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STA Weekly Report – When Reliance on Central Banks Dominates the Market

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When Reliance on Central Banks Dominates the Market
Employee stock ownership plan is a tax-smart business strategy
401k Plan Manager

The markets are a strange place today. In 2018, most asset classes finished the year in negative return territory, with money market and short-term bonds being the exception.

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For most of 2018, U.S. GDP grew at the strongest since 2010. Corporate earnings grew by double digits, thanks to corporate tax cuts. Consumer and small business confidence found themselves at a peak. Investors as a result were worried about Fed tightening interest rates at a time when the global economy was potentially heading for a slowdown, exacerbated by trade wars that promised to disrupt global supply chains. With these concerns, it is no wonder why we witnessed a sharp selloff in December.

Source: Bloomberg

Six months later, markets have made a sharp U-turn with almost every asset delivering positive returns in 2019. This includes stocks, bonds, real estate and even cash. So what changed aside from the calendar year? The Conference Board’s leading economic indicators are telling us that the U.S. economy is likely to continue cooling. Global manufacturing PMI indexes are showed economic activity declining from the peak. Market conditions, as viewed by purchasing managers, are contracting. Trade tensions with China remain and offer no clues on their resolution. Brexit negotiations have seemingly gone nowhere. While geopolitical risks in the middle east have also increased over the last week, nothing is all that different compared to last year.     

Source: Bloomberg
Source: Bloomberg

Investor’s views, however have responded. Investors now believe that the Federal Reserve, joined by other powerful central banks, will soon provide a boost to the world economy by reintroducing accommodative monetary policy. Yes, six months after they lifted interest rates from zero percent to slightly over two percent in four years, there is talk of reversing course.

In May, traders were pricing in one rate cut by end of 2019. Now they are betting that three rate cuts will occur in 2019, although the Fed currently is evenly divided between the cut and no-cut camp.

Markets are indeed in a strange place. When investors started worrying about a growth slowdown and trade uncertainty last September, interest rate expectations dropped, and equity markets sunk. The same worry remains, interest rate expectations have plummeted further, yet the stock market has reached all-time highs.

Source: Bloomberg

The 10-year Treasury yield tends to move together with the equity market because a bright growth outlook typically boosts investor confidence and increases borrowing costs. The Treasury yield and stock market, however, are taking a divergent path this year with the gap between them widening since the beginning of June.

Source: Bloomberg

Thanks to the strong rally in global government bonds, the world now has $13 trillion of negative yielding debt, a new record and only adds to the conundrum investors face today – does it make sense to remain exposed to equities and fixed income or is an inflection point ahead that could roil markets? Only time will tell.  

Source: Bloomberg

Negative Foreign Yields Lead Treasury Yields Lower

Bond yields are dropping all over the world. The British 10-Year yield fell this week to the lowest level since 2016 (0.80%). The Japanese yield remains in negative territory.

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Nearly a quarter of bond yields in global developed markets are already negative (below zero); that includes nearly a half of the eurozone. French and German yields are near their lowest levels on record. Most of the attention, however, is being given to the 10-Year yield on the German bund which is the benchmark for the eurozone. And has the most influence on Treasury yields. 

Chart 1 compares the 10-Year German yield to the 10-Year Treasury yield. And it shows the U.S. yield following Germany lower. The gray area shows the German yield peaking early in 2018 and falling sharply since then. The green weekly bars show the 10-Year Treasury yield falling sharply this year. Its yield has fallen to 2.00% which is the lowest level since late 2016. The red area shows the German yield falling below zero into negative territory (-0.31%). The fact that foreign yields are so much lower increases the demand for higher-yielding Treasuries which pushes their prices higher and yields lower. Lower foreign yields also reflect weaker foreign economies, which is also weighing on the U.S. economy leading to lower Treasury yields. 

This week’s dovish turn by central bankers in the U.S. and Europe have pushed global yields even lower. That of course is bullish for bond prices. And has pushed global stocks sharply higher. Falling U.S. rates have also weakened the dollar which has boosted the price of gold to the highest level in six years. The Japanese yen, which is highly correlated to gold, closed at a 52-week high. A falling dollar has also given a boost to emerging markets, especially ones with commodity exposure. Chinese stocks also had a strong week. 

Chart 1

Global Stocks Rally

The weekly bars in Chart 2 shows the MSCI All Country World iShares (ACWI) trading near the highest level since the start of 2018. A weekly close above its April high would be an impressive upside breakout. The ACWI includes the U.S. market which is still the strongest in the world. The S&P 500 hit a record high on Thursday, with the Dow and Nasdaq not far behind. Foreign stocks, however, also had a strong week and may be nearing an upside breakout of their own. 

The weekly bars in Chart 3 shows the MSCI All CountryWorld index ex USA iShares (ACWX) having an even stronger week (+3.2%) and right up against its April high and a potential “neckline” extending back to last July. The ACWX includes foreign developed and emerging markets. EM markets, however, gained nearly twice as much as foreign developed markets (4.8% versus 2.5%). Asian markets led by China were a big reason for that. So were gains in commodity and oil producing countries like Brazil and Russia which benefited from a big jump in the price of oil (helped by a weaker dollar and mid-east tensions). 

Chart 2
Chart 3

Gold Breaks Out to Six Year High… Recent messages have suggested that falling bond yields, and a weaker dollar, were bullish intermarket signs for gold. And they certainly were this past week (thanks largely to statements from the Fed and ECB). The monthly bars in Chart 4 show the price of gold nearing $1400 for the first time since 2013. The chart shows that gold has been forming a potential bottom since late 2015. This week’s upside breakout is a very bullish development for the yellow metal. The green bars show the close correlation between bullion and the Japanese yen which hit a 52-week high this week. That’s also based on a weaker dollar which lost ground against most foreign currencies. Gold miners also had a breakout week. 

The weekly bars in Chart 5 show the VanEck Vectors Gold Miners ETF (GDX) rising to the highest level since 2017 (and on rising volume). The fact that the GDX weekly gain of +6.2% was even bigger than gold’s +3.8% gain is a positive sign. As explained in a previous message, gold shares usually rise faster than the commodity when the metal is in an uptrend. As it now appears to be. 

Chart 4
Chart 5

Weekly Global Asset Class Performance

Source: Money Crashers

An Employee Stock Ownership Plan (ESOP) is a Tax-Smart Business Strategy
As Seen in the Houston Business Journal on December 12, 2005

Written by: Scott A. Bishop, MBA, CPA/PFS, CFP®

As the baby boom generation of business owners approaches retirement, more and more are interested in selling or otherwise cashing out of their businesses.

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In the 1990s this could have been accomplished through roll-ups, initial public offerings or sales to industry consolidators. However, in the post-9/11, post -Sarbanes Oxley, and “post-tech bubble” world, more business owners are turning to a time-tested strategy of selling their businesses by “going public, privately” through the use of an employee stock ownership plan (ESOP).

By utilizing an ESOP, business owners can create significant income tax advantages for both themselves and their companies while allowing them to diversify part or their entire stake in their company. All this and the doors stay open, the employees keep their jobs and the name stays on the door. ls it any wonder that ESOPs are enjoying a resurgence in usage?

Many business owners are unfamiliar with ESOPs, even though they’ve been around in essentially their current form for over 20 years. ESOPs are remarkably flexible plans that permit business owners to accomplish a variety of business and personal financial planning objectives.

For example, ESOPs may serve the company as a means of corporate finance to fuel growth, to increase capital available to purchase fixed assets such as buildings or equipment, or to acquire the stock from retiring or disinterested shareholders.

Since ESOP stock must be valued by an independent appraiser each year, disputes involving the valuation of the company’s stock may be minimized and firm values may be established for planning and financing purposes.

If the company’s objective is to minimize income taxes, an ESOP is an excellent tool that may be used to create tax deductions of up to 25 percent of the company’s payroll plus any interest incurred by the ESOP for the acquisition of the sponsor company’s stock.

Often, the objective of the business owner who is selling his business is to minimize the size of the check that he writes to the IRS for capital gains taxes upon the sale of the business. (Currently, the capital gains are taxed at a maximum of 15 percent of the gain, but the tax percentage increases back to 20 percent in 2009.) The sale to an ESOP, properly arranged, can result in postponing and potentially eliminating capital gains taxes on the entire transaction.

Beyond the company’s purely financial and tax motivations, an ESOP may be a cost-effective way to motivate employees and to boost productivity by giving each employee a stake in the future performance of the company through employee stock ownership. And this benefit is gained without surrendering the control of the day-to­ day decision making by the business owner.

Setting Up A Plan
An ESOP is a tax-qualified employee retirement benefit plan like a pension or a profit-sharing plan. The employer establishes a plan, names a trustee and funds the plan initially with cash.

What makes the ESOP unique is that the plan is designed to own stock in its sponsoring company. Therefore, future employer contributions may be in cash (which can be borrowed from a bank) with which the ESOP may use to acquire stock. Future contributions may also be in company stock.

Stock contributions have the effect of creating a tax deduction without expending the company’s cash.

The plan trustee holds the stock for the benefit of the employees who participate in the ESOP. As participating employees approach retirement age, they are given the right to convert their ownership of stock to investable securities or to receive their retirement benefits in stock.

Postponing Capital Gains Taxes
An owner of a C-corporation can defer capital gains taxes indefinitely on the sale of company stock to an ESOP by taking advantage of a Section 1042 rollover, Section 1042 of the Internal Revenue Code permits owners to defer capital gains taxes on the sale of company stock to an ESOP — if the sales proceeds are
reinvested in qualifying replacement securities within a set time frame (subject to several other technical requirements).

If the owner chooses to sell the replacement securities, substantial capital gains taxes may be incurred. However, if the replacement securities are still in the owner’s portfolio at the time of his death, the deferred gain escapes capital gains taxes permanently. (This tax break will be limited in 2010, the year the federal estate tax is repealed.)

Thus, by selling to an ESOP, the owner of a closely held business can obtain liquidity for all or a part of his ownership interest. Therefore, instead of having the bulk of his personal wealth tied up in the fortunes of just one company, the owner can use the proceeds from the sale to invest in a well-diversified portfolio of securities.

ESOPs are Not for Everyone
ESOPs are not a panacea. They do have some disadvantages.

The first is the expense of establishing and maintaining the ESOP. Because ESOPs are still a relatively unique form of retirement plan, the costs of creating the plan documents and the ongoing expenses are much more expensive than those of a traditional profit-sharing plan or pension. Adding to the administrative expense is the cost of an annual business valuation; these costs can be as much as $10,000 or more.

A second concern is financial. While the many advantages of ESOP transactions should facilitate the financing and acquisition of the owner’s stock, the ESOP structure may complicate critical negotiations with lenders who are unaware or are unfamiliar with the application and advantages of financing through an ESOP.

Lastly, ESOPs are often touted and wonderful tools to increase employee spirit and productivity. While several studies have indicated this to be true, it is almost impossible to conclude that increases in productivity were caused exclusively by the ESOP.

To know what is right for him, a person can contract with someone with ESOP expertise to conduct a
feasibility study to determine how an ESOP might apply in his given fact pattern. The study should consider the value of the company, the demographics of employees, the financial future of the company and its industry, the goals and objectives of both current and future ownership, the current and projected cash flow and the income tax situation of the company.

In reviewing the study, the owner should then be able to decide whether to implement or forgo the ESOP as a prudent solution.

When an ESOP is right, it is an incredibly tax efficient, financially sound tool that can help assure the timely, successful transition of business ownership.

© 2005 American City Business Journals Inc.

Important Disclosure:
Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC (“STA”), or any non-investment related content, made reference to directly or indirectly in this article / newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this article / newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  STA is neither a law firm nor a certified public accounting firm and no portion of the article / newsletter content should be construed as legal or accounting advice.  A copy of the STA’s current written disclosure Brochure discussing our advisory services and fees is available upon request. Please Note: If you are a STA client, please remember to contact STA, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. STA shall continue to rely on the accuracy of information that you have provided.


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