Altus Insight - January, 2013

The Altus Insight


“For the past three years America’s leaders have looked on Europe’s management of the euro crisis with barely disguised contempt. In the White House and on Capitol Hill there has been incredulity that Europe’s politicians could be so incompetent at handling an economic problem; so addicted to last-minute, short-term fixes; and so incapable of agreeing on a long-term strategy for the single currency.

Those criticisms were all valid, but now those who made them should take the planks from their own eyes. America’s economy may not be in as bad a state as Europe’s, but the failures of its politicians—epitomized by this week’s 11th-hour deal to avoid the calamity of the “fiscal cliff”—suggest that Washington’s pattern of dysfunction is disturbingly similar to the euro zone’s.” Economist, 1/5/13

We have been failed by our representatives in Washington. These politicians, these supposed leaders of our country, and thus, the supposed leaders of the free world, have shown us that just being in a leadership position does not mean a person has the qualifications to lead, even if that position of leadership is among the most powerful in the world as President or Speaker of the House.

Yes, I am referring to the circus that is Washington, and specifically, the fiscal cliff negotiations and outcome. Here are very brief cliff notes as to how the fiscal cliff even came to be an event. First, when the debt ceiling was reached in 2011, the compromise to increase the ceiling was that a bi-partisan commission be constructed that would provide a list of budget cuts and/or tax increases to Congress. If Congress didn't approve that list (in its entirety) mandatory cuts to entitlements and military spending would automatically kick in January 1st of this year. Congress never even got the chance to vote. The leaders on the debt commission were never able to come to agreement to supply a list of changes for vote. January 1st of this year, these (large) cuts were supposed to automatically take effect. Simultaneous to the budget cuts going into effect, federal income tax rates were scheduled to increase across all income levels due the expiration of tax cuts George W. Bush and Congress enacted during his presidency. According to people the press felt had the credibility to be quoted, the combination of the cuts in spending and the increase in taxes would send the country into an immediate and massive recession; and that recession must be stopped at all costs.

There very likely was truth in theory of a recession (though the size is debatable), but what was never discussed, at least not in the press, is that the increase in taxes paired with the budget cuts would positively impact the country’s deficit. Never mind that smoking causes cancer, what is more important is it reduces my jitters. The growing hysteria on the street pushed the politicians to do something. And this was a huge opportunity to do something great for the future of the country. Elections had just ended, the worry of reelection was past (at least temporarily) and the President was entering his second term knowing he had no concern of re-election and that it was four years to build a legacy.

So what happened? Not much of anything really, unless you make over $450,000 a year, in which case your taxes went up. Or unless your industry had a friend in Mr. Biden, who was not shy in telling the world of the “deal” he had constructed, in which case you received some special favors. Instead of making changes to benefit the country for a generation, our leaders not only kicked the can down the road (until later this spring…this time at least), they explicitly overruled a previous, supposedly binding, agreement. Being the leaders they are, the leaders of the two parties of course came out with a united front to the country, explaining the hard decisions, explaining why the sacrifices are for the good of the country, clearly explaining how the parties were going to work together moving forward so issues could continue to be resolved…They didn’t? You mean they went to the press claiming wins and losses? True leadership at its finest.

More explicitly, the Republican leaders achieved nothing. Absolutely nothing. With an opportunity to force changes that would lead to a better fiscal situation for the country, they completely caved on their demands for 1st No new taxes, and more importantly, 2nd No new taxes without corresponding cuts to spending. Leaders, more worried about the sensation of the moment than doing what is right or what they promised to do.

More explicitly, the President granted special privileges and favors, 100% opposed to campaign promises. Additionally, there was zero of the “fair” share that was thrown around consistently in the negotiations. Also, opposite to the promise that the middle class wouldn’t be hit with a tax increase, the social security tax was able to reset 2% higher (though this seems to be a necessity).Leadership.

Most explicitly, this win for the Democrats, and absolute spanking for the Republicans, doesn’t touch the debt issue at all, instead resulting in an increase of $3.9 Trillion over the next decade (according to the CBO). For perspective, that is roughly $12,000 per US citizen and $24,000 per tax payer.

Here is what also happened:

  1. Households that make over $450,000 will be dealt a 13% increase to their marginal tax rate (35% – 39.6%).
  2. After the press and opponents ripping Mr. Romney for his use of offshore tax shelters, the “deal” provides a “pass through” exemption allowing U.S. companies to set up tax havens outside the U.S., the Caymans for example (sound familiar?), through which they channel income and even charge the U.S. parent expenses that effectively move profit from the U.S. to lower taxed countries. Obviously, this results in a decline in tax revenue for the U.S. Additionally, the “deal” included tax breaks for offshore loans, referred to as “active financing”. This is to the apparent benefit of less than 50 of the largest U.S. corporations.
  3. The media also criticized Romney for him making his money in the world of Private Equity. Private Equity is assumed to kill U.S. jobs and obtain favorable tax treatment through “carried interest” tax rules. This “deal” included tax breaks for Private Equity and Hedge Funds. While this is to my personal benefit, what happened to the promise to crack down on Wall Street?
  4. Massive tax deductions for Hollywood.
  5. Huge tax benefits for wind energy. To the tune of a roughly estimated $1 million in tax credits for every large wind turbine. Note that a tax credit is far more valuable than a deduction. A tax credit reduces a tax bill dollar for dollar, meaning a $1 mil tax credit results in an extra $1,000,000 beneficiary’s pocket.
  6. Benefits for rum importers.
  7. American Samoa economic development credits.
  8. And the list goes on…

Instead of solving problems, our leaders are making them worse.

So where does the profit mentioned in the title of this article come in? These changes (or lack thereof) benefit specific industries and companies within those industries. Doesn’t it make sense that the wind power producer will benefit by saving $1 million per turbine? In this case, the company benefits, the shareholders benefit, and by extension, land owners with appropriate properties benefit, component companies benefit, etc.

As mentioned above, favorable tax treatment is still given to Wall St. There are hedge funds and private equity companies (such as Altus Equity) that are pairing cheap money with these continued tax treatments and turning it into a strong current yield for the investors. Of course, in most cases, these types of investments are limited to accredited or sophisticated investors.

In the short to midterm, the government’s refusal to deal with the debt issue, paired with their teammate of choice in the Federal Reserve, will continue to provide cheap money and low inflation (at least measured). This means lower cash yields have a higher investment yields than those same yields would have provided in periods of higher inflation. It also allows for longer term equity investing by locking in the cheap money. Patiently investing into future cash-flows, while simultaneously avoiding short term negative cash-flows, is the best way to obtain true investment wealth (writer’s opinion). Short term profits, or trading profits, are difficult in this environment, but the factors allow for the long term accumulation of excellent investment. Even when investing in investments with strong current yields, make sure there is a component of that investment (possibly even the yield as in the case of rents) that can benefit from an inflationary environment. Even though inflation is currently low, there is strong economic theory indicating that due to current economic policy, at some point in the future, the inflation rate will move quickly upward. When that occurs, investments with fixed yields (like bonds) stand to lose considerable value, both in terms of market price and in terms of inflation adjusted returns.

The fiscal and political environment make for a difficult investing environment, but by being active and doing research, a prudent and patient investor can turn these difficulties into opportunity.