Financial Markets Update - Ahead to US Elections 2008
Politics / US Utilities Jul 06, 2007 - 08:45 PM GMTBy: Roger_Conrad
Political parties' power waxes and wanes in Washington, DC. But regardless of who's in or out, the size of our federal government and its social and economic mandate continue to grow, for better or for worse.
At its core, politics is about interest groups. Those who get their views heard and acted on are the winners. Those who don't—or, worse, are trumped by others' interests—are the losers. And the larger the government grows, the more critical it is to be on the winning side.
For investors, that's worth remembering as we enter another national election season. Not since Richard Nixon has an incumbent president been as irrelevant to the national political debate as Mr. Bush. And that's put the package of pro-investor tax cuts he championed in 2003 legislation on the endangered list.
In case anyone has forgotten, the 2003 act cut the maximum tax rate on dividends to 15 percent, with a rate as low as 5 percent for low-income payers. It also knocked down the rate for long-term capital gains to the same level and reduced the rate on the estate tax as well.
Despite strong Republican majorities in both houses of Congress, a compromise was needed to get these reductions through. As a result, they were given a six-year lifespan. Extending them beyond 2008 requires new legislation.
To date, none of the leading presidential candidates have taken a stand on the investor tax cut issue. A President Romney might be more inclined to reintroduce investor tax cuts again than, for example, a President Clinton. But there seems to be little will to introduce the possibility of tax increases, at least in an election year.
Equally, in the Democratic-controlled Congress, there seems to be little appetite for repealing the cuts in advance of their sunset.
And even a bill to tax hedge fund managers utilizing limited partnership structure to minimize taxes—which has the obvious political appeal of attacking ostentatious wealth—is being met with caution. Sen. Schumer (D-NY), for example, has been practically mute on the issue.
The upshot: The fast fade of the Bush presidency has gravely endangered the investor tax cuts introduced in 2003. But they're not dead in the water. What's needed is for the interest group that backs them to get behind renewing them, and that's we investors.
The sunset of investor tax breaks won't demolish the US stock market. It will likely increase the appeal of the remaining tax-advantaged investments, such as municipal bonds and possibly limited partnerships.
It's debatable how much impact doing away with these taxes would have on stocks or other investments currently taxed at a maximum rate of 15 percent. Arguably, the cut was never fully priced into anything because it was always assumed to be temporary. Finally, with America's population aging—as is the case throughout the developed world—corporations will still be incentivized to pay big dividends when they can afford to.
Failure to re-up the investor tax cuts, however, would definitely be a negative, particularly if there's no fix for other dysfunctional elements of the tax code such as the Alternative Minimum Tax. And once the fear of enacting tax increases and redacting tax cuts is overcome in Washington, the risk of more will only rise in coming years.
As a result, it's important for income investors to let their views on this tax cut be known, well before 2008 voting. I suggest a brief note to your congressman and senators, such as this:
Dear Congressman, I'm writing in defense of the Jobs and Growth Tax Relief Reconciliation Act of 2003, specifically the reduced tax rates on dividends and capital gains that are scheduled to sunset in 2009. For the past five years, these lower rates have helped individuals stretch their savings to meet the rising cost of living. They've also helped our stock market attract capital and produce solid returns for investors. Finally, the lower tax on dividends, which are already taxed as corporate income, has encouraged long-term investment. Some mistakenly view the 2003 act as helping only the very wealthy. But during the past five years, it's helped millions of individuals like myself live off our savings. Please consider renewing it before 2009. Thank you for your consideration. |
Remember that in politics, it's the interest groups that best present their views and desires that win. The odds may be against renewing lower tax rates on dividends now. But the more who voice their views on the issue, the better its chances will be in 2009.
IN THE STATES
The 2008 election will almost certainly bring some form of carbon regulation. A change of party control in the White House would also bring different leadership to the Federal Energy Regulatory Commission (FERC) and the Federal Communications Commission (FCC), the chief national regulators of the energy and communications industries, respectively.
The eight years of President Bill Clinton's administration were generally marked by moderate policies toward the power, natural gas and communications industries. For example, an unprecedented wave of industry mergers was allowed to proceed.
Moreover, there's a broad consensus that healthy utilities are essential for keeping customer rates at moderate levels for the long haul. That currently runs across party lines nationwide, including states that Democrats carried in governors' races by double-digit margins.
It's still possible a dark horse candidate will charge in and impose more punitive ideas on industry. But a future President Clinton, President Romney or President Giuliani will be looking to keep the industry healthy as it continues its massive wave of capital spending.
Indications are that carbon regulation would be markedly similar under any in this front-runner trio. That would entail a cap-and-trade system, which would allow companies flexibility and time to meet a tightening regime of restrictions on how much carbon they emit.
As I've written in Utility & Income, the most likely initial result will be an upsurge in use of natural gas to generate electricity.
That would be a plus for North American gas producers, including the battered Canadian drilling industry, which is now operating at barely half its level of a year ago.
My favorites for conservative investors are majors such as CHEVRON CORP and EOG RESOURCES, and utility producers such as ENERGEN CORP.
More aggressive investors will want to look at gas-leveraged Canadian trusts such as ADVANTAGE ENERGY INCOME FUND.
Wind power producers such as AES CORP and FPL GROUP are also in line to profit as demand for their output soars nationwide. So are nuclear players such as DOMINION RESOURCES and DUKE ENERGY. It will be years before they build new capacity. But in the meantime, what they do own will produce higher and higher profit margins, as the price of King Coal (50 percent of US electricity output) rises with the cost of carbon credits.
As for the losers, that will depend heavily on regulation. The good news is it looks like a settlement may be in the offing for AMEREN CORP and EXELON CORP in their battle to prevent a rate freeze in Illinois.
The two companies and their chief antagonist—the state Attorney General Lisa Madigan—have asked federal regulators to delay action on a complaint regarding the state's recent power market auction. In a statement, the trio said they were trying “to reach a global settlement of this and other pending litigation.”
A deal would reduce risk dramatically for both companies.
Unfortunately, coal-dependent Ameren will still be heavily exposed to future carbon regulation and, therefore, to a new round of rate proceedings in Illinois. Exelon, however, is heavily nuclear and will only benefit from Ameren's woes in the state.
ALLEGHENY ENERGY may be headed for an even-bumpier ride. The company has now received negative rate rulings in both West Virginia and Virginia regarding recovery of certain costs involving power purchased from its unregulated fleet of electricity generating plants. That augurs extremely poorly for its odds of recovering the upcoming cost of carbon regulation.
The biggest problem coal-burning utilities face on the carbon regulation front now is the lack of a commercially available and economic technology to reduce carbon emissions. Until one is found, regulatory support on both the state and federal level will be critical. And it will be essential to keep a sharp eye on the states to see who's being cooperative and where the ever-present danger of a revival of utility bashing lies.
As for communications, the only real remaining state regulatory issue is removal of restrictions allowing phone companies to offer cable television services, without going through an expensive and time-consuming franchising process. We'll get another read on how this is going with the release of second quarter earnings from AT&T CORP and VERIZON COMMUNICATIONS, the two giants making the most-concerted effort in this area.
Indications are that both continue to get their hookups in a timely fashion wherever they make the effort. Officials remain broadly supportive, both to limit the power of the cable television monopoly and as a way to continue the rapid, overdue upgrade of America's broadband infrastructure, which lags well behind that of many nations, including most of the Baltic region.
There's one issue on which a change in party control at the FCC could make a real difference: so-called “network neutrality.” At issue is the ability of those who build and operate communications networks to differentiate levels of service.
For example, under a network-neutral system, all network owners would be required to offer their highest quality of service to all their customers. That would prohibit a network owner from offering a higher level of service—i.e., faster and more reliable—to a customer willing to pay more for it.
Last month, the current FCC—whose five commissioners are composed of three Republicans and two Democrats, owning to a Republican being in the White House—voted on party lines against imposing a network-neutrality standard. That would technically allow, for example, AT&T to offer a super premium broadband service to its highest-paying customers.
As of yet, with broadband markets growing so rapidly, no network provider has attempted such as standard. But major Internet service and content providers such as GOOGLE are already gearing up to oppose it and have made some inroads, particularly among Democrats.
A Democrat in the White House wouldn't necessarily advocate a network-neutrality standard, and a Republican wouldn't necessarily oppose one. But this will be an issue to watch closely as November 2008 approaches.
RATES SPIKE AGAIN
Long term, fundamentals hold sway over how businesses and their stocks perform. And few factors will affect things as much as regulatory developments, particularly for utilities.
Here in summer 2007, however, interest-rate volatility continues to hold sway, for utilities as well as all income investments. This week, the benchmark 10-year Treasury note yield briefly dipped below 5 percent on fears the economy is cooling off. It then reversed sharply and exploded to the upside later in the week as employment numbers came in better than expected.
The current yield level of around 5.2 percent is only a trading day or two away from hitting new multi-year highs. Should that happen, a new run to 5.5 percent or higher would appear to be in the cards, and we'll likely see more selling of income investments.
As I've said before, unless they're accompanied by real changes in economic growth and inflation, rate spikes are always short-lived because they sow the seeds of their own reversal. The spikes that occurred in 2003, 2004, 2005 and 2006 all ended within a matter of months as rising market interest rates did the Federal Reserve's dirty work and put the breaks on whatever growth there was.
Of course, market history always repeats itself until it doesn't.
And sooner or later, a rate spike will occur that will last a while longer and do a lot more damage than those before it.
The key thing to remember is it never makes sense to sell out of good businesses solely because interest rates are rising. And that goes even for the sectors considered the most sensitive to rising rates, such as utilities.
As I pointed out in the July issue of Utility Forecaster, since World War II, there have been a dozen selloffs of 10 percent or more in the Dow Jones Utility Average that were caused solely by rising interest rates. Those selloffs took prices down an average of 14.5 percent, top to bottom, over a period of about 11 months, not including dividends.
The fear and despondency went on for a while. But most of the actual damage occurred in the first couple months of the selloff. By the time anyone reacted, it was too late.
The only time it's made sense to sell good positions is when fundamentals have deteriorated. That was definitely the case in 2001-02 for the utility sector, which was turned on its ear by the collapse of ENRON, massive overbuilding of power plants and the threat of a call on hundreds of billions of dollars of debt.
Ironically, interest rates were actually falling in 2001-02.
In contrast, fundamentals for the utility industry are in the pink of health today. Some areas of the group will perform better than others in coming months--namely those that can grow, those tied to energy and companies involved in mergers. But by and large, positions in good businesses will be worth sticking with, regardless of a hyperventilating media that will no doubt argue otherwise.
It's also worth pointing out that at least two broad groups of income investments look set to move counter-cyclically to the rate spike. First, adjustable-rate securities ratchet their distributions higher when rates rise. That will benefit funds that own them, such as the closed-end ING PRIME RATE TRUST.
The other group to watch is Canadian income trusts. Barring a still-possible change in the Canadian government, trusts will be taxed as corporations beginning in 2011. But because they've been pricing in this probability since mid-November, there's no downside on that score.
Moreover, a growing number appear to be able to dodge much of that prospective tax burden; the average Canadian corporation pays less than 7 percent of income in taxes, as opposed to a stated top rate of 31.5 percent.
Trusts have also been increasingly targeted for takeovers by private capital. Oil and gas producer trusts' assets and cash flow gain value when energy prices are strong, which should continue until there's a lot more conservation, use of alternatives like nuclear power, new conventional reserve discoveries and very likely a global recession. And the strong commodity prices mean a strong Canadian dollar, which increases the US dollar value of trusts' distributions and share prices.
Already, we've seen this group stand up to rising interest rates, even on some of the worst trading days. Paying the biggest yields in the world, they're likely to prove valuable havens as long as this rate spike lasts.
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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