Wednesday Briefs – 7 April 2021

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THIS WEEK: The Mother of All Melt-Ups (MAMU); Infrastructure Benchmarking; Minimum Global Tax.

MAMU and MASR

This page called the market recovery correctly since the very first Wednesday Briefs in March 2020 and also called the subsequent meltup as early as last June. Since the more recent date, the S&P 500 and Nasdaq Composite are up about 30% and 40% respectively. Now as the rally makes new highs, some are calling it the Mother of All Melt-Ups (MAMU) and drawing comparisons to late 1999-early 2000, an analogy we first made last July.

This dream scenario for investors has fallen in place thanks to a combination of rising S&P 500 earnings, low interest rates and big government spending. Big tech names such as Microsoft, Apple, Facebook, Google and Amazon are all pushing higher at or near their all time records. Meanwhile pandemic-struck laggards (travel, retail etc.) are staging strong recoveries across the board. In December, we foresaw the mother of all sector rotations (MASR).

Once vaccines have spread to the majority of the population, the pent-up demand to be unleashed this summer could be absolutely epic in scale and breadth. After fifteen months of abnormal restrictions, the thirst to live in full will not be easily satiated.

In February, there were real concerns that this bull market may be disrupted by rising treasury yields. These concerns seem to have faded for now. The 10-year yield is now significantly higher than three months ago but stocks have continued to power ahead. The speed of the increase in yields is as important as the increase itself. Slow-rising yields are deemed manageable or even desirable because they signal an improving economy. But faster-rising yields are more worrying because they raise fears of incipient inflation.

While the going is good, the main risks on the horizon are therefore 1) a faster rise in yields, 2) an exogenous event, geopolitical or otherwise, or 3) a resurgence in Covid infections, which now seems unlikely in the US. As to the stretched valuations of many companies, everyone seems determined to look the other way for as long as possible. Though unwise on the face of it, this is a prerequisite for anyone wishing to participate in the rally.

It is worth noting that vaccine progress has been slower in Europe and at other favorite pre-pandemic destinations. This means that travel and leisure spending within the United States may exceed current projections by a long mile (no pun intended). Travel, leisure and hospitality names will do very well if they can meet the demand.

Infrastructure Benchmarking

The benefits of good infrastructure are well known and result from higher productivity. But infrastructure spending is nearly always mishandled. Few major projects reach completion without first suffering major cost overruns and delivery delays. A good, though admittedly unscientific, rule of thumb is that every dollar spent on US hard infrastructure (hard = roads, bridges, transit, airport and other civil engineering works) includes 50 cents of waste in the form of unnecessary regulation, excessive design modifications, or inefficient administrative procedures.

Two recent cases are New York City’s Second Avenue subway line and the California high-speed rail link. The Second Avenue subway stations are architectural marvels but they cost a lot of money. The contractors had to dig lower than typical in order to avoid older infrastructure (gas, water, electric etc.) that is already in shallower ground. The California link is significantly shorter than was initially planned and is way over budget and has been delayed several times.

As discussed with cities expert Aaron Renn in a recent podcast (starting at 43:50), one reason for this poor performance may be due to insufficient benchmarking. Every new project could benefit from what was learned in a previous similar project.

Second Avenue subway 72nd street station.

For example, the Second Avenue subway may have been built more efficiently had there been an attempt to learn from and to benchmark to a similar project in another city. New York Magazine reported in 2019 that the cost of building a subway station in New York is three times the equivalent in London or Paris. Given the longer history of these two cities, with every dig resulting in new archaeological finds dating back to Roman or pre-Roman times, we probably could learn something from their processes.

And the California line is already at over double the original estimated cost for a shorter distance and a later delivery. It may have been built faster and at lower cost if there had been a systematic effort to explore how other countries do it, for example France or China. But public works are often led by government agencies that sometimes have a too-proud attitude towards other countries and suffer from a not-invented-here or not-decided-here syndrome.

Minimum Global Tax

No such misgivings at the Treasury Department nowadays where Secretary Janet Yellen is looking across the border to harmonize corporate tax rates. On the eve of President Biden’s bid to raise the tax rate on corporations, Ms. Yellen proposed a global minimum tax rate on corporations. This initiative is meant to deter companies from relocating their headquarters to lower tax jurisdictions.

But tax rates are only part of the game played by corporations seeking to optimize their after-tax profits. In addition to nominal tax rates, different countries have different tax deductions or loopholes, and different regulatory regimes.

Different countries also have different needs and require higher or lower revenues. Rich country governments are facing an entitlements tsunami as birth rates decline and growing numbers of boomers retire. Less rich countries have no such social programs or have a lower dependency ratio (the ratio of dependents to workers) and would in theory need lower tax rates.

The net effect of the minimum global tax is that it may reduce the number of companies relocating their headquarters from one rich country to another, say from the US to Switzerland. But some of these companies may relocate to less rich countries. The Tax Foundation provides an overview of corporate tax rates all over the world and notes that:

“Of the 223 jurisdictions surveyed, 15 currently do not impose a general corporate income tax. Except for the United Arab Emirates, all these jurisdictions are small, island nations. A handful, such as the Cayman Islands and Bermuda, are well-known for their lack of corporate taxes.”

Twenty other countries including Ireland, Cyprus, Qatar, Paraguay and Hungary have corporate income tax rates at or below 12.5%.

In its effort to harmonize tax rates, the Treasury may also consider doing away with the global taxation regime on individuals whereby a US citizen (or permanent resident) is subject to the full US tax rate, net of taxes paid in her country of residence. No other major country in the world imposes such global taxation irrespective of residency. Yet a change of current policy is highly unlikely at a time of soaring budget deficits.

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