Robert Gottliebsen

Why the world will change next week

If you are like me, you've become rather sick of the daily episodes of the Donald Trump serial. And so, this week, I vowed that I would write about something else.

But when Trump announced that he would be introducing his tax package next week it was clear that this will be so important to global markets that no other subject really makes sense for this week, so please forgive me.

To underline the close links between the tax measures and the market, on Friday (our time) Treasury Secretary Mnuchin said he wanted significant tax reform before August, which made the market nervous because traders felt the Trump Administration was softening its line, deferring the corporate tax cuts for five months. The greenback fell, copper fell back and US growth stocks slipped.

But the importance of this tax statement really came home to me when I was yarning to a few BHP people who are almost on the edge of their seats with excitement. If Trump actually does what he says he will do they will be able to get started on developing one of the world's biggest untapped copper mines – the Resolution mine in Arizona.

To date Trump has made many fundamental errors, but basically he has been carrying out the promises he made to the electorate. If he continues to do this in tax, and in particular embraces also what the House Republicans want, then by the end of next week the world will be a different place assuming he can pass the legislation. He probably will gain congressional approval because the Republicans support most of the measures.

In Australia we tend to simply describe what is ahead as a reduction in the US tax rate from 25 to between 15-20 per cent. If that is all that is involved the global impact will be greatly restricted. But there is much more in the Trump tax package. In the election campaign he vowed to give companies an immediate write-off on all capital expenditure, but then to make interest non tax-deductible.

A new American economy

You saw earlier this week that BHP was using its spare cash to buy back bonds. It was doing that for long-term safety reasons, but thousands of cash-rich American companies will want to buy back their debt if interest is not tax-deductible. Accordingly, we are going to see fundamental changes in the way American and global businesses are structured. The private equity people in New York are pressing Trump to give them a choice between no interest deductibility and capital expenditure write-offs, and the present system.

We will need to see if they win, but if their pleas are rejected then the highly leveraged equity capital structures become yesterday's story. There will also be a tax incentive for American companies to bring their money back home – probably a tax of 10 per cent on the profits as they come in. Again, no one is quite sure how effective this will be, but there is a chance that it will suck a lot of money out of the rest of the world. Certainly that is the plan – and the US is hoping the extra revenue will help pay for the tax cuts.

The market has been really excited by these plans believing they will kickstart the US economy. If Donald Trump's tax package is substantially different to the above, then there is likely to be great market disappointment.

And there is also another part to the package. Trump wants to impose tariffs to raise a substantial amount of the money outlaid in the above measures. But the House Republicans don't like tariffs and they want a scheme whereby companies that import goods will not get a tax deduction. And so, under this scheme, if you are retailer you will not get a tax deduction on your imports. You will get a tax deduction if you buy American goods.

If all your purchases are imported then your turnover less labour and other domestic costs becomes your taxable profit. If Trump does this it will cause an enormous global revolution. It will boost American inflation because retailers and all other companies will have to raise their prices. There are signs of labour shortages in the US already, so wage rates will rise. In turn that will lift American interest rates and almost certainly increase the American dollar (I am always nervous about predictions regarding dollar values).

I don't know if Trump will introduce this last leg of his tax plan but it is absolutely essential because, in rough terms, the outlays finance about half the cost of the other measures. It is important for Eureka readers to equate the above expected measures to what Trump actually does. And naturally, of course, we will help with the process.

Trump and the railways

And just before I leave the subject of Trump, let me relate a fascinating story which underlines the market enthusiasm for the new president. In the US there are two railroad companies; Kansas City Southern, which operates north-south with a large amount of goods travelling to and from Mexico, and Union Pacific Corporation, which carts goods east to west including a lot of coal and minerals.

Over the years both stocks have moved roughly in line with each other. But since the election of Trump as president suddenly Union Pacific Corp has jumped 21 per cent while Kansas City Southern has fallen 6 per cent on the expectation of less goods coming from Mexico. The accompanying graph explains it all and I publish that graph because it does underline that the market is expecting big changes from Donald Trump.

I am telling you this story because it is an indication that the market may have gone too far with their enthusiasm for Trump. Imports from Mexico are not going to suddenly cease and it will take time before the taxation measures are converted to action. But that tax package will be the key to movements in the market.

Chart: Kansas City vs Union Pacific, past 12 months

Source: Bloomberg, Eureka Report

BHP and the dollar

Now returning to BHP. The "big Australian" actually called it wrong when it comes to iron ore and oil. Last year BHP was a bull on oil prices because, firstly, it believed there would be a production constraint agreement within OPEC and, secondly, that underlining demand would cause longer-term shortages.

Conversely, it was very nervous about iron ore prices. As we know oil has improved in price but nowhere near the substantial price enjoyed by iron ore. In this week's preliminary profit, BHP again expressed nervousness about iron ore and remains a long-term bull on oil.

It is backing the bullishness with substantial investment in US oil and gas. If BHP is right and iron ore falls, then the Australian dollar is very vulnerable. And just to underline that BHP takes its belief seriously, the group's bond buyback was decided after BHP stress-tested its business with a substantial fall in the iron ore price. We have an exciting week ahead.