What I Care About This Week | 2021 Apr 26

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by Franklin J. Parker

The Summary

  • Durable goods orders post this week and we also get data on personal incomes for March. Those plus the home price data and initial unemployment claims posting will give us a read on the health of ongoing spending and whether that spending is translating into corporate expansion and investment. Home sales are beginning to be constrained by materials and this has started to push home prices higher. Housing is a component of so-called “core” inflation, so higher home prices translates into higher inflation.

  • We are now in the heart of earnings season. Of the companies that have reported so far, most have beat expectations, with the biggest upside surprises from Energy. Consumer staples (19% reported) have been disappointing with only 65% of companies delivering a beat. See the “Chart of the Week” for a breakdown.

  • The Bank of Canada has become the first central bank to signal the slowdown of quantitative easing. The BoC will reduce the current pace of government debt from C$4 billion to C$3 billion and expects to begin raising the benchmark interest rate in the second half of 2022. So far, the Federal Reserve and European Central Bank have avoided an end to QE, though many economists now expect the Federal Reserve to end, and begin to reverse (called “tapering”), the current program by the fourth quarter of this year. In my view, investors must be diligent on this data point as I see it likely to create some tumult in risk markets.

The Details

The big market-moving news last week was the Biden administration’s proposal to increase capital gains from 20% to just under 40% on people who earn $1 million or more in income. Risk markets sold off sharply, only to subsequently recover (probably on the realization that passage of such a proposal is unlikely).

While most investors will not be affected by this tax change directly, it does change the metrics and structure behind several types of investing. To illustrate the significance of the change, let us consider an example.

Suppose an investor subject to the higher capital gains rate is considering investing in a startup. In order to fund the project, she needs to sell some existing stock or, more likely, redirects the capital from the exit of a recent startup. If 95% of that capital is taxable as gains (not uncommon in venture capital), it would take almost five years to simply breakeven—and that assumes 15% growth per year! For comparison, under current capital gains rates, it takes about three years to recover the cash paid in taxes.

For public market growth projections (7% per year), the breakeven on switching investments goes to almost 9 years! Under the current rate it is in year four. In both venture capital and public markets, the increased capital gains rate almost doubles the breakeven rate of exiting and reinvesting those gains.

And that is before any additional taxes a state may levy.

In California, for example, the combined capital gains rate would be as high as 57%. Our breakeven for venture capital grows to an excess of 10 years (with a 15% growth rate), which is longer than the typical 7-10 year life of a fund!

Under these proposed capital gains, the incentive to our investor is to not exit their current venture. The incentive shifts to simply hold current investments longer. While on the face of it this seems like a good incentive, it has the effect of reducing capital available, specifically for startup companies.

As I’ve said before, our role as investors is not to opine about the merits or demerits of a policy proposal. Rather, we must adapt to new rules quickly and attempt to understand the effect new rules may have on both our existing and potential investments. Here are the knock-on effects I would expect should this tax increase come to pass.

First, we would likely see a change in the way venture capital funds are organized. Rather than a 7-10 year life cycle, we could see a shift toward 15-20 year funds. This has a secondary effect of slowing startup growth more broadly—a startup company that might take 10 years to compete its life cycle would take closer to 15 or 20. Recall, the most successful and prolific VC/PE funds are in California and New York, both high tax states. Their adaptation to new rules affects those of us in lower-tax states like Texas.

Second, this would likely create an incentive to hold real estate as it enjoys the advantage of the 1031 exchange and current income. A 1031 exchange allows an investor to roll a cost basis from one property to another—effectively deferring capital gains taxes. I would also expect an increase in the use of tax-deferred wrappers for risk capital, like custom annuity contracts or life insurance policies, a boon to insurance companies.

Third, capital flight from coastal states to central and southern is likely to increase as investors seek to lower their tax burden through geographical arbitrage. A well-heeled investor living in California who exits $10 million worth of startup companies per year would save around $1.2 million per year by moving to a no-income-tax state. Investors living in existing states could possibly get ahead of that flight by purchasing real estate of all kinds in the highly-trafficked areas.

Fourth, economic theory would suggest (and my own research backs this up) that lessened returns on investments that carry the same risk increases an individual’s propensity to spend today. Rather than merely accept lower returns, there will be increased incentive for wealthy people to spend their cash. Luxury goods providers could see a boost to their top line revenues.

Fifth, I would expect this policy proposal to create a headwind for market prices in the short term. Likely, investors would sell off assets to pay the current (lower) gains rate. While short-lived, it does provide an opportunity for patient investors to deploy cash (assuming the new cash isn’t an exchange from another investment in a taxable account).

All of that said, and though I am no political analyst, this proposal appears very unlikely to pass. With the Senate split 50-50, the Democrats cannot afford to lose a single vote from the moderates of their own party, and even representatives from California and New York are likely to mobilize in opposition. My estimation is that Biden is taking a page from Trump’s book: go big out of the gate, give away a lot in negotiation, and you end up where you wanted to be in the first place—a tax rate that is slightly higher, but not as dramatic as it first sounded.

I suggest investors sit tight for now and let the politicians do what they do.

Chart of the Week

Earnings season is in full swing. Apple and Caterpillar, both economic bellwethers, report on Wednesday. So far, earnings season has been quite strong. If tech and industrials can continue posting strong results, and we get a glimpse of the service economy staging a strong comeback, we may well grow in to the high valuations in stocks.

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