Daily Comment (October 27, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] As we detail below, Q3 GDP came in stronger than forecast.  And, yesterday’s spate of tech company earnings were quite solid.  Equities and the dollar continue to rally and interest rates are grinding higher.  Here is what we are watching:

A budget passes the House: As expected, the House passed a budget but the measure made it by a mere four votes.  The measure failed to attract any Democrat Party votes and GOP members from high income tax states tended to oppose the measure as well.  A tax bill could make it through the House over the next two weeks, but the Senate will be a different story.  If a deal does get passed (and we put the likelihood at a coin flip, at present), it won’t happen until probably late Q1 or early Q2 2018.  As the bill is developed, opposition will grow as lobbyists will try to preserve tax breaks.  At this juncture, the most controversial issue is the ending of State and Local Tax (SALT) deductions.  If this measure does pass, it could further polarize the nation politically and geographically.

Will repatriation occur?  One of the expected benefits of corporate tax reform is that money held overseas (which isn’t taxed under current law until it’s repatriated) will come flowing in, funding new projects and boosting the dollar.  Although a deal could bring the former, don’t count on the latter.  Brookings[1] notes that much of this money is already in the U.S.  Under American tax law, the earnings held overseas can be repatriated without triggering a tax event if it isn’t used for dividends, buying companies, loan collateral or making investments.  In other words, the money is already in the banking system but it is affecting the economy through bank lending, not through direct action by firms.  Thus, a deal to “bring back” the money will help stocks (we expect it to be used mostly for dividends and stock repurchases) but it won’t boost wages, investment (at current low interest rates, there is no legitimate investment project that isn’t already being made) or the dollar.

Catalonia: Catalan President Puigdemont was unable to convince his regional parliament to organize new elections and has moved to declare independence.  PM Rajoy will now almost certainly move to depose the Catalan government and take direct control of the province.  New elections will likely come in the next six months.  So far, the financial markets are taking all this tumult in stride.  Eurozone equities are higher this morning, although Draghi’s policy changes being taken as dovish and the weakness in the EUR are probably more than offsetting anything happening in Spain.  However, this drive to self-determination and the withdrawal from the center across Europe is a broader problem that will need to be managed in the future.

Will Venezuela default?  PDVSA, the Venezuelan state oil company, will need to make $985 mm in debt service payments today, and another $1.2 bn by next Thursday.  Although the country has used its 30-day grace period on some loans, these bonds don’t have this vehicle and so the money is due.  Default is looming if they fail to pay; if the debt is restructured, it would be one of the largest in history.  It is also possible that creditors will attempt to seize assets, including the Citgo refineries here in the U.S. (there are three, representing about 750 kbpd of capacity).  Although official reserves are $9.9 bn, it isn’t clear how much of that has already been pledged as collateral.  Credit default swaps put the odds of an official default at 75% over the next year.

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[1] https://www.brookings.edu/blog/up-front/2017/10/25/repatriated-earnings-wont-help-american-workers-but-taxing-those-earnings-can/