Monthly Archives: January 2018

Dylan Grice on Value Investing

From Advisor Perspectives, by Robert Huebscher:

Grice is a portfolio manager at Switzerland-based Calibrium AG. He previously served as an investment strategist at Societe Generale, and he spoke at that firm’s annual investment conference in London on July 9.

1. Value investing is an intellectual fraud

“What is investing if not for value?” Grice asked, rhetorically. He defined traditional value investing as betting with the odds in your favor or buying dollars for $.75.

The “value” adjective is not necessary, Grice said. “It is like fast sprinting or wet swimming.”

Grice then drew a distinction between fundamental, Graham and Dodd-style value investing, and factor, or quantitatively-based, strategies. He acknowledged that the 1992 Fama-French research showed that you could exploit statistical patterns of cheapness.

He then presented data comparing the small-cap Russell 2000 index relative to its value counterpart, going back 15 years. The annual value premium has been -44 basis points, Grice said. It is not just the Russell indices where value has failed. He said that using the MSCI world index data, the value premium has been -38 basis points over the same period; with emerging markets it was -12 basis points.

It is widely known that growth stocks have outperformed value in the U.S. over most of the last decade, and that value has been the winning strategy over longer time frames. Grice’s analysis was important because he compared value to a broader index and over multiple markets, using only the last 15 years.

But what he said next should be carefully considered by devotees of quantitative investing.

The value premium is not like the liquidity premium, Grice said, which inherently justifies a higher return for its risk. The same is true of the premia associated with credit risk or duration.

“Why should I get persistent risk premium for a cheap multiple?” Grice asked.

“Value investing is far too easy,” he said. “Anyone with a Bloomberg for Factset terminal can do this. It was a historical anomaly because it was cheap.”

“It’s now gone,” Grice said. “The value anomaly has been arbed [arbitraged] out. Value does not equal cheap.”

Quantitatively-based value investing is not the same as fundamental research, he said. Fundamentally-based investing is “hard,” he said, “and it’s got to be harder than quantitative analysis.”

The challenge for advisors is that there is no way to conclusively prove Grice’s claim. We know that quantitatively-based value strategies, unlike the broad capitalization-weighted index, cannot be pursued by all investors. Eventually capital flows to value strategies must erode returns, but we have no way to know for sure when this will happen – or if it already has.

Grice’s assertion should not be dismissed. One cannot be certain that value will “revert to the mean” and resume its long-term outperformance relative to growth the broader market. We’ll have to await further research to see the extent to which asset flows to value strategies, which have been substantial over the 15-year period he studied, have eroded returns.

This is really an interesting claim, and one that I (and I’m sure many others) have wondered for years  now.  There’s another important piece of this claim that is not discussed in this piece – idk if Grice addressed it or not.  That is, what if the value premium is gone? What does that mean for investments based on that premise? What should an investor expect from that portfolio relative to a growth portfolio or a balanced portfolio?  My question really concerns forward looking returns.  If the value premium is gone, does that mean value stocks and all the rest of the stocks now have the same forward looking return? If this is the case, then value investing may not be an advantage, but it may also not be harmful.

2. Absolute return is a myth (everything is relative)

It is generally understood that valuations, using metrics such as the Shiller CAPE ratio, are predictive of returns over long time horizons. The U.S. market is in the top quintile of historical valuations, Grice said, implying a sub-2% real return over the next decade.

“That seems clear cut and obvious,” he said, “but look closer and you see cracks.”

Grice provided data on the range of those return forecasts. Top decile valuations imply returns ranging from -2.4% to 8.7%. Thus, for the next 10 years one could “quite reasonably” make 8.7%, he said. “So how practically useful is this information? It should be a warning sign.”

Using U.S. equities, Grice then compared a buy-and-hold strategy to one based on market timing. His timing model was based on the CAPE ratio and it adjusted allocations depending on the quintile of historical valuations (he did not provide more specific details). His market timing model beat buy-and-hold, he said, but the bulk of the returns came in 1920s.

“There was no value added in the last 70 years,” he said. In addition to the S&P 500, Grice said that finding held for the FTSE 100, DAX 30 and Nikkei 225.

“Valuations matter,” Grice said, “but they’re difficult to measure and get right.”

Forward-looking return estimates are better than naïve extrapolations, he said. But the problem with focusing on U.S. equities is that there have been only seven signals in 100 years, based on valuations being in the top or bottom quintile. “There is not enough data to have statistically significant results,” he said. “The problem is that we don’t get enough movement.”

But if you look at signals across multiple asset classes, you get more useful data. Grice has analyzed valuation-based strategies using bonds and equities. He constructed a model that determines the equity-bond allocation based on the relative valuations of the two asset classes, and said that it outperforms a naïve buy-and-hold strategy. (He said his model used mean-variance optimization based on Sharpe ratios, but did not provide additional details.) Indeed, he said, his relative performance-driven portfolio “did very well.”

“The importance of valuation reveals itself when you add more asset classes to the portfolio,” he said. He has tested his findings for markets in Japan, across Europe and in different European countries. “Valuation is phenomenally powerful but only on a relative basis,” Grice said.

Right now, he said, equities are attractive relative to bonds. “Equities are not that bad,” he said, “given the unattractiveness of the opportunity set.”

OMG I could not love this more.  I had the same issue trying to make an investment model out of CAPE.  My conclusion was that 7 signals in 100 years can only lead to a model that is data-mining, in addition to being basically useless.  I wonder how this compares to Meb Faber’s dynamic allocation model?

His third point is “there is no bond bubble.”  You can click on the link to read that part, bonds are boring.

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Coal vs. Renewable Energy

OK, so solar just took a blow via new tariffs.  Here’s a story about renewables to brighten your day.  From ThinkProgress 1/10/18:

Solar, wind, and battery prices are dropping so fast that, in Colorado, building new renewable power plus battery storage is now cheaper than running old coal plants. This increasingly renders existing coal plants obsolete.

Two weeks ago, Xcel Energy quietly reported dozens of shockingly low bids it had received for building new solar and wind farms, many with battery storage (see table below).

The median bid price in 2017 for wind plus battery storage was $21 per megawatt-hour, which is 2.1 cents per kilowatt-hour. As Carbon Tracker noted, this “appears to be lower than the operating cost of all coal plants currently in Colorado.”

The median bid price for solar plus battery storage was $36/MWh (3.6 cents/kwh), which may be lower than about three-fourths of operating coal capacity.  For context, the average U.S. residential price for electricity is 12 cents/kWh.

Bid summary from XCEL's 2017 solicitation (part of its 2016 Energy Resource Plan).
Bid summary from XCEL’s 2017 solicitation (part of its 2016 Energy Resource Plan).

Note that by definition, half of the bids are below the median price — and there were 87 bids for solar plus storage, meaning many bids were quite low (see table above).

There were 96 bids for wind power alone — at a median price of 1.8 cents/kwh — which means some were very low-priced indeed. The tremendous number of bids in Colorado reveal the power of competition in driving prices down.

But it’s not just Colorado whose energy markets have been turned upside down. In November, we reported on the remarkable findings of the financial firm Lazard Ltd., which found that in many regions of North America, “the full-lifecycle costs of building and operating renewables-based projects have dropped below the operating costs alone of conventional generation technologies such as coal or nuclear.”

Moreover, Bloomberg New Energy Finance projects battery prices are projected to drop another 75 percent by 2030, even as solar and wind prices also keep dropping sharply. As a result, the price for dependable power from renewable energy sources is just going to keep going lower and lower.

 

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Negotiation Tactics

Of course some of this is right up to and maybe over the line of manipulation.  But a lot of it is NOT, and is just dealing with how we are wired as humans in a way that is constructive for everyone.  The Chris referred to in this post is Chris Voss.  He was the FBI’s lead international hostage negotiator and he’s the author of an excellent new book: “Never Split The Difference.”

From theladders.com:

  • Don’t be direct: Direct usually comes off as rude, no matter your intentions. Be nice and slow it down.
  • Don’t try to get them to say “yes”: Pushing for a “yes” makes people defensive. Try to get a “no.”
  • Do an “accusation audit”: Acknowledge all the negative things they think about you to defuse them.
  • Let them feel in control: People want autonomy. Ask questions and let them feel like they’re in charge.
  • The two magic words they need to say: Summarize their position to trigger a “That’s right.”
  • Listen for levers: They might only need the orange peel. Listen, listen, listen.
  • Keep asking “How am I supposed to do that?”: Let them solve your problems for you.

Emotions are critical. Most deals end because of negative feelings and most deals close because people like one another. So don’t alienate the other side — unless you are trying to kill the deal. (And that’s an effective technique as well.)

But what you really want to do is what that magic phrase “How am I supposed to do that?” accomplishes so well. It allows you to say “no” without making an enemy. Chris sums it up nicely in his book with a quote.

From Never Split The Difference:

“He who learns to disagree without being disagreeable has discovered the most valuable secret of negotiation.”

Discussions and negotiations aren’t about war or winning. It’s about finding a way for everyone to get what they want and to be happy with what they get. For the people closest to us, it’s also about understanding them better through listening.

And that’s what builds relationships that last.

A little more detail on the keys I found most interesting:

1) Don’t be direct

Straightforward and honest are good qualities. But when you’re too direct in a negotiation or heated discussion, it can come off as blunt and rude. You sound like you don’t care about the other side and just want what you want.

Skipping listening, empathy, and rapport is what turns an easily resolved dilemma into a fight. And you never want to turn a discussion into a war. Be nice and slow it down. Here’s Chris:

Don’t think, “I’m a very direct and honest person. I want people to be direct and honest with me, so I’m going to be direct and honest with you.” Well, that happens to come across as being very blunt and overly aggressive. If I’m not aware that my direct and honest approach is actually offensive to you, then I’ll be mystified as to what your problem is. Meanwhile, dealing with me might feel like getting hit in the face with a brick.

“Cutting to the chase” can feel like an attack. So slow down. Smile. Use a friendly tone or a calm voice.

3) You need to do an “accusation audit”

If it’s an argument with a loved one or a business negotiation that’s headed south, the other side probably has made some accusations about you. “You don’t listen” or “You’re being unfair.

And the common response is to start your reply with “I’m not ____.” You deny their feelings. Boom — you just lost the patient, doctor. They now assume you’re not on the same page. That they can’t trust you.

So what does Chris say to do instead? List every terrible thing they could say about you.

6) Listen for levers

Sometimes you feel you have no leverage. But Chris believes there is always leverage. You just have to find it. And you do that by listening and asking questions — which nicely builds rapport and makes your counterpart feel in control at the same time.

Negotiation is not a fight. It’s a process of discovery. When you know their real needs, the real reasons they are resisting you, then you’re able to address those directly and problem-solve.

What’s interesting to me is that they use the word “levers” and “leverage.”  I guess you can look at it that way, but really you are looking for points of agreement and ways to make a situation win-win.

7) “How am I supposed to do that?”

Playing dumb works. In fact, being helpless works too. Asking “How am I supposed to do that?” is deceptively powerful.

It gets them to solve your problems for you and in a way they deem acceptable. 

From Never Split The Difference:

Calibrated “How” questions are a surefire way to keep negotiations going. They put pressure on your counterpart to come up with answers, and to contemplate your problems when making their demands… The trick to “How” questions is that, correctly used, they are gentle and graceful ways to say “No” and guide your counterpart to develop a better solution — yoursolution.

By getting the other side to think about your situation it very often gets them to grant concessions. And they’re concessions that they’re okay with and will likely stick to because it was their idea to offer them. Here’s Chris:

You want to make the other side take an honest look at your situation. It’s the first way of saying “no” where you’re doing a lot of things simultaneously. You’re making the other side take a look at you. You make them feel in control, because it’s a good “how” question. You don’t want to say it as an accusation. You want to say it deferentially, because there’s great power in deference. You want to find out if they’re going to collaborate with you. 9 times out of 10, you get a response that’s really very good.

Keep asking it. In hostage negotiations Chris would ask it over and over: “How do we know the hostage is safe?” “We don’t have that kind of money. How are we supposed to get it?” “But how do we deliver the ransom to you?”

Now I know what some of you are thinking… Eventually they’re going to say, “You’re just going to have to figure it out.” And that’s fine. That’s the signal you haven’t “left any money on the table.”

This last point is a great one.  It’s the classic way that women get their ideas heard in meetings.  One important point that he left out here is that you can steer the “how” questions to lead to the idea that you have.  Of course, as women are painfully aware, this leads to you getting credit for exactly zero ideas.

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Lady Economists

*sigh*  From the NY Fed:  ht Noah Smith via Twitter.

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Making and Keeping Friends

From Eric Barker:

This is how to make emotionally intelligent friendships:

  • Know thyself: To get the friendships you want, you have to know what you want.
    • How many friends would you optimally have? What level of closeness do you need? How frequently do you want to communicate? You want to ask yourself, “What features of a friendship will be most fulfilling to me in the long run?
  • Make time: More accurately, make it a priority. We all waste time. So, uh, just don’t waste time alone.
  • Must, Trust, Rust, Just: The first two are key. Strengthen the “must” and try to elevate the “trust.”
    • “Must” friends: The inner circle. The closest of the close.
    • “Trust” friends: Not inner circle, but people you trust, share confidences with and know are there for you.
    • “Rust” friends: They’re pals simply because you’ve known them a long time. (If it had more than that, they’d be “must” or “trust.”)
    • “Just” friends: Closer than acquaintances and you may see them regularly with a group, but you’re not tight with them and don’t have a big shared history.
  • Be proactive: In case you need confirmation, waiting for the phone to ring does not, in fact, make the phone ring.
  • Communication: Create safety, be vulnerable, be emotionally expressive and use active listening. And a sincere compliment never hurt either, beautiful.
  • Upkeep: You’re not too busy to send a text message every two weeks. If you think you’ll forget, put it in your calendar.

And what should you look for when meeting new folks who might become future “must” or “trust” friends? All the research agrees: similarity is key. Not only does it draw us to people, it also makes friendships more likely to last.

From Buddy System:

Similarities also occur when tastes and interests match up, and similarities make friendships easier to maintain. And, unless you are interested in hanging out with people who make you feel bad about yourself (not a good interest to have), finding someone who conveys that you are likeable to them will be very reinforcing to your self-esteem.

Beyond similarity, you should also look for people you want to learn something from. Since you took the time to sit down and “know thyself,” think about the person you want to be. Your best self.
Who do you want to rub off on you? To make you a better spouse, parent, worker or human being?

Research shows your friends often know you better than you know yourself. So not only does being closer to friends make your life better, it’s also the path to getting to know yourself better.

Read the whole thing.  The details are important.

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Time Management

Another outstanding post from Shane Parrish at Farnam Street Blog:

A manager’s day is, as a rule, sliced up into tiny slots, each with a specific purpose decided in advance. Many of those slots are used for meetings, calls, or emails. The manager’s schedule may be planned for them by a secretary or assistant.

Managers spend a lot of time “putting out fires” and doing reactive work. An important call or email comes in, so it gets answered. An employee makes a mistake or needs advice, so the manager races to sort it out. To focus on one task for a substantial block of time, managers need to make an effort to prevent other people from distracting them.

Managers don’t necessarily need the capacity for deep focus — they primarily need the ability to make fast, smart decisions. In a three-minute meeting, they have the potential to generate (or destroy) enormous value through their decisions and expertise.

A maker’s schedule is different. It is made up of long blocks of time reserved for focusing on particular tasks, or the entire day might be devoted to one activity. Breaking their day up into slots of a few minutes each would be the equivalent of doing nothing.

A maker could be the stereotypical reclusive novelist, locked away in a cabin in the woods with a typewriter, no internet, and a bottle of whiskey to hand. Or they could be a Red Bull–drinking Silicon Valley software developer working in an open-plan office with their headphones on. Although interdisciplinary knowledge is valuable, makers do not always need a wide circle of competence. They need to do one thing well and can leave the rest to the managers.

Meetings are pricey for makers, restricting the time available for their real work, so they avoid them, batch them together, or schedule them at times of day when their energy levels are low. As Paul Graham writes:

When you’re operating on the maker’s schedule, meetings are a disaster. A single meeting can blow a whole afternoon, by breaking it into two pieces each too small to do anything hard in. Plus you have to remember to go to the meeting. That’s no problem for someone on the manager’s schedule. There’s always something coming on the next hour; the only question is what. But when someone on the maker’s schedule has a meeting, they have to think about it.

It makes sense. The two work styles could not be more different.

Where it gets tricky is when you have to do both.

The important point to note is that people who successfully combine both schedules do so by making a clear distinction, setting boundaries for those around them, and adjusting their environment in accordance. They don’t design for an hour, have meetings for an hour, then return to designing, and so on. In his role as an investor and adviser to startups, Paul Graham sets boundaries between his two types of work:

How do we manage to advise so many startups on the maker’s schedule? By using the classic device for simulating the manager’s schedule within the maker’s: office hours. Several times a week I set aside a chunk of time to meet founders we’ve funded. These chunks of time are at the end of my working day, and I wrote a signup program that ensures [that] all the appointments within a given set of office hours are clustered at the end. Because they come at the end of my day these meetings are never an interruption. (Unless their working day ends at the same time as mine, the meeting presumably interrupts theirs, but since they made the appointment it must be worth it to them.) During busy periods, office hours sometimes get long enough that they compress the day, but they never interrupt it.

Likewise, during his time working on his own startup, Graham figured out how to partition his day and get both categories of work done without sacrificing his sanity:

When we were working on our own startup, back in the ’90s, I evolved another trick for partitioning the day. I used to program from dinner till about 3am every day, because at night no one could interrupt me. Then, I’d sleep till about 11am, and come in and work until dinner on what I called “business stuff.” I never thought of it in these terms, but in effect I had two workdays each day, one on the manager’s schedule and one on the maker’s.

 

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New tax law impact on capital markets

From Bloomberg, via MSN Money:

Farewell, Ireland: It looks like corporate America will finally bring that cash home.

For years, the likes of Apple Inc. and Microsoft Corp. have stashed billions of dollars offshore to slash their U.S. tax bills. Now, the tax-code rewrite could throw that into reverse.

The implications for the financial markets are huge. The great on-shoring could prompt multinationals — which have parked much of their overseas profits in Treasuries and U.S. investment-grade corporate debt — to lighten up on bonds and use the money to goose their stock prices. Think buybacks and dividends.

It’s hard to say how much money the companies might repatriate, but the size of their overseas stash is staggering. An estimated $3.1 trillion of corporate cash is now held offshore. Led by the tech giants, a handful of the biggest companies sit on over a half-trillion dollars in U.S. securities. In other words, they dwarf most mutual funds and hedge funds.

“There is going to be a significant unloading,” particularly of Treasuries, said Reuven Avi-Yonah, a professor who specializes in corporate and international taxation at the University of Michigan Law School. “The general consensus is that the best use of the funds is to distribute it out to shareholders.”

That conclusion runs counter to the long-held promises of the Trump administration and Republican lawmakers, who repeatedly suggested their tax rewrite would encourage U.S. companies to bring the money home to hire workers and invest in their businesses.

The $14.5 trillion Treasury market, of course, can absorb the selling pressure of even the largest corporate holders. There’s little to suggest multinationals will immediately liquidate their investments. Many analysts say companies, rather than selling, could just let their holdings gradually mature.

Yet even at the margin, a drop-off in demand could add to the government’s burgeoning funding costs. Not only are interest rates on the rise, but the most sweeping tax cuts in a generation, which could end up mostly benefiting shareholders, risk leaving the government with trillion-dollar shortfalls for years to come — an expense that taxpayers would ultimately have to bear.

And since Treasury yields are the global lending benchmark, any upswing could also ripple through the real economy in the form of higher rates on everything from credit cards to mortgages. Since September, 10-year yields have climbed over a half-percentage point, hitting a high of 2.595 percent this month.

More Acute

While multinationals may be less inclined to sell their corporate bonds, at least initially, the impact could be more acute, analysts say. In recent years, firms such as Apple and Oracle Corp. have become some of the top buyers of company debt. Apple alone holds over $150 billion in the bonds, exceeding even the world’s biggest debt funds. The market itself is also less liquid, which means it takes far less to move the needle.

Big corporations could dispose of a “few hundred billion” dollars of their total debt investments, said Aaron Kohli, strategist at BMO Capital Markets.

a close up of a map: More Expensive, More Permanently© Bloomberg More Expensive, More Permanently

Repatriation has come back into focus ever since President Donald Trump signed the tax overhaul into law in December. Besides reducing taxes across the board, it did away with a decades-old provision that allowed companies to put off paying taxes on foreign profits until they brought the money home.

Of course, it’s important to understand that for most multinationals, offshore cash is really only “offshore” for accounting purposes. Under the old tax system, earnings attributed to foreign subsidiaries, often based in jurisdictions with low taxes or lax regulations like Ireland or Luxembourg, could be repatriated and remain earmarked as “held overseas” — so long as it was stashed in U.S. securities. Apple, for example, manages its hoard from Reno, Nevada, where its internal investment firm, Braeburn Capital, is located.

“The term overseas cash can be a bit of a misnomer, as it doesn’t have to be overseas and in fact a lot of it isn’t,” said Michael Cahill, a strategist at Goldman Sachs Group Inc. That should limit any appreciation in the dollar related to repatriation over the longer term.

Now, multinationals have eight years to pay a one-time tax on the accumulated income. Foreign earnings held as cash or equivalents — previously taxed at a 35 percent rate when repatriated — would be subject to a 15.5 percent rate. Non-liquid assets would be taxed at 8 percent.

Hot Topic

“Most multinationals will no longer tie themselves up in knots with their Treasury function with a big pile of cash that’s trapped in a foreign corporation and invested in securities and that they can’t use,” said Richard Harvey, a former top tax official at the Internal Revenue Service and Treasury Department, who now teaches tax law at Villanova University.

Goldman’s Cahill predicts corporate cash will be a hot topic on conference calls as earnings season heats up. Any repatriation will likely come from money already parked in U.S. securities.

“Repatriation headlines from the earning calls could cause investors to react,” Cahill said.

His analysis showed that eight firms — led by Apple, Microsoft and Google’s parent Alphabet Inc. — accounted for almost two-thirds of the overseas cash held by S&P 500 companies. According to the most recent filings, they had over $500 billion in U.S. government bonds and corporate debt, data compiled by Bloomberg show. (The top companies generally hold securities due in under five years, according to Bank of America Corp.’s Hans Mikkelsen.)

Sheltering Profits

Apple, which has become something of a poster child for multinationals accused of sheltering profits overseas, had $60 billion in government debt and about $153 billion in company bonds. Microsoft held almost all its cash in Treasuries and debt issued by federal agencies, totaling $122 billion. Alphabet had $66 billion, with about two-thirds in government securities.

How much money multinationals eventually repatriate is anyone’s guess. But tax experts and analysts agree that whatever they raise from selling bonds will likely go to enrich shareholders.

According to a recent study by Bloomberg Intelligence, the tax overhaul could lead to buybacks jumping by more than 70 percent on an annualized basis to $875 billion. The analysis was based on the growth in completed repurchases in 2004-2005, the last time a tax repatriation holiday was in place.

a screenshot of a cell phone: Tax Repatriation a Boon for Buybacks?© Bloomberg Tax Repatriation a Boon for Buybacks?

Apple may increase buybacks by $69 billion, adding to the $166 billion it spent on repurchases from June 2012 to September 2017, according to Gene Munster, a co-founder at Loup Ventures.

“There will be reasons for some very large bondholders to maybe shake some of these bonds out of the portfolio,” said Guy Moszkowski, a banking analyst at Autonomous Research.

Apple spokesman Josh Rosenstock declined to comment, as did Microsoft representative Sarah Elson. Google’s Winnie King declined to discuss the company’s plans for its overseas cash before its earnings in February, while Cisco spokeswoman Andrea Duffy said the company is reviewing the tax changes and that it will address the subject on its earnings call next month.

Big multinationals have good reason to bide their time, according to Richard Lane, a senior analyst at Moody’s Investors Service. Because their debt investments are so extensive, companies could end up inflicting losses on themselves with any large-scale selling.

“I don’t think there will be a rush to the door by these companies to sell this debt and causing increasing yields and lower pricing,” said Lane.

Regardless of what happens, what’s clear is that U.S. multinationals will have little incentive going forward to hoard low-yielding Treasuries or investment-grade corporate bonds as a way to avoid the IRS. Under the new tax law, companies that pay relatively low global effective tax rates — a sign they’re using tax havens — would pay a minimum U.S. tax.

Even if companies don’t sell outright, there’s going to be a “demand shock,” according to Michael Cloherty, head of U.S. interest-rate strategy at RBC Capital Markets. The longer-term risk is that “the biggest buyer in some of these markets disappears.”

 

Keep in mind the data from my last post when thinking about this.  $500M in assets, held in corporate and government debt, versus outstanding debt of $230T, with central banks holding (and having to buy to maintain) nearly $20T.  It’s not really “the biggest buyer,” but still substantial.

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