SECOND QUARTER ECONOMIC OUTLOOK – May 5, 2021
Reopening Surge and Supply Chain Disruption Driven Inflation
The pandemic year of 2020 quickly attracted bargain hunters to Wall Street but left Main Street struggling with lockdowns, lost jobs, and the lost ability to move about freely. The Fed and their peers around the world slashed interest rates and rescue packages to businesses, tenants and taxpayers preempted more severe damage to the economy. In 2021, Main Street is starting to catch up to Wall Street after a large ramp-up in vaccine distribution and The American Recovery Act in March which sent a third massive round of stimulus out to many US citizens. The rapid rise in the stock market since the March 2020 lows and the rock-bottom interest rate-driven real estate price rally have increased household wealth to all-time highs. Most economists now forecast US annual GDP growth to reach levels not seen since the mid-1960s.
Presently the reopening of the US economy is creating high levels of job openings particularly for “low preparation” jobs (the majority of what was lost through the pandemic). We are in the midst of a short time when many of the low prep workers are still disincentivized to return to work because they have received and set aside much of the large government stipends in relation to their normal wages. This is ultimately and finally driving wage inflation which did not come about following the GFC of 08-09. It is likely that soon, workers besides those closest to retirement will begin seeking employment again as they reach the end of unemployment benefits, depleting savings accounts, and the lifting of eviction moratoriums.
The global pandemic brought about global supply chain disruptions that have yet to normalize from what started as workplace shutdowns and rippled all the way through to supply depletion and distribution logistics interruptions. There is a definite push to solve reliance on other countries for supply chain continuity but this takes time and investment.
While we see inflationary pressures of pent up demand, supply chain constraints, and the massive amounts of stimulus money increasing the money supply, in the US we simultaneously have many disinflationary pressures:
- A global economy where producing some goods abroad keeps prices lower
- An aging society that spends less until healthcare costs pick up late in life
- Population growth stalling and actually dropping with lower immigration
- Technological advances that save company money making their goods less expensive
Coming out of a recession, it’s normal to see mild inflation as it is indicative that the economy is healthy. A balancing of inflationary and disinflationary pressures will eventually temper spike inflation in the near term.
The UK is ahead of the vaccine distribution schedule but Europe has struggled with botched vaccine distribution and only between 10% – 20% of the population has received their dose. The IMF has instituted the European Recovery Fund. This is fiscal federalization that is essentially wealth redistribution and lowers the chance of large defaults by the fiscally weaker countries and those still suffering rolling lockdowns. Eventually, Europe will gain speed and its economy will reopen. This stronger growth will continue to make the US Dollar weaker which is in itself inflationary but it simultaneously good for those companies that derive a good chunk of their earnings overseas. A weaker Dollar will provide a tailwind to profits while pushing up the price of imported consumer goods.
China seems to have moved past the pandemic and is focusing on rapid GDP expansion and building its threat to trade partners and neighbors. Emerging markets have been most reluctant to increase sovereign debt through stimulus issuance making their balance sheets most attractive while they remain priced at value levels. All combined, non-US equities trade at a 26% discount to US equities and will rally when we finally get to a worldwide synchronized recovery.
Tight supplies worldwide for goods and services support price increases. This broad inflation is likely to be short-lived and longer-term, inflation will normalize. We believe the best remedy to stave off the damage rising inflation has to retirement portfolios is to invest for cash flow that can be adjusted upward as inflation increases. We believe one of the best ways to invest in this is in cash-flowing real estate that can adjust its rent collections over very short time frames like hotels which change their rates daily as well self-storage and multi-family housing which adjust either month-to-month or on a year or shorter leases. In general inflationary environments are good entry points for investing in industrial commodities but we believe this is even more true as the efforts to relieve supply chain constraints reinvigorate manufacturing to an even larger degree than is usual. We continue to hold the stock of companies that have healthy balance sheets with the ability to maintain competitive advantages over their competitors to protect long-term profits and market share.
The Optivest Advantage – Prepared for any Tax Changes
In the coming months, we will continue to see more headlines regarding tax proposals on both an individual and corporate level. It can be difficult to sift through the details and more importantly predict the likelihood of what may transpire. Instead of focusing on things we can’t change, let’s dial into what Optivest does every day to help ensure your hard-earned wealth will provide income and opportunity for generations of your family.
We at Optivest are constantly striving to minimize any income tax effects from your investments when possible. As we are active managers, we work to anticipate any investment changes to your portfolio with a sensitivity to what that net tax effects will be. Our management approach utilizes tax-loss harvesting, tax-free investments, and most importantly tax-sheltered investments when appropriate. We also integrate Financial Planning to ensure we have a solid understanding of your assets, cash flow, and tax situation to ensure we are deploying the most tax-efficient strategies for you now and in the future.
Throughout the year, we look for opportunities to utilize tax-loss harvesting to minimize any capital gain taxation. For example, in 2020 our tech-focused positions overall had significant growth and became oversized based on our model weightings. As a result, we decided at the beginning of this year to take some of those gains and rebalance the models back to the appropriate weighting. When doing so, we looked at each account and household for any losses that would allow us to offset the gains we realized when rebalancing. By utilizing this approach we prevented you from realizing significant taxable gains and at the same time, we are able to minimize the risk of a concentrated and outsized position.
In terms of tax-free investments, when appropriate we might deploy a municipal bond strategy. The interest income earned from most municipal bonds is exempt from all federal income taxes regardless of your tax bracket. Additionally, municipal bonds can be free of state income taxes as well. In most states, the interest income from municipal bonds issued by an issuer in the state is free from state income taxes in that state. As a result, the higher the investor’s tax bracket, the benefit of the tax-free income becomes greater. A person in the 35% tax bracket receives more benefit from the tax savings than does a person in the 25% tax bracket. For investors in high-tax states such as California and New York, the benefits of tax-free bonds are even greater than for residents of states without any state income tax such as Texas or Florida. As an example of a municipal bond’s tax-equivalent yield, please see below.
At Optivest our niche has always been direct real estate. The value of holding direct real estate is not just an investment that can appreciate and produce income, it is also because of the tax-advantaged nature associated with these types of investments that can produce “tax-sheltered” income. As most private placements are structured as partnerships, each partner’s share of income, deductions, and credits are “passed-through” to the individual partner via Schedule K-1. Rental income is usually taxed at the individual’s ordinary tax rate, however, for the most part, rental income may be sheltered by the combination of depreciation and other operating expenses, and often a loss is “passed-through” to the partner. These losses not only help the investor to avoid paying tax on the rental income, but they can shelter other passive income (e.g. from other rental property investments), or are suspended and carried forward until (a) the investor has passive income in future years that can be offset by these suspended losses, or (b) the investment is sold. However, depreciation is recaptured upon sale of the asset at a tax rate of up to 25%. This can be reduced or eliminated by current and suspended passive losses, or by using strategies like reinvesting the gains into a 1031 exchange.
When considering the added value of the income being tax-sheltered, this, in turn, increases the tax-equivalent yield compared to another stream of income which would be taxed entirely. A tax-equivalent yield is how you compare the after-tax yield of a fully taxable income stream to the after-tax yield of a tax-free or tax-sheltered income stream. It’s a formula that takes your tax brackets into account to help you determine which type of investment is your best option for generating the most tax-efficient income. The less tax you pay increases your actual income yield and total rate of return. With investments like our real estate holdings, we are able to help insulate our clients against some of the existing and proposed tax legislation. The example below demonstrates these factors.
As it stands today we have seen the trend of the tax proposals in both the American Jobs Plan and the proposed increase in capital gains tax for those earning $1 million or more. The current suggested plan is that investment income like capital gains would see an increase in the tax rate to 39.6% up from a current rate of 20%. In addition, a 3.8% tax on investment income used to fund the Affordable Health Care Act would also be kept in place, meaning the new Federal marginal top rate would be as high as 43.4%. If you include the top tax rate in California, this means the total marginal tax rate for realized long-term capital gains could be 56.7%. With potential tax exposure so magnified, tax-efficient investing is more important than ever.
Regardless of the outcome of proposed tax legislation, we at Optivest strive to preserve your hard-earned wealth. The potential for an increase in capital gains tax rates is not a good reason for goals-based investors with long-term financial targets to abandon the potential wealth compounding feature of equity markets. This is not to say that because of tax consequences alone we would pass up on a great opportunity, but with our strategies, you can get the best of both worlds. Appreciating, income-producing, and tax-efficient growth to benefit you and future generations to come.
Gold has been a long-standing investment at Optivest. There are many benefits to having gold in your portfolio: it has a historically low correlation to other assets; it can be used as a hedge against inflation; and it is often sought after in times of economic instability, geopolitical tensions, and political crises. After thorough due diligence, the investment committee decided to expand our metal allocation across various precious metals that not only share similar characteristics of gold but also have industrial applications that are forecasted to see higher demand. These included silver, palladium, and lithium.
Silver is similar to gold in that its price fluctuates based on its perceived role as a store of value. However, an additional driver of returns for silver is its industrial applications. Silver has long been used in electronics and medical products but is seeing renewed interest from innovative new technologies in solar and 5G technology. According to Goldman Sachs, solar investments account for 18% of silver industrial demand. President Biden has an aggressive goal of installing 500 million solar panels over the next five years. Silver also plays a prominent role in 5G network equipment. With the expected rollout of 5G networks across America, silver is sure to be in high demand in yet another industry.
Palladium has numerous uses in medical, electronic, and industrial applications. The rare metal is most notably used in catalytic converters, which is a device that is used to control emissions in automobiles. Palladium is currently in short supply. Coupled with a bullish global economic outlook and higher expected automobile purchases, we expect palladium to outperform many of its peers in the commodity space.
Lastly, we included a lithium mining company called Albemarle (ALB). Lithium is an essential material used in lithium-ion batteries, which is used primarily in electrical vehicles and renewable energy storage. The growth of these industries and their dependence on batteries is driving unprecedented demand for lithium, which has caused many lithium mining and battery production companies to rapidly scale and expand operations. Albemarle is one of the world’s largest lithium producers and has no plans on slowing down. Albemarle plans to expand its lithium production capacity from roughly 85,000 metric tons (2019) to 155,000 metric tons by the end of 2022. We expect the company to continue investing in increasing its lithium capacity beyond 2022 by either acquiring new mining assets or entering joint partnerships with existing operators. Lastly, Albemarle continues to produce strong margins due to its Chilean operations as it is the world’s lowest-cost source of lithium.
We believe these assets will provide strong risk-adjusted returns to our strategies. Each investment has a low correlation with existing securities, performs well during uncertain economic conditions, and acts as a hedge in the event we encounter inflationary pressures. Lastly, an allocation to precious metals will strongly complement the existing themes that we have implemented throughout our strategies.
Single Women Investors and Their Unique Challenges
This quarter, in place of an update from the Optivest Foundation, we wanted to introduce a new initiative that Optivest Wealth Management is starting.
We recognize that women are at greater risk than men to reach retirement security given that they are at the wrong end of the gender pay gap, they take more time off from careers to raise families and they have longer life spans. We want to be a resource to divorcing couples to help these couples understand that all assets are not necessarily equal because of the difference in growth potential, tax consequences, and liquidity.
A recent survey shows that 40% of married women handle the day-to-day household finances and married men tend to concentrate on investing for the long term. This creates great insecurity for women coming out of divorce or entering widowhood and creates fear that we believe we can help resolve or at least reduce. We see many single women fear the unfamiliar territory of investing and often hold too much cash and bonds and not enough stocks resulting in too much low return and not enough high return potential.
Our interest in being charitable is driving our latest initiative to offer financial planning to couples and/or the newly single and widowed to empower them and help alleviate stress where we know we can help. Please feel free to introduce us if you think you know someone who could use our thoughtful care and financial savvy. In most cases, this is offered pro-bono as we believe there are many women out there who likely just need conflict-free advice. We still focus our wealth management practice on high-net-worth families and estates.
Reopening of the economy will release a surge of demand and then eventual normalization. It is important to remember that this recent recession was caused by an exogenous event, it was not caused by excess or a broken cog in our global economies. This recovery is proving to be the fastest recovery from recession on record as we manage the spread of Covid-19. However, the pandemic will leave many scars which we can all only imagine. The worst residual economic effect will be the sickness of increased debt levels across much of the world’s developed countries’ balance sheets which will drag growth and likely spurn higher taxes. This is the year we should sit with your tax and estate advisors to ensure we have an agreement on what is best for you and your family.
Leslie, Matt, Ryan & Ashlee