RF Executive Summit

• August 1, 2023

Host: Steve is a managing director within Morgan Stanley Wealth Management's Global Investment office in New York. He serves as a senior investment strategist and head of the portfolio analytics and cross asset strategy team. Along with his team, he is responsible for quantitative analysis to support the firm's asset allocation, manager selection and portfolio construction decisions. The team oversees a series of ETF model portfolios and several firm discretionary portfolios and provides investment strategy through special reports and periodicals, including the monthly topics in portfolio construction piece. Join me in welcoming Steve. [applause]

Steve:  So, we're going to talk first about the long term outlook because I think it's important to understand how it will change as a result of where we are from an interest rate perspective. And then we'll look at what's called the weather, or what's going on in the market today. So what I'm showing you here is our analysis. We update this each March. And by doing so, it helps us to grasp what might be realistic or expected over a seven year timeframe. You can see this gray line here next seven years, whereas the historical 20 year period is in the light blue, and then our current 20 year forecast is in the dark blue. Over the last 20 years or so, you had the opportunity of increasing returns by taking more equity versus fixed income. So these are stock and bond portfolios.

Looking ahead, that doesn't seem to be on offer to the same extent. And the reason why that is, it ultimately has to do with the fact that valuation for equity is relatively high, and we've moved into a new interest rate environment where higher levels of interest rates are offering a better opportunity set with fixed income. But unfortunately, equity returns are not significantly higher than that of fixed income.

So it is providing an opportunity to think of diversification. That diversification could come through global equities rather than simply US equities, which seem to have lower returns than the rest of the world over the seven year time frame, but also to have more of an alternative investment allocation. Because ultimately, we see that those asset classes could be both diversifying as well as helping on your total return.

To give further context to that change in regime, what we're showing here is the movement in the US 10 year treasury yield, which is in the dark blue line, and then nominal GDP growth. Nominal GDP growth is the sum of real GDP and inflation. And on a four year average basis, you can see that that's come up quite a bit from that time just before Covid, or going into Covid, where we had very tepid nominal GDP growth.

You may recall that after the global financial crisis, inflation rates around the world were relatively low, almost hinging on deflation. And global central banks worked very hard to stimulate the economy through quantitative easing to try to keep nominal growth higher, real growth positive, and try to boost inflation.

Well, post Covid, we've had a burst of higher inflation, and that has led to an also pretty strong burst of real growth, and so we have high nominal GDP growth. And attendant to that, we would anticipate that interest rates would likely move and stay higher.

So in a world where you have potentially two-plus percent inflation as a baseline, first is, say, 1% in the post crisis period, and then you have real growth at about 2%, a realistic nominal GDP growth range would be in the 5% range. And that dictates generally speaking that you would have higher expected interest rates. So that higher level of interest rates, that higher level of neutral rate from the Federal Reserve and other central banks will cause a different regime.

So let's go in now to talk more about what's going on in the near term. And this chart will help to motivate where we are from an economics perspective.

This is an indicator that we have called the Morgan Stanley cycle indicator. And you'll notice that there are colored lines here that are referring to different parts of the economic cycle. Each cycle may have all four of expansion, downturn, repair and recovery. But in this most recent cycle that we've started right after Covid, we've had a compressed cycle, a shorter cycle, and one that grew faster much more quickly, with higher inflation. That's been experienced around the world.

Much of that happened as a result of some of the extraordinary supply chain, and also stimulus matters. So stimulus was given through government programs to many folks because of the lockdowns that we experienced. And then also monetary policy was quite stimulative as well.

So we've experienced the boom of that, which has caused inflation obviously to rise, and it may be pressing in some places, in particular the US, but the reality is that what happens after this is relatively unknown. And we think that the uncertainties here are worth being careful or cautious about even though we think that the financial markets have probably priced too healthy or too sanguine an outcome, vis-a-vis the level of uncertainty that is there.

One way that I've tried to classify or categorize where we are is, if we think about the great rise that we had out of Covid, what type of landing will we have? And three possible landings that we'll consider today.

One, I call the no landing scenario, which is essentially a scenario where you would have such a soft landing that you'd end up not really feeling it at all. We might call this a mid cycle slowdown. That environment is possible, but I think it's overpriced in the financial markets, priced at probably a 70% probability.

The second possible landing, we'll call a soft landing, which is where you'd have a small, fall in GDP, but not so much that it would upset the labor market too much. And we would say that the financial markets are probably pricing that at maybe a 25% chance.

And then finally, that last possibility we would call a hard landing. A hard landing would be where you'd have a very disruptive labor market pullbacks, and pretty hard hit to growth. And that ultimately is, a hard landing would lead to probably pretty negative outcomes for most investors. And I would say the financial markets are pricing that at about a 5% outcome.

From a Morgan Stanley point of view. we would rate those three outcomes differently. The no landing scenario probably is a 10 to 20% opportunity. The soft landing, that's our base case, we'll call that a 70%, and that hard landing, we still think it's greater than 5%, but maybe somewhere between 10 and 20%.

The reason why all this matters, ultimately, is that all of these things will filter into corporate earnings and then lead to the potential outcomes that we see. But if the markets are priced for this mid cycle slowdown, which has happened before, there have been certain cases of that but it's very rare, one of the things you can do here is just trace the red line, which is the downturn which we currently find ourselves in, and you can see that sometimes it leads to a recession. Sometimes it hasn't though. And we saw a mid cycle slowdown here in the 1980s, and in the 1990s.

And a playbook that people might be thinking that could be repeating itself is that the challenge here is that everything in the world is indeed different. And there are a number of factors that would suggest that a soft landing to is much more likely than the no landing scenario. So I'll be going through that and what the implications are.

So, this picture here shows you the 10 economic leading indicators from the US conference board, and you can see that it's been a very effective indicator in calling recessions historically.

One of the items in that number of leading indicators is the yield curve. The yield curve traces out what happens between the two year and 10 year part of the interest rate curve. And we can see that that's highly inverted right now, indicating that in the future, we expect less aggressive or less tight monetary policy. And that typically shows recessionary characteristics in the future. That's just one of the 10 leading indicators.

But you can see that the 10 leading indicators have registered a fairly negative change over the last year. And you can see historically, that's been associated with other recessions. Whereas mid cycle slowdowns, I pointed to a couple of them. this 1990s scenario, we had a very small negative move in the year over year change for the indicators. But you can see that right now we have a more significant one.

So that gives us pause as one indicator of the potential for at least the soft landing versus the no landing scenario.

Another thing that's important to understand is that, as I mentioned back a few slides ago, we think the interest rate dynamics have indeed changed. And I think here, this is the US 10 year real interest rate, you can see how that has moved above zero, and pretty sizably above zero, at about 1.5%. Now, that 1.5% level may sound relatively low, but that actually is the highest level since the moments right after the financial crisis.

So during this long period here from 2013 to 2021, the Fed was really guiding interest rate policy to be very accommodative and to give stimulus through low real interest rates. We've seen that this real interest rate here is higher, and it's our view that the Fed is likely trying to guide the world to such a higher real interest rate. Because ultimately, that creates a scenario where you can actually have the ability to stimulate policy without using massive amounts of quantitative easing in the future.

So, this real interest rate feels more normal to us. And if you think about a real interest rate of 1.5% and break even inflation, meaning like the likely rate of inflation over the next 10 years of say 2.5%, that would give you a fair value for the US 10 year, at about 4% which is where we find it right now. So we can think of, you know, bond yields are pretty close to fair value, and this real interest rate here makes sense to us given what the Fed is trying to do.

Another thing to think about related to Fed policy, of course, is that the transmission mechanism through the economy is through the banking sector often too, and so we can see that the price of credit, meaning after the 5% of rate hikes from the Fed, that has increased the cost of credit, but the availability of it we think is something that is under appreciated.

You probably are well aware that we've had some regional banking stress in the US. And we can see that loan demand in Europe also was a little bit softer in the last few months. That's probably more from the demand side than a supply side of credit. But in the US I think it's to some degree an indication of both things.

But if we look at the supply side of credit, we can see that the senior loan officer survey from the Fed is pointing to tighter lending conditions. Why would that be? Well, they're trying to protect their own profitability? There actually have been a number of articles pointing to the ability for smaller banks to actually maximize their profitability or protect their profitability by actually being very cautious and shrinking their operations. That is, that they are wanting to cut back on lending that might be risky in order to preserve their interest margin.

So essentially, it's a case where you have potentially softening demand, which we'll talk a little bit more about in the US economy, and then also tighter credit conditions. And so we think that this is under appreciated because ultimately, folks have looked through that. And we'll go through why folks have looked through that to this point, but we think that this is a pretty important variable that has been under appreciated.

So let's talk for a few minutes about inflation. Inflation is softer in the US, softer in Europe. However, we don't think inflation is quote-unquote "dead" or dormant. The challenge we see is that ultimately, wages have indeed moved up. The US labor market remains relatively tight. And in Europe, you have goods prices are firmer than in the US. And also the potential for energy to be less of a favorable factor.

Over the last year or so, we've seen energy prices fall by quite a bit, which has helped to headline inflation to come down. But if you look over in Europe, you still have a five-plus percent inflation rate in Europe. That's worse in the United Kingdom. And then in the US, we have a 3% headline inflation rate. But core inflation is running a bit hotter.

And this here is a good picture of the wage situation. So we see average hourly earnings of about 4.4%. And the Atlanta Fed's wage growth tracker is showing about a 6%. We can also see that there have been a number of labor market negotiations recently that have led to higher wages, which again is indicative of an inflationary mindset among consumers, which is understandable, since they can see the prices of the things that they consume, particularly food, housing, and a number of other key products, are higher. Substantially higher and well above the trend that people had expected prior to Covid. So there's an inflation adjustment that people are making. And ultimately, I think that that ingrains a higher level of base inflation.

Again, we have the energy component that could be more of a positive or upward lift to inflation after having a negative effect in the last year. What I mean by that is if crude oil prices just move a bit higher, that net-net is a factor that drops away, which had been an inflation positive, in the sense of causing it to go lower over the last year.

This is another way of looking at inflation, sticky versus flexible. The sticky component things that are falling under food, shelter and transportation, running at a 6.1% annualized rate, versus the flexible CPI running at a negative 0.2% rate. Those are things like energy, vehicles, apparel and travel.

So a lot of these are related to the fact that energy prices are down. And you also saw in the vehicle that the supply chain has improved. But food, shelter and transportation are things that are stickier, and they still remain relatively elevated.

So how have people reacted to this? Well, ultimately, Fed policy expectations have shifted quite a bit this year. Right before the regional banking crisis, we had, relatively, a view that rates were going to stay high for longer. But then earlier this year, we saw quite a bit of a soft landing view, that basically that the Fed would start cutting rates even in the second half of this year. And that was in response to, again, the pressure from the regional banking crisis. But looking now into July, we can see a continued higher rate for some period of time, and then a Fed that gradually cuts into next year.

So the question here is, is this feasible? Because typically, what you see is the Fed policy, when they begin cutting, it tends to be a little quicker than that. And it's reacting typically to negative impacts in the economy. So the question would be, what would be the catalyst for the Fed to do this? And ultimately, I think it would have to be more economic weakness, and probably it would lead to a faster set of cuts, which won't be very good for markets.

But anyway, this is what we might call a very rosy scenario, because it's suggesting that you could have inflation having died or been killed, and then you can basically move back to a more normalized level of policy. That's what markets are betting on. So the pricing of equities and many other things is hinging on this.

But let's look at equities here. So far this year, we've really seen a dominance of the top 10 stocks in the S&P. And we've seen this degree of concentration work around the world. Some of it has been very focused on the AI theme of artificial intelligence, but we can see even broader than that, tech communication services and consumer discretionary have been very leading sectors. Those three sectors were the worst sectors in 2022, but then have had a really strong rebound this year.

Some of those things have been some confidence on that inflation is indeed under control. Other things include the idea that earnings would be basically able to power continued growth in those sectors. And I think artificial intelligence has been a buzzword that has gained a lot of attention across many sectors, but particularly in those three, helping their price earnings multiples to rise. So I think one of the things we'll point out is that multiples have really been the driver.

So looking at this slide, we can see that earnings expectations for the S&P have trailed lower for most of the year, although they're still showing healthy growth, particularly for 2024 and beyond, which we'll look at in a moment. But we can see that really, this has been about valuation. You can see here, the S&P's valuations have moved quite a bit higher. But then if you look at the top 10 names, you can see a very high valuation of 31.8 times, whereas the S&P is at about 19.5 times. So those top 10 names really are getting a valuation premium over the index, and that has been helped, of course, by many of the artificial intelligence themes that we've been mentioning here for the last couple of minutes.

So this really has been the call, that it's hard to get right, the movement in valuations is very challenging to call. And ultimately, we think that there's too much in premium or too much PE movement that's happened on a positive direction, and this is what leads us to be cautious at this point on equities. And I'll go through that more in the next few minutes.

So why be cautious on valuations? This is looking at price of earnings versus real treasury yields. As I mentioned before, they tend to, real treasury yields have been held lower by the Fed for a long time, but since they've moved to a more normalized policy, they've allowed them to move higher.

And you can see that, typically, valuations and real treasury yields tend to move in pretty much lock step. We've seen a differentiation between those two over the last few months, which in our view is something that, you know, likely to be faded. Either you're going to have real treasury yields fall, which would be indicative of the softer economy typically, or you'd have to have price to earnings multiples fall, which seems more likely to us.

And so this gap here is something that we think should be heated, and is showing basically how folks have priced in a very bullish earnings outlook for the future. Because ultimately, think about price to earnings multiples as a confidence gauge, confidence in the future earnings power of companies, and people generally are willing to pay up as our earnings expectations are moving higher.

Another way of looking at valuations is through the equity risk premium. The equity risk premium here is shown for the S&P 500 as well as for the information technology sector. Generally speaking, the higher the equity risk premium, the more attractive equities are relative to fixed income. Equity risk premium is calculated as one over the price to earnings multiple, or another way is earnings divided by price, forward earnings divided by price, minus the bond yield. So it's basically saying, what could equities earn for the investor, minus that which bond yields are yielding. So in general, the idea is the more earnings you're getting per unit of price for stocks, you should be happy about that relative to the bond yield.

Right now, we can see that yields have moved significantly higher over the last year or so. As well, we've had price to earnings multiples go higher. So you've had both of those factors lead to this downward movement in the equity risk premium.

And generally speaking, if you think about your 10 year returns, not necessarily your one year returns or six month returns or three month returns, but your 10 year returns generally are fairly well described by this equity risk premium. That is, the higher the equity risk premium, the higher your expected long term returns, and, unfortunately, the lower your expected long term returns.

So this is a good way of encapsulating some of the things I mentioned at the top, which is that equities may not give as much benefit over the next seven years as we previously experienced.

So you essentially have an equity risk premium that's, we would say, relatively unattractive. If it got to the 350 or 400 range, we'd be quite interested. But we're quite a bit away from that, and particularly on technology stocks.

Now, looking at this chart, you might say, well, that's all well and good, but hasn't the equity risk premium been lower in previous episodes? And that certainly is the case. It was lower in the late 1990s. But that's not necessarily an analog we'd really want to hold on to as a great example. Because as you may know, equity valuations were very elevated in the late 1990s, and ultimately had a very discontinuous and disappointing pullback in valuations in the early 2000s, when interest rate policy started to bite.

Let's take a look now at breadth. Breadth is looking at the way that stocks are performing as a group. And the breadth here, we can see in a number of different statistics. One way of looking at it is the equal weight versus Cap weighted S&P.

Equal weighted S&P simply takes each component on an equal weighted basis. The Cap weighted is based on the index that you see published and talked about most of the time.

The equal weighted S&P typically should outperform when you have broader participation from more stocks. And we saw that for the year 2022. However, almost all those gains and maybe even more of those gains were were reversed as the Cap weighted S&P, meaning that concentrated S&P, and the high percentage weight names, those names significantly outperformed early this year.

So that has caused a very interesting scenario here, which has made it challenging for active managers. Because simply put, when you have fewer names that are outperforming, it makes it incredibly challenging to have selected those names. Another way of saying that is, being overweight, the largest names in the index, is generally not a great strategy. But that was the strategy for the first six months of this year. A way of looking at that is to look at the percent of stocks outperforming the S&P, and you can see on a year to day basis, it's very low -- 28%, which is the lowest level in our study here, dating back to 2007. And it compares very negatively to the 59% that outperformed last year. Last year was sort of a heyday for selecting managers that had a broader set of allocations as the equal weighted S&P was doing well.

So let's continue on. Let's talk to earnings now. So this is really where we think the rubber will hit the road. We think a PE multiple, we acknowledge that we were off base on the PE multiple so far this year, our US equity strategist, Mike Wilson, noted that on Monday. However, we think we're still on base, and we think this ultimately is going to be very challenging to achieve.

So what you can see here is this is the year over year EPS growth for the S&P, and you can see the heady growth that's expected, averaging about 10% a year for the quarter starting in the fourth quarter. So, ultimately, if that were to occur, that's really what folks are banking on with the level of valuations we see.

But if this were flatter, or maybe even towards zero for a couple of these quarters, how would the markets react? And we think that ultimately valuation multiples would have to come down. And ultimately, the index level would have to come down. And that's really what folks haven't really thought through, we believe. Because if indeed we're having a soft landing rather than that no landing scenario, this is going to be very difficult to achieve. Because basically, this requires corporate margins to have likely moved higher, and real growth to be very strong, and for operating leverage to work. I'll go through some of those factors in the next few slides.

This is a way of looking at some of the things that kind of are, again, disconnects. We talked about the valuation disconnect from rates. But here we can see activity disconnects from stock prices.

Historically, you can see that there's a very strong relationship, typically, between the ISM manufacturing index and the forward returns of the S&P. And we can see that that has broken down pretty well here in the last six months or so. So that's somewhat interesting. We also can see that the M2 growth -- M2 growth is essentially looking at the amount of money supply that's coming into the global economy, and we can also see that that has differentiated pretty sharply as well.

So we have a situation where global central banks are tightening, manufacturing activity is slowing, and yet equities have powered higher mainly, again, on the valuation multiples. And so we think that these are probably more indicative of forward earnings opportunities. So that, again, calls into question this bullish pattern.

Let's talk a little bit more about earnings here. This is discussing the topic of negative operating leverage. Operating leverage is simply how sales turn into earnings. And if your sales are positive, generally speaking, you're going to have some impact on your earnings. Because if you have a margin greater than zero, you're going to earn potentially more. So the question is, what about margins?

So looking at the right, you can see this is the rolling three month margin for the S&P, and you can see how it very sharply rose right after the pandemic, but it has been coming down. The idea behind most folks, the consensus estimates, are that this actually kicks up again. But we think that that's going to be quite challenging because of the way that the economy moves. And that is essentially that a lot of companies benefited in this period here from rising inflation. Because they were selling older goods at higher prices and volumes were rising. So you had price and volume working in your favor, and your operating margins could be higher.

Unfortunately, now we have volumes stagnating a bit, and we have prices slowing down. So it's harder to pass through the increased prices to consumers simply because the corporate pricing power is less after several years of inflation.

So we think that this is really a key factor that is underestimated and under appreciated, is that ultimately corporate margins probably move maybe back to their pre pandemic average rather than staying here in this elevated territory. And the difference here is that it has a sizable impact on earnings outcomes.

This is another way of looking at that. So we're showing you the year on year growth in earnings. And our forecast here is really staying within these bands. So ultimately, you can see how we had very strong earnings in the period right after Covid, and we're just suggesting that it would come back maybe towards more of a normalized level.

Another way of looking at this, if you can visualize it, would be drawing a trend line and we over earned and went way above the trend line, but we may need to come back towards that trend line simply by dint of gravity.

This is another way of highlighting the way that the economy passes through financial, the transmission mechanism is what we call financial conditions. You can notice here that this tends to be a mirror image. So what we've seen here this year is that financial conditions have really eased. The reason for that is that you have you have a financial conditions that are passing through the benefits of lower credit spreads, higher equity prices, and yields that are relatively contained so far this year. So that's set up a bullish backdrop and we'll go through a little bit more on the financial conditions in the next minute or so.

But the point behind this is that it's hard to see how financial conditions continue to get easier or continue to benefit the economy from here. Because some of the factors that helped in the first half of the year might be considered one offs.

One one-off factor is essentially the rundown in the Treasury general account. That's something that the US was dealing with as a result of its budget crisis. That has been basically started to be replenished, but that acted as an offset to the monetary tightening through quantitative tightening that the Fed was doing. And so that helped the global economy and the US economy, and, we think, equity valuations.

Another way of looking at this is if we look at all of liquidity conditions, which is shown here in the light blue line, and the S&P. And we can see that there's a very strong relationship here, or has been over the last few years. But it seems to have broken down a bit here recently. And again, we think that this is probably a recoupling situation rather than continued decoupling. This shows you the movement in the Treasury General account and how it had gotten run down over the first half of the year and likely starts moving higher, meaning that there's an issuance of debt or treasuries, which ultimately causes this to move lower. So that's something we're seeing for the second half of the year.

Another thing to consider is where investors are positioned. Investors have been positioned in a very bullish fashion, we think, now, that is different than where we were at the beginning of the year. But we think that folks have re-risked. A couple of ways that this has taken place are through positioning that we can see from the CFTC. And then we can also see the bullish sentiment from various surveys. So these are shown here on the bottom.

But ultimately, the way that this plays out is that folks have a greater amount of risk sentiment now than they did before, and it actually, it's a contrarian indicator, typically. So, what I've typically found is that you want to trend follow sentiment rising, but then you want to fade it once it gets high. That should make sense in the sense that when there's a high level of sentiment, it can lead to some degree of complacency.

We also have the additional factor that valuations have risen, that follows with sentiment, and volatility has fallen. So that's allowed people to take more risk without feeling like they're taking more risk. So, volatility could theoretically rise and that would potentially dampen some of that risk sentiment and therefore potentially dampen valuations.

So to finish up, let's talk a little bit about valuations around the world. We've painted a fairly negative picture of US valuations. But if you look at the rest of the world, there's some more reasonable bargains outside the US, looking at Japan, Europe or emerging markets. We would signal that emerging markets are our favored region right now. We also like Japan. Europe a little less so. So Europe and the US would probably be equal to underweight. Japan would be equal to overweight, and emerging markets would be overweight, simply on valuation, as well as relative growth opportunities.

Looking at the emerging markets in Japan, you have a very different inflation scenario where it's possible for stimulus to be in place, for example, in China, as well as in Japan, because you have relatively low inflation and in some cases, deflation, depending on the index you're looking at. So that allows for probably stronger growth there and greater opportunity for equity multiples to potentially expand. Whereas in the US, they're just too high. So that's really what we have on currently.

So ultimately, you know, this is a question we've been getting, are we wrong or are we early? I would say we were off base on valuations. But I think that we're ultimately going to be right on earnings, and that valuations will recouple.

And so essentially, this idea that there are no landing, or very soft landing would happen, I think is really the base for the bull case. And that there are great opportunities, if we can just look through 2023 earnings, the bulls say, basically, 2024 would be much, much better. And then Fed policy is ultimately engineered on an immaculate disinflation, and everything will be fine. And ultimately, we have AI to benefit from us. And then maybe there's even cash on the sidelines.

I struggle with a number of those arguments which I've laid out for you, but I think the cash on the sidelines one is just not true. Because ultimately, as a percent of S&P market cap, there's not as much investor cash on the sidelines. Corporate cash, yes. Certainly there are higher levels of corporate cash on balance sheets. But if we look at investors, I don't think that there's an unlimited amount of additional risk that people can take.

So we've laid out the bear case fairly clearly. And ultimately, we think that the soft landing scenario, meaning, not the no-landing, but the soft landing scenario, is more likely.

So some sign posts for looking that you might get more bullish. You'd have to have a larger equity risk premium, lower for PE multiples, which we've discussed now multiple times, lower earnings estimates, potentially moving to a Fed that has paused, and ends QT, and has some clear guidance on cuts. That's probably quite a few months off, but that's where we are. And then unemployment maybe needs to go up, which would signal a less tight labor market.

And then we'd also need to see some oversold conditions. Well, right now, we have over bought conditions. So pretty much none of these are true. The new leadership is questionable. We've seen some tentative movement here, but all the others of these are definitely not yet here. So that leads us to be cautious at this point, as I've laid out.

So let's look ahead, though, to give a little positive information as we wrap up here before we can go to Q&A. So, one thing we do always want to look at is, what might the next period look like, and what are some themes that we might want to play?

So you'll see these several "D" themes -- digitization, de-globalization, decarbonization and defense, are all things that we are interested in as investors. We think that AI ultimately benefits the users of technology more so than the creators. So we think that there's much benefit to be had among some of the names that maybe didn't benefit from that 2010 tech revolution. Things like industrial financials, and other companies that are operating that that could benefit from technology.

Deglobalization is another interesting theme. Ultimately, we're seeing friend shoring and near shoring that's leading to a building of factories in the US and other countries, where there's a friendly relationship. So ultimately, that's going to lead to infrastructure spending and a reconfiguration of supply chains. So ultimately, we think that industrials and materials could have some benefit over the long run.

Decarbonization is a very complicated theme in the sense that, certainly the direct way of looking at that is through electric vehicles. But it's also possible that you'd see commodities still have a strong bid for them, because ultimately, if there's less investment in commodity production, and they the supply and demand dynamics are tightening, that could lead to a higher floor for things like copper and crude oil. So it's a two edged sword with decarbonization. The electrification of vehicles seems to be a very strong theme. But I think the degree to which that plays out, ultimately, it's still uncertain. So I think you probably could hedge yourself by having a long position in the electric vehicle components as well as through commodities.

And defense and cyber security. Probably don't need any overview there. But frankly, the world is more complicated than it has been. So we can see that that will be an area that will continue to attract attention.

So the last parting hopeful thing, this is a view from expectations of productivity growth. And it's our view that productivity growth does really improve over the next 10 years. Because you can see that, essentially, computers basically came in here, and then sort of, web tech came in here, and we think there will be a third wave of productivity growth here in the next 10 years or so, that's benefiting from many of the factors that we just described over here. So productivity could be a very strong growing thing over the next few years.

So with that, I'll stop and see if anyone has any questions. I'll keep the screen share up in case anybody wants to refer to any of the slides in those questions that we can go back to.

Host: Please, if you have a question, just raise your hand and someone will take a microphone to you. Steve, we will begin a dialogue here while our audience members prepare their questions. The first question I have for you -- based on the forecasted efficient frontier graph, is it fair to say that Morgan Stanley expects a portfolio 100% in bonds and 100% in equities to generate an average annual return of sub 2% and 4% respectively?

Steve: Great question. I'll answer that. So, ultimately, it depends on the type of bonds you have. I think you're looking at probably somewhere between 4 and 5 or 6%, depending on your specific allocation. So it varies by the specific allocations. But I think from a grounding perspective, I would say that a reasonable expectation for a diversified portfolio that's in fixed income and equities would be in the 4 to 5% range.

David: Hi, Steve. David Slater with RF. My question was, right now, if the yield to maturity on the US 10 year is around just under 4%, if interest rates do come down and that yield to maturity went from 4% to 3%, what would that equate to as far as the capital appreciation and the price of that bond?

Steve: Great question. So the duration typically of a 10 year bond is about 7.5 years. So under the scenario that you just shared, if you assume that that would happen over a one year time frame, you'd have the coupon of about 4%, and the capital appreciation would be about 7.5%. So that gives you a sense.

To give you other points on the yield curve. Typically a five year bond has about a 3.75 year duration, and a 20 year bond typically has about a 12 to 13 year duration, and a 30 year bond would have about a 17.5 year duration. So take your 1% change in interest rates and multiply it by those levels of duration, and that'll give you a sense of the capital appreciation.

Host: Steve, a lot of elements in your presentation spoke to the recession. When does Morgan Stanley expect the recession to arrive? And how severe do you expect it to be?

Steve: Sure. So I would suggest that the recessionary conditions would be considered to be a soft landing. So I think ultimately we see a relatively non-severe for the economy, but less good story for earnings. So think about corporate earnings and the economy as being linked, but not exactly the same.

And so our view is that you have a soft landing for the US economy and for the global economy, but we think that corporations have over earned and probably need to come back to earth, and that has us cautious on exit. So hopefully, that makes sense in terms of differentiation.

In terms of when would the slowdown occur? We probably see that, I would say, in the fourth, to first quarter of next year that you'd see the slowdown occurring in the economy, with corporate earnings kind of moving around the same time. So that's our view.

Host: Okay. On slide 15 and 16, you noted that in 2023, year to date, only 28% of S&P 500 stocks are outperforming the S&P 500. This means that 72% are underperforming. Where do you see the best value within that 72%?

Steve: Sure, great question. So, I would say defensiveness is theme that I would probably look to at this point. Things that have really underperformed that look attractive to us, I would say, you'd want to look for dividend-growing stocks, dividend-paying stocks, and those stocks that have more reasonable valuations. So ultimately, we like quality and value. And then if you're going to look at anything in the growth space, we'd be looking for growth at a reasonable price, not at any price. So I think those are ultimately what we would be looking for. So quality value. Basically dividend paying stocks that have quality balance sheets and reasonable profitability. And then on the growth at a reasonable price, that's simply looking for stocks that have decent growth prospects, but their valuations have not accelerated to, you know, the eye watering levels of some others.

In terms of sectors, over weights include consumer staples, utilities and health care. We think health care is a sector that's gotten quite beat up this year but looks pretty attractive based on its valuations. And we don't think there are fundamental changes in the business prospects, but the sector has been unloved based on what has been loved this year.

Host: Okay. Why are so many variables decoupling?

Steve: Great question. I think a lot of it comes down to this. People are looking through 2023 as a mid cycle slowdown. And if that's the case, they basically are looking forward to a rosier future ahead. That is not our present case, and probably not the future case, in our view. So we think that ultimately folks have looked through any negative scenarios, and so I would say that it's a pricing of a rosy future, is ultimately the decoupling. But it does make it very hard as investors to see those things. But generally speaking, as I mentioned a number of times, we believe in the recouping rather than the decoupling. We think the decoupling ultimately was led by a few exogenous variables which we went through, and it's hard to see that repeating.

Host: Awesome. Steve, with that, I think we've come to the end of this segment this morning. I want to thank you very, very much for a very, very insightful presentation. Please, a final round of applause for Steve. [applause]

Steve: Thank you, everyone. Goodbye.

Optimizing Corporate Returns & Agility

By: David Slatter,
Vice President & Group Head of Investments
RF Bank & Trust

RF Bank & Trust · David Presentation

Host: We would like to welcome our second presenter to the stage. With over 20 years of experience in bringing wealth management services to the region, David Slater is skilled in wealth creation and market analysis. David leads the investment strategy for the RF group of companies as the vice president and group Head of Investments, and regularly provides regional and global economic forecasts to help guide clients' investment decisions. He holds a Master's of Economics degree and a Master's of Business Administration degree from York University. Please help me welcome to the stage, David Slater.

David: Morning, everybody. Thank you for coming. I know that the weather made it a challenge. The roads were a challenge. But it's great to see everybody here.

I know that previous presentation was pretty darn heavy. [laughs] A lot of graphs. A lot of -- what should I say? -- analysis that goes into those graphs. And you know, Morgan Stanley is our custodian. So just to be clear, they're not our advisors, they're just our custodian. But of course, as a client, a good custodial client, we have access to their research. So you will see some overlap with my presentation and their presentation. But that's because they're one of the sources I use for data and information. Of course, there's the world of Bloomberg and there's the world of the Internet, so there's a lot of sources to pull from.

Today's agenda. Just want to go over a little bit of overlap between what Steve talked about and what I'm going to talk about -- global economic forecasts, US interest rates, probability of recession, a look at global, regional GDP numbers and where the Bahamas fits in, versus many of the other countries in our region. Then we're going to talk about the Bahamas and our economic outlook.

And then I'm going to get into kind of the meat of the discussion. Let's talk about solutions for companies, right? It's going to be more and more important, I think, that companies manage excess cash efficiently and generate a higher return on that cash, while maintaining liquidity. We'll talk about a solution for that.

And then talk about corporate capital structure. The panel discussion later on will talk about the green paper on the corporate tax. So once you have corporate tax in play, you need to really assess your capital structure and determine what's the optimal structure to have. In other words, probably adding debt.

So, this is a busy graph, but basically the green is good and the yellow is bad. So on the left, we're looking at GDP growth expectations for 2023, '24 and '25. And what I do is I track this on a monthly basis. And if the numbers change, then I note that.

The yellow shows you that in 2024, GDP growth expectations are decreasing, versus what they were a month ago. But we do have some uptick in 2025 numbers, but mainly in Asia. The US, obviously the key number to look at, seeing that our economy is highly correlated to the US economy.

I remember years ago at university, somebody did a basic regression analysis, and it was like 90% of our GDP growth is a function of US GDP growth, whether it's 60, 70, 80 or 90, the point is, the most significant variable for us is the US economy.

Well, the US economy is expected to grow by only 0.6% next year. Now, whether or not that includes a soft landing with, say, two months of just barely negative growth at the beginning of next year or the end of next year, it's hard to say. But the point is growth expectations for the US are slowing. Growth expectations for Canada are slowing. They're our second most important source of tourists. The Euro Zone also down to around 1% next year, probably our third most important source of tourists. So we need to pay attention to what's going on in those economies because that will dictate what's going to happen in our economy.

I mentioned, Asia is kind of the bright spot as far as growth expectations. So if we talk about global investing, that's probably where you want to make sure you have some exposure, to Asian equities.

The scary bit would be Latin America. You look at inflation, on the right side, of 18% next year. Well, that's all driven by Argentina. Argentina is expected to have inflation of 100% next year. If you strip out Argentina and you look at Brazil, that's more like 2 to 3%. So you need to bear that in mind.

So US yield curves. The US yield curve and the change over the last 18 months. So you can see the red line would show where the US yield curve was at the end of 2021. Short term interest rates, effectively zero -- 0.25%. The yield curve was normal shape. The yield went up as you went out in time.

What's happened since then? Well, the US Federal Reserve, to fight inflation, has increased the fed funds rate by 500 basis points. The expectation is later today that'll increase by another 25 basis points. And there's a possibility of a further increase in September. Less likely than the increase today.

Well, what happens when interest rates increase? And you can see, the green line would represent the US yield curve at the end of June. Interest rates go up, bond prices go down. That's why I asked that question earlier. I said, if the US 10 year treasury note goes from 4% to 3%, you don't just have the coupon you're earning, you also have the capital appreciation.

So as Steve mentioned, you look at the duration of the bond, and then you multiply that by the percentage change. So 1% decrease in the yield, the duration of, I think he said seven point something. So you get a gain of seven point something percent in the price, plus you earn the 4% coupon. So you're looking at a double digit return on a US 10 year T bond, if that happens. Whether US interest rates come down is not an issue. Whether they will, it's a function of when they will. So that's the debate.

Next slide. We're going to get through the... Hopefully my graphs are a little easier to comprehend. You know, I need to make sure I can understand them in detail myself.

So here we're looking at the inversion of two of the yield curves. You've got the two year and the 10 year. That's the one that most economists look at. And I've also got the three month and the 10 year.

The point is, the red line represents zero. They're equal. If you go below the red line, that means that the yield to maturity on the two year is greater than the 10 year, and it becomes what's called inverted.

So if we go back, you can see the green line slopes from high to down. It's downward sloping. So that's an inverted curve. Well, throughout history, when the 2 year and 10 year yields became inverted, there was a recession that followed. It doesn't mean the inversion creates the recession, but it means that the conditions are right for recession. So, eight times in the past this has happened, and there's been a recession within 18 months.

The market is debating whether or not this time is unique. Some people say no. Morgan Stanley says yes. The Fed -- let me show you the next slide. Alright, we'll get to it. Let's go back to that.

So it just shows you. This is something I track on a monthly basis just to see how the yield curves are acting. And then this is just to kind of support my position. You have this busy graph is from the... This is the probability of recession according to treasury spread. And this comes from the Federal Reserve Bank of New York.

And basically what it's saying is they think that there is a 63% chance of recession between now and June. So within the next 12 months. But to show you how diverse the opinions are, Goldman Sachs feels it's 20%. The Duke University Professor Campbell Harvey, who actually initially pointed out this relationship between inverted yield curve and recessions, his view is that the big question is not whether the downturn is coming, it's how severe it will be. And then you have Bloomberg, the strategist at Bloomberg, he too is of the view it's about when. Not whether but when, and to what extent. So we've got, you know, diversion of opinions which is important for an active market.

Stephen talked about one of the leading economic indicators we look at, it's the conference board of US leading economic indicators. There's 10 specific metrics that go into this. And you can see that December of 2021 it peaked, and since then, it has been decreasing. And actually it has been decreasing at about 9% year over year. In other words, strong indicator of a pending recession. Okay, we'll see. So it's down around 9% year over year.

Here's another chart. I pulled this from the actual conference board website. The red line. So when the index goes below the red line, then that is a recession signal. Well, we're well below the red line. So according to this metric, a recession is on its way.

Why is that important? Recession in the US, slow down in the Bahamas. You know, as a business person, you should be budgeting, going forward with the expectation of slower growth in the economy, which would usually mean slower revenue growth, which would mean tightening the belt to some extent, which would mean becoming as efficient as possible. Especially if the corporate tax is on the way. And that's what we'll discuss in greater detail in the panel discussion.

What's going on regionally. So according to the IMF, the Bahamas is expected to grow at 2% per year, basically from 2024 going forward. That's consistent with the 1.9% expected for the US. So, you can take a plus or minus 0.5% around the 2% to give you an idea.

So the growth of the Bahaman economy is expected to be at like long term inflation. Nothing exciting. Not the end of the world, but nothing too exciting. Barbados is in a similar boat around 2.4%.

Guyana, if you're aware, the discovery of oil offshore and the oil revenues, their economy is growing, expected to grow at 30% per annum for the next five years. If you strip out the oil... This ESQ is the source of this. If you strip out the oil, they're still expected to grow around 5%.

Dominican Republic, growth of 5%. They've been kind of the star within the region for a number of years now. I think a function of low cost structures. So the tourism sector is very competitive, because the cost of the product is very low.

Jamaica around 2%, Trinidad and Tobago, around 2.5%. So that 2% growth rate is really the expectation for most of the economies in the region, of which the Bahamas is included.

So what's been going on in the Bahaman economy? Well, you know, tourism drives our economy. And let's look. This is total arrivals. And basically, the key message here is that total arrivals now is higher than it was in 2019. So pre-Covid, we're ahead of pre-Covid numbers.

So for example, in Q1 of this year, we were 31% above Q1 of 2019. And we know March was when Covid really hit. So that's a good metric to compare.

And what's driving our total arrivals? Well, you can imagine, primarily the cruise sector. So here we see the cruise numbers. So cruise numbers, Q1 of this year, 42% ahead of Q1 of 2019. Obviously, the Nassau cruise port being completed is a big part of that, and also just the attraction of it. You know, even when it was being constructed, I'm sure it was something to talk about within the cruise industry. So that should bode well for strong cruise numbers going forward.

But as we know, what should I say, cruise passengers pay the tip, arrivals pay the mortgage, right? So here's a look at arrival numbers. Actually not bad. Strong recovery in arrival numbers. So these would be stop over visitors.

We can see that at the end of Q1 this year, we're basically in line with Q1 of 2019. I think it's around 3% below. But, you know, it's good, strong trend in numbers. The challenge here will be hotel room capacity. There comes a point where you simply cannot house more tourists, more arrivals. So there comes a point where, unless we expand the capacity of hotel rooms, then we just can't take on more tourists, to a great extent.

Government debt. One of the key challenges for our economy going forward is the fiscal situation we have. I know it's a busy slide, but basically, you can see both graphs to the right are going up. The top line is total direct debt. This comes from the Central Bank of the Bahamas statistical digest. So it's not me making this up.

Total debt. Direct debt continues to grow. The bottom chart is external debt. External debt had leveled off. But in May... Success was being achieved in slowing down the growth of total debt. So the size of the deficit was coming down. But in May, I noticed that total debt increased by 286 million, of which 244 million was external debt. So, I don't know if just everything was put back to May? But anyways, the reality is a sharp uptick in total direct debt and total external debt in May.

As you know, we we've heard that the target for debt to GDP is 50%, that's always talked as like the optimal ratio to aim for. Well, let's look at where we are.

So this data comes, the total direct debt is from the Central Bank, and the GDP estimate that comes from the World Bank, using current prices. Using that data at the end of 2022, the debt to GDP ratio is 95%.

This does not include contingent debt. This does not include the government's portion of public corporation debt. This does not include pension deficits. There's a lot of other pieces of debt that aren't factored into this 95%.

So, what's the reality? The effective rate is far in excess of 100%. What does that mean? That means the government's ability from a fiscal standpoint to deal with external shocks, if they happen, is very limited.

If you see where we went before Covid, and Dorian, to where we are now, 56% debt to GDP before Dorian and Covid --  to 100%. Well, we just do not have the fiscal capacity to deal with another Dorian or another Covid pandemic, unless we really do a good job of tightening our belts.

And we're not going to tax our way into fiscal health. Obviously generating tax revenue is part of the solution. But there also needs to be austerity, fiscal austerity, cutting back on expenditure relative to the growth rate of GDP.

This table here shows the GDP forecast. This is from a Statista source. So basically the point is that they see our total GDP growing to around 17 billion by the end of 2028. Well, for the debt to GDP ratio to be 50%, then our debt would have to be 8.5 billion. Well, that ain't happening. Not sure how we get the 50% debt to GDP ratio.

Yield curve. How do you price debt in the Bahamas? How do you price government bonds? How do you price corporate bonds? How do you price preference shares? Well, you need to have a yield curve. Well, in the Bahamas, what is the yield curve? Well, the purple line is the US Treasury curve. The green curve is the secondary pricing of government bonds issued by the central bank. So that's the central bank's view of the yield curve for B-dollar debt.

The blue line takes the US Treasury curve and adds on a credit risk spread. So the US is AAA, the Bahamas is B. That's 13 places below. Every time you go down, the credit risk goes up. Well, right now, the credit risk spread is approximately 5.5%. This would be from a guy named Aswath Damodaran, who's a valuation guru at the New York School, NYU. So if you just tack on the 5.5% on the US Treasury curve, you get the blue curve.

What's the red curve? The red curve is the yield of maturity on Bahamas bonds issued in US dollars and traded globally. Well, you can see the red curve and the green curve diverge quite a bit.

So what the global market thinks our risk is, and what the central bank says, are diametrically opposed. One could argue that US dollar versus B-dollar, slightly different risk risk metrics. So Barbados, the US holders of debt took a bigger hit than the Barbados dollar holders of debt, when they defaulted in 2018.

Not saying we're going to default. I'm just saying that the risk that you need to factor in when you're making a decision on what a reasonable price is, needs to be, I think, reasonable.

So what do we have here? Kind of a rough estimate. What do you think the yield curve range should be for the Bahamas? That shaded area. It's kind of like a 3% to 5% premium above the central banks yield curve.

So what does that mean? That means when I'm going to price a bond, or price a preference share or price a new offering that comes to the market, I'm not going to price it based on the green curve. I'm going to price it on that shaded region.

So let's look at a real world example that I pulled together. Because we're talking about corporate taxes later, right?

So in this case, I looked at FamGuard. So FamGuard, at the end of 2022 in their financials, they paid -- what do they pay -- 3.4 million in premium income tax. So they charge a premium income tax on gross premiums generated. Their net income was 9.8 million. If you add back the 3.4 million in premium tax, you get net income before premium tax, of 13.2. So effectively, their tax was 26% of revenue. So their effective corporate tax rate is 26%.

That applies to all insurance companies. That applies... Any company that pays business license fee, you can do this analysis and determine -- what is my effective corporate tax rate?

Some of the corporate tax rates in the region. Over to the right, you see Jamaica's 25%, Ireland 12.5, Singapore 17, New Zealand 28, Australia 25.

In the Green Paper that's been circulated on corporate tax for the Bahamas, the statutory rate is noted as 15%, and that's across the four different scenarios. The idea was that 15% would be on pillar two firms, generating consolidated earnings of in excess of €750 million.

I see Kevin Marie, one of our panelists in the back there, he can give you a heck of a lot more accurate detail on this paper, and expectations going forward.

For local firms, the corporate tax rate range, ranges between 10 and 15% depending on the scenario. Is that a reasonable? Well, Ireland's at 12.5. So, you know, Ireland would be a good model to follow, in my opinion. So that sounds reasonable.

This is just cost of capital 101. So I'll just give you the meat of it. I've got a scenario where a company's only got... They got 50 million in capital of which 20% is debt, 20% pref, 20% equity. Their cost of capital is 9%. The weighted average of these three sources.

If they were to increase the debt to 50% of total capital and reduce the other two sources down to 50% combined, they get a weighted average cost of capital around 7.9%.

What does that mean? That means that, you know, when you're looking at a project, what you can take on what you can't take on. If I can generate capital at 7.9% versus 9%, that increases the number of projects I can take on.

So as far as the private equity market versus looking to acquire a competitor, or looking to expand to another island, having a lower cost of capital allows you to take on more projects.

Corporate cash... So, yeah. So I talked about it earlier. If you have a company, or an individual, and you've got cash sitting in the bank and it's earning you, you know, that whopping whatever it is, not much, we have a solution at RF. We simply allow individuals or corporations to set up a discretionary managed account. The minimum is half a million, but we can put you into our prime income fund, but it's a series that has no early redemption penalties. So the idea is, monthly redemptions, earning 3.3% annualized at the moment, and that's increasing. So if you've got half a million or more sitting in the bank and you're earning whatever you're earning, and you think about 3.3, 3.4, 3.5%, and you say, alright, for every million dollars, that's $35,000 that I'm giving the bank. If you like giving the bank money, keep the money there. If you want the money in your pocket, especially with corporate tax coming and other things, slowing economy, you need to be more efficient with the way you manage your funds, then give us a ring and let's see what we can do.

This shows you the performance of that particular fund over time. So, previous in the past, it was up over 5%. It's come down to 3.1% last year. It's currently tracking at around 3.4% per annum. And simply, it's a function of too much of a good thing.

Covid hit. We thought we were going to need a lot of cash to pay out redemptions. The reverse was the case. Money flowed in from the banking sector, because people weren't getting a return. And it was sitting on an excess amount of cash. As that cash is invested, the performance has been improving.

So it's a situation where it's got a very ample amount of cash to make investments to boost the performance. So we think the performance of this fund continues to tick upward over the next few years.

Quick look at some of the local equities because everybody likes to. A lot of people think our local equity market is a joke, right? Nothing trades. There's no benefit to it. Why would I invest? Well, the green is double digit growth in share price. The red is double digit decrease in share price, over the last six years and going into this year.

So these are the five bank stocks. So Bank of the Bahamas, you see a lot of green. Well, that's because it started at a price of like 90 cents when it started to recover in 2018. So if you start from a very low, low base, you can have very significant improvements in performance.

Finco. It's got five boxes that are double digit growth. Fidelity Bank, four boxes, double digit growth. Commonwealth Bank, alright, it had a slow period there, in 2020 and 2021. But it's made a nice recovery this year. And then CIBC has been bouncing around a bit, but generating a decent rate of return over this period.

What individuals need to look at is you need to look at normalizing earnings. In other words, the provisions that are taken and written back, if you strip that out, you get an idea of what they're actually doing, you avoid this volatility.

Well, what I love is the fact that a lot of investors don't do that. And they sold in 2020. I was buying in 2020. So I love it when investors actually make irrational decisions and don't actually look at the numbers because it creates opportunity. Especially in the Bahaman equity markets, because it is thinly traded. Excess return potential, excess risk if you need to get out. But that's why you have a diverse portfolio and a lot of cash, so you don't need to engage in a fire sale.

Insurance. No reds, only greens. So, Family Guardians had a very strong run. FamGuard, why is that? In early 2018, they said let's get back to what we do well, strictly insurance. They sold off subsidiaries that were an insurance based and they focused 100% on their business, and actually they've been doing very well.

Colina has had a good run the last couple of years. JS Johnson is just like, slow and steady, Eddie, good, strong dividend. And Bahamas First, you know, it came out, finally, they listed on BISX. This initial jump has pulled back a bit, but for the most part, the insurance sector has been strong as well.

So exposure to Bahaman banks and Bahaman insurance companies, highly recommended, if you're going to be investing in the Bahaman equities.

Let's look at some other equities out there. You can see there's more green than red. I'm not going to go into exact detail on all of them. But we do monitor their financials, we do assess their performance, come up with estimates, we think, of earnings and dividend payments in the year ahead, and we have a stock rating sheet that we go by.

So what do we have here? So this is just some of our funds and their performance over time.

Basically what I want to speak to is a couple of things. Number one, you should expect a higher rate of return with more risk. The Prime Income Fund is the lowest risk. Secure Balance Fund adds equities, is slightly more risk. And the targeted equity fund is almost purely equities.

Well, over the last five years, the Prime Income Fund at 4%, Secure Balance Fund at 8%, targeted equity at 13%. So you're getting the return you should get for the additional risk you're taking.

We have some US dollar funds. We have two funds where Bahamans can take B-dollars, and invest in US dollar exposure. One is the high yield fund. You can see it's had a rough go of it, but then all fixed income has had a fairly rough go of it, with interest rates down at 0.25%. In fact, in 2022 it was down 4%.

But if you were exposed to a portfolio of US treasuries in 2022, AAA rated US government treasuries, you'd have lost 11%, because the yield curve jumped to the extent it did that I talked about earlier.

What else is going on? We've got a new Strat equity fund. There was an article in the paper recently. And the idea is, there's a lot of good private companies out there, and they're looking to either expand or they're looking to take some money off the table. So after we review them, if we feel they're warranted or a good investment, then we'll sit down and make an offer. And if we can come to an agreement, the objective is we'll make a minority investment, 20, 30, 40%. We don't want to control the company, we don't want to run the company. We're looking for good operators and we want a piece of the action.

So this fund allows RF investors to benefit from that work we're doing. So, Jim Wilson, who's here, he heads up our investment banking team and he runs the Strat equity fund. We made our first investment, and I think it's going to be very successful for investors, and we're looking at several others at the moment.

What else is going on? I mean, our investment banking team is not on this slide, but I'm going to speak to it.

We're working on a regional US dollar debt offering at 9%. So once again, how do you invest in that? Well, you could buy investment currency and buy it. If you are allowed to hold us dollars and invest without buying investment currency, you can invest in it.

Then locally, we've got an equity offering that's coming to market, and we've got two debt offerings. One is around 12%. Now, this would be much higher risk, right? Aggressive offering. So if you can weather the volatility, you may want to look at that. And then there's a PPP project we're working on. If that happens, we're looking around 8% on that piece of paper.

So there's some opportunities out there to gain some some attractive yields.

Rachel. How are we looking? All right, make sure I don't run over time.

Alright, don't laugh. It is the laffer curve. And basically this shows that there comes a point where you keep raising tax rates, total tax revenue decreases. So this is a message to those people looking to set the corporate tax rate in the Bahamas. There comes a point where you may raise that percentage, but the total revenue you earn is going to go down.

And why would that happen? Some companies are going to leave the market. As the cost of doing business goes up, there comes a point where somebody says, you know what, I've had enough, I'm closing shop. Gone. Or they get acquired by their entity. So entities that have more scale and more capacity to whether these increasing costs of doing business, they acquire those firms.

But guess what they bring, they bring efficiencies. They don't need to employ as many people. So therefore the total number of employees in the economy goes down. There comes a point where you tax the economy to a state where it simply can no longer grow, and therefore the total revenue you can generate decreases as you raise the rate of taxation. Whether it's at that rate or somewhere to the right, is debatable. But it stands, right? So there comes a point where taxation becomes detrimental to your effort to raise tax revenue.

Just two more slides. So let's look at some of the areas that I think company leaders should be focusing on. Number one, you need to officially manage cash flow and minimize the cash drag on performance. If you have a float of cash that you need so much for operations, but there's a balance that just kind of always seems to be sitting in the bank, let's get that working for you. I want you to earn some money on your money.

Number two, optimize your capital structure, especially if the corporate tax comes into play. I mentioned earlier, there is the ability to deduct interest expense up to 30% of the EBITDA, I think, and it applies to all the different scenarios. So that gives you a tax shield, right? So if you can add debt to your capital structure, the interest expense and the debt, you get the deducted it, in effect, from your corporate tax. So keep that in mind.

And I mentioned earlier, we don't expect economic growth to be staggering. We expect it to slow down around probably 1.5 to 2% for the next five years. So when you're doing your budgeting, bear that in mind.

And we recommend that you find a trusted advisor to assist you with these challenges. It's always beneficial to have an entity or an individual, or both, that you trust that you can bounce ideas off and get their opinion. You may tell them, oh, you know, thanks, but this time I'm not going to accept your advice. Turns out you were wrong and you realized, boy, I made a mistake. I should have listened to that advice. But it's always good to have informed entities to bounce ideas off. Whether it's RF, whether it's your accounting firm, whether it's your legal advice. Make sure you've got a trusted advisor or advisors that you can rely on.

Last slide. I think there's going to be a material increase in bond offerings going forward, especially with the potential corporate tax coming in coming in line. Also, I think as people realize... So many Bahaman companies are like, I don't want any debt, I don't want to owe anybody anything. But the most expensive form of capital is the equity in your firm. If you got a return on equity at 15% and you decide the best way to raise capital is to sell equity and give them the 15%, you're making a mistake. Especially if you could borrow at 6%. Use other people's money to grow your shareholder wealth. Don't give up your wealth. Tell the people.

What else is going on? Greater focus on equity, private equity deals? I think you're going to see that. Our fund. But also I think, as firms start to realize this is an opportunity to raise capital and do things. I think you're going to see more and more of these deals come to market.

I think you're going to see a consolidation across industries, as those companies that are poorly capitalized or inefficiently run, they're going to exit the market or they're going to be bought up.

And then, I think you're going to see an increase in public-private partnerships, simply because the fiscal constraints that I mentioned earlier, they're there. So in order to do capital projects, I think the government is going to have to reach out to the private sector to bring private capital into these offerings.

So stay tuned, and RF will tell you what we're working on and what we can share with you.

Thank you. [applause]

[inaudible question]

Yeah, so it's important it's important to have realistic expectations. So as an analyst, when I'm thinking about looking at what I think a company is going to generate, for example, in 2024 and beyond, the top line growth has to be a function of something. It can be a function of the overall economy, so I need a realistic expectation of GDP growth. Could be a function of, they're just doing better than the competition, they're going to take market share. That's another factor.

But you're right. The first thing you start with is a realistic expectation of the overall economy and its growth. And if we're primarily dependent on tourists from the US to drive our economy, and the US economy is expected to grow here, maybe for short periods of time, we may outperform, but over the long run, it's not reasonable to expect that we will outperform the US economy.

[question] -- [inaudible] I think the government have to do a better job of managing PPP. I'm involved with a PPP right now that is not paying what is supposed to be paid. I've been on to the government, the government is not properly managing. So you trying to convince these people to invest in PPP, the government is not really managing these things.

I can't speak for the government, I can't speak for other entities. All I know is when RF gets involved in a deal, we make sure we structure it so we think the risk has been mitigated, and the return is appropriate. And if it's not, then we don't do the deal.

[question] The premium tax that you are treating as a corporate tax. As far as I'm aware, that tax is passed on to the customer. Is it not the equivalent of saying, well, 10% that is a corporate tax?

Really, just trying to give kind of an estimate of what is currently being paid by the company. You're right. But if they're able to pass it on, then they...

I mean, you know, obviously if they're able to. So maybe the effective tax rate is less than the 25%. I was just using a kind of as a case study to say, you know, the effective tax rate of FamGuard, for example, is 26%. But you're right, if they're able to pass on 15% of that, and it's only 10%, it's really just for uh a guide to say -- currently companies are, not all companies get to pass it on. So some companies do have to eat that.

So maybe 26% is the maximum, the reality may be less than that. But it's just really to say that there's currently a corporate tax out there, so the government needs to be conscious of when they implement a corporate tax, that they don't simply double up. There's got to be reduction in one, increase in the other. I know at the end of the day, they want to maximize, they want to increase total revenue earned. So at the end of the day, it's going to be, it won't be positive to the bottom line of the publicly traded companies, which we consider going forward as far as earnings and PE multiples and the like.

But good point. I mean, it was just really more academic than precise.

[question] Where do you see opportunities from a growth and investment standpoint? You talked about the private equity fund that you're growing. Is that any particular sectors or size of companies, micro, small, medium, large? What do you see as opportunities?

So, our minimum is 5 million, as far as an investment in one of these companies. So that kind of puts a floor on what we'll look at. And each investment is independent. So even though it's a Strat equity fund, each investment is siloed. So you're not investing in the amalgamation of all of them, you're investing in that specific deal. Deal one, I like, deal two I don't like, deal three at, oh, four, I like, seven, I like.

And then the idea is, if possible, we want to take these entities public. So that comes as kind of an exit strategy. So we get to be an investor and benefit from what we think is a good company with a strong operator. And then there's an IPO down the road, and then the general public gets to share, be an investor as well. So that's kind of the model we're implementing.

So, no specific industry, is a good company with a good operator, and we think it's a good investment, we'll go into it.

[question] What are your expectations, if any, as to whether or not the country might get some debt relief, as was pointed out. I mean, even looking at your charts, we've gone from 58% to almost 100%, largely on the back of Dorian and Covid. Well, Covid is a global, but Dorian can be largely based on the increase in climate risk.

I'm going to defer that to the panel discussion. [laughs] I mean, I don't think it'd be debt relief on existing debt. But maybe there's sources of capital. I mean, you hear it in the paper, I'm not sure how likely it is, whether it's a carbon credit or, you know, credits for the fact that our sea bed absorbs so much CO2, and the fact that, you know, we emit so little versus how much we absorb, relative to the big players.

If that happens. Excellent. That's a game changer. Suddenly we get hundreds of millions of dollars, or billions of dollars of some kind of assistance. Then we sit back and reassess everything.

[question] The other thing is that, seems to me that the country has an expectation of services from the government which exceeds their actual tax percent of GDP. Would that be a correct assessment?

The point I made. There comes a point where increasing the rate of tax leads to actually less tax revenue. And part of that would be if individuals and corporations are not pleased with the service being delivered for what they're paying. Some people make a decision with their feet. And individuals too. I mean, you've got individuals here who have companies, they have the ability to relocate, sell the business, take the money and run. So there comes a point where people move with their feet. If they can. I'm not going to get into government policy and efficiency. I'll let the government answer any of those questions.

Alright. Well, thank you very much.

Bahamas Corporate Tax Discussion

Simon Wilson, Financial Secretary and Kevin Moree, partner at McKinney, Bancroft and Hughes. Moderated by Jim Wilson, RF Bank & Trust

Host: The Ministry of Finance announced in May the release of the Green Paper on corporate income tax strategies for the Bahamas, which aims to solicit feedback to achieve greater efficiency and equity in the business tax regime in alignment with global taxes. The Minister of Finance noted that the goal is to ensure that the government explores all of the right options to support growth, investment and development.

Coming to take us on a deep dive of this topic are two subject matter experts. Leading our discussion on CIT strategies and their impact on business in the Bahamas is Jim Wilson, RF Vice President and group head of investment banking.

Joining Jim, we have Simon Wilson. Mr Wilson was appointed Financial Secretary on January 1st, 2016. He holds a Bachelors of Science degree in Economics from the University of the West Indies and a master's degree in Economics from Florida State University. Mr Wilson has over 30 years of experience in the Ministry of Finance, having served in various capacities including deputy financial secretary and head of the economics unit.

Completing the panel today is Kevin Moree. Kevin is a partner at McKinney Bancroft and Hughes, one of the largest and oldest law firms in the Bahamas, and specializes in civil and commercial litigation, tax law and financial services law. He co-chairs the firm's practice groups for tax and trade and financial services and regulations and regularly advises clients from various jurisdictions on Bahamas tax matters, leveraging his litigation expertise should the need arise for him to represent them in dispute resolution proceedings. Please help me welcome the experts to the stage. [applause]

Jim: Thanks very much, Jackie and good morning to everybody. Thanks for coming out today and thanks to our panelists as well. I'm just going to mention, Jackie did refer to the Green Paper that came out in May that the government issued. And so obviously the discussion today will center around that Green Paper and where we are right now and any extensions to dates etc.

But within the framework, there's also Pillar Two, and I'm not sure if everybody is aware of what Pillar Two is. Pillar Two is basically a global agreement. Well over 140 countries, I think thereabouts 130, 140 countries have now agreed to sign on to a minimum tax, an average minimum tax.

Now, at this stage, of course, it only applies to companies generating over 750 million Euros -- I think Jackie had mentioned this earlier as well -- in revenues. Of course, that's just, as I think Kevin mentioned that when we were chatting earlier, that's the frog in the pot or whatever, the crab in the pot. Because that level will just be reduced in time once companies and the countries get used to that tax burden.

That amount, now, I don't know what, I'm sure panelists may know how many companies in the Bahamas that might affect, but within the framework of that, is that 15%, is that something that we want to implement here as a minimum tax? What does that look like?

The Pillar Two does allow for flexibility in countries in terms of how it's implemented and a tiered system of corporate tax. So without further ado, I'm just going to jump right into the questions.

First question for Kevin, and please feel free to jump in as well if anybody has any questions along the way.

How does the current business license tax in the Bahamas differ from the proposed corporate income tax?

Kevin: That's a good question, important. I think there's probably four main differences. So the first one is the basis on which it's calculated. So business license, as we know is on gross turnover. And so that doesn't take into consideration any expenses and deductions. And so the corporate income tax is going to be looking by its name on income. So it will consider deductions and expenses. So that's probably the biggest difference.

The second difference linked to that is going to be the rate. We're going to be looking at much higher rates for a corporate income tax. But that has to be viewed in light of the fact that the figure that's being considered is an income or profit based figure as opposed to gross turnover.

The third main issue in my view is the availability of deductions and exemptions. There's relatively small category of deductions and exemptions available under the current business license regime. And depending on what's ultimately decided, because this is all very early stages. The Green Paper says it time and time and again, this is really just to get the ball rolling, but I would expect that the corporate income tax regime would have a much larger category of exemptions and deductions.

And finally, and from a commercial perspective this is really important, I think a major difference is going to be the costs associated with compliance, the administrative and compliance cost. And you can think about the filing requirements, the audit requirements, when you're looking at the deductions and exemptions available, the actual manpower required to ensure that you're taking advantage of as many of those as possible, and a litany of other considerations which ultimately will be an increase in costs under a corporate income tax regime, as opposed to the current business license regime.

Jim: Thanks, Kevin. And Simon, why is the change needed?

Simon: Thank you. I think you explained why a change is needed. The Bahamas is a member of the global community. We pride ourselves in being a well regulated jurisdiction and as a result, we have to conform to, I guess, the standards of well regulated jurisdictions. 140 countries signed up to Pillar Two. As a financial services center it will be impractical for us to not sign up, so that's why.

Jim: Okay. This is for either one of you, both of you? What are the potential implications if we weren't to go along with that?

Simon: I mean, clearly for us, it will mean an isolation from the financial services system. You know, we are already facing pressures on correspondent banks. Can you imagine a world where you can't do basic transactions, you can't go on and use your credit card to purchase something from Amazon? That is really the future we're looking at if we decide to ignore the global community in these standards, especially United States.

Jim: So you're referring there to correspondent banking relationships collapsing, etc.?

Simon: Exactly. And they are already under pressure. If, I dare say, if the Bahamas did not sign on to Pillar Two with the 140, we will have seen further withdrawals of the very few correspondent banks now.

Kevin: And, I think that's linked to blacklisting. We all know, unfortunately, over the past decade or more -- don't comply, blacklist, negative impact on correspondent's banking.

And that's an interesting topic in and of itself is -- what can be done to prevent or at least decrease the reliance on correspondent banking. And I think the other factor to be considered... And at the bare minimum rate where only multinational corporations with revenue in excess of 750 million euros, that's a relatively small amount. But if it does increase, then I think there would be a loss of revenue available to the government because those entities have to pay this tax.

So they're either going to pay it to us if we have it on our books, or it's going to be paid to their parent jurisdiction. So I think that's been a big consideration, rightfully so in the government's mind when seeing this.

Now, that's the sort of option one in the Green Paper, where you're only covering what the OECD is requiring you to cover at this point.

Jim: Yeah. So Kevin touched on it and I think David may have in his presentation as well. Currently, the Green Paper is considering four different options. Well, maybe there's more Simon's giving me a...

Simon: I think what the Green Paper is doing is providing a framework for discussion. So at the Ministry of Finance, we have not made a determination on any option, there's no favorite. And there may be more options available, we don't know all the options. This is just a forum discussions and say, hey, business community, wider community, what are your thoughts? How do we frame this? How do we make this work for everybody? As impractical as it may sound, that is the overall goal. We want a solution that will foster and improve the business environment.

Jim: What's been the general feedback so far?

Simon: The feedback is in two types. Type one, we do have some businesses that fall in this category of revenues over 750 million Euros. And as Kevin said, their preference is to pay taxes in the jurisdiction of where they operate from. So they have a clear preference to pay taxes in the Bahamas. So they are obviously supporter of an option where there'll be a CIT which will allow them to pay taxes here.

Like many of them say, we have employees here, our children go to school here, so obviously, we want to support our local community.

And then the other feedback is that there is the fear of the unknown, that this is the first step towards an income tax regime CIT, perhaps a personal income tax, and so there's a fear of that. Now, even though the government has made it quite clear in the Green Paper and elsewhere, a PIT, a personal income tax is not on the table. There's still... Can we trust that, will you change, will you pivot your position at sometime the future and so forth?

Kevin: And I think from the private sector, my experience has being clients are generally receptive. That's subject to a number of caveats. So one of the big ones is the devil is in the details. And right now because we're at a stage, there aren't many details and that's because we're at the beginning. So hopefully they'll come and that'll foster further discussion.

Another concern is the technical ability in both the public and private sectors, that this can be a very complicated tax regime. It's going to be more complicated than the current business license regime. There's no doubt about that. As to how complicated it is will depend on the details, but there are serious concerns about the training and the experience and expertise in the jurisdiction to properly implement this, again, both in the public and the private sector.

Timing is a big concern. In the Green Paper, it does recognize that there could be a staggered approach, not necessarily options one through four, or maybe other options as as the FS said. But not bringing this on too quickly to create confusion unnecessarily.

And another big concern is how are these funds going to be spent by the government? So again, like the FS said, there's a recognition of funds being paid to a government that are ultimately beneficial to residents and citizens, whether that's by the way of education, health care, other infrastructure, that is more appealing. But if there is some uncertainty or a feeling that these funds aren't necessarily going to ultimately benefit the overall economy, that's been one of the major concerns as well.

Jim: Reduction of debt may be one of them too.

Kevin: Precisely. And I mean that's another point, is looking at both sides of the budget. So obviously, one of the foundational factors of this is to increase revenue for the government. And a lot of the feedback says, well, what is the government doing to cut expenses? So it works on both sides of it.

Jim: Do we think we have enough accountants to do this? [laughter] A very practical question.

Kevin: I think depending on how complex it is, it's already... And many of you may appreciate that even under the new Business License Act, there's increased requirements in terms of audit financial statements through a new business license. That has raised questions over the volume of properly trained accountants to deal with that. And that only, I think, is a precursor to that issue being raised again in the context of a corporate income tax.

Simon: I think this issue of capacity I think is a valid question, of world of great concern. But I also think that the government, as well as the private sector, have a duty to make their investments to compete globally. We can't compete globally without making those adjustments.

So for example, it's far easier for us to increase business license rates than to improve compliance. Compliance, the returns from compliance are minute. But lower rates means more investments by the business community. And so we have to improve compliance. I think that the same thing applies with the CIT. The cit is going to increase cost for some businesses. It's going to make them do things they are not doing currently. But those things are necessary to compete globally.

Jim: Okay. Good response. Now, do you see the CIT, the corporate income tax, is that going to replace some other taxes? Business license fee, the excise taxes or anything else? Does it lead to a reduction in VAT? Like, how do you see this being implemented?

Simon: If it's implemented. The government has said publicly that the minimum tax that it needs to run the economy, run its operations, is 25% of GDP. We start with that premise. [indistinct] amount is generated through VAT and customs and excise duty. A much smaller percent is generated from business license.

Jim: I was surprised actually. The doesn't seem that large.

Simon: Very, very small. Because most businesses in this country don't pay any business license tax. Roughly one in 10 businesses pay business license.

Jim: Is that just enforcement, compliant?

Simon: Well, I think Mr Chipman asks a very good question. Why is that? It's a couple of reasons. One reason is, a low compliance rate for business license, which is really a challenge. The second reason is that the design of the tax itself allows firms to disguise their revenue.

And if you noticed the amendments, or they replace the new business license, because we repeal and replace the act, has given the tax authority far more powers to address that.

So, previously, we could not deal with a tax scheme. Now we can deal with tax scheme. Those are the same provisions that you'll see carry over if you move to a CIT. Those provisions will carry over into the CIT, in terms of how do you deal with issue of compliance, and combating abusive tax behavior.

Kevin: I think on that note, it's important as well, speaking about feedback from the private sector and particularly in the early stages, there's been a lot of discussion about having a collaborative and cooperative relationship between the public and private sector. There are many businesses and perhaps industries which feel like it's always adversarial, particularly with the introduction of a completely new regime. But the hope would be through public education, through meetings, through recognition. If a filing has been done improperly, they don't come down with a sledgehammer. That's also, I think, a really important factor. Because we would all be learning this together. And you want everybody to be compliant and act in good faith, but it's going to be difficult for the first little while.

Simon: We understand that. And I think if you look at our approach to the AT, there was very gradualism. We don't see any new taxes as a mechanism to get the private sector. We believe in working collaboratively, sitting down and working through issues.

Now, there comes a time when we believe that there's a level of maturity, that our approach will obviously evolve. Because we expect the business community to evolve with us.

Jim: Do you see -- and I guess maybe for both of you, maybe more for Simon -- but do you see a corporate income tax evolving to include all businesses in the Bahamas? Do you see it being phased in to over a certain revenue level? Or how do you see this being implemented?

Simon: It's too early to say. But if you look at the current system now, there's a reason why there is a clear preference to maintain the status quo. Because the government has signed agreements where we have given wide swaths of the economy exemptions from income tax. So it's a very difficult discussion to say, we can move the CIT, where you have significant economic actors who have a legally binding exemption for income tax.

Kevin: And then you have a whole area under the Hawksbill Creek Agreement, which would be interesting to see how that plays out. And that begs the question, if the government comes to the position that they cannot implement a corporate income tax, what is the OECD going to say about that? And it's unfortunate that we have to consider what a super national organization is going to say about our sovereign decisions, and maybe that's another discussion for another time.

But that's also. It's the HOAs for private companies, and then the Hawksbill Creek Agreement overall, for Freeport.

Simon: So that's why it's important. That's why the green paper process is so important. Because the government can't make the decision [indistinct] It impacts too much people, it impacts agreements, impacts legislation. Everybody has to understand that we have to move in unison in the private sector.

Jim: How will this impact... So, I mean, we've got heads of agreement out there for some of these large groups...

Simon: We don't know. That's why we've started green paper first. That green paper is going to evolve into a white paper at some time. Based on the white paper, it will evolve into draft legislation. And then finally, legislation.

There are a number of very technical discussions have to take place. And in some cases, bilateral discussions with persons who have agreements or expectations of the operation being free of income tax for extended period of time.

Jim: Because that definitely impacts the revenue line, doesn't it? For the government I mean.

Simon: It does.

Jim: And do you see this being a flat tax? A progressive tax, as it moves forward? No idea?

Simon: No idea. I can tell you a lot of things I see with the current tax regime. But, you know, the approach we have taken when we look at the CIT is that the CIT is because of global factors. It is not to solve our fiscal situation.

Because we don't know when the CIT is going come into play. It may come into play... It might come into play in 15 years. It might come into play in 15 months. We don't know. 15 months is unlikely, for a lot of reasons. But, it may come into play in five years or so forth.

We have a current fiscal situation that we manage now. I don't think nobody in the Ministry of Finance or the Finance Minister is looking at the CIT as a mechanism to solve that. So we're not thinking about flat, progressive, aggressive. None of those thoughts.

Jim: Just keep it simple.

Simon: Yeah.

Kevin: I think it's important to note, too, what David had mentioned during his presentation, is the 15% is the effective tax rate. And so when you look at deductions and exemptions, it's a double edged sword. Because you may have a very wide category of exemptions and deductions. But that may mean that the headline of the statutory rate needs to be 20, 22%, to end up with a 15% effective tax rate. And I think from the C suite executive level for each business, and perhaps each sector, that needs to be considered as to how is that going to impact you? If you make a lot of charitable donations and you would expect that to be a deduction, for example, are you then going to be looking at maybe a rate which is at 20 or 22%, or would it be better just to keep it clean, so the rate is lower, but you're not --

Jim: No deductions.

Kevin: -- entitled to so many deductions.

Jim: Interesting. I hadn't really thought about it. But you're right. It does say it's an effective 15%.

Family Islands have traditionally enjoyed certain tax benefits, property tax, etc. Will the corporate income tax apply to Family Island businesses?

Simon: Business license applies to Family Island businesses.

Kevin: Well, if it doesn't, we're going to need to invest in Family Island infrastructure. Because I think a lot of people are going to be moving there.

Jim: One of the... And this is my own personal thinking, now, in terms of corporate income tax versus some of the other taxes that we have in the Bahamas, has always been, it's the ability to broaden the tax base that we have. And at 750 million, to your point, there's a few businesses here. They're prepared to pay it here. I don't know how much of an impact that has on us in the Bahamas, on our bottom line.

But will the non domestic banking services who are operating here in the Bahamas, will they be subject to a corporate income tax? [slight pause]

Simon: Good answer. [laughs] I think we should also... I should also fly. You know, when you look at the business license regime, you'll see an expansion of categories of businesses who are subsidy business license.

Jim: Okay.

Simon: So, obviously, currently, our model is let's broaden the base, let's prepare businesses for this eventual transition that may occur. So in this year's business license, for example, we have categories of financial services entities that were previously exempt from business license, or pay a nominal business license, who now pay on a [indistinct] basis with a cap.

Jim: Interesting. Okay. And will corporate, the government-owned entities, will they pay the corporate income tax?

Simon: They pay business license now.

Jim: Okay.

Kevin: But if it's based on income... [laughter]

Jim: We'll see a drop in government revenue.

Simon: I don't know. I think whatever we do will have to be at a minimum revenue neutral. I mean, whoever makes that decision. Because obviously, we have a very small, a very narrow tax base. Even at 25% GDP, for the Caribbean region, that is very, very narrow. And our tax base, believe it or not, is a very fragile tax base. You just need one or two occurrences elsewhere that have a dramatic impact on our tax base. So we have to be, in design, whatever new tax regime that we have, we have to make sure the minimum, it is revenue neutral.

Jim: Kevin. This one's for you, I guess, from the legal profession, what legislative changes do you see being needed to be implemented as part of this process?

Kevin: There's going to have to be a lot, I think. I mean, obviously, there's going to have to be legislation put in place to give effect to this Pillar Two model. And depending on how that's done, it may start with just the adoption, generally, from, I think always, the OECD provides a template. And then, because hopefully we're not going to have personal income tax, there's going to have to be legislation to deal with that. It's going to have to be anti-avoidance legislation. Because we would all know this is a loophole from long time ago that all of a sudden, salaries increase for the owners of companies, to get money out before it attracts the tax. So there's going to be legislation presumably that has to deal with that. There's going to be legislation.

I quite happily, thus far in my tax career, haven't had to deal with transfer pricing. We're going to have to get legislation that deals with transfer pricing. That's going to be a very real issue that needs to be dealt with.

I think hopefully it should also attract some legislation that deals with curbing government expenditure, and perhaps deals with how these taxes are to be applied. You know, you have the consolidated fund, but there's a legislation that says that, you know, 50%, 75%, 90% of corporate income tax is to be used for these purposes.

So I think there'll be a suite of legislation that's needed. And perhaps amendments too. Things like the Hawksbill Creek Agreement, like we discussed before. So there's going to be some very busy drafters, whenever the time comes, because it's still early days. But there'll be a lot of changes, I think, that will have to be looked at very carefully.

Jim: Well, Simon, you mentioned 15, it isn't going to happen in 15 months. But if you had to take, you know, in terms of some of these legislative changes and some of the other adoption, the feedback process, how long do you see this being before we're looking at a corporate income tax?

Simon: I can't say with any certainty. But I'm thinking, if I was to make an educated guess, I'll say no earlier than 48 months from now.

Jim: 48 months?

Simon: No earlier than 48 months.

Jim: So four years.

Simon: Yeah. No earlier. Because, if you think of what we have to do from our side. Yes, we have to go through this whole drafting process and so forth. We have to buy the system, the application. We have to have the application designed to meet the legislation requirements. That's not a very straightforward process. We eventually have the VAT. We have to make a determination how persons are going to file. That sounds simple, but that's not a very straightforward process. We have to make sure that if it's substantial revenue, or any type of revenue, how do we account for in terms of filing days? And all our compliance programs?

So administratively, that's a huge undertaking. We do have mechanisms, fiscal rules, which limit how we can use funding. So that's not new. We do have in the Business License Act, we have now put in anti-avoidance language. [indistinct] transactions and so forth.

And I think through the tax appeals tribunal, we are building a case law on tax matters, which we did not before, before for VAT or business license. Everything was not clear to the business community or what was acceptable, or was not acceptable. So we're doing some things now which will prepare us, obviously, for the [indistinct] decisions made by the government.

But still, it will be a massive undertaking. And if my boss said to me, well, Simon, we'll do it as soon as possible from right now, where we are, that will probably take us, I would say, five or six years, 60 to 72 months.

Kevin: So just to clarify. Is this for a more comprehensive change to the regime? Or even if we were just to do that very basic option one, for just a 750 --

Simon: If we just, even that very basic option one.

Kevin: We're still looking at what, four years?

Simon: Minimum of four years. Because that very basic option one, when you go through all the details, that very basic option one, it will unpack. The cup underneath. We have the table for some entities that may have agreements.

So for example, you might have a company which has agreement that might fall in that category. A company which has [indistinct] area which [indistinct] category. So we had to make those adjustments there. So it is not straightforward. The [indistinct] will make you believe it's this, but it's not.

Kevin: You've had European countries who have had to push back for 12 months, and they're amending an already existent corporate income tax regime. And the green paper recognizes this, and yeah, you have to work with what you got. But even the data in the green paper says, is based on jurisdictions who have already had a corporate income tax regime in place. So these figures that are being used are not exactly on all fours with us. Because we would be starting from scratch. And I don't envy you and your team's job. Because you really are sort of feeling around in the dark. Because the data just isn't there, when you're trying to say, what is the impact on FDI? What is going to be the impact on unemployment?

And there's a chart in there, which is helpful, and it's all negative. But we don't know if that's an accurate representation. Is it going to be worse than is expected? Will it not be as bad as expected?

And presumably, I mean, that's part of this process as well. Not only the technical aspects and the legal drafting, but the analysis of the data to try to really get a feel as to what the impact is going to be on the jurisdiction.

Simon: That's critical, actually.

Jim: Well, on Pillar Two, though, I mean, they've got some deadlines in there. I think December this year, December next year.

Simon: But even those deadlines, Jim, have been adjusted. Because the reality is, is that the technocrats at the OECD who designed Pillar Two, when you take it to your home jurisdiction, even the most advanced countries find difficulty doing it.

United States was a huge proponent of the flat tax, and even even they realize that we probably can't get this through Congress, in a time frame that we've agreed to at OECD level.

Kevin: And their MO, Jim, again, as we know, is to try to force these deadlines. And then at the last minute, push it back, and then at the last minute, push it back in recognition of what would have been pleaded months and years before -- we can't meet that deadline. We simply can't do it. And that just seems to be a strategy, I suppose.

Jim: Yeah. And the reason I was asking the question is, I mean, you know, we're already been fighting with blacklisting and everything else. And if they've set some artificial deadline of whether it would be the end of this year or the end of next year and we can't meet it, does that mean we're going to be subject to more penalties or something?

Simon: Unfortunately that is the way they operate. OECD, the EU, FATFA, it's always a penalty basis regime, where they believe penalties are more effective than discussion.

But the reality is that as a country, we have to be very mindful that we don't do anything which might be rash, which we could do harm the economy, that we can never recover from.

If you look at what's happening elsewhere, you have many examples of countries who immediately took action, and then saw capital flight. Even in this region. They took action, saw capital fight, or saw a situation where the fiscal situation deteriorated. We are in a very fragile fiscal situation.

I mean, yes, there's been overall economic improvement. Yes, revenue numbers have improved. But we have an extremely high level of debt. An extremely high level of foreign currency debt, which we have to manage in an environment where global markets are very uncertain.

And so it'll be ludicrous or crazy of us to rush this, get something wrong, cause capital flight, we're still not over FDI. The economy probably will never recover, not in our lifetime. And so it's better to be cautious, go through this process, and make sure that we have everything lined up properly.

Jim: Agreed, agreed.

Do we have any questions from the audience? About 100? There you go. [laughs]

[question] What type of exceptions [inaudible]

Simon: I can't say what type of exemptions will be allowed. But I can say to you, we will not be creating something new, from scratch. So if you look at what's generally available in other regimes, we'll probably be adopting some of those exemptions. And obviously, with a Bahaman flair. [laughter] Whatever that means.

And in terms of disclosure. I mean, those of you who have businesses, and who interact with the Department of Revenue, know that our model has matured, where we now requiring a much higher degree of disclosure.

Some people might say it's more intrusive. But that's part of the maturity of a tax authority. And that will continue.

Kevin: The interesting thing, and I think it's quite cool, with exemptions is it does give the government an opportunity to steer corporate funds.

And so let's say, for example, a Bahaman is climate resistance. And they say, any expenditures to assist with climate resistance, so let's say you donate to increase the height of a sea wall or something like that, that will be, maybe not an exemption but a deduction. And there's different categories that you could put in place so that businesses will be spending that money in areas to assist with the country overall.

And that can be a very useful way to get projects done that don't need to be fully funded by government, to really focus on key areas that need to be addressed at that moment in time. Then it can be changed as needs go. And then obviously, the businesses would be getting deductions which helps them with their bottom line.

So that's again, an area for C-Suite executives, I think at this point to say -- I have a budget for charitable donations or whatever it is each year, if I had to break that down into specific areas, what do those areas look like? And you should raise that in the feedback at an early stage to get that. I think in the minds of the people who are going to be considering these things.

Jim: Just to help guide public policy somewhat?

Kevin: Exactly.

[question] This is a question for Mr Wilson. We talk about the cost of capital and capital risk, the flight of capital with this new corporate income tax. When you think about it, right, one of the attractions of coming to the Bahamas was because of no corporate tax. With the implementation now with corporate tax, what fallout do you see? Because a lot of people may just say, well, there's no benefit in doing business here anymore. So what would be the attraction for me to continue doing business in the Bahamas?

Simon: So I think that's why the approach has to be very cautious. So obviously, we watch our competitors. So it will be fool hardy of us to put in place a corporate income tax model, and there's no similar regime in Panama or Turk Caicos, or down in the Caribbean or Bermuda or Cayman. You'll hear a big sucking sound of investment going in those areas. We have to be very cognizant of that.

You know, we've seen it before where we've put in place regimes that we lost forever. The famous example. we all know about is Captive Insurance. Was here one day, gone the next day. And no matter all the entreaties of governments and insurance regulators and investments and so forth saying, you know what guys that was just a mistake, we didn't interpret it properly, you need to come back. Gone forever.

So we have to be very very, very careful, because we know this capital is very, very mobile, and all forms of capital, not just on the financial sector, all forms of capital. Investments in hotels, investments in any businesses, they're all very mobile. You know, an investor who's building a hotel, he's not going to say I got to be in the Bahamas. He's saying, I need a [indistinct] return and if CIT impacts that return, I'll be someplace else. And we have to be cognizant of that.

Jim: Just a question I saw. I think the deadline for feedback was July 3rd?

Simon: That was extended.

Jim: What was it extended to?

Simon: I think the end of August. I think the Prime Minister in his budget communication announced an extension, or the week before the budget communication. I I think he had a statement with respect to it.

Jim: Kevin talked about potential incentivizing private sector to take on certain public sector capital improvements, whether it's for climate change or protection. You talked about that applying to the corporate tax, those incentives could be implemented today with respect to business license fees. Has the government given any thought to deductions on business license fee if the capital is invested as you wish?

Simon: So I think if just go back and something I said earlier, our business license revenue is paltry. It's very small, it's like 130 million dollars. And in that 130 million dollars, you have premium tax for the insurance companies, taking all of it and that's probably around $40 million. So you're looking at 90 million dollars in business license revenue,

On that 90 million dollars in business license revenue, about 20 firms account for about 70 million dollars. And I think, this is why we talk about the narrowness of the Bahaman tax space.

There's essentially around 40 companies that pay around 60% of the taxes in this country. Any one of those 40 companies that decide we're not going to play ball with you, I have great difficulty every month to meet salaries. That's a narrow tax basis.

So this is one of the reasons why we don't have incentives in the Business License Act. Because if you [indistinct] business license are, one of those companies could say, you know what, guess what, I'm going to take advantage of that incentive and I'm going to wipe my entire tax obligation. This is the reality that we face when we do fiscal management and so forth.

We do have an incentive though. If you invest in government securities, you know, a tax business license. So that's my plug. [laughter]

Kevin: You could do incentives, but capped at a relatively small amount and then spread across a number of businesses who took advantage of it.

Simon: But the big businesses say... So for example, there's a business say who went to a entire renewable energy project, good for climate change, good for BPL and so forth. If I were to have renewable energy incentive and that business took advantage of it, I would have lost a substantial amount of revenue because I'm already losing revenue by the fact that their electricity expense is going down.

So then when the electricity expense goes down, you know what happens? My tax revenue has to go up because I have to give the electricity company the money to offset for them having a low electricity bill.

Jim: We all feeling that right now. [laughter]

Simon: But I feel it more than anybody else because remember now what happens is that as the electricity bill goes up, obviously my electricity bill as the government goes up. But guess what, when people don't pay, I have to provide the gap funding necessary to keep the company going. And you know, like I was telling somebody a couple of days ago, the funding that we provide to the electricity company is not in a promissory note, it's in cold hard cash.

We have to actually take that cash which we collect from custom duty, we collect from VAT, and we actually have to write a check and transfer money into a bank account.

Jim: Because you got to pay for the fuel.

Simon: Exactly. Because the fuel suppliers is not going to say to us, you know, I love the Bahamas, the beaches are nice. The fuel supplier is going to have a very, very frank conversation. And I've been in those conversations and they're not very pleasant.

Lawrence: Or I would love to assist you with the privatization of the power companies. [laughter]

[question] If I can ask you, or maybe comment, you've talked about needing to be cautious in terms of the decision making around this and the concerns around flight of capital.

But maybe talk through concerns around capital that may be sitting on the sideline, not able to make an investment decision because there's the uncertainty, right. So I will tell you from a Deloitte standpoint immediately as this Green Paper hit, we had clients all around the world, plus sort of local clients saying, well, you know what's happening, what are you thinking, what does the timeline look like? Because that impacts their thinking about investments coming in, or even from a local standpoint, how they deploy investment.

So how do you sort of think about that and maybe urge some while being cautious that we don't have an infinite timeline from a decision making standpoint, even if implementation takes a while?

Simon: So I think that's a cost that we're willing to bear. So we realized by publishing a Green Paper that may have made persons on the margin to decide, we're not going to go ahead with your decision making. We're not going to make that investment in the Bahamas until it's done.

But the reality is this, if we did nothing, the pressure from the OECD and the EU and those bodies, the pressure is real, you know. And it doesn't come in your face in the paper, but when you see, for example, normal transactions that you are doing being impacted and you don't know why because somebody at a desk in Washington, in the Federal Reserve say, you know what there's a transaction in Bahamas, my boss say flag all them.

So we made a conscious decision that we have to come out, because we have to demonstrate to the international community, yes, we are serious about our commitment on Pillar Two.

Lawrence: I was not suggesting that we should not have come out with the Green Paper, more so that we don't have the infinite timeline to make a decision around it.

Simon: No, but Lawrence, I think the trade off is this, if you make a decision early and we implement early, we lose. The fallout will be tremendous. It's a balance. We have to make the decision at the same time as our competitors, at the same pace.

We talked about this for the last 20 years, level playing field. And those of us who remember what happened in 2000, we have the companion legislation, we say off the black list, this is forever gone, forgotten. 23 years later, we're still on one black list. [indistinct] many black list since then. And all the promises of 2000 have gone, because the people who we were working with, they're not honest brokers, they're not Bahamans. They're not going to keep their word, they can tell you one thing and they're going to change and you can be stuck.

Jim: Any other questions. Yeah, John?

John: Yeah, again for Mr Wilson, you use the word compliance quite a few times. And I think anecdotally there are a large number of companies or individuals with business license that are under reporting revenue to stay under 100,000. While that probably is not going to have much of an impact on the business license fees, the fact that staying under 100 means they're ducking out of the VAT collection. I think that's probably where there's a significant loss of potential revenue to the government.

Are there are steps being taken to bring these people into compliance, because when you move into corporate income tax, you're going to want them in that as well?

Simon: So there are steps being taken. I mean, we have taken a stance to be aggressive with our compliance, because we realize that we cannot go back to the business community and say pay more, a higher effective tax rate. That's a non-starter. If we did our model, you know, I would love to be able to keep VAT 12% and get rid of all the exemptions.

And perhaps we'll have a surplus now, and politically it would be an uproar, and that'll be a job again. [laughter]

Simon: So the reality that we have is that we have to focus on compliance. Not just compliance in the province. We did an exercise in Harbour Island. We spent about $30,000, $40,000, Harbour Island and do the exercise. And we discovered one business, owned by... One business of many businesses, but this one particular business owned by a non-Bahaman, who is resident in Miami, that was generating $5 million a year, wasn't paying any taxes. One year, declared $9000, next year, he declared $12,000. You know, these [indistinct] declared. And they were being approved.

But this one business, the business is so good, the fella had his own private wine, his own private labeled wine in the Bahamas. He was in Miami. He never came to the Bahamas. He was in Miami, but he has his own private label wine. So you send down wine. He was in destination weddings. And we have cases of that, not just in Harbour Island, but through the entire Bahamas, where persons take advantage of what they perceive as holds on compliance that we have to address. And we are working to address them.

[question] This question is for Mr Wilson. And you've heard this from me before. I'm all for compliance. And of course, I'm sure everyone in this room is all for compliance, but it's the way it's done by the taxing authorities, I think, is in need of softening.

Just to give an example, you know, you'd be just sitting at work one day, and two people show up demanding with the receptionist to speak with the CFO, and they drop a letter -- within seven days, provide, like, 20 different things. And it's like, where is this coming from?

So my, I guess, humble request is just like how we work with audit firms in order to plan. Plan engagements, you know, to try and get them to soften their tone when they come. And they demand things when they walk through the door. And I think that would aid in the non-adversarial relationship between businesses and taxing authorities. And that's just my five cents.

Simon: And, and I think once we get the LTU to start the last tax [indistinct] establish, you will see a very positive change.

But I will also say to you that in the next couple of weeks, you will probably hear about examples where the tax attorney has acted in a manner which you might consider un-Bahaman, very extreme. So there's a tradeoff. There's a trade off. So yes, for large businesses, and for all businesses, we are going to be more transparent how we operate. And that's a modern tax agency. We'd be more transparent, we can be softer.

But where we see cases where there has been consistent non-compliance, I think you will see that we are going to be much more firmer in our approach. And people like Mr Murray here will be making a lot more money. Because they will be coming to him for support.

Jim: Any other questions?

[question] Not to continue going down the rabbit hole. But Mr Wilson, what do you see if any the impact of the CIT on the other tax bases? In other words, VAT, and/or the duty and tariff regime.

Simon: So, independent of that, the duty and tariff regime, hopefully, as we improve our compliance with customs, hopefully you continue to see reductions in duties and excise tariffs. That that is a clear goal in our fiscal plan. We see that as an unreliable tax base. VAT has been proven to be very robust. And has been a godsend, really, for the Bahamas. We see VAT staying. So that's what we see. So, even independent of the CIT, as we improve compliance, customs duty and excise tax rates will continue to decline. VAT, I think, is here to stay, because that is a very stable tax base.

[question cont.] And that doesn't surprise me. But what I meant more specifically is from the corporation's point of view, is the CIT just purely incremental? Or are they going to have some --

Simon: You got to read between the lines. [laughter]

[question] One more question, Mr Wilson, I think during Mr Slater's presentation, we spoke about tax... I mean, in terms of taxing your way out of what the mess we're in now, right? And whilst we might be increasing taxes here and there, are there austerity programs in place? Or what are you doing about austerity programs, in terms of expenditures?

Simon: So, I think, we don't get enough -- well, we, as the government -- hasn't gotten enough credit for the steps we've taken, the austerity steps we've taken.

The expenditure budget, year over year, increased by less than 1%. Less than 1% year over year. And even though... Think of all the things that happened and was done -- pay the res, the vendors, we increase minimum wage, we sign industrial agreements, we hired staff -- all these things were done without a dramatic jump in expansion.

So I think sometimes the government gets short shift in terms of what has happened, in terms of margin, the expenditures, fiscal expenditures. The same thing with transfers of public corporations. We've reduced those transfers of public corporations, and they have been very, very difficult, internally, decisions made. The same way, the controlled expansion budget. Because, you know, the budget is a manifestation of the government's political objectives. And sometimes it's a very difficult discussion to have with the politicians on the policy level to say -- some of the things that you've put there, we can't do, because the money isn't there.

But so far, we've been able to do that. And we have not gotten, what I can say, the credit for doing it, and even the numbers show it. The deficit will not be reducing if it wasn't controlling expenditure. And it has been reduced. We were 14% in '19, '20, or 2021, and then now, this year, we are at zero point... Project to be 0.9%. That's a big jump.

[question cont.] [inaudible]

Simon: I think the messaging has not been very strong. And also, sometimes when people look at a one off event, or so forth, like for example, people complain to me about the 50th anniversary, and say, you know, you spent a lot of money on the 50th anniversary.

Granted, yes. But that was done. That was fully funded, and that was done by making adjustments elsewhere. And we've made adjustments elsewhere. We've reduced, for example, the cost of our meals. We've produce about 20,000 meals a month, the government. And we reduced that by almost 60% -- the costs, not the quality, the quantity, the costs. We change our purchases and habits.

[indistinct] came out, and those people who are in the business of selling to the government will know that we have a very vigorous procurement practice, and we've seen the savings.

So we're doing things that are very important. We're making a huge investment now on our information monitoring system. Because we know that we have a very inefficient payroll system. If we fix that, that could be huge savings. So we've been smart with our investments.

And these things aren't sexy. I mean, accountants think it's sexy as they put in the Oracle system. But most people don't give a...

But those of us in the environment know that, hey, the taxpayers expect more from us. They expect a more efficient government. I can't go with a straight face and say to the taxpayer, you know what, I want to increase your taxes, but I can't tell you how much employees I have. Which is a situation we are in to some extent now, but smaller investments, and so forth, we'll be able to do it.

Jim: I think we're out of time. I want to thank our two guest speakers here. BFS, Mr Simon Wilson, and Kevin Moree. And thank you for taking your time. Simon. I know how busy you are, and trying to balance things. So, thank you very much. Of course.

I think two quick takeaways for myself. Number one, I'm pleased to see that the government is taking its time in introducing, making any changes to the tax legislation. I think that you'd call that, you don't want to be the first mover disadvantage, I guess, in that case, as Simon pointed out, in terms of jumping ahead of the countries we compete against for the foreign dollar.

And secondly, I think is to encourage everybody, if you haven't already done so, is please read the green paper and provide feedback. We've got to participate. This is the opportunity. People always complaining government's doing this or government's doing that. This is your opportunity to participate and provide your feedback.

Thanks again guys. [applause]

 

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For more information about the presentations, or to get a copy of the slide decks, please email: david.slatter@rfgroup.com