It's a simple question.
The answer is a tough pill for small cap investors to swallow. Here's the nasty investing reality from our Senior Macro analyst Darius Dale.
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Without great media fanfare stateside, the European Commission (EC) issued two important statements last week concerning taxation:
1. Called out Belgium for its "excess profit" scheme that gives preferential tax treatment to multinational corporations
2. Issued updated rules to align the tax laws in all 28 EU countries in order to “fight aggressive tax practices by large companies”.
For investors with exposure to multinational corporations in Europe that may have been receiving favorable tax packages, the impact from the new Anti Tax Avoidance Package could have significant consequence. Below we briefly review the background of preferential taxation for multinationals in Europe and discuss the implications of the newest changes.
Background: Countries throughout the EU have incorporated different tax schemes to encourage multinationals to domicile and do business in their borders for many years. Competitiveness has become an increasingly important issue for member states since the Eurozone was hit by the fallout of the global economic recession and the Eurozone ‘crisis,’ beginning with issues around Greece’s sovereign credit rating that was first called into question around 2008.
Since then, the proverbial periphery (Greece, Spain, Italy, Portugal and Ireland) in particular was asked to implement austerity measures, which translated into freezing spending and balancing their budgets to produce surpluses. They also enacted market reforms to make themselves more competitive — simplifying tax codes, opening up markets to foreign investment, lowering wages, slashing welfare, and giving less protection to workers so it was easier to fire them.
What specifically was carried out varies across states, but what’s notable is that multinational companies across many member states received preferential tax treatment and selective subsidy compared with other companies.
Belgium is Flagged: Last week the EC called out Belgium for its "excess profit" scheme (which has been in place since 2005) that gives preferential tax treatment to its multinational corporations. Specifically, the EC called on Belgium to recoup approximately €700 million in owed taxes from 35 multinational companies. Of those companies the list includes the likes of Anheuser-Busch Inbev and British American Tobacco.
The “excess profit” scheme allows multinationals to discount profits that stem from the benefits of being a multinational, including cost synergies or reputation, from their tax bill. The image below reproduced from the EC shows, in very basic terms, just how favorable the scheme is for multinationals over non-multinationals, which did not get to participate in the excess profit scheme.
For reference, the Belgian Government is considering appealing this decision.
EC Leveling the Playing Field: Beginning in 2015, the EC reports that it began using new investigative tools, including broader tax transparency sharing across the member states (introduced by Regulation 734/2013) to determine which countries are/aren’t in fair tax compliance in its quest to level the business “competitiveness” playing field across member countries and for large and small business alike.
Belgium joins Ireland, the Netherlands and Luxembourg, all of which that have been investigated (and continue to be) by the EC for their tax structures with multinationals.
The EC decided in October 2015 that Luxembourg and the Netherlands have granted selective tax advantages to Fiat and Starbucks, respectively. And the EC has three ongoing investigations into tax concerns regarding Apple in Ireland, and Amazon and McDonald's in Luxembourg.
This follows an announcement two weeks ago that Google agree to pay £130 million in back taxes owed in the UK.
Broader Implications: In updated statements last week the EC submitted a new Anti Tax Avoidance Package (to be signed off by the member states), which amounts to updated language and frameworks to police and level the tax playing field across the entire 28 member through increased transparency.
One line that jumped out to us: “There is no attempt to interfere with countries' sovereign right to decide their own corporate tax rates. However, countries also have a right to protect their tax bases against aggressive tax planning and unfair tax competition.”
Essentially the new measures intend to focus most on leveling the tax playing field within a country between a multinational and all other large and small business, however it appears that the door has been left open for tax “haven” countries (those who with a lower corporate tax rate vs other member states intend to attract foreign business to their borders) who also could be compliant with the EC’s tax standards.
We suspect that all member states will be reviewed for their tax structures in the coming months and years. Just which countries are up next on the block is hard to say. Ireland, Netherlands, and Luxembourg were countries that had particular “reputations” as notable tax havens (with preferential treatment) within the EU.
With “competitiveness” at the sovereign level an ever hot topic, we’ll continue to update you as we learn more about the EC’s reach across the member states.
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Takeaway: The recessionary bell tolled loudly in yesterday afternoon's Senior Loan Officer Survey data as banks are tightening the screws on credit.
How The Economic Machine Works
For anyone interested in a simple and (moderately) entertaining primer on the role credit plays in economic growth, we recommend Ray Dalio's youtube video "How The Economic Machine Works". In a nutshell, he explains how credit is simply the pull forward of consumption, which is why the credit cycle drives the business cycle. With that in mind, the Senior Loan Officer Survey data out yesterday afternoon is indeed troubling.
Two of Three C&I Measures, CRE Standards, and Expectations are Negative
The Fed released its 1Q16 Senior Loan Officer Survey yesterday afternoon. The survey was conducted between December 29 and January 12 and covers lending standards and loan demand across business and consumer loan categories.
In the previous survey (4Q15) banks began tightening, on net, C&I and CRE lending standards. This quarter (1Q16) not only did the net percentages of lenders tightening standards for those categories increase, but demand for C&I loans declined. Additionally, the Fed's survey this quarter included special questions regarding forward expectations, and loan officers indicated that they expected a further tightening of standards, increasing of spreads, decreasing volumes, and deteriorating credit quality over the course of 2016.
A small silver lining is that consumer lending showed benign conditions; a net positive, albeit sequentially smaller, percentage of banks continued to report easing of consumer lending standards.
Here is the main takeaways this quarter:
1. A net percentage of banks tightened C&I lending standards for the second quarter in a row. Moreover, demand for C&I loans inflected into negative territory this quarter. 11% of banks saw C&I loan demand decrease from large and medium firms (13% saw it decrease from small firms), signaling that borrowers expect a decreased need for capital.
Here's why this matters. We've gone back historically and looked at the Senior Loan Officer Survey many different ways in an effort to discern its usefulness as a forward indicator. After much trial and error, our biggest takeaway is that when two of the three C&I questions have turned negative historically, it has portended a recession in the near future. This isn't coincident, it's causal. Banks tightening the screws, increasing the price of money or reporting reduced demand for money all portend a slowing of econimc activity. The problem is that the cyclical activity tends to autocorrelate, or self-reinforce. In other words, banks tighten credit => consumption/investment decline => workers are laid off => delinquencies rise => banks further tighten credit => and so on and so forth. Below is a chart showing the three questions in the C&I survey back to 1990. To be clear, we've inverted the primary y-axis and we've also reversed the demand question so that all three categories are directionally consistent, i.e. when credit is constricting/price is rising/demand is falling, the survey measures on this chart fall, and vice versa.
Perhaps of equal interest is the fact that the Fed has historically had an enormous policy cushion in response to recessions. The table below shows that since 1969, the Fed has eased by an average of 750 bps in response to every recession. The last two cycles have seen the Fed ease by 560 bps and 520 bps. The challenge this time around is that the Fed's current policy cushion is 36 bps.
To summarize, credit conditions are tightening, which has historically ushered in a recession, and the Fed's short by around 5 percentage points on its ability to soften the blow.
The Data: The percentage of banks tightening C&I lending standards for large and medium firms increased to 8.3% in 1Q16. This is the only instance since the last recession that a net positive percentage of banks tightened standards two quarters in a row. The chart below illustrates.
Here's the Second Most Important Takeaway This Quarter:
2. CRE Tightening. Commercial real estate lending also saw continued tightening this quarter across all three categories: C&D, Nonfarm Nonresidential and Multifamily. Unfortunately, the survey format changed with the 4Q13 survey when the Fed replaced the single category of CRE loans with the three aforementioned subcategories. As such, it's not possible to compare apples to apples historically. That said, in the 10 quarters since the new format began, this marks the third (and third consecutive) quarter in which standards have tightened on C&D loans. It marks the second (and second consecutive) quarter in which Nonfarm Nonresidential loans have seen standards tighten. The Multifamily category has been bouncing between easing and tightening over the last two years, but it has never reached as high as the 22.6% of banks tightening this quarter.
And Here's the Third:
3. Banks expect things to get worse throughout 2016. This quarter's survey included special questions on lenders' forward expectations for standards, spreads, volumes, and quality, and the results are not inspiring. The first chart below shows that banks expect standards to tighten in all commercial and industrial categories in 2016. They also expect to increase spreads across all surveyed loan categories. Also, while banks expect increasing C&I volumes, a significant percentage of banks expect CRE, multifamily, and GSE-eligible residential mortgage volumes to decrease over 2016. Finally, the second chart below shows a sea of red in expectations for credit quality. There is not a single category in which banks expect improvement in credit quality. To put it simply, a net positive percentage of senior loan officers believe that we have reached and moved past the inflection point of deteriorating credit conditions.
Given the increased number of negative responses and the negative forward expectations, we appear to have reached the inflection point signaling that Financial equity prices are past their peak. Unlike the prior positive tick in 1Q12, this time the economic cycle is showing many signs of being late stage, and the survey has deteriorated further quarter over quarter.
The chart below looks at the historical C&I lending standards (LHS) juxtaposed against the S&P 500 Financials Index (RHS). C&I lending standards have historically begun tightening coincident with or ahead of peaks in Financial equity prices. We've highlighted in green the periods during which Financials stocks have risen. In the 1990s it was clear that lending standards were tightening by late 1999, suggesting the roll was near. In the 2003-2007 period standards began to tighten in 2007.
A Quick Review of the Senior Loan Officer Survey by Category:
C&I: The Canary In the Coal Mine
C&I loans continue again signaled the credit cycle peak with standards tightening for two quarters in a row now. The net percentage of banks tightening standards for loans to large firms moved from +7.3% in 4Q15 to 8.3% in 1Q16. Additionally, +4.2% of banks tightened standards for C&I loans to small firms.
CRE: Tightening Across the Board
Banks continued to tightening standards for all three CRE categories in 1Q16. Additionally, the percentage tightening standards for multifamily loans, which had previously swung back and forth from negative (good) to positive (bad), is definitively positive (bad) at +22.6% in 1Q16. This inflection in CRE standards adds to our concern over the inflection in C&I standards.
Meanwhile, demand for all three categories of CRE loans increased, albeit at sequentially lower percentages, in the first quarter.
Residential Mortgage: Mixed
Starting in 1Q15, the Federal Reserve broke the survey's residential Prime and Nontraditional categories into six new categories and kept the Subprime category for a total of seven different categories. The six new categories include: (GSE-Eligible, Government, QM non-jumbo/non-GSE eligible, QM jumbo, Non-QM jumbo, and Non-QM/non-jumbo). The categories we're most interested in are the GSE-Eligible (Fannie/Freddie) and Government categories (FHA/VA) since these two categories account for ~90% of all origination volume. The GSE-Eligible category showed 14.3% of banks, net, eased standards Q/Q in 1Q16. Government standards were unchanged. Standards for Subprime auto were also unchanged, an improvement from the 20% tightening in 4Q15. All four other categories eased.
We pay little attention to the demand component of the Fed's Survey because it reflects shifting refi demand and isn't a good barometer for purchase activity. Nevertheless, we include both charts below.
Consumer Loans: Easing
Standards for credit cards, auto loans, and consumer loans ex-cards and autos all eased in the third quarter.
Joshua Steiner, CFA
Jonathan Casteleyn, CFA, CMT
In this HedgeyeTV video excerpt, Potomac Research Group Senior Telecommunications & Cable analyst Paul Glenchur discusses how key FCC decisions on the set-top box market, net neutrality and sponsored mobile data could affect companies like Verizon, Netflix, and Facebook with Hedgeye Internet & Media analyst Hesham Shaaban. Glenchur also weighs in on what a Republican presidency would mean for mergers and acquisitions in the telecommunications sector.
Paul Glenchur, Senior Analyst, Telecommunications-Cable
Paul Glenchur is ranked among leading telecommunications policy specialists, combining his legal background with industry experience. Prior to joining Potomac Research, Mr. Glenchur was the senior telecom and cable analyst with Schwab Washington Research and later the senior telecom policy analyst with the Stanford Group. Mr. Glenchur also has an extensive legal background – he served as an attorney on the FCC’s cable and common carrier bureau, as an associate with the Washington law firm of Miller and Chevalier, and as Counsel to the Assistant Secretary of Energy for Congressional Affairs. Before moving to Washington, he was a judicial law clerk to Judge Thomas Tang of the U.S. Court of Appeals for the Ninth Circuit. Mr. Glenchur is a graduate of the University of California at Berkeley and earned his J.D. at the University of California Hastings College of the Law, where he was an editor of the law review. Mr. Glenchur is a member of the Federal Communications Bar and has testified before House and Senate committees on telecommunications issues. He is also a member of the Supreme Court and Ninth Circuit bars.
Takeaway: Please join us for our call Thursday, Feb 4th at 1:00pm EST. Dialing instructions will be published Thursday morning.
We will be hosting our quarterly INTERNET BEST IDEAS Update Call this Thursday, February 4th at 1pm EST. We will be reviewing the major themes and incremental developments to our Best Idea Short theses (YELP, TWTR), and will be discussing two recently-closed Best Ideas that we have added to our Bench in the opposite direction (LNKD as a potential Short, P as a potential Long). The emphasis of this call will be to outline our view over various durations (particularly 2016) as well as the upcoming catalyst calendar; identifying the major catalysts and risks to each company over the near-to-intermediate term.
Join us for our call Thursday, Feb 4th at 1:00pm EST. Dialing instructions will be published Thursday morning.
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