FACTs
Fiscal Adjustment Cost
Templates for Selecting
Budget-Advantaged Stocks
GGA Profile
Team members include:
Dick Gephardt, President and CEO
Tom O’Donnell, Managing Partner
Tom Blank, Executive VP
Scott Brenner, VP
Clients include:
Anheuser-Busch
Boeing
GE
Goldman Sachs
Google
NBC
Peabody Energy
Port of Oakland
UnitedHealthcare
Visa
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David Ahn
Prior Experience:
• Director of Research, Hanover Investment
Group
• Graduate Fellow, Department of State
• Senior Analyst, Driehaus Capital
Management
• MA, Johns Hopkins University, School of
Advanced International Studies
• BA, Yale University
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I.Fiscal cliff
II.What’s the trade? Actual examples.
III.What’s the FACT product?
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4 Horsemen of the fiscal apocalypse
1. Government shutdown threat – October 1,
2012
2. Bush tax cuts, payroll tax cut, and other
provisions expire – January 1, 2013
3. Sequestration – January 2013
4. Debt limit – Will have to be raised in the first
quarter of 2013
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Fiscal Cliff
Tax and spending cuts per year, indefinitely
Expiration of Bush tax cuts
$340b
Other expiring tax cuts
$ 60b
Automatic sequester cuts
$ 88b
Expiration of payroll tax cut
$153b
Doc Fix
$ 25b
Medicare tax
$ 28b
Total
$710 billion
As % of GDP…………………………………………4.5%
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Government shutdown threat
• The House passed a budget with discretionary spending for
FY2013 of $1.028 trillion; $1.047 trillion was agreed to in last
summer’s Budget Control Act.
• This sets up another government shutdown threat by the end
of the fiscal year (September 30).
Preliminary forecast: We expect a series of continuing
resolutions (which use the prior year’s funding levels) to fund
the government until the next Congress convenes in January.
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Tax Cuts
• The Obama Administration proposes extending the Bush tax
cuts for families earning less than $250,000 a year. Cuts for
those earning more would lapse when the Bush tax cuts
expire at the end of 2012.
• The Republican proposal is to continue the Bush tax cuts for
everyone, regardless of income.
Next Step: House Republicans plan to vote this summer to
extend all the tax cuts for about 12 months. Obama has said
he won’t extend them all. Both sides will have to see if they
can settle their differences before the November election. If
not, they’ll have to deal with the tax cuts in the lame duck
session.
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Sequestration
• 9% cut in domestic discretionary
programs
• 8% cuts in mandatory programs
other than Medicare
• 2% cut in Medicare provider
payments
• 9% cut in defense programs
Preliminary forecast:
Negotiations to limit the
sequestration will fail, and
then it will kick in for several
months, if not permanently.
Bipartisan Policy Center
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Debt Limit
• The U.S. is projected to reach its $16.394 trillion debt ceiling
in late 2012 or early 2013.
• Because Treasury can utilize “extraordinary measures” once
the limit is hit, immediate congressional action is not
required; extraordinary measures may allow the US to remain
within the limit until February 2013.
Preliminary forecast: We expect an increase that will last up to
12 months, but no grand bargain. Tax reform has to be part of
any grand bargain. This will be late 2013 at the earliest.
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Debt Limit
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I.Fiscal cliff
II.What’s the trade? Actual examples.
III.What’s the FACT product?
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What’s the trade?
Rob Dugger, a former partner at Tudor, and I developed the
framework of Fiscal Adjustment Cost Discounting.
The central idea is that a fiscal crisis brings investor expectations
of fiscal adjustments forward and into their investment planning
horizons, i.e. into the timeframe where investors price in events.
Usual expectations of Fiscal Adjustment timing
Short-term Future
0 to 3 Years
Investment
Planning Horizon
Medium Term Future
3 to 5 Years
Long- Term Future
5 to 20 Years
Expected Time for
Fiscal Adjustments
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Crisis-Driven Expectation Shift
The July 2011 debt limit fight moved expected fiscal adjustments
from the long-term into the short-term
Short-term Future
0 to 3 Years
Medium Term Future
3 to 5 Years
Investment
Planning Horizon
Expected Time for
Fiscal Adjustments
RESULT:
Long- Term Future
5 to 20 Years
Expected Time for
Fiscal Adjustments
Budget Crisis
FAC Discounting - Stock
Selling and Treasury Buying
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Summer 2011 Paradox
Why did Treasury bonds rally and stocks sell off in the face of
a default threat?
1. In early summer 2011, federal agencies notified private
contractors that they would stop payments if the debt
limit was not increased. Treasury did not send such a
letter to bondholders, signaling that bondholders
would get priority over contractors.
2. That was the signal that Treasury bonds would rally even
though there was a threat of default and then a
sovereign downgrade by S&P. Stocks sold off because
many companies rely heavily on government spending
and taxing. Investors priced in the risk that this
revenue stream could halt.
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Bond Market Rally
We made the contrarian call to buy Treasuries on June 30,
2011, ahead of the debt limit negotiations and default threat.
10-year Treasury yield in 2011
Client note: “Why Bill
Gross is wrong on his call
to sell Treasuries”
Bill Gross says he’s
selling Treasuries
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Stock Market Sell-off
European credit markets drove U.S. stocks in 2011, but U.S.
fiscal problems deepened sell-offs.
S&P 500 vs European corporate CDS index (inverted)
Congress barely
passes “easy” CR
Supercommittee
failure
Default threat, Budget
Control Act, U.S.
downgrade
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FAC Discounting on the Industry Level
FAC discounting is not limited to the macro level. Shifts in
investor expectations of fiscal adjustments occur on the
industry level as well.
Short-term Future
0 to 3 Years
Medium Term Future
3 to 5 Years
Investment
Planning Horizon
Expected Time for
Fiscal Adjustments
RESULT:
Long- Term Future
5 to 20 Years
Expected Time for
Fiscal Adjustments
FAC Attack
FAC Discounting –
Stock Selling
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Example 1: Cruise Lines
NY Times article February 1, 2011:
“The Carnival Corporation wouldn’t have
much of a business without help from
various branches of the government. The
United States Coast Guard keeps the seas
safe for Carnival’s cruise ships. Customs
officers make it possible for Carnival
cruises to travel to other countries. State
and local governments have built roads
and bridges leading up to the ports where
Carnival’s ships dock.”
“But Carnival’s biggest government benefit of all may be the price it pays for
many of those services. Over the last five years, the company has paid total
corporate taxes — federal, state, local and foreign — equal to only 1.1 percent
of its cumulative $11.3 billion in profits. Thanks to an obscure loophole in the
tax code, Carnival can legally avoid most taxes.”
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Cruise lines underperform
The NYT article triggered FAC Discounting. It brought forward investors’ expectations
that cruise lines’ tax loopholes would close. We’ve isolated this effect on the stock
price. This chart starts on the day the article was published.
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Example 2: Private Equity
Carried interest has long been on the chopping block of tax
breaks to eliminate. A timeline:
July-September 2007: The Senate Finance Committee first held hearings
on the issue.
December 2009: The House used elimination of carried interest as a “pay
for” as part of H.R. 4213, the bill to extend unemployment insurance. But
the final law did not eliminate carried interest.
Every February from 2009-2012: President Obama proposed repeal in
each of his budgets – FY2010-2013
January 24, 2012: Mitt Romney releases his tax returns for 2010 and
2011. Carried interest is the main reason his tax rate was 13.9% and
15.4%, respectively. Romney’s campaign policy director said Romney
would consider repealing the loophole as part of tax reform.
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Private equity underperforms
Congressional attention on carried interest over the years made it a prime target for
repeal. Romney’s tax returns and the subsequent attention triggered a FAC attack.
Investors priced in higher tax rates for private equity firms.
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Looking ahead: Stock Options?
Stock option accounting background:
•On their P&L, companies count the exercised option price,
not the stock’s market value, as the cost
•But for tax purposes, companies can deduct the market
value of the stock, usually much higher
Timeline:
July 14, 2011: Senator Carl Levin (D-MI) introduces S.1375 Ending Excessive Corporate Deductions for Stock Options
February 1, 2012: Facebook’s IPO filing says its stock option
deduction will be so large it won’t pay taxes for 2011
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Budget advantages by S&P sector
This is a rough calculation of how much the 10 S&P sectors relied on the government
in 2010. In very general terms, we recommend rotating out of the top sectors and
into the bottom ones.
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I.Fiscal cliff
II.What’s the trade? Actual examples.
III.What’s the FACT product?
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FACT Product
1. Alerts
a. When the risk level of a provision changes
b. Other additions to the database
2. Database
a. Hundreds of tax and spending provisions
b. Risk that their repeal will be priced in
c. Which industries will be affected
3. Weekly Report
a. Macro FAC risk level
b. Discussion of political risks
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Alerts
We will send an alert when we see a significant change to the FAC
Discounting risk level of a provision, for example:
ALERT – FDA user fee reauthorization
May 30, 2012
Positive for generics over brand-name pharmaceuticals
The House committee responsible for the FDA user fee reauthorization bill (H.R.5651) voted on Friday night to
pass a version very similar to the Senate version (S.3187), which passed the Senate on May 24 with a 96-1
majority. Expect the House to pass H.R.5651 today. Then the bills will go to a House-Senate conference, but
since they are quite similar the conference should go smoothly. We expect a bill on the President’s desk by the
July 4 recess, well ahead of the 2007 reauthorization’s expiration on September 30, 2012.
For the first time, generic drug companies will pay user fees to help cover the cost of the FDA approval process.
Although generic companies will have to pay about $300 million per year in user fees, they will receive
significantly faster approvals, eventually down from 30 months to 10 months. With generic competition coming
to market sooner, we expect a cut in brand name drug revenue projections and a jump in generic drug revenue
projections. Expect generic pharmaceutical stocks to begin outperforming brand name pharmaceutical
stocks.
More details about this provision are available on our FACT database:
http://fact.spoiltvictorian.com/index.php?r=provision/view&id=6
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Database Provision Page Snapshot
Click on the database provision for a more detailed explanation
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Database Snapshot
Hundreds of sortable tax and spending provisions:
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FACTs Weekly Report
Perceived FAC risk level: LOW
Tax hikes are inching onto the Republican table
Wall Street is now aware of the timing and magnitude of the fiscal cliff. It’s too soon to develop
possible political outcomes and trade off them, but some comments over the past week started to
shape the debate, especially on taxes.
Speaker Boehner drew the same line in the sand for the next debt limit showdown, expected in
February 2013. He will only accept a debt limit increase in the same proportion as spending cuts.
President Obama shot back the next day and said there should be no conditions.
Boehner was likely trying to appeal to his Tea Party caucus. But there appears to be a consensus
among moderate Republicans (Boehner is among them) to accept tax increases as part of a deficit
reduction deal. The Wall Street Journal, the business voice of moderate Republicans, published an
op-ed by Robert Rubin calling for tax increases as part of a deal. The Washington Post reported that
fewer Republicans are signing Grover Norquist’s anti-tax pledge. There appears to be a slow but sure
moderation in Republicans’ anti-tax stance.
This is progress, albeit a baby step. But even if Republicans put tax hikes on the table, the even
harder job is to agree on which taxes to raise and which tax loopholes to eliminate.
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FACTs
Fiscal Adjustment Cost
Templates for Selecting
Budget-Advantaged Stocks