FINANCIAL REVIEW

War, Inversions, and Climate

Sinclair Noe — September 23, 2014

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Financial Review

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 116 = 17,055
SPX – 11 = 1982
NA – 19 = 4508
10 YR YLD – .03 = 2.53%
OIL + .06 = 91.62
GOLD + 8.10 = 1223.90
SILV + .05 = 17.88

First up: war. You’ve probably heard by now that the US launched several airstrikes against ISIS targets inside Syria and, separately, in potentially averting an imminent threat to the homeland from an al Qaeda group called Khorasan. Many of the targets were in and around Raqqa, Syria, believed to be an ISIS stronghold. Several Arab nations took part in the US-led operation: Jordan, Saudi Arabia, Bahrain, Qatar and the United Arab Emirates. A spokesman for the Pentagon said they are still assessing the effectiveness of the bombing campaign but the Pentagon believes they were “successful in hitting what we were aiming at.”

The airstrikes against Khorasan was in response to threats, however officials so far have provided no details about the terrorists’ planned attack or the credibility of the intelligence they had on it. A Pentagon spokesman said “the individuals plotting and planning it were eliminated.”

The Syrian government says the US told it of plans to carry out airstrikes. The State Department immediately denied that it gave prior notification. Reuters reports Iranian officials were informed of the airstrikes in advance, but not specific targets. Meanwhile, the Israeli military said that it had shot down a Syrian fighter jet that had “infiltrated into Israeli airspace,” the first such incident in at least a quarter of a century. It is thought that the jet wandered into Israeli airspace accidentally. Maybe, but it also illustrates the possibility of unintended entanglements coming out of the conflict.

In economic news: manufacturing activity is near a 4-1/2 year high in September and factory employment is up, but housing prices were sluggish in July.

Financial data firm Markit said its preliminary or “flash” factory purchasing managers index came in at 57.9, unchanged from August when it touched its highest level since April 2010. A reading above 50 indicates expansion. Manufacturing activity in the third quarter was the strongest since Markit started tracking it in mid-2007. Factory jobs rose for a second straight month, and new orders held steady above 60 for the third time in the last 4 months.

The Federal Reserve Bank of Philadelphia said its new general activity index for non-manufacturing firms in the mid-Atlantic region jumped sharply. The increase in activity reflected more new orders, sales and full-time hiring. Service sector employees also worked longer hours, while firms increased their capital spending.

The Federal Housing Finance Agency said home prices increased 0.1% in July, and 4.4% in the 12 months through July, the smallest gain since September 2012.

Further data showed euro zone business activity in September was the weakest this year, while factory activity in China picked up only slightly.

The Treasury Department today announced new rules to crack down on corporate tax inversions. The idea behind inversions is that a US business merges with or is acquired by a foreign company in a country with a lower tax rate; by redomiciling, or moving their headquarters to the lower tax rate country, they can lower their tax bill, even if they keep most of their business in the US. Obama applauded the Treasury for taking steps to reverse the trend of companies seeking to “exploit this loophole” to avoid paying their fair share in taxes. Yet he said he was still calling on Congress to pursue broader tax reform that would reduce the corporate tax rate, close loopholes and make the tax code simpler.

The new rules will mean little for companies that have already inverted, but for at least 10 companies in the midst of completing such deals, and for those considering inversions, the impact will be significant. Most pending deals could become more costly for the buyers, such as AbbVie, and its $54 billion deal to acquire Ireland’s Shire, as well as Medtronic and its $42 billion takeover of Covidien. Neither of these transactions, the biggest of the year, was expected to fall apart completely, partly because paying a break-up fee to walk away would likely be even more costly. AbbVie would have to pay Shire a $1.6 billion penalty if it were to renege on their merger agreement. Medtronic has a contract that lets it or Covidien walk away from their deal if the US Congress changes tax law. The Treasury’s new rules fall short of that, so a break-up fee likely would loom in this case, too, if the merger were called off. Burger King said it will proceed with its $11 billion deal with Canada’s Tim Hortons, stressing that the transaction was not about tax benefits.

There are also some new rules unveiled by the Treasury today, and some of these tax evasion schemes have names that sound like they came right off the playground. One rule will prevent inverted companies from using “hopscotch” loans that allow them to avoid dividend taxes when tapping tax-deferred foreign profits. Another rule will bar inverters from gaining access to offshore profits by using “decontrolling” strategies that restructure foreign units so they are no longer US-controlled. The Treasury is also tightening limits on the levels of ownership that the former US investors can have in an inverted company for it to qualify for foreign tax treatment under US law, a move that will make it harder to do the deals. And then there’s the “spinversion” which is a partial inversion where the US company transfers some of its assets to a newly formed foreign corporation. That corporation is then spun off to public shareholders. New rules would treat the spun-off company as a domestic corporation.

Ultimately, this is an issue that will require legislative action, but for now, it will be more difficult for companies to skip out on their tax obligations by moving offshore; more difficult but not impossible. I suspect there are a lot of tax attorneys working overtime today.

The United Nations Climate Summit kicked off today in New York. The summit was convened to lay the groundwork for nations to sign a binding emissions treaty late next year during climate negotiations in Paris. In speeches delivered at the summit, diplomats from 120 countries laid out a series of new, nonbinding climate commitments. Here is an overview of what world leaders have pledged so far: President Obama delivered an address at the summit this afternoon where he announced an executive order requiring federal agencies to take climate change into account when doling out dollars for international aid and investment abroad. The US has previously pledged to curb emissions 17% from 2005 levels by 2020.

The EU unveiled a new commitment to slash greenhouse-gas emissions 40% from 1990 levels by 2030. British Prime Minister David Cameron said that the U.K. is on track to cut emissions by 80% by 2050. Cameron did not, however, announce any new targets not already agreed to by the country. China’s Vice Premier repeated China’s previously stated goal of cutting carbon emissions by 40 to 45% from 2005 levels by 2020. Iceland said that it aims to power its economy entirely with clean energy, but did not set a date. Mexico announced that it aims to generate more than one third of its electricity from zero-emissions sources by 2018. Costa Rica will be powered purely from clean energy by 2016. And a whole bunch of countries pledged hundreds of million to the Green Climate Fund.

Sounds familiar, right? But maybe this time will be different, and the reason is because this time it might actually pay to go green. All things considered, the cost of curbing carbon emissions may be considerably cheaper than earlier estimates had suggested. For all the fears that climate change mitigation would put the brakes on growth, it might actually enhance it.

Last week, an international commission published the “New Climate Economy” report concludes that efficient investments could deliver at least half of the emission cuts needed by 2030 to keep global temperatures in check. And they could do so while delivering extra economic gains on the side. Side benefits include things like lower health costs.

And it looks like corporations are getting on the climate change bandwagon. Tim Cook, CEO of Apple was in New York, and he said: “The long-term consequences of not addressing climate are huge,” he said. “I don’t think anyone can overstate that.” Google executive chairman Eric Schmidt announced Google would stop funding the American Legislative Exchange Council, or ALEC, claiming the Council had been “literally lying” about the reality of climate change. Schmidt said: “The company has a very strong view that we should make decisions in politics based on facts — what a shock,” said Schmidt. “And the facts of climate change are not in question anymore. Everyone understands climate change is occurring and the people who oppose it are really hurting our children and our grandchildren and making the world a much worse place. And so we should not be aligned with such people — they’re just, they’re just literally lying.”

The basics of climate change have been understood for a long time, don’t seem to be budging much and yet remain challenged by many non-specialists. What’s significant then, in such a public debate, is who acknowledges those basics, as much as what is said. That’s why it was news when former Treasury Secretary Hank Paulson called for a carbon tax, when the Rockefellers, the first family of oil pulled out of oil sands or, the head of the world’s largest company by market cap endorses a brand new climate and business initiative by showing up and saying absolutely anything at all. Tim Cook also challenged the still-common fallacy that good business and environmentalism are mutually exclusive. “Too many people believe you can do this or that,” he said. “If you innovate and you set the bar high you will find a way to do both.”

The World Bank yesterday released a list of 73 countries and more than 1,000 companies that support a price on carbon dioxide pollution. Apple, which now powers 73% of its facilities with renewable energy and has raised its environmental profile, was not among the signatories.

Thursday, July 24, 2014 - Bankster Logic

Financial Review with Sinclair Noe

DOW – 2 = 17,083
SPX + 0.97 = 1987
NAS – 1 = 4472
10 YR YLD + .05 = 2.51%
OIL - .03 = 102.04
GOLD – 10.10 = 1294.90
SILV - .54 = 20.47

An extremely flat day on Wall Street but good enough for another S&P 500 record high close.

In economic news: Initial claims for state unemployment benefits declined 19,000 to a seasonally adjusted 284,000 for the week ended July 19, the lowest level since February 2006. In the past six months, unemployment has fallen much faster than expected, from 6.7 to 6.1%. The labor market is still struggling with long-term unemployment and part-time jobs instead of full-time work, but it seems to be making progress.

One area not showing progress is wages. The Labor Department released its latest report on median wages; on a year-over-year basis, median earnings were up just 0.8% in the second quarter, to $780 per week, not enough to keep pace with inflation. The median wage data is a bit different from the weekly earnings data that comes out of the Labor Department’s payrolls report. That one is the average earnings, and what is likely happening is the growth for top earners is pulling that series up more. Average earnings are up 2.1% year-on-year. The report also showed that women earned 83.5% of what men did.

The Commerce Department said new home sales dropped 8.1% to a seasonally adjusted annual rate of 406,000 units in June. It was the biggest decline since July of last year. May and April sales were revised lower. Therefore, this was a very weak new home sales report, but earlier in the week, we saw a strong report on existing home sales.

Let’s move over to earnings reports:

Amazon.com can sell stuff, they just have not figured out how make a profit. Amazon is expanding grocery service, they introduced a new smartphone, and a set-top box for TV streaming, and they managed to increase revenue 23% to $19.34 billion from $15.7 billion in the earlier period. They also reported a loss of $126 million or 27 cents per share.

Caterpillar has the exact opposite problem; revenue fell but they posted a higher profit. Caterpillar’s revenue numbers have now fallen in six of its past eight quarters, with the quarterly year-over-year decline averaging 8.3%. In the last quarter, sales fell 3% from a year ago to $14.1 billion, while profit increased 4.1%.

Starbucks posted fiscal third-quarter profit of $512 million, or 67 cents a share, up from $417 million, or 55 cents a share a year ago. Revenue for the three months ended June 29 rose 11% to $4.1 billion from $3.7 billion.

Signaling a major turnaround in the airline industry’s fortunes, the nation’s three major legacy carriers; American Airlines, United Airlines and Delta Air Lines — all posted record profits in the past quarter. Delta reported net income for the second quarter of $801 million, up 17 percent from the year-earlier period. United Airlines, which had a loss in the first quarter and has struggled with its merger with Continental Airlines, posted a $919 million second-quarter profit. Douglas Parker, the chief executive of American Airlines, said today that the airline’s second-quarter profit, excluding special charges, of $1.5 billion was its best quarterly earnings performance ever.

General Motors posted second quarter earnings of $190 million on revenue of $39.6 billion, up from $39.1 billion in the same period a year ago. The problem for GM has been recalls for safety issues, which have killed 13 people. GM set up a compensation fund with $400 million; they have also paid $2 billion this year for the recalls, and they announced pretax charges of $874 million to cover future product recalls. GM is likely to feel the financial repercussions of the millions of cars it has recalled for years to come. The company has recalled 29 million vehicles this year, many of which have not yet been repaired. To give a sense of the pace, GM recalled around 15 million vehicles for ignition switch related issues so far this year, and repaired around 560,000 in the second quarter. It announced a recall of more than 700,000 vehicles for a separate issue just yesterday. The surprising part is the increase in revenue, which comes in part from pricing, but also the bad press has not deterred buyers.

Businesses and individuals in the US have parked about $2.6 trillion in money market funds. It is generally considered a safe place to leave money short term, or that was the thinking until 2008, when money market funds broke the buck, dropping below par value of $1 per share. Turns out, the funds were not guaranteed. There is no government insurance on the safety of deposits, no regulator-required capital buffer to protect against losses, no central bank ready to stand as “lender of last resort” to keep a money market fund from suffering a short-term cash crunch. Of course, the Treasury and the Fed stepped in to bail out the funds and avoid a run on the funds, which would have been catastrophic.

Therefore, a mere 6 years later, the government has finally managed a few reforms, but they are not real reforms because the bankers fought reform tooth and nail.  The new reforms do not include capital buffers, but they will allow for a floating NAV, or net asset value. Therefore, your share in a money market fund may or may not be worth one dollar. Moreover, if you try to cash out, the funds can impose extra fees to slow down a potential run. That’s about it. After 6 years, I hope you feel safe and secure in the knowledge that nothing of any substance has changed in the last 6 years.

An examination by the Federal Reserve Bank of New York found that Deutsche Bank AG’s giant U.S. operations suffer from a litany of serious problems, including shoddy financial reporting, inadequate auditing and oversight and weak technology systems. In a letter to Deutsche Bank executives last December, a senior official with the New York Fed wrote that, financial reports produced by some of the bank’s US arms “are of low quality, inaccurate and unreliable. The size and breadth of errors strongly suggest that the firm’s entire U.S. regulatory reporting structure requires wide-ranging remedial action.”

Deutsche Bank, one of Europe’s largest banks, was a forceful opponent of the Fed’s push to force foreign banks to comply with the same capital requirements as domestic banks. Officials from Deutsche Bank argued that the Fed’s requirement was too restrictive.  This year, the Fed went ahead with those tougher capital requirements for foreign banks. However, it gave most of them until the middle of 2016 to comply. Yes, of course it is theoretically possible that management could go through and fix everything that is wrong with the firm’s US operations but, really, this is more of a tear down job.

Dark pools are where institutional investors can place large buy and sell orders without alerting the broader market. Prices and transactions are not reported; it is the furthest thing from a free and open marketplace.  Different financial institutions run a variety of dark pools. Barclays runs one of the biggest dark pools called Barclays LX. They have been sued by the state of New York for fraud; the suit alleges Barclays favored high frequency traders over other investors in the dark pool and they falsified marketing materials, inaccurately portraying the concentration of high-frequency traders in the market, and misrepresenting a service that purported to protect investors from predatory trading behavior.

Today, Barclays filed a motion to dismiss the lawsuit, and this is classic bankster logic; they argued that Barclays’ customers were sophisticated enough to understand that “glossy marketing brochures” about the dark pool, did not reflect its actual composition; their customers knew better than to rely solely on the marketing materials. So, they basically admitted they were lying in their marketing material, but their clients were smart enough to know that banks are liars.

President Obama called today for Congress to end a tax loophole that allows big corporations to designate a foreign country as their official address, in order to avoid US taxes. The corporation does not have to move their actual headquarters, just set up an address overseas. Obama called on members of Congress to close the loophole even if they disagree with his broader calls for changes to the tax system that would lower corporate rates and close several loopholes, including that one. The legislative effort is unlikely to succeed in Congress.

Companies ranging from banana distributor Chiquita Brands to Medtronic have reached nine inversion deals this year. The whole idea is to pay fewer taxes while still enjoying the benefits of doing business in the US. Of course, the legal change of corporate headquarters is essentially a process of renouncing citizenship, and it just seems corporations should face the loss of citizenship the same way people do, which means they should pay an exit tax. There are other ways to put an end to this inversion tax evasion scheme. Moreover, if we do not, you can count on executives whose companies were born of American ingenuity and which make their profits from American customers (including the government) will troll international waters for opportunities in low-cost tax havens. It’s a race to the bottom.