OCIE Cybersecurity Report Shows “Overall Improvement”

The SEC Office of Compliance Inspections and Examinations (“OCIE”) examined 75 broker-dealers, investment advisers and investment companies as part of its Cybersecurity 2 Initiative to assess industry practices concerning cybersecurity preparedness. OCIE National Examination Program staff reported an overall improvement in awareness of cyber-related risks and the implementation of certain cybersecurity practices since the OCIE’s Cybersecurity 1 Initiative.

According to the OCIE Risk Alert, the Cybersecurity 2 Initiative examinations focused on written policies and procedures, and included more testing of controls. Specifically, it addressed:

  1. governance and risk assessment;
  2. access rights and controls;
  3. data loss prevention;
  4. vendor management;
  5. training; and
  6. incident response.

Notably, the OCIE found that all broker-dealers, all funds, and nearly all advisers examined in the Cybersecurity 2 Initiative maintained written cybersecurity policies and procedures around the protection of customer/shareholder records. These findings contrasted with those of the Cybersecurity 1 examinations. The OCIE also found firms that were not “adhering to or enforcing” policies and procedures, and firms where guidance for employees was too general. The OCIE report included recommendations for improving controls in their respective cyber programs.

In a related white paper on cyber risk, the Bank for International Settlements Financial Stability Institute evaluated the regulatory and supervisory initiatives in a number of leading jurisdictions, including Hong Kong SAR, Singapore, the United Kingdom and the United States. The report reviewed supervisory approaches to assessing the cyber-risk vulnerability and resilience of banks. The paper also identified a trend toward “threat-informed” testing frameworks, which use threat intelligence to design simulated cyber attacks when testing the cybersecurity of an entity.

SEC Economist Examines Role of Artificial Intelligence

SEC Division of Economic and Risk Analysis Acting Director and Chief Economist Scott Baugess discussed the development and use of artificial intelligence and machine learning within the SEC, challenges presented by artificial intelligence technologies, and the future of these technologies within the SEC.

Mr. Baugess explained that progress in development of artificial intelligence technologies has made it necessary for regulators to examine the potential uses and impacts of this technology on the regulatory environment. He observed that while there is obvious value in potentially being able to more effectively predict investor behavior, “latent variables,” such as fraud which is not seen until it is found, make understanding likely outcomes an especially difficult task. Because of these unobservable outcomes and other difficulties such as translating languages, the application of machine learning to regulating financial markets is less straightforward than it is in other contexts.

Machine learning has been utilized by the SEC in various capacities, including to analyze tips, complaints and referrals and to identify abnormal disclosures. Mr. Baugess noted that machine learning is also useful for detecting potential investment adviser misconduct by identifying outlier reporting behaviors. While acknowledging the value of this form of analysis, he cautioned that reliance on machine learning technologies, such as feeding the results of unsupervised learning algorithms into machine learning, can lead to false positives, or instances where misconduct or SEC rule violation is errantly identified.

Mr. Baugess concluded by emphasizing that although machine learning will improve the SEC’s ability to identify possible fraud or misconduct, he expects that “human expertise and evaluations” will always be necessary in the regulation of capital markets.

Lofchie Comment: This is technology expertise that the SEC should consider outsourcing. Perhaps the SEC should call up the credit card companies and ask them for some lessons in catching fraudulent transactions.

Sargen: A Tale of Two Countries: UK and France

Highlights

  • Theresa May’s decision to call an early election as Prime Minister has come back to haunt her:  Labor Party leader Jeremy Corbyn mounted a credible campaign that denied the Conservative Party a parliamentary majority.  The outcome has added to uncertainty about how the newly-formed British Government will negotiate leaving the European Union (EU).
  • By comparison, the political picture in France continues to improve, as Prime Minister Macron’s newly-formed political party posted a decisive victory in the parliamentary elections.  This outcome has boosted hopes that Macron will press forward with plans to overhaul France’s antiquated labor laws.
  • The contrast between the fortunes of the UK and France is striking.  Britain’s economy was among the most dynamic in Europe one year ago, but its future is now clouded by political dysfunction, whereas Macron’s election has raised hopes that France can transform its economy and stabilize the EU.
  • Amid these developments, we continue to favor continental European equities, but are wary of the UK due to political and economic uncertainty.

UK Elections: Another Surprise Outcome

For the second time in twelve months, the electorate in the UK has defied the pollsters, this time by denying Prime Minister Theresa May and the Conservatives a clear parliamentary majority in the British elections.  When May called for an early election two months ago, the initial assessment of pollsters was the outcome would cement the Tory Party’s majority in parliament, thereby strengthening her hand in negotiating Britain’s departure from the EU.

Instead, the opposite happened. The opposition Labor Party, led by Jeremy Corbyn, a staunch left-winger, mounted a credible campaign that attracted younger voters who had abstained from voting on the referendum to leave the EU.  As a result, May is now scrambling to see if the Conservatives can form a coalition government with a splinter party that represents North Ireland.

Investors are now focused on what the change in political fortunes means for Britain’s exit from the EU.  If May and the Conservatives had won decisively, investors were expecting a so-called “hard exit”, in which the UK would sacrifice free trade arrangements with the EU for increased national sovereignty.  Now that the Conservative’s hand has been weakened, other political parties are insisting on participating in the negotiations with the EU, and the outcome could be a “soft exit,” meaning Britain would seek trade and financial concessions from the EU while surrendering some sovereignty to obtain them.

Beyond this is another looming issue – namely, how will the UK be governed when it is deeply divided as a nation?  According to The Economist, Britain’s main political parties appear polar opposite in many respects:  “Jeremy Corbyn has taken Labour to the loony left, proposing the heaviest tax burden since the Second World War. The Conservative Prime Minister, Theresa May, promises a hard exit from the EU.  The Liberal Democrats would prefer a soft version, or even reverse it.”[1]  Yet, The Economist goes on to observe that the Tory and Labour leaders, despite differences in style and core beliefs, have one thing in common: “Both Mrs. May and Mr. Corbyn would each in their own way step back from the ideas that made Britain prosper – its free markets, open borders and internationalism.”[2]

Since the Brexit vote one year ago, the UK economy has held up better than many observers expected, as a 13% – 14% depreciation of sterling versus the dollar and euro have helped cushion the blow on exporters.  However, the latest indications are the economy is slowing, as real wages have stagnated and public funding is stretched. As a result, investors are becoming nervous about the country’s future.


France: More Positive Surprises

Meanwhile the political picture in France continues to improve, as President Macron’s newly-formed political party En Marche scored a decisive win in the French parliamentary elections on Sunday.  With Macron’s party gaining a clear majority in parliament, the 39-year old president is in strong position to enact his pro-reform agenda that includes weakening France’s protective labor laws, changing tax laws, and reducing pension benefits for some workers.  Moreover, whereas a year ago France appeared to be swept up in an anti-European, anti-immigrant wave, the nation has now rallied around a centrist and unabashed globalist, who seeks to strengthen the EU.

The key challenge Macron faces is whether he can make headway in reducing France’s high unemployment rate, which stands at 9.6% – the lowest in five years. For decades French politicians have tried to reform France’s antiquated system, which makes it prohibitively expensive to fire employees, only to back away in response to public protests. While only 8% of French workers belong to a union, 98% are covered by national and industry-wide contracts negotiated by unions.[3]  This arrangement is particularly problematic for smaller businesses that cannot negotiate terms on their behalf.

Macron is attempting to rectify the situation by making it easier to fire employees, capping damages in unfair dismissal cases and decentralizing collective bargaining.  At the same time, he plans to expand worker protections by making those who voluntarily quit their jobs eligible for unemployment benefits.  Macron’s goal of transforming France’s labor laws by the end of summer is considered ambiguous, and it remains to be seen how he will stand up to tumultuous strikes and protests.  That said, this appears to be the best chance to reform the system in decades.  Should Macron persevere, France hopefully would see the benefits of declining unemployment, much as Germany did when it enacted its labor reforms during the past decade.  Note: Germany’s unemployment rate currently is 3.9%, well below other EU members.


Investment Implications

Weighing these considerations, we continue to favor European equities, as political risks in EU have diminished while economic performance has improved. (See Time to Consider Europe, May 23, 2017)  That said, we would underweight UK equities on grounds the political situation has deteriorated and there is considerable uncertainty surrounding Britain’s exit from the EU.

Equity Markets:  France (CAC-40) versus UK (FTSE), January 2016 to Present

Source: Bloomberg. Local currency returns.

 


[1] The Economist, June 3rd-9th, 2017, p.13.
[2] Ibid., p.13
[3] See Catherine Rampell, “Macron attempts a feat that Trump wouldn’t dare,” The Washington Post, June 8, 2017.

Bitcoin Exchanges Targeted in Cyberattacks

At least two prominent bitcoin exchanges were targeted by cyberattacks that interrupted normal operations and trading.

BTC-e and Bitfinex were targeted by distributed denial-of-service (“DDoS”) attacks, a form of cyberattack which typically uses multiple compromised systems to flood a target with message traffic that exceeds its processing capacity.  The attacks temporarily disrupted service for both exchanges but reportedly did not cause a loss of funds or protected information. According to a CNBC report, service interruptions like those caused by the DDoS attacks could allow traders to “manipulate the bitcoin market.”

Both exchanges have resumed normal service.

Sargen: Time to Consider Europe

Highlights

  • Emmanuel Macron’s election as President of France has buoyed European markets, as it is the third election this year in which populist candidates have been defeated.  Moreover, with Angela Merkel’s party scoring key wins in regional elections, her chances of being re-elected in the fall are high.
  • In addition to lessened political risks, investors have been attracted by better-than-expected economic performance in the European Union (EU) this year.  Germany’s economy has been the locomotive, and Macron’s election has raised hopes that France will finally embark on much-needed structural reforms and that a renewed Franco-German partnership will revive the EU, as well.
  • Weighing these considerations, this may be a good time to add exposure to European equity markets: Profit growth has surged recently and political risk has lessened, while the discount on European stocks relative to the U.S. is in line with long-term norms.  The main risks are that Macron may not be able to deliver reforms and a populist leader could become Italy’s next President.

Background: EU Political Risks Lessen, while European Economies Improve

At the start of this year, a key issue relating to Europe was the prospect that elections in several countries – notably, Austria, Holland, France, Germany and Italy – could result in populist victories that would threaten the EU’s viability in the wake of last year’s vote in the UK in favor of Brexit.  France’s election was perceived to be the most important, because Marine Le Pen, the far right candidate, advocated that France should leave the EU and the euro.  While the odds of this happening were low, investor concerns heightened leading up to the first round elections, when there was a possibility Le Pen and far-left candidate, Jean-Luc Mélenchon, could be the two finalists.  In the event, Emmanuel Macron, a centrist politician who campaigned as a reformer, emerged as the front runner and went on to defeat Le Pen handily in the run-off.

In the wake of these developments, European equity markets rallied at one point by 5%, led by an 8% advance for the CAC.  The rally not only reflects investor relief that France will remain a core member of the EU, but also that the tide of populism on the continent has been contained:  The French election is the third in a row in which populist candidates were defeated, and recent state elections in Germany indicate that Angela Merkel’s prospects for being re-elected Chancellor appear very good.

At the same time, the EU has experienced better-than-expected economic performance, led by Germany: The 2.5% annualized rise in German GDP in the first quarter was the biggest in four quarters, and was well above potential (1.8% according to European Commission estimates.)  Investment in machinery and equipment also picked up in the quarter, suggesting a broadening of the expansion, which had been led by personal consumption.  German GDP in real terms is now 8.5% above its pre-crisis peak in 1Q 2008, well above other EU members.  Meanwhile, unemployment in Germany has fallen below 4% from a peak of more than 10% during the crisis.

For the EU as a whole, real GDP growth was 2% annualized, the best showing in the past two years. The improvement in growth is linked to the European Central Bank’s policies to keep interest rates near zero while expanding its balance sheet via asset purchases.  In addition, the 10% depreciation of the euro against the dollar in the past three years helped boost exports.

As in the United States, so-called “soft data” such as purchasing managers’ indexes and sentiment readings show a marked pick-up since the latter part of 2016.  Indeed, according to Credit Suisse, the latest PMI readings are consistent with EU growth accelerating to 3% (see Figure 1).  We would note, however, that hard economic data does not yet indicate the improvement in business sentiment.  Nonetheless, the latest EC forecast calls for the EU to grow by 1.7% this year, which is a considerable improvement from the past few years.

Figure 1:  European PMI Surveys Point to Stronger Growth 

Source: Thomson Reuters, Markit, Credit Suisse.

Another positive development is headline CPI has accelerated this year and is approaching the ECB’s 2% target, after running close to zero in 2015-2016.  This suggests the threat of deflation is waning, and the ECB can consider normalizing interest rates if this pattern continues.  That said, we believe the ECB will be very cautious about tightening monetary policy.


Will Macron Transform France and the EU?

To some extent, the boost in European equities since the first round of the French elections can be attributed to a relief rally that Marine Le Pen was not elected.  Beyond this, in the wake of Macron’s very decisive victory, some observers have asked whether the election could represent a turning point for France and the EU: Macron is a reformer who also seeks closer ties between France and Germany, which constitute the core of the euro-zone.

Soon after his election, Macron visited German Chancellor Angela Merkel, and both pledged to work closely to draw up a “road map” of reforms for the EU, including the possibility of implementing treaty changes, if necessary.  Merkel noted that work first needed to be conducted on reforms that are needed before changes in the EU treaty would be implemented.  One of the most important is the need for greater fiscal sharing if the EU is to evolve from a monetary union to a fiscal union. To go down that route, however, Germany wants to be confident France is committed to structural reforms that will make its economy more dynamic.  The reason: Germany undertook a comprehensive set of labor market reforms in the previous decade that are credited for reviving its economy.

For his part, Macron has called for a “revolution” to simplify France’s Labor Code, which is a 3,600 page document that regulates nearly every aspect of employer-employee relations.  This will not be easy to pull off, however, as he will encounter strikers and protesters, as previous French Presidents have.  For example, Francois Hollande, Macron’s processor, backed away from embarking on labor reforms in the face of stiff opposition.  Other reforms being considered include cutting the corporate tax rate from 33% to 25%, and reducing the size of France’s bloated government.  The latter goal, however, is modest, as Macron seeks to slow the expansion of government rather than to reduce its size, which is the largest among the leading industrial countries.

Having formed a new political party, Macron must first build a coalition with existing parties, so that he can gain a legislative majority in the parliamentary elections in June.  Those he has recruited so far lean strongly to the left, with many coming from the reform faction of the Socialist Party.  To appeal to the right, Macron is credited with making a wise choice of Édouard Philippe as Prime Minister.  Still, it appears unlikely Macron will win an outright majority, and he therefore may have to rule with a coalition.  Consequently, it remains unclear how successful he will be in achieving reforms that France desperately needs.

The Case for European Equities

The principal reasons for considering European equities are that (i) earnings prospects have improved with the economic upturn, while (ii) Macron’s election and the rejection of populism in several key European countries have lessened political risk.

The improvement in European corporate profits is shown in Figure 2.  It illustrates how far they lagged the U.S. market when economic growth trailed that in the U.S., and how they have improved recently.  Among developed countries, European stock markets traditionally have been the most levered to economic performance, and this continues to be the case, as earnings growth in Europe has exceeded that in the U.S. recently.  Moreover, the percentage of European companies beating expectations is the highest in a decade.  An additional factor supporting corporate profitability has been the weak euro.  Although it has firmed against the dollar recently, it is still relatively cheap on a purchasing-power basis.

Figure 2:  European Corporate Profits Lag the U.S. Until Recently
12-month trailing EPS, Index, Jan 2006 = 100


Source: Datastream, JPMAM. April 28, 2017.

On the surface, it appears European equities may offer good relative value, as the discount of European multiples to the U.S. is about 15%.  The latter, however, is close to the average of the past decade or so, when one takes into account differences in the sector compositions.  Therefore, we consider European equities to be reasonably valued relative to the U.S.

The other major consideration is that political risk in Europe has diminished considerably with Macron’s election and the likelihood that Angela Merkel will be re-elected Chancellor of Germany.  This has contributed to inflows of funds into European markets recently.  The principal risk for investors is disappointment that Macron may not be able to deliver on his reform agenda.  Another risk is that populism could resurface in the Italian presidential elections that must be held no later than a year from now.

Weighing these considerations, I believe now may be a good time to add to European equities, after years of being cautious about European markets.

Comptroller of the Currency Steps Down, Expresses OCC’s Continuing Commitment to Innovation

Comptroller of the Currency Thomas J. Curry announced that he will step down from his position on May 5, 2017. In a speech at the “Fintech and the Future of Finance Conference,” at the Kellogg School of Management, Northwestern University, Mr. Curry reaffirmed the continuing commitment of the Office of the Comptroller of the Currency (“OCC”) to facilitate innovation. He acknowledged the growing impact of FinTech companies, as well as the potential complications that accompany their continued progress and advancement.

In his remarks, Mr. Curry reviewed the OCC process that led to proposals for granting national bank charters to certain FinTech companies. In response to the rapidly expanding FinTech sector, Mr. Curry explained, the OCC launched a “responsible innovation initiative,” which was intended to ensure cooperation between regulators, traditional bankers, FinTech companies and other relevant entities. The initiative, which explored obstacles to innovation and considered regulatory support measures, eventually devised a solution of granting national bank charters to certain FinTech companies. To that end, the OCC published a draft supplement to the Comptroller’s Licensing Manual on March 15, 2017 that detailed the process of evaluating bank charter applications from FinTech companies. Mr. Curry addressed the opposition to these special purpose charters by advising restraint:

“At the heart of the issue is the fundamental nature of the business of banking – the business of banking is dynamic and I would urge caution to anyone who wants to define banking as a static state. Such a view risks choking off growth and innovation. The federal banking system has served as a common source of strength for communities across the country and for the broader national economy for more than 150 years because it was allowed to adapt to meet the evolving need of consumers, business, and communities.”

Mr. Curry also touted the OCC’s new Office of Innovation, and claimed that it will have an even greater impact on the industry than the FinTech charters, since it will serve to analyze all areas of financial innovation and eventually provide consistent, confidential regulatory advice. He emphasized that the Office of Innovation was put in place to support banks and FinTech companies, and to provide evolving guidance as new opportunities for collaboration and advancement arose.

Mr. Curry – who completed his five-year term as Comptroller on April 9, 2017 – will step down from his position on May 5, 2017. Keith A. Noreika will serve as Acting Comptroller.

Sargen on Corporate Tax Cuts versus Tax Reform Revisited

Highlights

  • As part of “the largest tax cut in history” the Trump Administration is proposing to lower the corporate tax rate to 15% while shifting to a territorial system in which U.S. companies no longer would be disadvantaged on taxation of overseas profits.  The stated goal is to boost long-term economic growth through increased business capital spending.
  • The one page proposal, however, is really a wish list of tax cuts for corporations and individuals, rather than a plan to reform the tax code.  That is the goal of the bill Paul Ryan and House Republicans drafted last summer; however, prospects for its passage have been hurt by failure to repeal Obamacare.
  • While equity investors are banking on corporate tax cuts to be enacted later this year, the unanswered question is how they will be paid. The President and his supporters contend the proposal pays for itself with stronger growth.  However, the risk is the federal deficit will blow out from already high levels.

The Trump Administration’s Wish List

Throughout the 2016 campaign, Donald Trump advocated lower taxes for businesses and individuals as a way to bolster economic growth, and he called for the corporate tax rate to be lowered to 15% from the current rate of 35%.  Because there were few details to back this proposal, however, investors focused on the tax bill drafted by Speaker Ryan and the Republican House leadership, as it had broad support among the Republican rank and file.  It contained four key provisions: (i) reduce the corporate tax rate to 20%; (ii) allow immediate expensing of capital outlays, but exclude interest deductions; (iii) incent businesses to repatriate profits earned abroad; and (iv) implement a border-adjustment-tax (BAT) that would effectively subsidize exports and tax imports.

The intent of the Republican bill was to streamline the tax code and facilitate passage by making it deficit neutral.  With the first three provisions generally consistent with the President’s agenda, market participants focused on the BAT provision that is controversial because of the adverse consequences for firms that rely on imports.

In the wake of the health care fiasco, the prospects for a tax bill that is deficit neutral were dealt two major blows: (1) The failure to replace Obamacare meant the Republican leadership could not garner the projected savings in revenues of more than one trillion dollars over ten years that would have occurred if Medicaid expansion had been halted.  (2) The wrangling over health care made it less likely that the BAT provision would clear the tax bill, because it is too complex and too controversial.

As these developments unfolded, I envisioned a situation in which Speaker Ryan would tell the President that he could no longer support a 20% corporate tax rate unless additional revenues were forthcoming.  Instead, the President upped the ante on Speaker Ryan and the Republican leaders in Congress this past week by stating he favored a 15% corporate tax rate and that he was not concerned about the budgetary consequences. (According to the Urban-Brookings Tax Center, lowering the corporate tax rate to 15% could entail a revenue loss of $2.4 trillion over 10 years, or $600 billion more with a 20% tax rate.)  In addition, the Administration’s proposal appears to drop the BAT provision, which is estimated to generate more than $1 trillion in revenues over the next ten years, and is silent on the issue of deductibility of interest expense.

In the Trump Administration’s view, a lower tax rate would spur stronger economic growth, which would boost tax revenues.  The problem, however, is that tax cuts may provide a boost to the economy by increasing aggregate demand, but the effects are likely to be only temporary if they blow out the budget.


Do Budget Deficits Matter?

This issue loomed large during the 1980s when the Reagan Administration achieved significant tax cuts for businesses and individuals that helped boost the economy.  Although they were accompanied by a significant expansion in the budget deficit, interest rates plummeted from record levels, mainly because the Federal Reserve succeeded in reining in inflation and inflation expectations.  Accordingly, many people at the time concluded budget deficits did not matter for the economy or financial markets.

One needs to be careful about drawing this inference today, however, because the economic environment is very different.  First, inflation and interest rates are near record low levels, and they are likely headed higher as the economy improves and the Fed normalizes interest rates.  Second, the trend rate of economic growth has fallen from more than 3% per annum to about 2% p.a. in the past decade. The challenge the Administration and Congress face is that it is not easy to boost productivity growth and increase labor force participation.

According to the Congressional Budget Office (CBO) projections based on recent trend growth, the budgetary picture is about to worsen in the absence of any policy changes: The federal deficit is projected to grow from less than 3% of GDP to more than 5% by 2027.  This is mainly due to increased outlays for entitlement programs such as Social Security, Medicare and Medicaid owing to the aging of the population and medical costs that have outstripped the pace of inflation.  Stated another way, ten years from now all federal revenues would go to pay for entitlements and debt servicing costs, meaning that all discretionary programs would have to be covered out of deficit financing.

Supporters of lower tax rates counter the picture is far less bleak if trend growth of 3% is restored. (See the commentary by Stephen Moore “Growth Can Solve the Debt Problem” in the Wall Street Journal dated April 26.)  This line of reasoning, however, is risky, because one can always assume the problem away via optimistic growth rate assumptions.  (See the commentary by former CBO Director, Douglas Holtz-Eakin, “Trump’s Tax Plan is Built on a Fairy Tale” in the Washington Post dated April 26.)

So far, at least, financial markets have adopted a “wait and see” posture.  Equity investors are banking on a boost to the economy and corporate profits from tax cuts being enacted, while the bond market is dubious, but supported by lower interest rates abroad.

Speaker Ryan and Republican leaders in Congress, however, are more concerned about prospects for the budget. They are likely to push back on the President’s tax initiatives, especially when he is also supporting increased spending on defense and infrastructure and no checks on the growth of entitlement programs.  It remains to be seen, therefore, how the political process will play out, and whether the President’s tax proposal or the Congressional Republicans’ will prevail. Meanwhile the process is expected to drag on for a long time and possibly into next year.

GAO Reports on FinTech

The Government Accountability Office (“GAO”) issued a report on four types of financial technology (“FinTech”): marketplace lending, mobile payments, digital wealth management (also known as “roboadvisor”), and distributed ledger technologies (“DLTs”) such as blockchain. The GAO addressed functionality, risks and benefits, industry trends, and regulatory oversight.

The GAO did not make specific recommendations concerning oversight, noting that very little commonality exists between the differing types of FinTech. However, the GAO acknowledged the challenges involved in regulating FinTech:

“With respect to virtual currencies, federal and state regulators have taken varied approaches to regulation and oversight. The existing regulatory complexity for virtual currencies indicates that regulatory approaches for future applications for DLT will also be complex.”

Lofchie Comment: The GAO report serves as a good introduction to each of the four FinTech subsectors, and to some of the more significant legal and compliance issues that each business raises.

SEC Acting Chair Piwowar Emphasizes Disclosure in Regulation of Capital Markets

Before an audience of foreign regulators at the SEC’s 27th Annual International Institute for Securities Market Growth and Development, SEC Acting Chair Michael Piwowar addressed best practices for the regulation of capital formation. He emphasized the importance of disclosure for lowering the cost of capital and for protecting investors, and asserted that a guiding principle for regulators must be to determine whether the government is facilitating or interfering with the progress of capital markets.

Acting Chair Piwowar focused on the value of the disclosure regime. He said that prudential regulation in capital markets is a “misplaced idea,” and added that “while banks are in the business of minimizing risk, the capital markets are in the business of allocating risk.” He argued that disclosure is the most effective tool for allocating capital to the most efficient industries, and suggested that a disclosure regime for banks (which he called “market-based prudential regulation”) could also benefit investors.

In addition, he stressed that a regulatory agency should not “substitute its judgment for that of the market.”

Acting Chair Piwowar also touched on the subjects of enforcement, international cooperation, and emerging issues in FinTech.

Lofchie Comment: During his interim tenure, Acting Chair Piwowar is making significant efforts to return the SEC to its historical mission of enabling investors to make investment decisions on the basis of good corporate disclosure regarding facts of economic significance. These are necessary corrections to the course of an agency that had been used since the adoption of Dodd-Frank as an instrumentality of political partisanship without regard to the economic costs or the benefits of its rulemakings.

 

Sargen on Healthcare, the Budget, and Tax Reform

Highlights

  • Economic policies of the Trump Administration are key to assessing the economic and market outlook.  The Republican House tax bill drafted last summer and slated to be voted on later this year has been the focal point for investors. Meanwhile, they are assessing the Republican replacement plan for Obamacare and the 2018 budget proposal submitted by the Office of Management and Budget (OMB) this past week.
  • Both plans are highly controversial, and it remains to be seen what will ultimately be enacted. The proposed budget would fund a 9% increase in military and security spending via steep cutbacks in non-defense related programs that Congressional Democrats and some Republicans oppose.  The main worry for the Republican leadership, however, is that the replacement plan for Obamacare may not attract sufficient Republican support to ensure passage.
  • How these proposals play out could have important consequences for tax reform legislation.  The healthcare plan supported by Speaker Ryan will halt Medicaid expansion in 2020 and shift funding from open-ended entitlements to a per capita cap.  The Congressional Budget Office (CBO) estimates it will generate $1 trillion in savings over a decade, although it will also reduce the number of people receiving insurance substantially.
  • Prospects for enacting tax reform would be enhanced if the Congressional Republicans coalesced on a healthcare plan, whereas failure to reach agreement could jeopardize tax reform and lessen investor confidence.  The vote in the House this week will provide an early read.

Focusing on Economic Policies

One of our main messages for investors since the presidential election has been to focus on policies of the Trump Administration that will have an important bearing on the economy. They are the news that will drive financial markets, as opposed to comments and tweets by the President that many regard as noise.

Until recently, the only substantive policy proposal was the House tax reform bill drafted by the Republican leadership last summer.  It contains features that President Trump supports including: (i) a significant reduction in the corporate tax rate (albeit to 20% instead of the 15%); (ii) immediate expensing of capital outlays but no interest rate deductibility; and (iii) incentives for multinationals to repatriate profits earned abroad.

The most controversial element is the border adjustment tax (BAT) that effectively subsidizes exports and taxes imports of overseas affiliates.  The intent is to eliminate incentives for U.S.-based firms to shift production abroad, and the BAT is also estimated to create more than one trillion dollars in tax revenues over a decade.  The latter is deemed essential by the Republican leadership to ensure tax reform is neutral for the federal budget.

The prospect of significant tax reform combined with regulatory relief, in turn, has been a major driver of the stock market rally since the election.  Indeed, some surveys indicate that approximately 70% of those polled believe legislation will be passed later this year.  The principal uncertainty is whether the BAT provision will clear the final bill.  If not, prospects for the budget deficit expanding considerably are higher, as it will be difficult to make up the loss in revenues.

Beyond this, investors suspect the budget deficit is set to widen during the Trump Administration for the following reasons: (i) President Trump supports a large increase in military and security spending as well as a one trillion dollar infrastructure program; (ii) during the campaign he indicated he would not touch entitlement programs such as Social Security, Medicare, and Medicaid; and (iii)  the President has stated he would help pay for these programs by making large scale cuts in other discretionary spending; collectively, however, they account for only 15% of total federal spending.

With the House Republican leaders recently having drafted legislation to replace Obamacare and the Office of Management and Budget submitting its plan for discretionary spending in the coming fiscal year, investors are now examining details of both plans and assessing the prospects they will be enacted.


Linking OMB’s Budget Plan and the Republican Health Care Bill

The budget plan submitted by OMB and the Republican bill to replace Obamacare were submitted separately; consequently, they have each drawn considerable scrutiny.  To understand them better, however, it is important to recognize that both are key components of the FY2018 budget plan that will be enacted later this year.

The plan submitted by OMB last week, for example, applies only to discretionary federal spending, which represents about 30% of total federal spending.  Under the OMB proposal, military and security outlays would increase by 9% in FY2018, and would be funded entirely through cutbacks in other programs, of which the largest would be for social programs and the EPA.  However, because Democrats and some Republicans are staunchly opposed to large-scale cutbacks in non-defense spending, the OMB plan is widely perceived to be an opening move by the Trump Administration that lays out its priorities.

The main areas of spending that are not addressed in the OMB proposal are mandatory programs, which consist of entitlements (Social Security, Medicare and Medicaid) and net interest payments on the national debt.  Of these, the fastest growing segment is Medicaid, which was expanded as part of the Affordable Care Act (ACA) and resulted in the largest gain in insurance coverage, about 11 million people.  As currently constituted, it is an open-ended obligation of the federal government.

Robert Samuelson of The Washington Post observes (March 20, 2017) that Medicaid increasingly is another mechanism by which government skews spending toward the old and away from the young: “Although three-quarters of Medicaid recipients are either children or young adults, they account for only one third of costs.  The elderly and disabled constitute the other one-quarter of recipients, but they represent two-thirds of costs.”  Samuelson concludes that getting Medicaid costs under control is a much needed reform, considering the aging of the population, with the number of Americans 85 and older expected to increase by 50% by 2030.

This is where the Republican Health Care bill comes into play, as one of the key provisions is phasing out Medicaid expansion through 2020.  Under the Republican bill the program also transitions to a system of block grants to each state that is based on per-capita payments for the Medicaid population.  According to the Congressional Budget Office (CBO), the Republican bill cuts spending by $1.2 trillion net and it eliminates new taxes worth just shy of $900 billion through 2026, of which the vast saving is from reduced Medicare expense.

That’s the good news. The bad news is the cost saving is attributable to fewer people enrolling for medical insurance: CBO estimates there will be a decline of 14 million enrollees next year relative to the Obamacare tally and a cumulative decline of 24 million by 2026.  Even if the CBO estimates prove to be too high, they pose a political problem for the Republican leadership in Congress, who must bring the conservative wing of the Party that favors a quicker end to Medicaid expansion into the fold together with moderates in the Senate who are concerned about a voter backlash if coverage is diminished.

At this juncture, it is unclear whether the Republicans in Congress will be able to find an acceptable compromise.  The first clear indication will come this week when a voted is slated in the House of Representatives.  While conservatives favor an earlier end to Medicaid expansion or simply repealing the ACA, such action would still leave in place the expensive open-ended federal Medicaid commitment.

Thus far, President Trump has been supporting Speaker Ryan’s plan, but he could switch tactics if passage of the bill appears in trouble.  Also, if the President continues to back the plan, he will be criticized for breaking his campaign pledge of not touching entitlements and his assurance that no one will lose coverage under the Republican plan.


Implications for Tax Reform

The resolution of the Health Care bill not only matters for healthcare spending, which comprises 28% of total federal outlays, but also for the passage of tax reform.  If the Congressional Republicans are able to coalesce around a healthcare bill that can pass Congress, it bodes well for the passage of tax reform legislation that investors are counting on.

Conversely, should Republicans be unable to agree, it would damage the chances for meaningful tax reform and harm their chances for maintaining control of Congress in the 2018 elections.  Daniel Henninger of the Wall Street Journal (March 10, 2017) characterizes the Republican dilemma as follows:

            “The day the Republicans clutch on this (healthcare) reform, there will be six-column headlines across the Washington Post and New York Times: “Trump Abandons Promises on Health Care”

            “It will be a fast ride downhill from there. That is because the health-care reform bill is inextricably linked to the politics of tax reform, the second pillar of the Trump legislative agenda.”

The challenge of confronting entitlement program expansions is particularly formidable now, as the aging of the baby boomers implies a steady increase in the size of the federal budget deficit in coming decades absent any changes in current policies (see Figure 1).  Indeed, by 2025 people 65 years and older will comprise 20% of the total population.  Meanwhile, with the added pressure to increase military and infrastructure spending the inevitable question investors must ask is “who will pay the bills?”  Once market participants understand the nature of the fiscal predicament, investors may reassess the optimistic assumptions that are embedded in financial markets today.

Figure 1: CBO Projections of Federal Budget Deficit Assuming No Change in Policies  

Source: Congressional Budget Office.