Summary:
2020 is in the running for one of the most bizarre years in American history. We’ve all spent most of the year just trying to decipher what’s happening. Some of us have been fortunate in the midst of it, and some of us have experienced great loss. At CoCreate Financial, we’ve been doing everything we can to support our local economy, from trying to help business owners make decisions on relief options to more than 100 contacts with legislators and officials. The way we see it, if our economy died and took our client’s livelihoods, it would be even more impactful than a market drop. There are quite a few things no one has ever seen before, including widespread economic shutdowns mandated in most states and massive stimulus packages that dwarf anything previously imagined. I’m tired of the term, but 2020 has truly been an unprecedented year—unlike any other. Our 2020 economic update is mostly an article about risks we are looking out for with hope and optimism.
We’ve also had our heads down, diving deep into a myriad of data and research trying to foresee various outcomes, both short-term and longer-term, that could affect the businesses our clients own in their portfolios. This has meant making meaningful, educated conclusions based on all of the available data in an environment when that data often means something different than it did before the shutdowns. That meant having to determine appropriate adjustments to the information, which was changing at a very rapid pace with very little consistency. This has made it difficult to put together relevant publications of any nature. By the time you finish a Google search on the topic of the day, the world has moved on to a new issue or data-point that appears to be contradictory to the first on the surface.
As we reach a point in time with a little more stability in data, we look forward to putting this year’s election season behind us. Overall, the businesses that are surviving the closures have shown their strength and have grown in their ability to adapt to new situations. There are substantial risks to mitigate in the near-term and long-term for investment portfolios, but we should see continued growth, albeit slower growth, for those who are invested selectively in high-quality businesses with a long-term perspective. We’ll address some of them below:
The Covid Closures
We’ll be brief on the topic of Covid-19 and its effects on the economy. They are extreme and very dramatic. They are also very temporary. There are three primary reasons the Virus and the gubernatorial closures will have a limited ongoing impact. The first is the amount we’ve learned about the virus and how to treat it. The initial wave of Covid in the US was dramatically different than the second, with deaths and hospitalizations decreasing by astonishing proportions after their March peak (even while cases rose to new levels. We made great strides in testing, intervention techniques, and therapeutics. Since the time we began to see such drastic improvements in our response, Covid statistics look much more like those of illnesses we’ve lived with every day and payed less attention to. Because of this, we believe the impacts of Covid-19 on the economy will not be permanent.
Secondly, most people seem to believe the Covid situation has been turned into a political issue and the election is immanent. We agree. We also think that much of the Covid propaganda (from all sides) will quiet in November and getting life back to normal will become the path to every politician’s next reelection.
Third, as we’ve watched the numbers, from unemployment to the number of people looking up directions on their phones each day, something significant began to stand out. First, people self-regulated before governors issued their various mandates and then after a period, people slowly began to reengage life. Unemployment is still high, but it is artificial because most of the businesses that have survived are already wanting to re-open and re-hire the workers they temporarily laid off. Americans have been making every sacrifice they can to keep from spreading the virus or contracting it, while continuing to live life to the best of their ability regardless of their governor’s orders. They have been putting conscience and necessity ahead of rule which will help us survive our politicians who care more about the outcome of the election than they do the people they supposedly serve.
The biggest long-term impact will be the extreme number of businesses that are not reopening their doors. In a quarterly economic report published by Yelp regarding the status of their listed businesses, some 55% of businesses that reported closing for Covid stated they would not re-open their doors. To date, there are more than 100,000 permanent closures that we know of. That number has undoubtedly grown as the year has progressed. To reach a full recovery, we will need to replace these businesses with new ones.
There is a positive side to the employment situation in that businesses have had the opportunity to creatively redesign their staffing structures and those with an entrepreneurial spirit have dreamed up new ideas. They will create exciting new businesses out of a combination of passion and necessity. While we don’t believe these silver linings make the shutdowns tolerable—especially considering their impact on things like domestic violence, child abuse, addiction, and suicide, but we do believe in our ability as Americans to make the most of it.
Stimulus???
Pumping money into the economy in a crisis makes a big difference. In the midst of state governments shutting down commerce, it was perhaps necessary for survival. When we see it play out, stimulus packages look a lot like an athlete on steroids—it enhances immediate performance, the athlete gets credited with an exceptional feat of athleticism and experiences the long-term health consequences of steroid use. In terms of Stimulus, the Cares Act stimulus was far and away the most effective stimulus package in recorded history. Not only was the amount of federal dollars handed out off the charts, but it was done in a way that actually made it into the hands of businesses and consumers. We don’t have much to compare this to and can’t even look at the “Quantitative Easing” that was intended to stimulate the economy after the 2008-09 crisis because those funds never made it into circulation. This shouldn’t cause any kind of crash. Instead, it will slow the overall growth of the economy and should cause astute investors to select individual investments rather than trying to replicate the US economy broadly.
Government Debt always Mortgages the Economy’s Future
When it comes to personal finance, we like to say “debt always mortgages the future.” This is true in Government Fiscal Policy as well. The more we borrow, the more we have to pay back at a future date. If we look at the US Economy in terms of GDP (essentially the dollar value of all of our commerce), there is a finite amount of money to go around. The government taxes individuals and businesses and also spends a piece of the pie (GDP). When they have more debt to pay, they need a bigger slice, which takes resources away from individuals and businesses who are the ones produce economic growth. Deficits don’t cause crashes, but create long-term obstacles for the growth of the economy. It is conceivable, however, that a rapid rise in US debt could result in the US government’s bond issues affecting the marketability of other fixed income securities (we’ve been avoiding these in our accounts because of their instability after Dodd Frank, QE, and potentially now this).
The recent stimulus package will cause higher inflation rates for the remainder of the 2020s and perhaps longer.
“The Fed,” meaning the Federal Reserve Bank and its board decide what rates they will pay to banks or other major financial institutions that want to borrow from them. They will lend and recall these loans to influence how much capital is floating around in the economy. This activity influences inflation, and the Federal Reserve has had a intermediate/long-term goal of 2.0% inflation. We’ve experienced inflation below 2.0% for some time, so they have recently announced they are willing to let inflation exceed 2.0% to bring balance around their target.
Inflation has to do with how many dollars are in circulation relative to the stuff being bought & sold. Simply put, if a dollar bill is hard to come by and a box of cereal is not, then you can buy a lot of cereal with your dollar. If one hundred-dollar bills rained from the sky and covered the ground, one dollar wouldn’t buy much of anything at all. We measure this in economics. “M1” is how much money exists, which is whatever the Government creates at its whimsy. The government can create tons of money that never enters into the economy (which is what happened in response to the Great Recession). It basically sits on the shelf and has no impact on the economy. When it actually goes into use, it becomes “M2.” To our knowledge, the amount of money in circulation (M2) has never “rained from the sky” like it did earlier this year. Investments and financial plans will need to accommodate for higher levels of inflation for the foreseeable future.
Tax/Economic Policy
It’s important to remember that every politician’s approach to governing involves tradeoffs based on their political priorities. Our assessment of economic and tax policy is mathematical rather than philosophical and will be critical in projecting potential outcomes over the next 6 years(ish). in our assessment of this, we’re attempting to look at the economic/fiscal policies in isolation from everything else, which is not how any of us should consider our ballots. You should vote by making educated decisions on a number of issues that reflect your personal convictions. Also, the economic/tax situation doesn’t change on election day. Frankly, the President isn’t actually as important in these policies as we tend to think. Many of these issues will be addressed in Congress. We will have time to patiently adapt after the election, though “the markets” may quickly overreact and then level out.
The Incumbent’s tax/economic policy
Fun Fact: the federal government has never balanced a budget when their spending has exceeded 19% of GDP.
We’ll spend less time addressing the philosophies of our present administration because a second term will likely bring similar results. The extreme political fighting between parties in the media and on twitter acted like a smoke-screen as the President was more active in policy making than almost any other president in history (whether you feel its for better or worse). The President loosened regulation that various industries felt was overly burdensome in favor of free-markets and consumer choice, began to overhaul the tax system and negotiated new trade deals that removed hundreds tariffs that were disadvantageous to the United States. Admittedly, we didn’t believe the latter would work out, but it’s hard to argue with the economic results. That’s not to say these things don’t come with a cost, but the economy liked the policy enough that it remained resilient in the midst of a crisis the likes of which we haven’t seen since the Civil War. We’re getting back on track.
If there is a downside to the President’s fiscal policy, it’s that he is overeager to stimulate the economy and is too willing to borrow money to fund excessive government spending (more on that later).
The Challenger’s proposed tax/economic policy
Biden, the Challenger’s, proposed policy looks like what you would expect from someone running for office—its convoluted and lacks detail. If he wins, we’ll eventually see it with more clarity. What Biden and Harris have proposed isn’t great news for the overall economy, but economics isn’t really on their list of political priorities. Again, we’re not trying to endorse a candidate, we’re just looking critically at one issue in isolation.
Impact on Businesses
If Biden’s administration is successful at implementing their proposed changes, they will add a number of different taxes to businesses, from raising tax rates on business income to adding a tax on US-based businesses assets that are not currently US-based and doubling the Global Intangible Low Tax Income. These changes will add about $2.6 billion to the government’s revenue, but will change profit margins substantially. The hit would be about 500,000 jobs and a decrease in the intrinsic market value of impacted businesses somewhere between 3%-10%. This will be a difficult challenge especially when paired with the reinstatement of regulations that were challenging to businesses. Again, this is one issue among many, and his intent would be to expand entitlements with the $2.6 billion to offset the difference. One of the biggest challenges with this policy is that it will reduce private retirement funding sources by that same 3%-10%, and the 2.6 billion likely won’t be enough to replace it.
Impact on individuals
The challenger’s proposed policies will impact individuals differently than corporations. For individuals earning over $400,000/year, the impact may be rather extreme. The marginal tax rate will increase to 39.6%, and it will limit itemized deductions to 28% of their incomes (most of which are charitable contributions). It’s important to make note that his promise not to raise the marginal tax rate for those earning less than $400,000/year does not necessarily mean the taxes they owe will not increase. The Tax Foundation reports in their extensive analysis, “The bottom 20 percent On a dynamic basis, the Tax Foundation’s General Equilibrium Model estimates that the plan would reduce after-tax incomes by about 2.5 percent across all income groups over the long run. The lower four income quintiles would see a decrease in after-tax incomes of at least 1.1 percent. Taxpayers in between the 95th and 99th percentiles would see their after-tax income drop by 2 percent, while taxpayers in the 99th percentile and up would have a more significant reduction in their after-tax income of about 7.6 percent.”[1]
Perhaps more significant to the individual at all income levels is how his policies will impact 401(k)s and retirement savings. After the impact of the corporate tax changes reduces intrinsic values of 401(k) investments, his proposed plan will make dramatic changes in the deductibility of retirement savings and the availability in employer plans.[2] The proposal intends to eliminate deductibility of 401(k) contributions (to be taxed at withdrawal), and replace them with a matching tax credit. We’re ok with this at first glance because it could mean lower taxes for savers in the immediate future, but it will actually end up causing substantial government budget issues over the long-term as it disrupts the tax deferral system on which retirement savings accounts rely. Biden’s plan will also reduce the total amount an individual can contribute each year to 20% of their income or $20,000 (from 50% & $53k) including their employer’s contribution. This will have a tremendous impact on individuals at all income levels and disincentivize employer benefit plans altogether.
Once more, this is not intended to be a pro-Trump or anti-Biden commentary. They have different priorities, and our focus is on projecting a range of potential economic outcomes and developing a corresponding playbook to help maintain our clients income and account values over the long term. We are preparing for each risk and opportunity as they seem to arise, and very unlikely that Biden’s policy will bear much resemblance to its current form after the House and Senate put it together.
The most significant thing nobody is talking about.
Over the past decade, it’s been hard to keep pace with the growth of huge Facebook, Amazon, Google (now Alphabet Inc), and Apple stocks. There is even an acronym, FANG (N for Netflix). Together, Facebook, Amazon, Alphabet and Apple make up about 17% of the S&P500 (which is why index investing has appeared to be so attractive).
We are about to see the end of an era, and it’s been on the horizon for a very long time. Yesterday, the House of Representatives Subcommittee on Antitrust issued a 449 page report detailing their investigation on the ways in which these companies have violated antitrust rules, abused customer privacy, and used their monopolies to control/eliminate their competitors and the free press. It was a fascinating read; however long. The committee stated that the house should pursue vigorous enforcement of antitrust laws against these companies. This will change the fabric of the S&P 500 and the way many people think about how to invest.
I remember two times in my career in which the average stock was down about 33% but the S&P 500 was not largely because of these companies. There were two things that thrived in these “silent bear markets,” strategically selected, dividend-yielding stocks and the “FANG” stocks (including a few similar companies). These Big Tech companies have had a huge impact in broad-based market returns. Finally, the government has recognized these as monopolies in a bipartisan investigation and will likely split them into multiple entities. We are working on another article to explain the impact of this in more detail, but in short, it will make mirroring the S&P 500 quite unattractive as an investment.
Consider this, if the average value of these 4 companies is 58 times their earnings (PE ratio) and the Government eliminates the competitive advantage attributable to their respective monopolies by dividing each company into 4 separate entities (the number 4 is arbitrary for illustration), the resulting companies may each be members of the S&P 500, but none of them will likely have significant influence on its return because of their reduced size. Furthermore, if their earnings multiples are close to a historical average for the other companies in the S&P 500 without the benefits of monopoly (about 15.8), then their cumulative values drop by 72.8% and the effect on the S&P 500 index is a 12.3% decline in value. From there, the S&P 500 will look much more like an average than an outlier. With the exception of Apple, who we expect to be just fine based on the specific findings, we had very little exposure to these companies because of the imminent and inherent risk that is just now materializing.
Strategy
Dividend-yielding equities have a distinct advantage in higher inflationary environments.
Not only are we at the beginning of a rising interest rate environment, which always causes the value of fixed income instruments to decline, but we’re approaching a season in which inflation will begin to accelerate (meaning that the fixed payment you receive today will buy less stuff tomorrow). The only way to increase your fixed income is to sell the investment at its reduced value (absorbing the loss), to buy new investments that pay more. To get the increased payments, you will likely be taking on more risk and paying a higher price for it.
Alternatively, dividend yielding stocks are an attractive alternative in this environment for producing income. When speaking of companies with good financial strength, we know that the dividend payments are extremely stable. Historically, these high-quality companies even tend to increase their dividend payments in times of extreme economic crisis. This gives you a rising income rather than a fixed income. More important to our inflation protection strategy, owning businesses (stocks), naturally adjusts to the strength of the dollar. Consider this example, as inflation occurs, the candy bar that cost 5¢ now costs 50¢. The Candy Co. has adjusted their prices to account for the strength of the dollar, their cost shifted from 3¢ to 30¢ which means their profit margin is the same. If they generally pay out 50% of their profit to the people who own the Candy Co, then the dividend has risen perfectly with inflation. In an ideal world, the Candy Co. would also find ways to increase their profit and grow their payout even more. Dividends are the ideal alternative to replace fixed income in a rising inflation environment.
Avoid broad-based investments (i.e. index fund investing) and make business-minded investment selections
We can expect the S&P 500 to lose its luster in favor of strategically identified investments. This is a highly complicated issue which we are tackling in an upcoming article, but it is significant for anyone engaged in “index investing.” Many investors have joined the fad of buying S&P 500 index funds started in the late 90s because of their low cost and competitive return. The biggest reason for the trend has been because of the obscene amount of marketing resources that were expended to promote these funds which back a now-studied and disproven theory that you can’t do better than the index.
There are a number of things that often don’t translate into the consumer’s thought process when it comes to the S&P 500. The most relevant of which is the concept of a “Cap-Weighted Index.” The S&P 500 is a cap weighted index, which means that each company participates in the overall performance of the index based on its total market value (called Market Capitalization). In today’s stock market, the top 10 or so companies account for the bulk of the index’s return. Over the past 5 years, the “FANG” stocks (Facebook, Amazon, Netflix, and Google) have been primary drivers in the S&P 500 index performing exceptionally well.
With the onset of bi-partisan work to “vigorously” pursue anti-trust enforcement against Amazon, Google, Facebook, and Apple, we’ll see a significant change to the structure and performance of the index. Investors will no longer be able to rely on the momentum of Amazon, Google and Facebook to make their index fund efficient.
Monitor cash allocations and consider hedging strategies on a security by security basis.
The markets tend to overreact to headline news… even when it is as significant as election results. The best tool in our belt to manage the risks and opportunities we will see in the coming months is our cash allocation. As broad market risks grow, we can increase cash proportionally. Increasing cash allows us to mitigate losses and then reinvest at discounted prices. If the market explodes on a given headline, we can sell investments at a higher price to reinvest when the broader markets return to their normal levels. When dealing with the longer-term impacts, we need to remember that we are investing in individual businesses rather than the broader market. Each of the businesses in which you own an equity stake, will experience the impacts of these issues differently. As potential long-term risks grow for a particular company or their business model, we have a number of different choices depending on the probability and severity of whatever is on the table. We will want to be ready to hedge against certain risks (such as limiting losses with options contracts, though this comes with its own cost), limit our exposure to the company, or transition to a competing business that has a better opportunity to thrive in the environment.
[1] https://taxfoundation.org/joe-biden-tax-plan-2020/
[2] There is a great detailed article on the topic of 401(k)s at https://www.forbes.com/sites/ebauer/2020/08/25/joe-biden-promises-to-take-away-401k-style-retirement-savings-whats-that-mean/#6c4fc7164eb0