The monster under the bed

Alfred E. Neuman

One of the fun things about being a personal finance writer is the number of “Dear idiot” letters you get. Stories about the Federal Reserve Bank tend to get them. (“You idiot! Don’t you know the Federal Reserve is evil?”). So do stories about taxes. (“You idiot! Don’t you know that Girl Scout cookies are deductible?”)*

Inflation is another source of contention, particularly if you note that inflation has been moderate, which it has been, whether you’re using the Consumer Price Index, the GDP Price Deflator, or even the Billion Prices Project. But your perception of inflation depends on what you spend the most on. If you have kids in college or if you rely on prescription drugs, your personal inflation rate is pretty high.

Those who grew up in the 1970s and early 1980s recall when a 5% inflation rate was considered moderate, as opposed to the most recent 2.2% rate. And they fear a resurgence of inflation, with good reason: It erodes the value of retirement savings and pensions.

The consumer price index has averaged a 1.7% annual gain the past decade, and actually dipped into deflation — a period of falling prices — during the Great Recession. And the forces of deflation are still all around us: The favored tactic of technological disruptors such as Amazon, Uber and others, is to drive prices down and drive competitors out of business. This was a favored tactic of the Gilded Age, aided even further by the gold standard, which tends to favor deflation over inflation. I go on at some length about the subject here.

The Federal Reserve traditionally raises interest rates to slow the economy and cool inflation, and it lowers rates to stimulate the economy and encourage inflaton. The Fed has already nudged short-term interest rates higher five times since 2015, but rates are still extraordinarily low by historical standards. Most think the Fed is acting not out of fear of inflation, but out of fear of not having any ammunition to fight the next recession, whenever that may be.

Tomorrow’s Consumer Price Index report hits the headlines at 8:30: The consensus forecast is for a 2.1% year-over-year change for 2017. Anthing higher, particularly for the core CPI (less food and energy) is likely to make for an upsetting day in the bond market, where yields have been creeping higher and prices lower. The iShares Core U.S. Aggregate Bond ETF (AGG), a useful proxy for the bond market’s total return, has already fallen 0.57% this year, according to Morningstar.

Right now, there’s a balance between inflationary forces — a strong economy and fiscal stimulus — and deflationary ones. In the normal course of events, the Fed tightens too much during inflationary periods, causing the economy to slow, earnings to fall, and stocks to tumble. So there’s reason to watch inflation warily.

Is it time to panic? Well, no. It never is. If you’re particularly concerned about inflation, you might consider a fund that invests in Treasury Inflation Protected Securities, whose price is keyed to changes in the CPI. The current yield on TIPS shows that Wall Street expects inflation to remain at 2% the next 30 years. If you think they’re wrong, then one good pick would be Vanguard Inflation-Protected Securities Fund Investor Shares(VIPSX).

It may well be that technological changes have redefined the upper bound of inflation in the economy. Tomorrow’s CPI print is no reason to go running from the room in terror. But it’s worth keeping an eye on the monster under the bed this year.

* They aren’t, if you eat them.

A change of heart

A Christmas Carol is about a change of heart — in this case, the heart of Ebeneezer Scrooge: 

Oh!  But he was a tight-fisted hand at the grind- stone, Scrooge! a squeezing, wrenching, grasping, scraping, clutching, covetous, old sinner!  Hard and sharp as flint, from which no steel had ever struck out generous fire; secret, and self-contained, and solitary as an oyster.  

The spirit of Scrooge — pre-haunting Scrooge — has been alive and well in American business for a good many years. Just as Scrooge rolled up the profits of his lending business while his clerk froze, U.S. companies have only grudgingly doled out wages. The chart, left, shows average weekly wages, adjusted for inflation, the past decade. Annual rate of increase: 0.52%.

At the same time, profits, cash and profitability at major U.S. corporations have been hitting new highs. This isn’t terribly unusual: Companies typically don’t raise wages unless they have to, and they don’t have to until unemployment falls below 5% or so.

Nevertheless, workers’ share of corporate fortunes have been unusually small, especially in light of productivity improvements. Workers have produced more, but received far less of that improvement than in the past. (Keep scrolling past the graph, because I can’t figure out how to decrease the white space that follows).

 

 

 

 

 

 

 

 

 

 

 

The tax reform bill passed by Congress assumes that corporations will pass on their massive tax savings to workers, and also use that extra money to reinvest in other businesses. Will it work? It depends on who you ask, which means that no one really knows. A few companies have already announced bonuses and cited the tax reform measures as their reason for doing so.

Some, such as Wells Fargo, have waffled on whether the increase was because of the tax bill or not. Others, like AT&T, have also announced layoffs at the same time.

Nevertheless, it’s entirely possible that at least some of corporate tax savings will, indeed, make it to employee salaries, new hires or even new factories. Alas, there aren’t many funds that specialize in employee happiness. But here are a few suggestions on what might make a good investment in light of tax reform:

  • Parnassus (PSRNX). This fund takes the position that companies that treat employees well tend to do well in the long run. It’s not infallible — awful companies prosper sometimes, too — but the fund has gained an average of 10.5% a year the past decade, vs. 8.3% for the Standard & Poor’s 500 stock index.
  • Financial funds. Tax breaks plus looser regulation generally should benefit banks. SPDR Capital Markets ETF (KCE) is a good low-cost choice, as is iShares U.S. Financial Services ETF (IYG).
  • KKR & Co. LP. The private equity and real estate manager specializes in merge and acquisitions. Should companies use their newfound cash to buy other companies, KKR is a logical beneficiary.

A cynic would observe that companies have long had the ability to give their employees a raise, and have simply decided to keep most of that cash in the CEO suite. A big infusion of cash from the tax bill could simply increase those tendencies. On the other hand, we can all hope for a change of heart — although, as was the case with Scrooge, the proof was in actions, not theory.

 

 

The season for giving

Most people who invest are periodically troubled by the actions of the companies whose stock they buy. While you probably won’t see a headline like “Equifax Sought in Bar Stabbing,” you probably have seen headlines like “Equifax CEO Richard Smith steps down amid hacking scandal.” You may also have noted that Mr. Smith left the company with an $18 million pension. Heck, I would have run the company into the ground for half that.

It’s no wonder that funds that screen for environmental, social and governance factors are becoming increasingly popular. Of those three factors, I’d argue that governance is the most important. (In fact, I did, right here in my latest column for InvestmentNews). Funds like Parnassus (PARNX) have fared extremely well by investing in companies that treat employees well, don’t cut corners to save costs, and don’t pay CEOs gargantuan salaries.

It’s the social part of ESG investing that gets sticky. Just this morning I got a press release for the eVALUEator Biblically Responsible Index (BIBLX). According to the announcement, “The index is designed to invest solely in companies with activities and practices consistent with Christian values. These standards allow BIBLX to limit portfolio exposures to practices related to abortion, pornography, alcohol, tobacco, gambling and anti-family entertainment.”

You may not be surprised to learn that the world isn’t in agreement on all Biblical principals. Mennonites, for example, would object to defense stocks; others cite an obligation to be good stewards of the earth and would avoid polluters. And, of course, there are those who don’t use the Bible as the basis for their faith.

If you can’t find a social fund that fits your specific views, it might be more effective to invest in a broadly based index fund or other fund and simply donate the proceeds to a charity that addresses your favorite cause. If you donate appreciated shares of a stock or fund, you can also sidestep any taxes on capital gains. And there would be a certain symmetry in selling shares of a major polluter and donating the proceeds to The Nature Conservancy or cashing in shares of a tobacco company and giving the money to The American Cancer Society.

 

Taxes and the urge to merge

Tax reform, in whatever final shape it takes, is likely to put lots of money into corporate hands. While these companies already have lots of cash — a record $1.8 trillion in nonfinancial companies in the Standard & Poor’s 500 index — giving them more cash may give them an incentive to actually, you know, spend it. I talk about one likely option in my latest column, here. 

On another topic, the Baby Boom Generation spans the years 1946 to 1964. There’s a big difference between the early Boomers and their younger siblings: If you were born in 1946, you came of age with the Beatles, the Vietnam War, Lyndon Johnson and Richard Nixon. If you were born in 1964, you grew up with The Clash, gas lines, Jimmy Carter and Ronald Reagan. More importantly, older Boomers are more likely to have pensions and more likely to have taken a beating from the past two bear markets. Younger Boomers? They probably don’t have pensions, they face soaring college tuition costs for their children — and some will retire just as the Medicare Trust Fund runs out of money. You can read about it here.

By the sweat of your brow

“By the sweat of your brow
    you will eat your food
until you return to the ground,
    since from it you were taken.”

One of the enduring mysteries of the U.S. tax code is why the system is harder on those who earn their income by the sweat of their brow as opposed to those who get money from their investments.

The tax code’s main purpose, of course, is to fund the activities of the government, and Americans have been having a lively discussion about the proper scope of government activities and how to pay for them for more than 200 years.

Over the years, however, the tax code has been used to encourage certain behaviors and discourage others. In its current incarnation, for example, we give deductions for contributions to some retirement savings accounts, because that’s a good thing. We levy tax penalties on early withdrawals from retirement plans, because that’s often a bad thing.

There are plenty of things to argue about with these types of tax incentives. What is curious, however, is the favorable treatment of investment returns over ordinary income. Currently, for example, employment income is taxed at a maximum 39.6%, while long-term capital gains are taxed at a maximum 20%.

Ostensibly, the lower tax rate for capital gains – the difference between your purchase price and sales price on a winning investment – is to encourage investment. As such, it has some merit: Congress cut the capital gains rate from 28% to 20% in 1982, and the stock market took off. (On the other hand, Congress returned the capital gains rate to 28% in 1987, and the stock market generally rallied until 2000).

Nevertheless, we as a nation tend to encourage hard work and look down on those who work as little as possible. And here we come to a paradox between the admiration for hard work and the tax code. Consider this comparison of two people, each with $300,000 in income, presented by Ben Steverman of Bloomberg.

Our first taxpayer is an emergency room surgeon. The other plays video games all day, thanks to his inheritance.

twogus

Now, as with all things taxable, there are some important caveats here. One is that under current law, if the heir’s parents gave him his capital in their will, the estate is liable for taxes under estate tax law. (Heirs don’t pay estate taxes.) That said, it’s unlikely that the parents paid estate tax: It doesn’t kick in until $11.2 million for a couple and $5.6 million for a single individual. About 11,300 estate tax returns were filed for people who died in 2013, of which only 4,700 were taxable, fewer than 1 in 550 of the 2.6 million people who died in that year, according to the Tax Policy Center.

This is largely an investment blog, so it’s useful to point out that lower corporate taxes in the new tax bill means that companies are more likely to increase dividends, buy back stock, or increase merger and acquisitions. All told, it’s hard not for investors to like the bill, because it will help returns from the money you earn while you sleep. But we’re a country that admires hard work. In the end, however, even with a tax break, those who earn their living by the sweat of their brow still wind up paying more.