Description

Note: My thesis is that border adjustability will be included in Trump’s tax plan. I’m shorting a basket of stocks that I think will be negatively affected by the provision rather than the XRT itself, which includes many stocks that are not relevant to my thesis.  

Thesis

·         Many retailers are now about flat after rallying on the Trump win due to hopes of (1) better growth leading to a value trade, which included a lot of low multiple retailers and (2) lower corporate tax rates, which the market believes will benefit domestic retailers that pay close to 40% tax rates.

·         Although retailers have high corporate tax rates, border adjustability would more than overwhelm the benefits from lowering the corporate rate to 20%, even after adjusting for significant, but not complete, dollar strengthening.

·         Even after the recent pullback, I believe the market is under discounting the odds of border adjustability passing because many investors believe the consequences would simply be too devastating for the provision to be put in place.

·         I believe the odds of border adjustability passing are around 70% because mainstream Republicans (Paul Ryan and Kevin Brady), Tea Party Republicans (Ted Cruz), and Trump’s advisors (Wilbur Ross and Peter Navarro), support the provision. When the most important groups in Washington support something, I think it is unwise to assume it won’t happen. Moreover, border adjustability raises about $1 trillion in revenue over 10 years, representing about 20% of the $5 trillion needed for the Republican plan to be approximately budget neutral under dynamic scoring.  Without border adjustability, many of the other provisions that Republicans have been fighting for for years will not be able to be included in the tax plan. Finally, lobbies that will likely support border adjustability have more spending power and give more money to members of congress who have key roles in designing the tax plan than retail lobbies.

·         The provision doesn’t actually have to pass for this trade to work. The market just has to increase the odds it is assigning of border adjustability passing.

What is Border Adjustability

Here’s how Alan Auerbach, the main academic proponent of the system, defines border adjustment:

“Border adjustments are taxes or tax exemptions that apply when payments for goods and services cross international borders … Border adjustments may be implemented as taxes on imports and rebates on exports, or by excluding overseas sales and purchases from the computation of taxable income.”

Since retailers import basically everything and export basically nothing, their profits would take a large hit due to border adjustability, all else being equal.

However, academics believe that all else will not be equal, and that the dollar will strengthen to offset the import tax and export subsidy, and consequently the change in policy ultimately would have no effect on the net income of corporations.  Here’s how Auerbach justifies his assumption that the dollar would strengthen to offset the trade effects of border adjustability:

“The key point is that the rate of border adjustments is paired and symmetric. Thus, the effects on trade of these two components – the import tax and the export subsidy – are offsetting. Adopting them together imposes no trade distortions even though adopting either separately would do so. To see this, consider them in turn. An export subsidy would make domestic exporters more competitive internationally, increasing foreign demand for their products. If adopted by the United States, such a policy would also strengthen the dollar as a result of the surge in demand for exports, which would partially reduce this demand surge by raising the cost of US goods abroad. But we would expect only a partial offset to the initial increase in export demand. With the exchange rate rising, there would also be a rise in US imports (due to foreign goods being cheaper as a consequence of the stronger dollar). If the dollar rose fully to offset the impact of the export subsidy, there would be a worsening of the trade balance, since only imports would be rising. A worsening trade balance is inconsistent with the rise in the dollar, so one can conclude that in isolation the export subsidy would raise exports.

A tax on imports, on the other hand, would raise the US price of imports and reduce demand for them. This would also lead to dollar appreciation (because of weaker US demand for imports), but not enough to offset the increase in import prices and the reduction in import demand. The same logic applies. A higher dollar and no decline in imports means there would have to be a fall in exports, and worsening of the trade balance, which again is inconsistent with the rise in the dollar. Once more, in isolation the import tax would reduce imports. However, imposing the same rate of export subsidy and import tax would lead to dollar appreciation, the first by stimulating net exports and the second by discouraging imports. Combining the two policies, at the same tax rate – that is, introducing border adjustments – would result in a policy in which each component leads to dollar appreciation, but where the effects on trade would offset. For, if the dollar appreciates by enough to eliminate any price changes facing purchasers that result from the border adjustments (i.e., raising the foreign cost of exports to offset the export subsidy and lowering the domestic cost of imports to offset the import tariff), there would be no change in US exports or US imports, no change in the trade balance, and no inconsistency of the trade balance with dollar appreciation.”

I don’t really understand the last part of the above rationale, but essentially the academic explanation for the dollar strengthening to completely offset the potential effects on trade is that in the long run imports and exports must be equal, and currency adjustments are the primary method to equalize the two. While this view is academic consensus, it is only necessarily true in the long run (the same long run in which we are all dead), as it is certainly possible to run trade deficits for decades. Most traders seem to believe that the dollar would only partially adjust, although no one I’ve spoken to has given me numbers with any confidence.

Why Border Adjustability Could Be Included

Mainstream Republicans and Policy Wonks Like It

Paul Ryan

Here’s how it is described in Paul Ryan’s “A Better Way” tax plan:

“Today, all of our major trading partners raise a significant portion of their tax revenues through value-added taxes (VATs). These VATs include “border adjustability” as a key feature. This means that the tax is rebated when a product is exported to a foreign country and is imposed when a product is imported from a foreign country. These border adjustments reduce the costs borne by exported products and increase the costs borne by imported products. When the country is trading with another country that similarly imposes a border-adjustable VAT, the effects in both directions are offsetting and the tax costs borne by exports and imports are in relative balance. However, that balance does not exist when the trading partner is the United States. In the absence of border adjustments, exports from the United States implicitly bear the cost of the U.S. income tax while imports into the United States do not bear any U.S. income tax cost. This amounts to a self-imposed unilateral penalty on U.S. exports and a self-imposed unilateral subsidy for U.S. imports.”

Kevin Brady

In a recent interview with C-Span Kevin Brady, Chairman of the Ways and Means Committee said this in response to a question on border adjustability that specifically mentioned the pain it would inflict on retailers:

“This is a key part to our built for growth tax code—its going to stay”

https://www.c-span.org/video/?420285-1/newsmakers-representative-kevin-brady

In addition to it discouraging tax sheltering and inversions and encouraging exports if the dollar does not completely strengthen, the Republican establishment likes border adjustment because it raises about $1 trillion, or 20% of all revenue raised in the Ryan Plan. Even with border adjustment, the plan loses $192 billion under the Tax Foundation’s dynamic scoring, which I’m told is more dynamic than the CBO/JCT models. Without border adjustment, how could the plan approach being revenue neutral? The first thing you would do is lower the corporate rate to 25% instead of 20%, which I estimate would raise $330 to $450 billion by keeping the ratio of tax rate to revenue raised constant under dynamic and static scoring. I don’t think Republicans would consider lowering the corporate rate to any value above 25% as this is the average OECD rate ex the US. With global corporate tax rates likely to continue trending down, Republicans would have difficulty justifying not at least matching the current OECD average rate, especially considering how rare and difficult it is to revise the corporate tax system. Another $450 billion could be raised by not repealing the AMT and estate taxes but this would be in opposition to everything the Republicans believe in. A further source of revenue would be to move individual tax rates up from the 12%, 25%, and 33% in the Ryan Plan but it is impossible for me to guess with any accuracy how much revenue moving these up a few percentage points would raise. My point here is that without including border adjustment, Republicans would have to make other significant sacrifices in their tax plan to approach revenue neutrality. As an aside, there simply is no money left for a trillion dollar infrastructure plan (but most value investors I speak to already believe that).

Keep in mind that mainstream Republicans have been working on this tax plan since last year, and were certainly well aware of the pushback they would receive from the retail lobby. I believe they also see border adjustment as a method to keep Trump from implementing explicit tariffs.  Here’s a quote from a recent CNN piece in which the authors claim that Trump’s people are floating the idea of 5%-10%  tariffs: “The senior transition official said the transition team is beginning to find "common ground" with House Speaker Paul Ryan and Ways and Means Committee Chairman Kevin Brady, pointing in particular to the border adjustment tax measure included in House Republicans' "Better Way" tax reform proposal, which would disincentivize imports through tax policy.” (http://www.cnn.com/2016/12/21/politics/donald-trump-tariffs/). Although I am not betting on explicit tariffs or a trade war, I do think its also notable that Trump’s buddy Icahn does not think it is out of the question and seems to view it as a necessary adjustment: "If you get into a trade war with China, sooner or later we'll have to come to grips with that … And maybe it's better to do it sooner, but that's not my decision at all."  (http://www.cnbc.com/2016/12/22/this-is-why-carl-icahn-is-concerned-about-the-market-in-the-short-term.html),

Donald Trump’s Advisors Like it (and he will too)

Wilbur Ross (Commerce Secretary) and Peter Navarro (director of White House National Trade Council)

I think the policy paper “Scoring the Trump Economic Plan” by Wilbur Ross and Peter Navarro, is required reading to understand Trump’s economic views.  While there are some points made for political reasons, I don’t think this paper is the kind of thing they expected most people to read (I don’t think most investors have read it either), so I think this is actually what they believe.  Peter Navarro is known to be extremely anti-trade/pro US manufacturing (see this documentary https://www.youtube.com/watch?v=mMlmjXtnIXI by him, which Trump called “right on”) but Wilbur Ross is perceived to be one of the advisors that understands business and will protect the stock market. I think this perception is wrong. I think both of them truly believe (1) we are being taken advantage of by poor trade deals and a bad tax structure (2) exports are very important to an economy and  (3) a border adjustable tax system with a 15% - 25% rate is the best way to encourage exports and get us back on a level playing field with the rest of the world. 

Here are some direct quotes from the paper:

“VAT rates are typically between 15% and 25%. For example, the VAT rate is 25% in Denmark, 19% in Germany, 17% in China and 16% in Mexico. Under WTO rules, any foreign company that manufactures domestically and exports goods to America (or elsewhere) receives a rebate on the VAT it has paid. This turns the VAT into an implicit export subsidy. At the same time, the VAT is imposed on all goods that are imported and consumed domestically so that a product exported by the US to a VAT country is subject to the VAT. This turns the VAT into an implicit tariff on US exporters over and above the US corporate income taxes they must pay. Thus, under the WTO system, American corporations suffer a “triple whammy”: foreign exports into the US market get VAT relief, US exports into foreign markets must pay the VAT, and US exporters get no relief on any US income taxes paid. The practical effect of the WTO’s unequal treatment of America’s income tax system is to give our major trading partners a 15% to 25% unfair tax advantage in international transactions. (While in principle, exchange rates should adjust over time to offset border adjustment, in the near term, exchange rate manipulation leads to major effects on trade flows.)”

“The WTO’s VAT Rules Are A Poster Child of Poorly Negotiated US Trade Deals”

“Donald Trump has pledged to renegotiate every one of these bad trade deals according to the principles of the Trump Trade Doctrine, i.e., any deal must increase the GDP growth rate, decrease the trade deficit, and strengthen the US manufacturing base.”

“Suppose the US had been able to completely eliminate its roughly $500 billion 2015 trade deficit through a combination of increased exports and decreased imports rather than simply closing its borders to trade. This would have resulted in a onetime gain of 3.38 real GDP points and a real GDP growth rate that year of 5.97%.” [Trump didn’t just make up the 6% GDP growth comment out of thin air. This is how he got that number.]

“Those who suggest that Trump trade policies will ignite a trade war ignore the fact that we are already engaged in a trade war. It is a war in which the American government has surrendered before engaging.”

Larry Kudlow (Likely Chair of the Council of Economic Advisers)

Kudlow is perceived to be vigilantly free trade, although he has spoken against China breaking WTO rules in the past. I watched the interview below live, and although this section is not in the clip, he did says something very similar to the ideas above that we must “level the playing field” and I’m almost certain this was in response to a question raising concerns about the border adjustment.  I interpreted the statement as him being in favor of the border adjustment while I was watching it live but I would like to see it again to be sure. http://video.cnbc.com/gallery/?video=3000577799

Donald Trump

I know I’m supposed to take Trump seriously, not literally (can we please stop using this quote) but Trump must have some ideas that he truly believes in. I think one of the ideas that he fervently believes is that Americans are being ripped off by bad trade deals and that manufacturing and exporting are important for a country to be successful. According to a contestant from season 6 of the Apprentice, which was recorded in the summer of 2006, during a prize dinner with Donald, “Trump expressed his dissatisfaction with the way George Bush was handling foreign affairs, particularly with China. He hated being beat by China even then!” (http://www.cosmopolitan.com/entertainment/celebs/news/a53886/apprentice-candidates-on-donald-trump/). So this is an issue that bothered him way back in 2006, long before he started running for president. You can’t become a manufacturing/exporting powerhouse without first disrupting importers. I think he views this as a necessary adjustment that will enable the middle and lower class to get high paying jobs in factories rather than in Walmarts.

Tea Party Likes It?

Ted Cruz (Kind of Tea Party)

Ted Cruz was in favor of border adjustability during his campaign. Here’s what his website said about the topic:

“Eliminates a current competitive disadvantage for American products through border adjustability: foreign imports will be subject to the Business Flat Tax and American exports will have the tax removed, giving U.S. businesses a level playing field.

Direct Implications

If I had complete information I would model earnings for each stock under one scenario where the corporate rate is lowered to 25% without border adjustability as an upside case and another where the corporate rate is lowered to 20% and border adjustability is included as a bear case and then try to put odds on each of those scenarios to estimate the value of each stock. While the bull case is easy to estimate on a first approximation, the bear case is extremely difficult because you have to estimate (1) how much the dollar rises, (2) how much retailers raise prices if the dollar does not strengthen enough to completely offset the tax and (3) the elasticity of demand after retailers raise prices. After trying to model each of these components I’ve realized that all of the effects are extremely nonlinear. For example, the chart below shows what happens to net income in a simple model where a company goes from a 30% rate with no border adjustment, to a 20% rate with a border adjustment tax, given different levels of dollar strengthening as a percentage of the tax. Given that realistic assumptions for each component above has very wide ranges and the outputs are nonlinear, trying to model outcomes with any precision is a waste of time. What is clear is that for most retailers there is significantly more downside potential from border adjustability and a 20% tax rate than there is upside from a 25% rate without border adjustability. Since I believe that border adjustability is likely to pass, on a first approximation this means that multiples should come down.

Instead of trying to measure precisely how much earnings will change under different scenarios, a better way to find winners and losers is to find stocks that get most of their sales from the US, import most of their products, sell products with highly elastic demand, currently have low tax rates so they won’t benefit even under the bull scenario, have large NOLs which will be written down, have high interest expense that will no longer be tax deductible, and are not growing so they won’t be able to deduct capex.

JC Penney fits every one of those criteria. It gets 100% of sales from the US, imports basically everything, is moving towards appliances which have more elastic demand (purchase of a washing machine is more likely to be delayed than clothing), pays no taxes, has $2.6 billion of NOLs, is expected to pay $370 million of interest next year, and is in secular decline. As a result of these factors, JCP should be worth less than it was in the previous tax regime whether or not border adjustability is included, yet the stock is slightly up since the election. Deckers and VF Corp also have sub 25% tax rates, get about two thirds of sales from the US, and are flat since the election. I’m focusing on retail here but tech hardware is another industry that would get slammed if the market begins to price in the risk that border adjustability is included in the tax plan.

Other Implications

If border adjustability is included in the tax plan and the academics are right, the dollar will strengthen 20% from here very quickly. This means China will have to devalue quicker and by a greater magnitude than it otherwise would have, or at least exert more effort to defend its currency. It also means countries with large amounts of dollar denominated debt (Chile, Turkey, Russia, Mexico, Philippines, Indonesia, Brazil) are going to have their debt service cost increase 20% with no offset. I’m not a macro investor but you don’t need to be one to know that this amount of dollar strength, especially over a short period of time, is bad for multinationals and emerging markets.

Risks

Retail Employs Many People/ The Retail Lobby is Powerful

Retail (not including restaurants) employs nearly 16mm people. Many of these people may lose their jobs if the dollar does not adjust to reflect the border adjustment and the retailing lobby will push hard to keep this from happening.

Of course the retail industry is going to argue against border adjustability. But manufacturers are probably going to argue for it just as hard. The manufacturing lobby spends slightly more than the retail lobby (https://www.opensecrets.org/lobby/indusclient.php?id=N03, https://www.opensecrets.org/lobby/indusclient.php?id=N15&year=2015). Add in the E&P lobby, which will benefit from border adjustment, and lobbies that are in favor of the border adjustment have more firepower than the ones that will be against it. Moreover, after looking at the top 20 donors for each Republican in the Ways and Means Committee and Freedom Caucus, only ~15% and ~20% of the dollars received by members of these groups were from retailers/multinationals. Therefore, I don’t know why it’s immediately obvious that the retail lobby is going to win.

Furthermore, Trump’s goal is obviously not to push 16mm people into permanent unemployment. He believes that many of the people working at Walmart are only in that job because their old jobs were stolen by foreign manufactures taking advantage of bad trade deals. With those deals revoked and a more level tax playing field, he believes Americans will be able to return to better paying manufacturing related jobs. I don’t think this is completely unfounded. Looking at the spread between the percentage of employment and the percentage of GDP for each industry, manufacturing is at negative 3.7% while retail is at positive 4.8%. It’s easy to say manufacturing jobs have been permanently destroyed because of automation and cheaper labor, but Germany and Japan’s spreads between percentage of employment and percentage of GDP in manufacturing are both about zero. This is discussed in Wilbur Ross’s paper:

“Note that the Trump regulatory reform plan will disproportionately – and quite intentionally – help the manufacturing sector. This is the economy’s most powerful sector for driving both economic growth and income gains. These income gains will, in turn, disproportionately benefit the nation’s blue collar workforce. Since the era of globalization, manufacturing as a percent of the labor force has steadily fallen from a peak of 22% in 1977 to about 8% today. To those who would blame automation for the decline of manufacturing, one need only look at two of the most technologically advanced economies in the world, those of Germany and Japan, each of which is a worldwide leader in robotics. Despite declines in recent years, Germany still maintains almost 20% of its workforce in manufacturing while Japan has almost 17%.”

Phase ins or Other Adjustments to Pure Border Adjustability

Maybe Congress will somehow phase in border adjustability to reduce the shock. There are two issues with this. First, this will reduce the direct revenue raised from the provision, which as I showed above, is required for the Ryan plan to approach budget neutrality. Second, if border adjustability is phased in and the academics are correct, the dollar would appreciate 20+% in anticipation of the full tax. This would hurt exporters without the offsetting benefit to importers. Other adjustments could include exempting raw material imports and exempting certain industries related to the “public interest” such as food, healthcare supplies/drugs. Even if it is ultimately implemented with some adjustments, which I think is likely, I think the path to this point goes through the market believing in full border adjustability, which will hit the retailers given how little border adjustability is priced in.

WTO

Most believe that applying border adjustability to an income tax rather than a sales tax is not WTO compliant. I actually think Trump would look at this as a positive aspect of the provision as it will enable him to demonstrate that he is keeping to his word of ripping up bad trade deals. It will also give him the opportunity to send the kind of vicious tweets that his base loves.  

Strong Christmas Sales

Consumer confidence has spiked since the election. This may lead to strong holiday sales. Most retailers report in the middle of February. The president is expected to submit his budget request in the first week of February (although new presidents sometimes take longer), which could include information related to border adjustability. If the budget request includes border adjustability, I think this news would overwhelm strong Christmas sales for the retailers.  

Catalyst

Budget talk.