The annual meeting of Berkshire Hathaway has been dubbed the “Woodstock of Capitalism”. People flock from all over the world to attend the event, held on the first Saturday in May in Buffet’s hometown of Omaha, Nebraska. It is covered live by CNBC, the one shareholders’ meeting to be accorded such an honor on an annual basis. Buffett is known as the first person who attained multi-billionaire status exclusively by investing in stocks. While having an insurance vehicle helped greatly, his ability to hold off investing until an opportunity of sufficient magnitude shows itself is one of his signature strategies. He is currently sitting on over $180 billion dollars in cash, awaiting the next market panic.
Most people attend or follow the Berkshire annual meetings to hear firsthand his chestnuts on investing. He did tease the crowd about a new holding he would reveal the following week (it was Chubb). However, the sagest prediction came when he was explaining why he was cutting back on Berkshire’s holding. Buffett evidently believes that capital gains taxes are slated to increase. For tax reasons, it is better to sell now when rates are lower than wait for them to go up, all else being equal.
This comment went over the heads of most at the meeting. It is possibly the most important thing he said. Taxes affect investing in two ways: it impacts what companies report as after-tax earnings, and it can impact the net result of investments through the capital gains tax rate.
Taking the two items in order: corporate income taxes determine the net profitability of the business. In 2017, when Trump cut corporate taxes from 33 percent to
20 percent, profits soared, as did the stock market. The Trump tax cuts are set to sunset (i.e. terminate) between 2025 to 2027. If Congress does nothing to extend them, they will revert to the pre-2017 levels.
Capital gains taxes were not directly affected by the Trump tax cuts. They are still considered a potential source of funding for the Government’s deficits, which grow due to demographic demand. In an effort to close the deficit gap, capital gains are a ready target. Bear in mind that, at the end of World War II, capital gains taxes could go as high as 70 percent. They are about 20 percent now.
Buffett is not taking a political position so much as acknowledging a financial reality. Continuing to rack up annual deficits in the manner of the United States is not
sustainable. As for those who allege that government spending is rife with waste, consider that over 70 percent of Federal Expenditures go to making Social Security and Medicare payments. Add another 5-6 percent for Defense spending, and there is not a lot left to cut. Shut down the FAA maybe? Abolish Homeland Security? Tell meat inspectors to go home? Sell off the National Parks system? Not likely.
As a country, having debt is bearable up to a point. Unlike the kitchen table analogies used to explain why we need to eliminate debt altogether, a country, unlike a
family, is a perpetuity. The ratio that best gauge’s debt is compared to a country’s GDP, which is its output of goods and services. The US is right now about 12 percent. Other countries have had higher ratios. Japan’s is over 200 percent, but that is in part because the Japanese people save about 20 percent of their income. In the US the same savings rate is around 4 percent.
An obvious question is whether the outcome of the election will change how the issue is approached. Democrats have talked of making sure families with incomes of under $400,000 per year are not affected. Republicans so far have floated the idea of higher tariffs on imported goods. This would fall harder on the lower income groups, as they pay out a higher proportion of their income on goods and services than the more affluent. Another reason there is a high chance of tax increases is due to the US’s need for foreign funds to buy the government bonds that finance the deficits. China currently is letting its US Government bond portfolio mature but is not buying new US bonds to replace. At one time China was the largest holder of US debt.
If foreign investors believe their investments in US debt are not stable, a severe reduction in foreign demand would ensue. This would require interest rates to rise to
whatever level to entice domestic investors to take their place. Since a consumer must decide whether to spend a dollar or save it, the shift to savings could precipitate a recession of some severity.
There is still time to address this matter in a rational manner. The closing of tax loopholes may help, as will a re-examination of taxes on inheritance. On this subject
everything has been discussed, from the elimination of the step-up in cost basis to taxing distributions instead of estates, even those to charities and non-profits. Under this idea, there would still be the ability to donate tax-free during one’s lifetime, as the annual gift allowance would be raised for transfer to individuals while still living. Nothing has been set in stone, but the environment is changing. Those who wish to ignore the issue stand the risk of being most affected.
The Economy
Economic activity continues to slow. Job vacancies are declining, as is the rate of people quitting their jobs before finding another one. The revelation that labor from immigrants, both legal and illegal, helped to propel the economy forward still gets a lot of discussion. If future demand does depend on population increases, immigration is the readiest source.
Inflation
Inflation seems to be coming down, but not fast enough to satisfy the Federal Reserve to reduce interest rates. Some forecasters seem to believe that inflation reductions are transitory, and inflation will accelerate later this year into next. The key issue seems to be labor. Almost 3,000 Americans are turning 65 every day. Their workforce replacements are often just not there.
Interest Rates
The Treasury Department sells Government bonds at auction. Various dealers, on behalf of their clients, bid for an issue based on its yield and time to maturity. In the past month or so, the auctions have had a problem finding bids for all the bonds being sold. This has required the Treasury to increase the coupon payment on the debt to attract more buyers. We believe this is not a good sign.
The Stock Market
The latest shiny object, Artificial Intelligence or AI, is distracting the market from a number of issues. The deficit discussed above is one. The slowdown in profit growth in many companies is another. Finally, there is the casino atmosphere created by everything from Crypto currencies to meme stock trading.
Stripped of its aura, AI is simply the concept of the decision tree married to the computer so that decisions can be made much more quickly. While it is a breakthrough in rote decision making, it is no better than its programming. Meanwhile, companies like Nvidia, which makes the chips for AI sell at a price that will require a 70 percent increase in sales and profits every year for the next five years to attain a market multiple at the end of that time. Such is not likely to happen.
There are parts of the market that have attractions. Specifically, catering to the over- 65 affluent in terms of travel, medical and other experiences look compelling, as does some investments in the energy supply that have not been bid up.
Warren M. Barnett, CFA
June 12, 2024
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