There is an opportunity for Europe to lead as a template for a better balance between individual and collective interests.

Tax union.

• Creation of an EU tax authority which will set the Unified Tax Code.
• Member countries will have representation in the EU tax authority which will set a Tax Benchmark.
• Member countries which have tax rates below the benchmark will be required to collect a proportion of the gap and pay this to the EU tax authority. The proportion is set at 10% in the first year and rises by 10% each year with 100% of the gap collected and paid to the EU tax authority in year 10.
• Member countries which have tax rates above the benchmark will pay 10% of the gap, which they have already collected, to the EU tax authority. The proportion is set at 10% in the first year and rises by 10% each year with 100% of the gap collected and paid to the EU tax authority in year 10.
• The Unified Tax Code will apply to personal and corporate taxes, as well as to inheritance, capital gains, asset (property or land) and other taxes.
• The Unified Tax Code will apply to VAT.

Tax devolution.

• The tax union applies only to federal taxes. Local taxes will be devolved to local tax authorities.
• The EU tax authority will determine how taxes in countries which do not distinguish between local and federal taxes is allocated.
• The convergence rules apply only to federal taxes.

General principles on Tax.

• Corporation taxes should be encouraged to converge as soon as possible to avoid tax arbitrage.
• Personal income taxes should be made more progressive with the introduction of new tax bands to cater to ultra-high incomes.
• Since tax rates will be made converge, double taxation treaties within the union and the concept of global taxation are academic. However, since the tax code is regional and not global, ex-union tax liability will have to be legislated for.

Sovereign wealth fund.

The European Union would establish a sovereign wealth fund. Unification of assets cannot be immediate so the concept of sub-funds or cells should be implemented initially.

The establishment of a sovereign wealth fund is part of a bigger effort to better define the balance sheet, the assets and liabilities of a country. It also allows countries to tranche their liabilities so that they can optimize their funding and provide investors with different investment opportunities in different claims.

All state assets should be contributed to the sovereign wealth fund so that they appear with full transparency on the fund’s balance sheet.

Each member has a sub fund, and each sub fund has its own assets and liabilities. Each sub fund will have its own credit rating and will generally face its own funding conditions.

The Union’s sub fund will house the common assets of the Union.

There is legal separation between sub funds so that the assets and liabilities of the sub funds are not commingled.

Budget union.

The state should only provide those goods and services which the market is unable or unwilling to do so. The federal budget should be parsimonious.

Budget union is not an explicit objective. Member states still collect their own local and federal taxes. Only gap payments are collected by the EU tax authority which funds the sovereign wealth fund. However, since the Unified Tax Code encourages tax convergence, any guidance towards a balanced budget or at least tendencies or limits towards budget balance will encourage budget convergence.

Budget limits.

Budget guidance will be given, perhaps, re stating the Maastricht conditions. Budget discipline will be imposed through the creation of the sovereign wealth fund since a profligate member will find its unsecured funding costs rising. If it turns to secured lending, it is no longer able to ignore claims on its assets since its sovereign wealth fund, the repository of its assets, will be subject to EU insolvency law, such law to be refined as necessary to be relevant to a sovereign wealth fund. A delinquent borrower may find its national monuments, utilities and other assets foreclosed upon.

Social security.

Social security should be harmonized. One element shall be a compulsory defined contribution pension scheme which will be funded by contributions from income as well as an employer contribution. Another element will be a social insurance scheme funded by tax.

The pension assets will be under substantial control by the workers so that no one need fund their sovereign or indeed any other member country if they do not feel so inclined. Assets will be held in custody and not on the balance sheet of the scheme. This is to prevent any de facto expropriations.

The social insurance scheme will be funded by taxation and is a general commingled pool.

To avoid benefits arbitrage, pay in rates and pay out rates will be harmonized.

Labour and individual mobility.

Labour mobility is a good thing but has to be managed. Immigrants need to be able to find jobs and fund themselves. They need to be accretive to the welfare of the host country both financially and socially. Immigration should be encouraged to fill jobs where there is a shortage of labour.

To discourage benefits arbitrage, benefits should be harmonized between member countries. Immigrants should draw on the home benefits system for before they can draw on the benefits system of the host country. In year 1, an immigrant shall be entitled to a quarter of the host country’s benefits and three quarters of their home country’s benefits, the host country entitlement rising and the home country entitlement falling by a quarter each year so that full transition takes 4 years.

Certain questions should be addressed regarding immigration:

• Are there sufficient suitable jobs? What is the impact on incumbents’ employment prospects? What is the impact on prospective employers?
• Is the immigrant accretive to the economy and society?
• Are there sufficient resources?
• Is there enough space?
• Are the cultures compatible and will the immigrant integrate into existing society
• Is the immigrant a refugee and what special conditions apply?

Settling in the EU:

Strict entry requirements apply. The above issues should be addressed in assessing eligibility.

Movement within the EU:

EU member country citizens should be accorded freedom to move and settle anywhere within the EU, however, movement should no longer be unmonitored. All movements across member countries’ borders whether by citizens or tourists should be monitored and recorded. Citizens or tourists should not normally be refused passage across borders.

US Fiscal Policy

The impact of fiscal policy on the US economy itself has unpredictable elements. The current outlook is that the fiscal plan will create more disposable income and allow more consumption and investment and that this is inflationary and pro-growth. However, there are redistributive properties to the fiscal plan that are likely to increase inequality which suppresses the propensity to consume thus increasing saving. There are also agency issues that might change the optimal debt equity ratio for businesses. Revoking the tax deductibility of interest, for example, will skew companies toward equity financing. The consensus expectation that companies will buy back more shares might not happen. Rising interest rates may also discourage debt finance.

Therefore, the supply of corporate bonds could be constrained while demand could rise which could cause a spread compression beyond historical levels.

A strong USD is positive for European and Asian exporters, all else being equal. However, US trade policy will reduce this impact. Also, countries which cannot fund cheaply in local currency and have funded or need to fund in USD will be at a disadvantage. USD funding will rise in more ways than one, the base line curve will rise but the shortage of offshore USD will raise funding costs even further. The strong USD and rising USD rates scenario favours most countries which can fund in local currency, which means Europe, Japan and China. China, however, has local issues which may lead to tighter financial conditions this year.

If US growth picks up, the trade balance will have a natural tendency towards deficit. This is the theory. Trump’s policies appear to attempt to grow the economy while managing the trade deficit towards balance. Energy self-sufficiency, trade protectionism, and domestic job creation which discourage offshoring and encourage re-shoring will compensate for the deficit tendencies of fiscal policy.

Rising Interest Rates

2008 marked a change in the way economies function and also lifted the veil on changes which had happened before the crisis but which were possibly covered by complacency. One major development is the role of central banks in the economy. Our understanding of how the economy works has not caught up with the fervour with which we have applied new techniques for managing the economy, and indeed how we chase yield and front run central banks.

One question which is useful to ask is, were falling interest rates a good thing or will they fall too far and threaten financial stability?

Japan’s experience with NIRP was not entirely a success and had to be modified to near total control of the shape of the yield curve.

Inflation has fallen and seemed unresponsive to falling rates in recent history. Is the correlation between inflation and rates negative or has the correlation turned positive? There are arguments why this could be so.

Rising rates could be the catalyst for a return to normal levels of inflation. Falling rates could have encouraged over-investment and over-capacity leading to too much slack in the economy and weak inflation. Rising rates could be the catalyst for rightsizing the productive capacity of the economy to meet demand.

At some level, rates could get too high, but what do we mean by too high, what level is too high? Public debt in developed countries has been rising steadily since 2007. In the US, debt to GDP has risen from just over 60% in 2007 to 104% in 2016. Trump’s fiscal plans will likely increase the national debt further. Higher interest rates imply a higher debt service and in normal circumstances, the ability of nation to service its debt is a factor in the pricing of its debt. Circumstances have not been normal for some time. If market reverted to the old logic, the cost of debt could rise significantly. Central banks have tamed the bond vigilantes but could they do it again? The Bank of Japan is in a unique position in that foreign demand for JGBs is small and it is able to co-opt the purchasing power of the Japanese public to monetize the national debt. This may not be feasible in USD.

Rates are artificially low. The US 10 year had traded to 2.6% recently and a yield of 3% or 3.5% would be unremarkable. In the short term, yield hungry investors could well bid down yields to 2%. The longer term reality suggests that, looking beyond the noise and volatility, rates should trend up with the 10 year yield trading above 3.5% in the next 2 years. If the correlation with inflation has switched, this could even create an inflation loop which could drive yields higher.

As for the Fed, the task has become harder, and it will likely become more sensitive to inflation. Cutting rates is easier than raising them.

End of the Bond Bull?

From the above analysis, the answer is, the duration bull market is over. However, turning points can span 2 to 3 years. This volatility threatens to be the unfriendly kind, the kind that has no predictable triggers, the kind that confounds the hedge funds who often claim that “volatility is good for us”, and the opportunity for loss will be greater than that for gain. For that reason, the prudent strategy is to hedge duration rather than to actively trade it for profit.

The credit bull market is a separate question. The repatriation tax amnesty, the lower taxes, the loss of tax deductibility of interest expense, the rising interest rates, and tighter financial conditions will likely result in a relative undersupply of corporate bonds while yield hungry investors and a potential rise in savings from a more regressive tax code is likely to support demand. The risk for credit is on the upside, that is, spreads can be expected to tighten and to do so beyond recent historical averages.

Parting Notes

The economy and how it functions, the relationships between agents, and the behaviour of agents, has evolved over time and current models may not be adequate to explain the dynamics let alone predict the path of prices and variables.

The cold war in trade which is now becoming a hot war is a part of a more fundamental tension. When global growth rates are high, people are more likely to share and cooperate and the cooperative behaviour implied by Folk Theorem’s hold. When growth is slow, people are less willing to cooperate and prefer to play security or short term strategies. Unfortunately, less cooperative behaviour may not be limited to commercial and economic interests but to geopolitical interests as well.

Another interesting develop
ment is the rise of machines. As automation replaces human labour questions beyond economic efficiency arise, notably, the question of who should own the machines. As long as machines do not represent too large a proportion of production, and as long as growth creates new types of jobs the need for an answer can be delayed, but at some point, the question needs and answer.

Last Tuesday, the FT asked the question “Where will corporate America’s overseas cash pile go?” Excellent question.

Until Trump proposed a repatriation tax and lower overseas corporate taxes, the share buyback binge which has propelled the US equity market for the past 7 years was set to peak. Goldman Sachs estimates that the tax holiday will result in 200 billion USD of repatriations. The expectation is that most of this cash will be directed at share buybacks and dividends, although share buybacks will likely dominate as the more tax efficient shareholder reward.

Let’s try to argue against this consensus scenario. There are basically three things you can do with corporate cash, you can buy back shares, you can buy other companies, you can invest in capacity, or you can retire debt. Interest rates are rising which implies that, one, indebtedness is expensive, and two, investment in capacity faces a higher hurdle rate of return. Buying back shares raises the leverage of the company making it relatively more indebted. Buying other companies raises leverage far faster than share buybacks. Investment in capacity may be justified if final demand picks up but, ceteris paribus, higher interest rates means less investment. How about retiring debt either through buy backs or simply attrition.

Net debt to EBITDA for S&P 500 companies rose from 1.1X in 2013 to 1.7X while total debt to EBITDA rose from 3.6X to 4.6X. This is a considerable increase in leverage in a short time. The scope for a deleveraging cycle is ample. If US companies embark on strengthening their balance sheets, by eschewing share buybacks and reducing indebtedness, the impact on credit spreads could be significant.

From 2002 to 2007, credit spreads tightened as leverage fell. From 2007 to 2008, leverage rose and credit spreads surged, although the catalyst to be fair was not in the corporate credit market but in the housing market. The credit rally from 2010 to 2014 coincided with balance sheet deleveraging. What is remarkable about the credit market has been the rally from February 2016 to date which has occurred while corporate leverage is still increasing. If corporates start reducing their leverage, we could be seeing a more sustained rally in credit and spreads reaching for the lows of the 2004 -2006 period.

If in the immediate aftermath of Donald Trump winning the US election, equities had crashed, credit spreads had widened, bonds had sold off, the dollar was strong yet gold had surged. And held on to these trends for more than a day. What would the present look like?

The only resemblance to the above scenario to the current reality is that bonds had fallen as inflationary expectations rose, driven by Trump’s spending plans and tax cuts. What might the analysis of this alternate reality look like?

The outlook for equities is poor. US equities are already facing a profits recession if not an economic one. The economic cycle is advanced and a slowdown is probable. Add to this higher debt costs and the impact on balance sheets which have in the last 5 years been expanded to take advantage of low rates, buy back shares and pay dividends, and the prospects for business look poor as debt service rises, leverage rises organically, and the refinancing becomes more expensive and difficult.

Equities will not be the only ones to suffer, credit spreads are likely to widen as credit quality deteriorates.

USD will likely be strong. The low repatriation tax and subsequent lower tax on foreign earnings is likely to encourage inflows. Interest rate differentials across the curve support the USD. As a net importer, the retreat from trade is net positive for USD.

The market reaction to a Trump victory would prompt the Fed to delay raising rates and to generally adopt a dovish stance. While this is at odds with the President’s wishes, the Fed will want to demonstrate its independence, stave off recession, or worse, stagflation, and would be tempted to consider resuming QE. That said, reviving QE would be controversial, so the immediate action is to do nothing. The yield curve steepens as capital seeks low to no duration risk free assets.

The picture for emerging markets would be complicated. As strong USD would be good for terms of trade, which are very important for export nations. However, countries with significant USD debt would face rising debt and debt burdens as rates also rose. High risk aversion is generally bad for emerging markets and the net impact would be bad for emerging market assets.

Ceteris paribus, the situation for Europe would be less poor. A weak EUR would be reflationary. While European yields would rise in sympathy with USD yields, the fact that Europe was deleveraging and Europe can raise debt in EUR, and the ECB remains in QE mode, cushion the blow on Europe. Any sell off would be a buying opportunity.

With the long duration USD assets off the table, the attention would turn to bunds and JGBs. Non USD duration would rally. Since short term rates dispersion was low, cost of FX hedging is also low. European rates would remain low and be capped even at the long end. For Japan, the aim of maintaining a steep yield curve beyond 10 years will become more challenging leading to a selloff in banks.

In summary:

US equities fall – economic cycle peak, earnings peak, higher debt service, pressure on multiples.

US credits widen – as above.

USD curve steepens – inflation fears pressure the long end. Fed holds the short end.

USD strong – Inflation, capital flows from tax changes, interest rate differentials.

European equities outperform – Weak EUR, less levered than US, lower debt service, re-rating potential.

European credit outperforms – as above.

EUR curve flattens – demand for duration not met in USD, FX hedging costs low, low inflation.

EUR weak – dual of strong USD.

Japanese equities maintain bifurcation along JPY lines.

JGB curve flattens – demand for duration not met in USD, FX hedging costs low, low inflation.

JPY weak – dual of strong USD.

Gold strong – Risk aversion and inflation hedge.

Every so often democracy produces a result that is extreme and polarizing. The personal qualities displayed by Donald Trump were far from desirable or exemplary and his proposed policies appear vague, incomplete or ill-conceived. Yet Trump addresses some deficiencies, even if his remedies may be questionable.

While 47% of eligible voters did not vote and more people voted for Clinton than Trump, the fact remains that over a quarter of the people voted for Trump. That’s 25% of people who chose a misogynistic, avaricious, egotistical, disingenuous tax evader. Some of this may have been a protest vote against an opponent they felt they could not trust.

However, it is more probable that Trump represents the feelings and ideology of more people than we care to admit. It is an uncomfortable truth about the human race, about ourselves. We are less likely to condemn or punish another if we have been guilty of the same crimes, even if to a lesser degree.

That Trump lost the popular vote may tempt one to redesign the voting mechanism, but no voting system is perfect. What America and indeed the world needs to do is to give Donald Trump the opportunity to prove himself worthy or not. America’s democracy means that a man untrained and inexperienced in the workings of government can now lead the country. There are, however, useful checks and balances in the form of Congress. If we have to worry it is that the Republicans control the House and the Senate, albeit with an insufficient majority to force policy through.

The demonstrations against Trump should stop, as should the calls for “faithless electors” to confound the election result, or actions to impeach the President Elect as a political means to stop him from taking office. If Trump is prosecuted for one of his allegedly sham commercial practices it should not be a politically motivated action.

To unfairly deny the President Elect is to deny democracy. America has the institutions and the systems to constrain a rogue President. In the meantime, Trump has 4 years to prove himself. If he doesn’t it will be 4 years lost and some work for his successor or successors to cure. There are worse outcomes in the world, incumbents who cannot or will not be removed, despots who outstay their welcome and defy the will of their people and nepotic dynasties. Trump at least is the will of a quarter of the people. The silent 47% bear some blame and chronic non-participation should result in a permanent loss of voting rights. The nation should pull together, including the 25% who voted against Trump, to steer the country to a better future, even with all the pushing and pulling associated with a liberal democracy. It would be wrong to simply work against the man. It might give him cause to undeservingly seek a second term. If he fails despite the support of the country then there is no excuse.