June ’21

The BAN Report: FDIC Quarterly Banking Profile / Out of Stock / Not Your Father’s Recovery / The Industrial Southwest / Higher Taxes-6/3/21

FDIC Quarterly Banking Profile

The FDIC released its Quarterly Banking Profile last week, the most comprehensive report on the condition of the US banking industry. A few highlights:

Overall, year-over-year comparisons look more favorable on the surface as its entirely a function of changes in provisions. Banks should be able to finally grow margins in the second half of the year as loan growth picks up and the rate environment becomes more favorable.

Out of Stock

The New York Times had a great story on “How the World Ran out of Everything,” which shows how COVID upended delicate supply chains and busted the Just In Time inventory mindset. Nobody has any slack, especially when demand estimates plummet and then skyrocket in just a few months.

But the tumultuous events of the past year have challenged the merits of paring inventories, while reinvigorating concerns that some industries have gone too far, leaving them vulnerable to disruption. As the pandemic has hampered factory operations and sown chaos in global shipping, many economies around the world have been bedeviled by shortages of a vast range of goods — from electronics to lumber to clothing.

In a time of extraordinary upheaval in the global economy, Just In Time is running late.

“It’s sort of like supply chain run amok,” said Willy C. Shih, an international trade expert at Harvard Business School. “In a race to get to the lowest cost, I have concentrated my risk. We are at the logical conclusion of all that.”

The most prominent manifestation of too much reliance on Just In Time is found in the very industry that invented it: Automakers have been crippled by a shortage of computer chips — vital car components produced mostly in Asia. Without enough chips on hand, auto factories from India to the United States to Brazil have been forced to halt assembly lines.

But the breadth and persistence of the shortages reveal the extent to which the Just In Time idea has come to dominate commercial life. This helps explain why Nike and other apparel brands struggle to stock retail outlets with their wares. It’s one of the reasons construction companies are having trouble purchasing paints and sealants. It was a principal contributor to the tragic shortages of personal protective equipment early in the pandemic, which left frontline medical workers without adequate gear.

Will companies learn from this? We suspect not, as the cost savings in Just in Time are just irresistible and there will be a tendency to view COVID as a once-in-a-generation event unlikely to be repeated soon. Perhaps, governments could consider stockpiling certain items, but that just shifts the responsibility to the taxpayers. Toyota, which invented the concept, ironically has had less issues because its suppliers are close to its base in Japan.

Not Your Father’s Recovery

The supply chain shortages are a result of an unusual economic recovery with a dramatic slowdown followed by a boom with the economy expecting to pass its pre-pandemic size this quarter.

“We’ve never had anything like it—a collapse and then a boom-like pickup,” said Allen Sinai, chief global economist and strategist at Decision Economics, Inc. “It is without historical parallel.”

When Covid-19 pandemic restrictions sent the U.S. economy into free fall last spring, economists and policy makers worried it would take years for workers and businesses to heal. They now expect the economy’s size to surpass pre-pandemic levels this quarter. Analysts project that by the end of this year gross domestic product will reach the path it was projected to follow had the pandemic never happened, and then exceed it, at least temporarily.

The recoveries from the 1990-1991, 2001, and 2007-2009 recessions were “jobless”: Weak demand reduced employers’ need for labor, keeping unemployment stubbornly high for years. This time, however, the labor market appears increasingly tight. The employment cost index in the first quarter rose 0.9% from the previous quarter, the sharpest increase since 2007. That’s even though the unemployment rate, at 6.1%, remains far higher than before the pandemic.

Consider how the last year has been for a town likes Wilkes-Barre, Pennsylvania.   The New York Times had a good illustration via photographs of its downtown.

In a survey in April 2020, more than half of the downtown Wilkes-Barre businesses that responded said they were at risk of closing permanently. In the end, only six did — most of them restaurants.

Low interest rates and falling rents have also aided entrepreneurship. A survey by the National Main Street Center of several hundred communities found that for every business that closed in a city the size of Wilkes-Barre, 1.4 new ones opened up. That ratio was lower in larger cities, at 1.1 new businesses for every one that closed.

Cameron English, the owner of a pet store called CDE Exotics, bought a five-story building at 95 South Main Street a few months before the pandemic and moved his business in. During the pandemic, the store offered curbside pet adoptions, with Mr. English saying ball pythons, bearded dragons and leopard geckos were especially popular.

The COVID-induced recession is similar to natural disasters, in which there is a big blow and then a strong recovery subsequently.

The Industrial Southwest

The Southwest region is seeing the most dramatic increase of manufacturing jobs as of late, as many companies are building new factories in the region.

The Southwest, comprising Arizona, New Mexico, Texas and Oklahoma, increased its manufacturing output more than any other region in the U.S. in the four years through 2020, according to an analysis by The Wall Street Journal of data from the Bureau of Economic Analysis.

Those states plus Nevada added more than 100,000 manufacturing jobs from January 2017 to January 2020, representing 30% of U.S. job growth in that sector and at roughly triple the national growth rate, according to data from the Bureau of Labor Statistics.

Executives say the region’s growing population makes for plenty of available labor, and its lower cost of living is a draw for new talent.

“I was surprised how straightforward a choice it was,” said Peter Rawlinson, chief executive for Lucid Motors Inc., an electric-vehicle startup that plans to open a $700 million vehicle factory this year in Arizona, where state officials rolled out the red carpet. “There was only one logical conclusion.”

Some growth in the Southwest has come at the expense of California, classified in U.S. statistics as part of the Far West. In 2019, nearly 2,000 manufacturing workers in Texas and more than 1,300 in Arizona arrived from California, the most in a decade, the most recent Census Bureau data show. More than 2,700 manufacturing workers have come to Nevada from California in 2017 through 2019.

Companies building factories in the Southwest include Intel, Lucid, TSMC, Steel Dynamics, and Haas Automation. The Southwest has huge tracts of open land, cheaper labor, and local governments eager to attractive manufacturing companies.

Higher Taxes

In order to fund domestic programs, President Biden is proposing to raise taxes on the highest earners, proposing to raise the top marginal tax rate from 37 to 39.6%.

President Joe Biden wants to raise the top income tax rate for wealthy households to 39.6%, from the current 37%, to help finance his legislative agenda.

That top rate would apply to single individuals with taxable income of more than $452,700 and married couples filing a joint tax return with income over $509,300, according to a budget proposal issued Friday by the Treasury Department.

It would also apply to heads of household with income exceeding $481,000 and married individuals filing separate tax returns with income over $254,650.

Additionally, there is a push to reduce deductions that benefit wealthier taxpayers. One of the targets is 1031 exchanges, which could be a big blow to the commercial real estate industry.

The so-called 1031 like-kind exchange rule, named after a section of the tax code, was created a century ago to aid family farmers. It has evolved into a beloved tool of property moguls, Fortune 500 companies and real estate trusts that can use it to create a daisy-chain of tax avoidance.

It works like this: An investor buys a building for $4 million and sells it later for $10 million. By redeploying the proceeds into a new property within six months, she can defer paying taxes on her gains. She can repeat that process indefinitely.

When coupled with another tax break that wipes out all capital gains at death, the 1031 provision can enable real estate investors to forgo capital gains taxes entirely, enabling family dynasties to pass on riches to heirs virtually tax-free. Some wealth managers call the strategy “swap ’til you drop.”

Critics say the 1031 break has strayed far from its original purpose and become a multibillion-dollar giveaway that would be better spent fueling infrastructure investment and social programs. Repealing it could add $19.6 billion in tax revenue over 10 years, according to a proposed budget published by the White House on Friday.

Real estate executives say that would decrease the number of transactions, squelch economic activity and reduce property values. The National Association of Realtors argues that 1031 exchanges are crucial to keeping the commercial real estate market humming and that they’re primarily used not by the super-rich, but by less affluent retirees, investors and landlords.

A higher marginal tax rate seems more likely than the elimination of popular deductions. The commercial real estate industry will be unified against ending 1031s, so there will be a fight ahead.

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