Market Recap – January 13, 2017

Markets Retreat, Financial Earnings and Corporate Taxes

  • Stocks retreated slightly in the 2nd week of the year
  • Initial financial earnings generally better than expected and optimistic about 2017
  • Is an overhaul of corporate taxes in the works?

Stocks retreated slightly this week in the second trading week of the year. The Dow declined 0.4% while the S&P 500 was off 0.1%. Markets are closed Monday in observance of Martin Luther King, Jr. Holiday.

JP Morgan, Bank of America and Wells Fargo kicked off earnings season today with numbers that generally beat expectations. While the 4th quarter numbers were good, most investors looked to improved future forecasts as the key takeaway. The banks are already seeing the benefit of higher interest rates and they expect economic activity to pick up in 2017. JP Morgan CEO Jamie Dimon noted strength in a number of areas, including wage growth, unemployment, consumer confidence, real estate, etc as the basis for his optimism this year. Next week we’ll start to see major non-financial firms start reporting such as IBM, GE and others. Read More

Corporate taxes are becoming a hot topic in the new Congress. Since we’re going to start hearing more about ‘Border Adjustment Taxes’ I wanted to review the current situation and what this potential change means. The US currently uses a global tax system. This means that the US taxes the global earnings of all US companies. The federal corporate tax rate is 35%, although most companies pay an effective rate below that level. Companies get credits for taxes paid overseas and can delay paying taxes on foreign earnings as long as the profits stay outside the US. We are the only country in the world that taxes global earnings.

House Republicans have an idea to completely overhaul the corporate tax code in ways that seem to have good and bad consequences. The key aspects of the new plan is to lower the tax rate to 20% and only tax US sales less US costs. This is called a ‘border adjustment tax’ which encourages domestic production and exports while discouraging imports. Under this type of system, all sales in the US would be subject to the tax. Expenses incurred in the US would be tax deductible, but expenses incurred outside the US would no longer be deductible. Sales on products exported to other countries would not be taxed.

In a simple example, if Apple sold a $500 phone in the US and it had US costs of $100 and non-US costs of $100, Apple would pay a 20% tax on $400, or $80. That’s the US revenue minus the US costs. If Apple sold two phones for $500 each, one in the US and one in Canada with $200 of US costs and $200 of non-US costs, Apple would pay taxes based on $500 of revenue minus $200 in US costs = $300. The tax bill would be $60. This is because Apple gets the deduction for US costs, but doesn’t have to pay taxes on sales outside of the US. This is how this type plan encourages exports.

There are parts of this plan that are very appealing. This system eliminates companies’ ability to move profits around the globe to low-tax countries because those transactions aren’t counted in the tax liability calculations. It also brings our corporate tax code and tax rate in-line with other industrialized nations. It also potentially encourages more companies to keep producing in the US or even move production back to the US. On the downside, this is effectively a tax on imports, which could cause price increases on a variety of consumer products. This could also cause large disruptions among companies and industries. We can see the difference by looking at companies like Harley-Davidson (almost all manufacturing happens in the US) versus a company like Walmart (most products sold are made outside the US). The proposed system would have drastically different consequences for these companies. Harley-Davidson would see its tax bill decrease because the tax rate is lower and it exports motorcycles to other countries. Walmart on the other hand would see its taxes skyrocket because a large percentage of its costs are buying inventory made overseas, which would no longer be tax-deductible. Some economists believe a plan like this would strengthen the US Dollar, thus making up the losses to retailers, and other large importers, since input costs would decrease. That sounds very theoretical to me and unlikely to happen exactly as planned. If you’ve made it this far, you can see this is a complicated issue and one that promises significant debate if Congress begins to consider this type of plan. You’re also more familiar with the issue than 98%+ of the public.

Oil declined again this week, closing down 2.2% to $52.45/barrel. The yield on the 10-yr Treasury declined again this week, closing at 2.39% from 2.42% a week ago. The average rate on a 30-yr mortgage declined, moving to 4.12% from 4.20% a week ago.

Close Weekly YTD
Dow Jones 19,885.73 (0.4%) 0.6%
S&P 500 2,274.64 (0.1%) 1.6%
Oil 52.45 (2.2%) (2.7%)
10-yr Treasury (∆ in bps) 2.39 (3) (6)

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