Author: Franklin J. Parker

by Franklin J. Parker

The Summary

• Durable goods orders post this week and we also get data on personal incomes for March. Those plus the home price data and initial unemployment claims posting will give us a read on the health of ongoing spending and whether that spending is translating into corporate expansion and investment. Home sales are beginning to be constrained by materials and this has started to push home prices higher. Housing is a component of so-called “core” inflation, so higher home prices translates into higher inflation.
  
  
• We are now in the heart of earnings season. Of the companies that have reported so far, most have beat expectations, with the biggest upside surprises from Energy. Consumer staples (19% reported) have been disappointing with only 65% of companies delivering a beat. See the “Chart of the Week” for a breakdown.
  
  
• The Bank of Canada has become the first central bank to signal the slowdown of quantitative easing. The BoC will reduce the current pace of government debt from C$4 billion to C$3 billion and expects to begin raising the benchmark interest rate in the second half of 2022. So far, the Federal Reserve and European Central Bank have avoided an end to QE, though many economists now expect the Federal Reserve to end, and begin to reverse (called “tapering”), the current program by the fourth quarter of this year. In my view, investors must be diligent on this data point as I see it likely to create some tumult in risk markets.
  

The Details

The big market-moving news last week was the Biden administration’s proposal to increase capital gains from 20% to just under 40% on people who earn $1 million or more in income. Risk markets sold off sharply, only to subsequently recover (probably on the realization that passage of such a proposal is unlikely).

While most investors will not be affected by this tax change directly, it does change the metrics and structure behind several types of investing. To illustrate the significance of the change, let us consider an example.

Suppose an investor subject to the higher capital gains rate is considering investing in a startup. In order to fund the project, she needs to sell some existing stock or, more likely, redirects the capital from the exit of a recent startup. If 95% of that capital is taxable as gains (not uncommon in venture capital), it would take almost five years to simply breakeven—and that assumes 15% growth per year! For comparison, under current capital gains rates, it takes about three years to recover the cash paid in taxes.

For public market growth projections (7% per year), the breakeven on switching investments goes to almost 9 years! Under the current rate it is in year four. In both venture capital and public markets, the increased capital gains rate almost doubles the breakeven rate of exiting and reinvesting those gains.

And that is before any additional taxes a state may levy.

In California, for example, the combined capital gains rate would be as high as 57%. Our breakeven for venture capital grows to an excess of 10 years (with a 15% growth rate), which is longer than the typical 7-10 year life of a fund!

Under these proposed capital gains, the incentive to our investor is to not exit their current venture. The incentive shifts to simply hold current investments longer. While on the face of it this seems like a good incentive, it has the effect of reducing capital available, specifically for startup companies.

As I’ve said before, our role as investors is not to opine about the merits or demerits of a policy proposal. Rather, we must adapt to new rules quickly and attempt to understand the effect new rules may have on both our existing and potential investments. Here are the knock-on effects I would expect should this tax increase come to pass.

First, we would likely see a change in the way venture capital funds are organized. Rather than a 7-10 year life cycle, we could see a shift toward 15-20 year funds. This has a secondary effect of slowing startup growth more broadly—a startup company that might take 10 years to compete its life cycle would take closer to 15 or 20. Recall, the most successful and prolific VC/PE funds are in California and New York, both high tax states. Their adaptation to new rules affects those of us in lower-tax states like Texas.

Second, this would likely create an incentive to hold real estate as it enjoys the advantage of the 1031 exchange and current income. A 1031 exchange allows an investor to roll a cost basis from one property to another—effectively deferring capital gains taxes. I would also expect an increase in the use of tax-deferred wrappers for risk capital, like custom annuity contracts or life insurance policies, a boon to insurance companies.

Third, capital flight from coastal states to central and southern is likely to increase as investors seek to lower their tax burden through geographical arbitrage. A well-heeled investor living in California who exits $10 million worth of startup companies per year would save around $1.2 million per year by moving to a no-income-tax state. Investors living in existing states could possibly get ahead of that flight by purchasing real estate of all kinds in the highly-trafficked areas.

Fourth, economic theory would suggest (and my own research backs this up) that lessened returns on investments that carry the same risk increases an individual’s propensity to spend today. Rather than merely accept lower returns, there will be increased incentive for wealthy people to spend their cash. Luxury goods providers could see a boost to their top line revenues.

Fifth, I would expect this policy proposal to create a headwind for market prices in the short term. Likely, investors would sell off assets to pay the current (lower) gains rate. While short-lived, it does provide an opportunity for patient investors to deploy cash (assuming the new cash isn’t an exchange from another investment in a taxable account).

All of that said, and though I am no political analyst, this proposal appears very unlikely to pass. With the Senate split 50-50, the Democrats cannot afford to lose a single vote from the moderates of their own party, and even representatives from California and New York are likely to mobilize in opposition. My estimation is that Biden is taking a page from Trump’s book: go big out of the gate, give away a lot in negotiation, and you end up where you wanted to be in the first place—a tax rate that is slightly higher, but not as dramatic as it first sounded.

I suggest investors sit tight for now and let the politicians do what they do.

Chart of the Week

Earnings season is in full swing. Apple and Caterpillar, both economic bellwethers, report on Wednesday. So far, earnings season has been quite strong. If tech and industrials can continue posting strong results, and we get a glimpse of the service economy staging a strong comeback, we may well grow in to the high valuations in stocks.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• Earnings! The major banks reported stellar earnings last week, though much of that came from trading in capital markets (IPO/bond issuance, market-making, etc). With interest rate spreads still narrow, banks have struggled to earn profits from traditional banking (taking deposits and lending money). At any rate, earnings season will be important as investors gauge the earnestness and momentum of the recovery in the real economy. Many big companies and consumer brands report this week, such as Coca-Cola, Proctor & Gamble, IBM, Netflix, and Chipotle.
  
  
• Fundamental economic data last week was quite strong. Retail sales figures grew by 9.8% month-over-month, which far exceeded the 6% expected, and inflation posted almost exactly as expected at 2.6%. Weekly initial jobless claims fell by the most since the pandemic started, an encouraging sign for the labor market recovery.
  
  
• This week is light on fundamental economic data (though earnings are important). The recovery in the real economy is going to test the market’s belief in the Federal Reserve’s patience—especially as asset prices continue to stretch already-lofty valuations. While the recovery is encouraging, the primary driver of this market is the Federal Reserve. News of “normalization”—while probably good long term—would be a short term headwind for market prices.

The Details

Let’s talk about cryptocurrencies.

I remember listening to a Planet Money podcast on how crazy the Bitcoin market was going. The price had doubled, then tripled. People were making a fortune, only to lose it all shortly thereafter. There was talk of regulation, of banning Bitcoin outright, and how people had their coins stolen from their digital wallets.

That was in 2011.

Since I started following cryptocurrencies in 2011, not much has changed in the chatter surrounding them. Prices have changed, of course, and Bitcoin has a few competitors now (Dogecoin, Ethereum, etc), but the general sentiment remains the same: cryptocurrency is considered a real part of the digitized future, fortunes have been won and lost, and security remains a top concern for owners of these digital assets.

Before we talk about my take on them, let’s first talk about what they are.

Let’s say I want you to hear a song I like. In the olden days, for you to hear the song, I would have to bring you some form of physical media: a CD or a cassette tape, for example. If I wanted to hear that song again, I would need to get it back from you before I could again hear that song I like.

The point is, in the olden days, either you or I had the song at a given time, but we couldn’t both have it at the same time (unless we were together in the same place). Now, however, I can simply send you the song file: you would have the song and I would have the song at the same time. It isn’t magic, of course, we’ve simply made a digital copy of the file—I own a copy and you own a copy.

The technology that drives cryptocurrencies solves this problem of “uniqueness.” Using this underlying technology, I could actually send you a unique copy of the song I like. It is like an old school CD or cassette tape: if you have it, I can’t have it at the same time. Unlike a CD or cassette tape I don’t give you anything physical, the transaction is entirely digital.

An obvious application of this ability to create unique digital files is currency. By creating a limited number of unique digital “coins,” they can be exchanged just like a currency. They don’t exist outside of the digital world, of course, but because they are unique, they function the same! And because they are not tied to any monetary authority, there is no real friction to cross-border transactions, or the regulations that govern traditional dollar-based banking. It is, in that respect, similar to digital gold or silver.

I do believe that the technology driving cryptocurrencies is going to be an important piece of our future (it has lots of applications beyond cryptocurrencies). But—and this is a big ol’ “but”—that does not mean serious, long-term investors should load up on cryptocurrency.

First, the very thing that makes cryptocurrencies an exciting headline and an exciting investment is what makes them terrible currencies. Bitcoin, for example, lost 8.7% yesterday. That isn’t particularly newsworthy, though, because Bitcoin moves around quite a lot (it was up 8% on March 13th, for example). But, if you are running a sandwich shop and you want to accept Bitcoin as payment for your sandwiches, it is very difficult to accept the risk that the market price of Bitcoin wipes out all of your heard-earned profits in a day. The volatility of cryptocurrencies makes them awful currencies!

My second point is best expressed through an example. Let’s say that in the mid-1980s you knew cell phones would be a big thing in the future. There was only one company you could invest in: Motorola. Motorola, however, underperformed the broader market in the coming decade, and eventually went out of business altogether! You could never have guessed that the biggest winner in the cell phone revolution was a tiny computer company called Apple. Motorola in the 1980s teaches us an important lesson: just because we get the trend and technology right, doesn’t mean we know who will win or lose in the coming decades.

Finally, and most importantly: I have no clue how to value a cryptocurrency. Unlike other commodities, they have no intrinsic value. Unlike a traditional currency, they have no significant demand from industry or commerce. Unlike stock in a company, they produce no cashflows (in fact, you typically have to pay to store them). In the end, there are no real tools to analyze whether a cryptocurrency is overvalued or undervalued. It is this problem that has kept me on the sidelines.

It is at this point I can hear you thinking: “but Bitcoin has gone from $0 to $65,000 over the past decade.” And you are right. My assessment has been flat wrong for a decade.

Even so, my general advice for investing in cryptocurrencies is the same as it has always been: only invest money you can afford to lose. I see them as I always have, as a gamble.

Chart of the Week

I have, up to now, avoided talk of Covid on this blog. However, as the economic recovery gains steam, it is worth noting the trends in the pandemic. Though Asia and Australia have generally contained the virus, and North America has begun to stabilize our caseload, Europe and South America continue to struggle. New variants are a risk, of course, but with the large economies Europe resurging in recent weeks, the economic toll is again in focus.

In short, the economic recovery depends on the continued improvement in Covid cases, both in the US and around the world. Though I haven’t talked much about it, this is an important data point!

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• On Tuesday, we get the latest read on inflation. Producer prices posted much higher than expected last week, though higher input costs have yet to be passed on to consumers. Food and energy have begun to run pretty hot, but the Fed likes to factor those out and look more closely at consumer goods. Even so, a headline inflation rate much higher than the expected 2.5% year-over-year would almost certainly push stock and bond prices down.
  
  
• Retail sales also post this week (Thursday), with the consensus hovering around a 5.9% expansion (though some estimates are as high as 7%!). Consumer spending is a key variable to the ongoing economic recovery—fully 2/3rds of the US economy is just people buying stuff. The stimulus program in March and the effects of the extreme weather in February are expected to combine to produce solid growth figures in retail sales!
  
  
• Biden has proposed a $2.3 trillion infrastructure package. Republicans have balked at the size of the deal, and even some moderate Democrats are expressing concern, both appear willing to consider a more targeted approach. That said, top Democrats seem more willing to move forward without bipartisan support. In either case, it is expected that a spending bill of this size would be mostly funded by newly-created money from the Federal Reserve. As with all monetary supply expansions, this has the side effect of driving up asset prices, and I expect this to be little different. Again, it is my view that so long as monetary policy is easy and the money supply is expanded, the bias in prices is up.
  

The Details & Chart of the Week

The ascension of China as the world’s economic superpower is so often talked about that the standard assumption is not if but when. It is easy to see why this is the standard assumption. Most economic growth models carry population and productivity as inputs, and with a population of 1.4 billion people, China need only slightly increase productivity to massively increase economic output.

Yet the not-so-often-talked-about addendum to this discussion is that, in the modern economy, not all economic output is created equal. The leaders of today’s economy do not compete just in manufacturing, but rather in information and technology. Today’s economic leadership is not defined by productivity on a factory floor.

In this week’s chart, Fathom Consulting illustrates the economic areas that China has both gained and lost ground over the past 15 years. These are not necessarily drawn from official figures, so they have sorted out some of the politically-biased reporting that we’ve come to expect from China’s official figures. What I find interesting is how China has held her own in several important fields—IT, New Energy, New Materials, and Medicine. She has lost substantial ground, however, in other key industries like Robotics, Aerospace, and Agriculture. Advanced Railway and Maritime Engineering are the only two places China has significantly increased her competitive advantage.

Said differently: it may well be that, through sheer numbers and ongoing productivity gains, China overtakes the US in economic output, but it is not raw output that matters. The type of output matters more than the absolute value of that output. South Korea is a perfect illustration of this fact. Though they are the 10th largest economy by output, they remain among the most important technological economies, ranking 1st on the International Innovation Index (China ranks 15th, and the US ranks 2nd). And remember, innovation is just a fancy word for an improving quality of life.

In the end, China has substantial ground to cover to gain a competitive advantage in the advanced modern economy. It isn’t enough to simply modernize or hold pace, since other countries continue to advance—she must advance more rapidly than other countries to gain true leadership of the global technological economy.

And even when China is the largest economy in the world, I find myself skeptical that this somehow dooms other countries to serfdom. Quality of life will continue to improve so long as innovation is central to our economic thinking.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• Investors appear to have renewed confidence in the economic recovery. Vaccination figures continue to rise, and Friday’s jobs report showing 911,000 jobs created in March blew past the expected 647,000. In total, the US economy has added 1.6 million jobs in the first quarter of 2021. At the current pace, all jobs lost through 2020 could be recouped by the end of the year.
  
  
• Today, the Institute for Supply Management released their non-manufacturing activity index and it came in at a whopping 63.7, which is the highest reading in the history of the index. Given that the service sector is two-thirds of the US economy, this bodes well for the continued recovery. On Friday, we get data on producer prices. This is considered an important data point as it is typically the first read on inflation. Reuters polls suggest a 3.8% increase in producer prices over last year. A figure significantly higher than this could give markets pause.
  
  
• Though I say it every week, it is worth repeating: the key variable in this market run is monetary and fiscal policy. The Fed’s current low interest rate and quantitative easing policy creates an upward bias in asset prices. Asset prices get a further boost from the deficit spending of the federal government which is financed by the Federal Reserve, of which Biden’s current ~$3 trillion infrastructure spending proposal is a good example. All of this cash finds its way into financial markets eventually, and it is currently fueling this bull run. The key variable to watch, then, is a shift in this policy.

The Details

Goals-based investing (GBI) has become a bit of a buzzword in finance. Unfortunately, like most buzzwords, most of the conversation around the topic is merely marketing.

But GBI is legitimately different from more traditional financial theory. Where traditional theory idealizes markets and investors, goals-based investing is concerned with how we can use financial markets to accomplish financial goals given real-world constraints.

Probably the most important difference between goals-based investing and traditional financial theory turns on the definition of “risk.” Traditionally, risk is defined as the amount of volatility (the up-and-downs) your portfolio is expected to suffer. Less portfolio risk, then, is less volatility. However, as you become less willing to accept volatility you also receive less return.

Goals-based investors, however, define risk as the probability of failing to achieve their goals. Portfolio volatility plays a role in that definition, of course, but so does return. The key, then, is to find the optimal balance between return and volatility that yields the highest probability of achieving your goals.

This redefinition of risk changes the conversation quite a bit. Cash, for example, has traditionally been considered the safest investment because it doesn’t change in value—it has no volatility. Goals-based investors, however, may well view cash as the riskiest asset class since, at times, it virtually guarantees the investor will not achieve her goals!

Investments, then, are simply tools to get various jobs done. To understand how to manage your investment portfolio, and to understand what risks you can afford to take, you must first understand the job you need doing. We cannot manage money in the abstract, as traditional theory may suggest.

Your investment portfolio must be fully defined by your objectives. If that is not the case, it wouldn’t hurt to open a conversation!

Chart of the Week

The prices producers pay (purple line in the chart below) usually moves with consumer prices (blue line in the chart below). This makes sense, of course, since manufacturers will tend to pass along their price increases to consumers. Consumer prices are the most widely followed measure of inflation, but the Fed generally prefers to look at “core” CPI, which factors out food and energy costs (black line).

For most people, however, food and energy costs are a substantial budget item. This is especially true for the poor who tend to spend a higher percentage of their incomes on food and a lower percentage on consumer goods. Recent food price inflation, then, should be a growing concern for policymakers as it is a cost borne disproportionately by the poor. Whereas consumer goods have benefited from disinflationary trends (like automation and off-shoring labor), commodities for which production cannot be so easily shifted (like food) have begun to see concerning levels of price increases—even after the Covid-induced supply constraints are factored out.

The recent surge in producer prices is also a concern, though the Fed has suggested that they expect it to be a transient effect. Polls of economists do seem to indicate a leveling off of producer price increases, but Friday’s figures will be very telling! Since inflation is the real constraint on current easy-money policy and ongoing deficit spending from Washington, these figures are getting considerably more attention than they used to.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• Markets were rattled on Friday (and Monday) by what appears to be the largest margin call ever. Bloomberg reports that the family office of Bill Hwang—a controversial Wall Street figure who previously pled guilty to insider trading—was behind the selling. Many stocks were effected, including the banks who lent Hwang the money, and traders are not sure if the sudden selling is over or if this could create systemic issues, yielding some nervousness in prices this morning.
  
  
• The Fed again reiterated its commitment to current policy. In a flurry of speeches last week, Fed officials basically said the same things they have been saying—they are going to wait until the actual economic data improves before normalizing policy. In a similar vein, the Biden administration is expected to reveal a $3 trillion infrastructure spending package, though quick passage seems unlikely.
  
  
• We get March jobs data on Friday, and consumer confidence tomorrow. The jobs data will be important because it is an indicator for Fed policy, and since consumer spending has waned recently a boost in consumer confidence could help bolster prices. Again: so long long as the Fed continues their current policy, our view is that the bias in prices is up.

The Details

Almost every economic growth model carries population growth as an input. All else equal, growth in population tends to fuel growth in the economy. Economists, then, spend quite a bit of time attempting to forecast how much the population will grow in the coming years.

As The Economist recently reported, Covid appears to have slowed the birth rates in developed countries, contrary to some predictions. The US and China, for example, saw a 15% decline in births in 2020. Of course, most developed countries have long had native birth rates well below the 2.1 children per woman required to maintain their population, so Covid has simply compounded a problem that has been in the works for some time: peak population. With the recent global deaths from Covid and the reduced birth rate, it appears the human population is now likely to peak and then begin declining sometime around 2050—about a decade sooner than previously expected.

And it isn’t the absence of labor force growth that is of most concern, that effect is likely to be offset by automation. It is the decline of innovation that carries the largest economic consequence. With fewer minds to solve problems, fewer problems will be solved. Standards of living could then begin to slow and reverse. If global fertility rates stabilize below the required 2.1 children per woman, mankind will have to learn to deal with a new problem: getting economic growth from an ever-smaller population.

There have been, of course, no shortage of doomsayers through the years proclaiming the coming decline of humanity. What those doomsayers repeatedly fail to remember is the power of unbridled innovation. Just when economists were predicting great famines across Europe due to lack of food, Fritz Haber invented a way to capture nitrogen from the air and make fertilizer. Crop yields massively increased and the famines were averted. Just when England had felled all her forests in support of the “great wooden wall” that was her navy, shipbuilders turned to steel and built inconceivably powerful ships.

In the end, I tend to believe in the plucky and inventive nature of mankind. We tend to solve problems, and I think this will be no different. Even so, population growth has slowed in recent years. One lesson that Japan has given us in recent decades is the drag on economic growth that ageing and shrinking populations can create in modern economies. While this is, in many ways, “tomorrow’s problem,” it is a large-scale force that we must consider as investors.

Chart of the Week

Despite all the market drama of the past month or so, the main stock market index, the S&P 500, was only down 5.8% peak-to-trough. After rallying back off of its low, it pulled back a mere 3.4% in the most recent two weeks. It is important to put these recent market moves in perspective, because once we do, it becomes clear that this is all pretty normal and shouldn’t be concerning to long-term investors.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• The FOMC meeting last week reaffirmed the commitment of the Federal Reserve to keep short-term interest rates low and asset purchases going, which is exactly what was expected. In addition, Powell advised markets that any inflation spikes are expected to be short-lived (largely due to the “bullwhip effect“).
  
  
• Yields continue their march higher, and investors betting on the Fed to intervene and curtail the increase in 10-year US Treasury yields were sorely disappointed last week. Higher borrowing costs are generally seen to hurt businesses reliant on cheap capital (like tech), and the rotation out of growth toward value is in full swing.
  
  
• Powell testifies before congress on Tuesday and Wednesday of this week, and critics of current Fed policy on both sides of the aisle are becoming more vocal. He is likely to face tough questions about inflation, asset bubbles, and prudence. On Friday we get a read on the health of US consumers with personal spending, income, and consumer sentiment posting.

The Details

A new consensus is emerging in economics.

In short, the consensus centers around the real constraints facing government borrowing. Traditionally it was inferred that governments must be responsible with their borrowing lest they go bankrupt. Under this new paradigm, however, bankruptcy is not considered a danger because governments can simply print more of their own currency to repay debts. In contrast to the traditional view, spending constraints come from economic dislocations like excessive inflation, asset bubbles, unemployment, and productive capacity, rather than from the difference between tax revenue and spending.

This shift in paradigm can be fairly readily seen in a breakdown of US debt ownership. As of July 2020, the largest holder of US Treasury bonds were US government related entities. The Federal Reserve owned about 36% of US debt, whereas social security, Medicare, and various government-related pensions owned around 28%. That puts the US government as the largest single holder of US government debt: 64% of debt outstanding is owed to entities tied to the US government. To place this in perspective, China—the largest foreign holder of US Treasuries—owns only about 4% of US debt.

This new economic consensus tends to give governments a much longer spending leash. Deficits are not viewed as a net negative always; rather, deficit spending is context-dependent. That is to say there are times when deficit spending is bad and times when it is good. More traditional guidelines are also abandoned: the Phillips curve (the link between inflation and unemployment) has been largely discarded, and the Taylor Rule (which has traditionally guided interest rate policy) have both left the policy conversation, to name just two.

Without the more traditional hard-and-fast rules, we must rely on the insight and wisdom of policymakers to manage the various economic variables properly. This creates risk, of course. An economy that is heavily reliant on policymakers is fragile with respect to bad policy. There is a legitimate risk that policymakers get it wrong eventually, and the subsequent economic dislocations do real harm to people.

As citizens, we all have opinions on whether such a shift in the economic paradigm is, long-term, good or bad. However, as investors, we cannot play the game we want, we must play the game that is actually on the field. Whether good or bad, this is the current economic consensus, and it has several outcomes, such as:

• central banks are a key variable in market returns;
• plentiful liquidity can override economic fundamentals (i.e. poorly-run companies can continue to succeed for quite some time);
• inflation is likely divergent—consumer goods (where automation can lower prices) tend toward deflation while commodities (where production is constrained by location) tend toward inflation;
• asset prices will tend to increase while wages will tend to stagnate.

To be fair, our current economic regime has no precedent, so it can be difficult to make confident predictions. In this environment, mental flexibility is likely to be an investor’s most valuable trait. As is usually the case, wisdom, prudence, and tradecraft stand to add considerable value to investors with goals to achieve.

Chart of the Week

Markets get a read on the most important component of US economic growth: consumer spending. The past year has seen a considerable contraction in spending from individuals. However, with the recent round of stimulus, a high savings rate, and the ongoing economic recovery, the US consumer is expected to come roaring back in the first half of 2021. This Friday, we get a sense of how much traction consumers really have.

Reuters polls expect consumer confidence to increase slightly to 96 (it was around 130 in February 2020), and personal consumption to have increased by 0.1% month-over-month.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• It is Fed week! The Federal Open Market Committee (FOMC) meets to debate ongoing policy as well as set the target Fed Funds rate. We expect no change in policy at this month’s meeting. However, investors will parse the Fed’s language to gauge when the they might begin to slow their current pace of asset purchases (known as tapering).
  
  
• Stimulus checks are expected to post to accounts this week. A survey by Deutsche Bank indicated that about a third of these checks would flow into stocks (an inflow of about $170 billion). Those inflows will probably be concentrated in “meme stocks” (like AMC and GME). MSFT is another benefactor of the stimulus package: nearly 1/3 of the funds directed toward cyber security are expected to flow to the software giant (some $150 million).
  
  
• Biden is expected to unveil a tax bill in the coming week or two. Among others, we expect to see an increase in corporate tax rates from 21% to 28%, increasing income taxes for people earning more than $400,000/year, and treating capital gains as income for people who earn more than $1,000,000/year. Once the bill is presented, I would expect investors to re-price shares in direct proportion to the new taxes. This would be a short-term repricing, though a protracted political battle would add to market volatility.
  

The Details

Tax policy is obviously a highly political issue. Because of its politically-charged nature, it can be difficult to garner clear analysis of its effects on markets. As investors, our first job must be to develop expectations which are as dispassionate and as accurate as possible, and since such analysis is difficult to find, I spent some time looking at markets in 1992—the last time tax rates were meaningfully increased. Some disclaimer here is warranted: there are always many factors influencing market prices. It is, therefore, very difficult to tease apart the effects of tax proposals from other macroeconomic factors that were in play at the time.

The story in 1992 is pretty simple, and coincides with our expectations. In February of 1993, Bill Clinton proposed increasing the top income tax bracket from 31% to 39.6% and higher brackets for corporate taxes (from 34% to 38%). Markets trended down about 6% over the following months, then traded sideways as the bill was debated in congress. It was a contentious proposal, and there were shifts in sentiment as the debate progressed. It seems reasonable to attribute some of the market selloff to investors adjusting their portfolios in anticipation of the coming tax changes.

When the bill became law in August of 1993, markets again adjusted. However, these adjustments were relatively short-lived, and markets found their footing in October of 1992, rallying to end the year 6% higher. And, of course, the 1990s would go on to be one of the best decades in stock market history.

In the end, tax policy does matter. Like any other factor, investors will adapt and adjust to accommodate it. However, it is not the only factor that matters to markets. Indeed, there are more powerful effects which can overshadow any tax policy effects (like economic growth and monetary policy). While investors should be cognizant of tax policy, it should not loom too large in portfolio decisions. As with anything, we must keep it in perspective.

The lessons of 1992 seem to indicate that policy debates can add to market volatility as investors jostle portfolios in anticipation of tax adjustments. However, that volatility tends to be short lived as tax policy fades into the background and other macroeconomic factors become top-of-mind.

Chart of the Week

We get data on industrial production this week. A look at the quarterly change in total productivity tells the story of who is working where. Much of the recent recovery in jobs has been in the services sector, which tends to be more labor-intensive than manufacturing—that is, the leverage of technology is more pronounced in manufacturing than in services, so a manufacturing worker is considerably more productive per hour of work than a services worker. From a metrics perspective, then, as services become a greater component of an economy, the economy appears to grow less productive.

In the most recent quarter, economic productivity contracted at the fastest pace since 1981, but this was after expanding at the fastest pace on record. The productivity expansion two quarters ago was driven by the re-opening of manufacturing capacity, while the recent decline is the story of re-opening the services sectors.

This is, in fact, good news, though it may appear to be bad. It is always important to dig into why a data point is what it is, rather than simply accept it at face value.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.