Economic Patriotism or Free Market Pragmatism

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The Obama administration is becoming quite critical of US corporations acquiring foreign firms in order to relocate their tax domicile to a country with a more favorable regime. Last week, US Treasury Secretary Jack Lew suggested American companies that have done so or are thinking about doing this lack a sense of economic patriotism. In his opinion, American corporations should not take advantage of the benefits of doing business in the United States and utilize loopholes in the US system in order to write down their tax liabilities. The President joined the chorus this week suggesting “some people are calling these companies corporate deserters.”

They’re both wrong.

US corporations are abiding by the current tax legislation that is in place. It’s simplistic and absurd to suggest they have a patriotic responsibility towards the United States. In fact, management of these corporations do have a responsibility, and that is after considering their stakeholders like their employees, suppliers, and customers, they are responsible to their shareholders. Thus, one would imagine US lawmakers would need to ensure that the United States is a competitive nation in terms of offering a favorable corporate tax rate that provides US business with the right incentives, but not put the onus on them to do ‘what’s right for America.’

For this, there is no question broad based corporate tax reform is desperately needed. It is evident from the fact that an additional 25 major US companies are considering relocating overseas by the end of this year in order to take advantage of a smaller tax bill. Senate Democrats have proposed raising the foreign ownership threshold required of a US company to re-domicile their tax base from 20 per cent to 50 per cent. Despite being backed by the current administration, this is not the solution. It is simply a Band-Aid fix, and one might even suggest that if such a significant tax advantage still exists, US corporations would flee more capital from the United States to acquire larger shares of foreign companies.

As The Economist points out, there are two major flaws with America’s tax code. First, on paper America’s corporate tax rate is 35%, which is the highest amongst the 34 member countries in the OECD, but their effective tax rate is less than the OECD average thanks to a laundry list of aimless loopholes. This alone illustrates the complexities and resulting inefficiencies in their tax code. The second is that the US taxes income regardless in which country it is earned, but doesn’t collect until funds are brought back to the US. This creates yet another disincentive to repatriate foreign profits and the consequence is less investment in the US.

If the US government wants better corporate participation at home, then it behooves them to rewrite the tax code. Ultimately, this is what will incentivize these same US companies that hold profits overseas to bring those profits home and lead to the positive contributions to the American domestic economy.

Memories of a Euro Crisis

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Gold prices gained for the sixth week in a row putting up the metals’ best winning streak since August of 2011. Beyond the technical factors that have been supporting this rally that started below 1,250 US per ounce, investors once again are demanding gold for its safe haven characteristics. It was the news of an extension of Portugal’s biggest bank missing an interest payment on their debt that saw investors sell equities and move into precious metals. And thus, the memory of the fears of a sovereign debt crisis in Europe (that investors had since moved passed), serves as a sobering reminder for the need of a hedge to equity exposure. This is amplified by the fact that we are in a rising interest rate environment when investors might want an alternative to bonds and other fixed income.

But it is interesting to think back to what the market reaction might have been two years ago if a similar event had happened to another one of Europe’s major financial institutions, and perhaps allows suggesting that the markets today are not as sensitive as they were in 2012. The selloff in the markets we saw on Thursday might have been much more drastic. And for that matter, the selloff could have followed through into Friday’s trading session as investors concern themselves over the condition of European banks’ balance sheets. Instead, banking fears in Europe translated to a half percent selloff in the S&P500 and the markets finished positive on Friday.

As immune as the markets may have been this week to the events in Europe, they have illustrated one thing, and that is as we remain in this low to moderate growth environment, we will continue to uncover vulnerabilities in our financial and economic system. This is simply because we are not seeing the robust economic growth that would allow us to put the crisis of 2007 behind us and move on. Portugal’s Banco Espirito Santo may not represent a major financial institution in comparison to perhaps the problems encountered by Spain’s Santander in October of 2012, and their exposure to the debunked Spanish housing market. But it does caution that there could be many more skeletons in the closet uncovered by this lifeless recovery.

The same is true for North America. Weak economic growth holds us back from correcting the shortfalls that led to the events of 2007. Despite analysts’ calls for a strong US economy in the second quarter of this year, it follows a near three percent contraction in the first three months. And it’s a similar scene in Canada, which is evident through the performance of a labour market in an economy that continues to illustrate a pure inability to create jobs.

My point is certainly not to be overtly bearish on some unforeseen events or hiding from what’s to come. Moreover, as the same structural problems are still prevalent in the global economy today, like stagnant employment growth, high government debt levels, and an ongoing societal debate surrounding social inequality, it’s hard to see what will spur a sudden shift to a rapidly growing economy. And for that reason it seems we can expect a few more shocks along the way, and investor’s continuing to turn to gold as the ultimate hedge.

Sanguine Markets

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A clear message from investors as we head into the July 4th Holiday weekend in the United States is that equity markets are poised to continue their march higher. Of the US indices, both the Dow Jones and S&P 500 continue in record territory, and the NASDAQ is just shy of it’s all time record high reached at the heights of the tech bubble in March of 2000. And what continues to give equity markets their buoyancy are the economic reports that continue to depict a American economy set to equalize the negative first quarter of this year.

Every economic release or piece of data put out this week points to the North American economy, particularly stateside bouncing back from that dismal performance in Q1. Auto sales had their best month since 2006, China’s economy continues to exhibit signs of picking up and in turn signalling strong demand for North American goods and services. As a result of this, Dr. Copper has bounced of its recent lows. But of course, the icing on the cake was the June job’s report with American employers adding a healthy 288 thousand positions.

It was the job numbers though that continues to be the single most important economic indicator for the markets. The health of the US labour market is the de facto concern for policy makers, and thus will continue to be their focus. This will lead an ultimately more dovish Fed to keep their policy more lenient. And although asset prices are not a direct target of their policy, with the Fed in no rush to raise interest rates, the equity market looks like they will continue to find buyers at these levels.

As BMO Capital Markets Chief Economist Douglas Porter observes, two decades ago the unemployment rate was as well at 6.1 percent, average hourly earnings were growing at 2.5% versus 2.3% today, and the consumer price index was at an annualized rate of 2.3% versus 2.1% today. In 1994, the Fed Funds Rate (their policy tool) was 4 percentage points higher than it is today. Obviously, more goes into what determines the FOMC to raise interest rates; however, this exemplifies they are in no rush to act anytime soon.

And this is what is supporting precious metals, particularly silver which made a tremendous 11% move higher in June. The question becomes whether the resurfaced optimism in the equity space will see downward pressure on the metals. Or (as we saw in June), will a cautious investor continue to question the gains in equities and maintain the bid for gold.