Cumberland Advisors Market Commentary –  Trump Tax Reform: Looking Backward and Forward

Two members of the research department of the Banque de France have published an interesting note important to US investors. We applaud the work of Cristina Jude and Francesco Pappada. The title is “Does the Trump corporate tax reform impact the composition of the US current account?” Here is a direct link to their paper: https://blocnotesdeleco.banque-france.fr/en/blog-entry/does-trump-corporate-tax-reform-impact-composition-us-current-account . We thank the authors and the Banque de France for permission to share this work with our readers.

Cumberland Advisors Market Commentary

The implications of their findings give us reason to pause and reflect on the impacts on US markets. Note how they describe the issue of “profit hoarding” and “profit shifting.” Also note the roles of “small jurisdictions,” which they list as Bermuda, Ireland, Luxembourg, the Netherlands, Singapore, and Switzerland. Their paper is well-documented, and links to their backup citations are in the paper.

I have been mulling over the implications of their comments on repatriation in particular. They present data to suggest that the transitory effects are nearly over. That development has implications for portfolio management. It also means that there are second-derivative implications as multinational corporations return to a baseline allocation approach to their foreign-sourced profits.

So the activity in stock buybacks and dividends and internal corporate decisions attributable to repatriation are shifting. Note that if repatriation had a positive effect on your portfolio, their research suggests that the positive force is spent or nearly so.

There is another secondary effect on the short end of the yield curve.

A multinational corporation that was engaged in “profit hoarding” parked cash in special types of accounts in order to qualify for deferral of tax to the US. Those accounts were often held in Treasury bills. The repatriation of those monies caused the Treasury bills to be sold and the cash to be moved into the US-based banking system. The entire process usually happened in one day. Note that the aggregate of Treasury bills and banking system aggregates was unchanged. It is the ownerships that changed.

Those changes occurred in the very short end of the yield curve. They happened at the same time that other forces impacted short-term interest rates, so there is no way to know how much of the volatility in the front of the yield curve was attributable to this transitory effect. What we do know is that the transitory effect is ending, if the researchers are correct in their observations.

Only time and retrospective research will reveal the impacts.

Our final takeaway is that the repatriation flows provided a tailwind to the US stock market. That tailwind happened coincidentally with other tax-code changes and with policy changes. It seems to be ending.

Without a tailwind, the US securities markets have to realign to its absence. We will see what that means this year.

At Cumberland we maintain a cash reserve in our US ETF portfolios. In our bond accounts we have been taking profits as the rally in the Treasury market has steamrolled and yields have dropped precipitously. We think it is time for more defensive posturing in bonds. Yields don’t fall forever, and stocks require earnings growth rates to rise.

Also note that the number of listed stocks in the US has been declining since the late 1990s (see Where Have All the Public Companies Gone? https://www.bloomberg.com/opinion/articles/2018-04-09/where-have-all-the-u-s-public-companies-gone). The average age of the remaining listed companies has nearly doubled. So we have a shrinking and older cohort of listed companies trading on the US exchanges (see How Did the U.S. Stock Market Get So Old? https://www.bloomberg.com/news/articles/2019-03-05/how-did-the-u-s-stock-market-get-so-old).

Fewer stocks, which are older and therefore more mature companies, combined with a post-repatriation paradigm – that is what faces the stock market in 2019–2020.
David R. Kotok
Chairman and Chief Investment Officer
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Cumberland Advisors invites you to our “Financial Markets and the Economy – Financial Literacy Day III” event, to be held April 11, 2019, from 8:30 AM to 4 PM at the Selby Auditorium of the University of South Florida Sarasota-Manatee.

Our focus is “Financial Markets and the Economy”, featuring:

Panels-
•    The Stock Market
•    Health Hunger and Philanthropy
•    How the World Looks to Me – A Global Economic Outlook

Special Presentations-
•    A Conversation with Susan Harper, Canada’s Consul Gen in Fla, on Trade/World Affairs
•    Keynote by Gretchen Morgenson, Senior Special Writer in the Investigations Unit at The Wall Street Journal and Former Business and Financial Editor for the New York Times.


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1Q2019 Review: Taxable Fixed Income

Short to intermediate Treasury yields declined throughout the first quarter as of March 19th, as the 30-year Treasury was flat at roughly 3.00%. The Treasury yield curve remains slightly inverted out to 5-years. This has benefited the Agency multi-step securities that we hold in portfolios, as we have witnessed an increase in calls as coupon steps are not justified by the inversion of the yield curve.

Cumberland Advisors Market Commentary

By the time this overview is received, the Fed will have made a decision to hold rates steady or hike the fed funds target rate. We expect the Fed Funds rate to remain unchanged at 2.25-2.50. In fact, the odds are higher that the next move will be a rate cut as opposed to a hike. The current rate-cut probability by the end 2019 is 25.1% versus a 0.5% chance of a hike, showing that market participants have major doubts on future rate hikes. We should receive additional clarity as to the direction of interest rates at upcoming Fed meetings.

With the uncertainty centered on the interest-rate environment, our portfolios have benefited from the inclusion of callable Build America Bonds, as they have provided a higher level of yield per unit of duration than shorter non-callable securities. Our taxable portfolios have also benefited from the inclusion of long tax-free municipals, as we have seen outperformance in that space. We will continue to manage portfolios defensively until more clarity on interest rates is revealed, and we will take advantage of opportunities as they become available.

Daniel Himelberger
Portfolio Manager & Fixed Income Analyst
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The Cumberland World Series Theory of the Bond

Most investors have heard of the “Super Bowl Theory of the Dow.” This theory, first proposed by sportswriter Leonard Koppett in the 1970s (source: Wikipedia), posited that when a team from the “old” NFL (the current NFC plus the Colts, Browns, and Steelers, who joined the AFC in 1970) won the Super Bowl, the Dow Jones Industrial Average would advance in the year following the Super Bowl.

 

If a team from the AFC won the Super Bowl, the Dow would decline. Amazingly, this theory has worked out almost 80% of the time, though the February 2017 Super Bowl, won by the Patriots (AFC), did NOT accurately predict the stock market (up in 2017). The correlation, of course, is just a coincidence: There is no connection between a conference winning the Super Bowl and subsequent returns in the stock market, and thus there is no reason to think that the Super Bowl can be used to predict markets.

But we decided to have a little fun; and since it’s World Series time, we wanted to see whether there was any tie-in to how the BOND MARKET did in the calendar year following a World Series win by either the American League or National League. The easiest data to use was the 10-year US Treasury bond and its return in a calendar year. We measured TOTAL return (coupon and price) and then took away headline inflation (CPI). (By the way, we have this data in our bond models, so it was easy to deploy for a “fun” topic.) We went back to 1966 to have a similar time period to the Super Bowl.

Our results are below:

How the BOND MARKET did in the calendar year following a World Series win by either the American League or National League

What do the results tell us?Frankly, not as much as we hoped.

Some notes: We used the full calendar year AFTER the World Series. And we ignored 1995, which followed a year when there was not a World Series due to the players’ strike. In the bond market, 1995 was a big year because the market rebounded after the carnage of 1994.

In the 51 years that we measured, the American League won the World Series 27 times and the National League triumphed 23 times. The bond years following an American League winner had a positive return 15 years and a negative return 12 years. The AVERAGE bond market return following an American League winner was 2.39%. The average UP year for an American League winner was 9.12%, and the average DOWN year following an American League winner was -6.03%.

The National League numbers look a bit more promising. In the 23 years that the senior circuit won the World Series, the AVERAGE return was 3.06%, 67 basis points higher than the average American League return (remember, these are total returns, inflation-adjusted). The average POSITIVE return for the National League was 9.18%, fairly comparable to the American League’s 9.12%. But the average DOWN year for the National League was -4.88%, considerable less than the American League’s -6.03%.

At some point we may go back another fifty years to add to the study, since we have a much longer record for the World Series than we do for the Super Bowl (which started after the 1966 season).

But the results would suggest that the bond market on average does better after a National League win in the Series, with a slightly better upside number and a considerably better downside number. What does 2018 hold? Well the American League Houston Astros won the World Series last year over the Los Angeles Dodgers. But wait – the Astros were a National League team until 2013! So with this mixed history, the 10-year Treasury to date has a total return of approximately -3% through the end of the third quarter, with inflation of approximately 1.4% through the first nine months. That’s a total return through nine months (after inflation) of roughly -4.4%. If we have a flat quarter, that should suggest that a down year this year would be more like a National League return (and Houston was an National League team for all but six years of its 56-year existence). Of course the returns will change between now and the end of the year. The volatility in the equity markets, slowing housing markets in a number areas of the country, and possible worries about SALT provisions in the tax bill may start to push more assets into a bond market that has been oversold in general – particularly given that trailing headline inflation has dropped from 2.9% to 2.3% in the past three months.

As for next year, we know we fare somewhat better with the National League, but GO RED SOX!

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
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Gabriel Hament
Foundations and Charitable Accounts
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The Tale of Two Ratios: Shorter and Longer

In a year when we have seen commentators talking about the relative flatness of yield curves, we have a conundrum when we look at the US Treasury yield curve and the US muni yield curve (shown here as the Bloomberg AA general obligation yield curve).

Market Commentary - John Mousseau

Curve 1 below is from the beginning of 2017. Curve 2 is from September 2017. Curve 3 is from September of this year.

Curve 1
Source: Bloomberg

Curve 1, at the beginning of 2017, shows a very cheap muni yield curve across the board. Muni yields were at or above Treasury levels at EVERY POINT ON THE YIELD CURVE. This reflected the entire uncertainty surrounding the presidential election. There were questions as to whether we would see a tax bill and how munis would be treated, fear of a big infrastructure bill (and uncertainty over how that would affect munis), what the president would do regarding a new Fed chair, and whether Fed policy would change. All in all, it was an extraordinarily cheap moment for muni bonds. The long end was particularly cheap, as the market had undergone a selloff in the wake of the Trump election, with extreme bond-fund selling.

Curve 2
Source: Bloomberg

Curve 2 is from September of 2017. What happened? Short-term muni yields dropped. The trend really started in the first quarter when then-Chair Janet Yellen made it clear that the Fed would continue on its path of raising short-term interest rates gradually (read: not at every meeting) but would need to keep raising rates to reflect an improving economy. Thus the shorter end of the market essentially began to go lower in yield to reflect the tax structure, and the ratio moves were dramatic for paper inside of five years. Longer munis continued to exhibit cheapness of yield relative to Treasuries. We believe this was related to market knowledge that there would be a change in the tax code coming with the tax bill and to the uncertainty as to how municipal bonds would be treated under that bill. The expectation was that municipal advance refundings (which allowed municipalities to defease older, higher-coupon bonds in advance of their call dates) would be eliminated. Bond markets also expected that private-activity bonds – issued by charter schools, private universities, state housing agencies, and airports among others – would be prohibited. In the end the tax bill eliminated advance refundings but allowed private-activity bonds. The cheapness in the long end of the muni market was due to the expectation that SUPPLY would bulge at year end to beat the tax code changes, and indeed that is what happened.

Curve 3
Source: Bloomberg

Curve 3 is from this September. Two observations jump out. The long end remains absurdly cheap. One factor is some erosion of the buying base. Banks have been smaller buyers of munis because of the lower corporate rate; and individual demand for long munis has been good, but bond funds have not recouped the outflow of funds that they saw in the wake of the 2016 election. The more dramatic move has been the continued drop in ratios inside of 10 years – in some cases to lower than the break-even rate if we assume an average marginal tax rate of 25%.

One of our thoughts is that investors are expecting a possible change in the makeup of Congress this fall and possibly a change in the White House in 2020 and a potential revision of the tax code again. The current individual rates expire in 2025. Therefore, investors are turning over muni portfolios faster and paying more for short-dated securities. They would therefore have money back faster if there if a tax law change in the wake of a switched Congressional majority.

However, we believe the longer end of the bond market remains an extremely good value. A 4% tax-free yield is the taxable equivalent of 6.35% if an investor is in the 37% top tax rate bracket. For states with high income taxes that are no longer deductible, a 4% in-state bond yield is worth even more. At the top state tax rate, a 4% New Jersey tax-free bond is worth 8.97% taxable equivalent; a 4% New York bond is worth 8.82% taxable equivalent; and a California 4% tax-free yield is worth 8.04% taxable equivalent. This is for AA or higher-rated securities. To position the 4% in-state bond correctly credit-wise, it compares to high-grade corporate and long, taxable municipal bonds at the 4.0–4.5% level or a BB junk bond long yield index of 6.5% (source: Bloomberg).  In general, the muni yield curve drifted up 20 basis points during the quarter, across from 2 years out to 30. This is in sympathy with the treasury yield curve, which also experienced slightly higher yield movements across the board.

Curve 3 also is a way to understand Cumberland’s current barbell approach to tax-free bond portfolio management. We want shorter-term securities turning over faster as the Fed raises short-term rates, but we want the longer end locked in because we believe the current cheap yield ratios will eventually go to 100% or below. This happened during the Fed’s hike cycle of 2004–2006, when long muni/Treasury yield ratios fell from 103% to 85%. Our approach should give long munis a great deal of defensive value if overall interest rates rise. It is this defensive quality that causes us to include some longer tax-free bonds in the management of taxable bond portfolios of clients such as pensions, foundations, and charitable trusts. The total-return characteristics of owning a tax-free bond at these levels is very compelling when the expectation is for lower yield ratios over time. Certainly it will take some time for the strategy to work out, as longer Treasury yields are somewhat anchored to the general low level of longer bond yields in the Eurozone countries.

As the Federal Reserve continues to raise short-term interest rates (and we believe they will continue to do so to get the fed funds rate decently above the level of core CPI [currently 2.2%]), we will eventually move some of the shorter end of the barbell out somewhat longer, some of the longer end (where most bonds are callable) to more noncallable structures, and some bonds to the “belly” of the yield curve (where we don’t want to be now but will certainly want to be if we get to a point where the economy slows).

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.