higher (and safe) yield to issue debt?  It is cheaper to do this and fund dividends, share buybacks etc. than repatriate.

This headline fits into a number of other commentators thoughts on corporate tax policy in the U.S. with the inevitable question of “Are U.S. corporate taxes too high?”  The answer to that question is not a simple one.  The “posted” corporate tax rate in the U.S. is 35% and is arguably one of the highest in the world.  However, there are a myriad of tax shelters, credits and subsidies that can substantially reduce this burden.  A good example of this is GE – the poster child for corporate America, especially given Mr. Imelt’s close ties to the Obama government.  Earlier this year, GE reported a profit of $14.2 billion of which $5.1 billion was sourced from U.S. operations.  But GE claimed a tax benefit of $3.2 billion.  What gives?  Well for one, GE has had large write-offs associated with GE Capital.  But over the past 5 years, GE has earned $26 billion in the U.S. and received $4.1 billion from the IRS!  To a shareholder of GE, that sounds just great (BTW we are short GE in some accounts) but as a citizen, that seems like corporates are not paying their fair share.  The New York Times reports that one Treasury official called GE the “world’s best tax law firm” given that its tax team includes former officials from the Treasury, the IRS and “virtually all the tax-writing committees in Congress” (http://www.nytimes.com/2011/03/25/business/economy/25tax.html?_r=1).   The real benefit to GE, though, is that it pays far less in taxes abroad (thanks to schemes in Ireland, etc.) and it does not have to actually pay taxes in America on those profits until they are repatriated )– this, the U.S. multinationals argue, is necessary to compete with the low-tax jurisdictions and emerging economies.  Ironically, former President Reagan would be rolling over in his grave right about now – his 1986 Tax Reform Act was aimed at closing the very loopholes and shelters that GE was exploiting way back then. 

Source: http://www.ritholtz.com/blog/2011/04/corporate-tax-rates-then-and-now/

In my opinion, the loopholes and special interest lobbying for tax breaks and subsidies has to go – it is clearly advantageous for those that can afford it and a real disadvantage to those who cannot.  It generates a ton of money for lobbyists, lawyers and accountants but generates little in the way of benefit to taxpayers.  In conjunction with simplifying the tax code, a move to lower corporate tax rates to a reasonable level (35% is far too high, especially given all the double taxation that goes on) so that U.S. companies can compete globally, benefit from what should be the best legal domicile in the world and ideally repatriate capital and reinvest productively in America.  Barry Ritholtz notes in his terrific blog (http://www.ritholtz.com/blog/2011/04/corporate-tax-rates-then-and-now/) the huge swing in the government tax burden from corporates to individuals – individual income and payroll taxes accounted for 81% of the U.S. Federal revenue generated in 2010.  Why is this important?  Simply put, America has to claw its way out of its debt and deficit problems – this will require a plan that in part raises taxes fairly and productively at both the individual and corporate level.  Based on the direction of the last 50 years, I don’t like the chances of the individual coming out on top. 

Next time, I will look at taxation at the personal level and the coming war on that front in the US and elsewhere.

Jim

I must admit that I am astounded at the performance of the U.S. equity market so far this year.  Talk about climbing a wall of worries – I speak to a lot of money managers who are nervous as hell about public policy and the government interference in markets.  I was reading a Jim Cramer post yesterday (yes, I am a fan and do subscribe to Real Money in full disclosure – he is entertaining, but also a very good market observer and he is all for the democratization of investment information which is terrific in my view) and he suggested that we are “not whistling past the graveyard,” but rather the market was going up because earnings and cash flow have been superb – top and bottom line.  And you have no argument – on balance, they have been terrific.  

Source: BCA Research, 2011
The question going forward though is, “are we at peak earnings and margins now for corporate America?” 

The outlook for further corporate profit margin expansion seems highly unlikely to us.  

Let’s first look at the cost side of the equation. Wages, which account for a large portion of firm costs, have been growing very weakly over the past few years. 

Source: BCA Research, 2011

Beneath the surface a number of issues continue to brew.  Firstly, there is a growing sense that “workers” are getting left behind as corporate profits continue to rise. While it is arguable that companies are increasing their workers’ wages in line with the growth in productivity, the disconnect comes when those wages are then placed against consumer prices for goods and services that have been rising much faster than the rate of productivity.  Secondly, as a result, there is a wider gap in income inequality, especially since food and energy costs bite into such a large part of lower-income family budgets.  I am not going to wade into the political consequences of this continuing, but issues like minimum wages, political backlashes, or greater union power (I am thinking about government employee unions) cannot be ignored. A record 44 million Americans are participating in the Food Stamp Program now.

On the productivity front, companies have not been re-investing in their capital stock

Source: BCA Research, 2011

Another component to consider is taxes.   It is certainly a well-known fact that U.S. companies have had substantial international operations channeled through tax havens.  Given the deteriorating U.S. fiscal situation and the general perception that U.S. corporates are not paying their fair share of taxes, this situation may not persist much farther into the future – or at least will not be allowed to grow in importance. 

U.S. multi-nationals have also benefited from a big decline in the U.S. dollar (especially versus the euro since Europe represents over 55% of overseas net income for U.S. companies).  It is very hard to imagine this continuing in perpetuity.

On the top line side, there is no doubt that GDP is highly correlated with corporate profits.  We are definitely in a “soft patch” now for the global economy and this has now manifested itself with falling year-over-year profit growth in the non-financial sector (see the first graph above). The $64,000 question is how much of this slowdown is priced in and whether this slowdown has legs to it or not.  Given that the consumer is 70% of GDP, with real wage growth anemic and deleveraging continuing on behalf of consumers, then perhaps this slowdown will have legs. Add to that the imminent cutbacks in government spending and the recently released “double-dip” in house prices, the concept of zero growth in Q3 is not out of the question.  The situation in Europe will certainly not contribute to growth and neither will China’s efforts to curb inflationary pressures produce much in the way of growth for U.S. corporates.  Unless we get QE3, it is hard to see how equities can advance from here unless the P/E rises.  Add to this the fact that many strategists have been scrambling to increase S&P estimates for this year and the next and you have the recipe for a big disappointment and substantial correction.

Jim McGovern

Footnote: _¹ Lombard Research, 2011