FIRST QUARTER ECONOMIC OUTLOOK – February 10, 2021

2021. Navigating from Pandemic Headwinds to Vaccine Tailwinds

by LESLIE CALHOUN President and CEO

In normal times, the dawn of a new year often brings an optimistic feeling because we naturally want to delineate the eras and make resolutions to learn from the past and look forward to a better year ahead. The start of 2021 has not brought the usual opportunities to make drastic changes as we are still in midst of a pandemic but there is indeed much for the stock market to be optimistic about.

The fourth quarter of 2020 brought us vaccine approvals, more policy stimulus, and clarity on the U.S. election outcome – the joint impact of these bolstered market optimism and capped off a year of unprecedented volatility. And when the holidays brought a surge in the virus worldwide, the U.S. equity markets largely looked past renewed lockdowns and deceleration in the pace of recovery. The S&P 500 reached record highs and returned almost 18% in 2020. Credit spreads tightened over this last quarter, and the U.S. dollar weakened versus a broad developed market basket. At year-end, the Fed emphasized a commitment to both its low-rate policy regime through 2023 and its current pace of asset purchases. Although some elements of the market are frothy, we believe the excesses are limited to select areas. If you strip out the FAAMNG stocks from 2020 performance, the S&P only rose 6% last year. Valuations of equity indexes look more reasonable relative to the backdrop of low-interest rates. Government bonds could be considered to be in a bubble but while bubbles collapse because of shifting sentiment or change in regulation, central banks worldwide have almost unlimited capacity to maintain their policies, if they see fit (in 2020 Central Banks worldwide printed more than $8 Trillion USD). We feel there is acute inflation in some assets such as residential/industrial real estate but the pandemic relief is disinflationary and the Fed needs to keep monetary policy ultra-loose over the medium term. Remember, inflation took nearly a decade to show up after the Great Recession. Forecasts vary but GDP growth is back in the forecast and the US undershoots the EuroZone and China’s expected expansion so investment diversified into these regions protect against pockets and creeping US inflation.

There will be bumps and bruises this year as the headlines have demonstrated recently through the enormous. Retail investors now account for 20% of US equity order flow, up from just 10% in 2010, and roughly equivalent flows from banks, hedge funds, and long-only funds combined.

The “Blue Sweep” election likely means more predictable domestic policies, smoother trade relations, and additional efforts to revive our economy. There is a razor-thin margin in Congress which means policy will continue to be debated and moderated. Democrats have neither the political capital nor the votes in Congress to make a sweeping change. We anticipate first a focus on additional economic stimulus and vaccine distribution then on to green initiatives and infrastructure. In the next couple of years, unwinding some of Trump’s corporate tax cuts will come before individual tax increases.

The US Fed will continue to anchor rates close to zero for years to come which drives investors to riskier asset classes in addition to setting businesses up for expansion easily financed in low rate times. In this low rate environment, fixed income is frothy and vulnerable, some equities are very expensive but there are pockets of opportunity. Our efforts to look for investment opportunities for both a more normal economy in which boomers are still aging, supply chains will relink and productivity will resume in a higher employment cycle.

Our real estate is treading water thanks to the Paycheck Protection Policy (PPP) and the CARES Act of 2020 which brought a temporary suspension of generally accepted accounting principles required for “Troubled Debt Restructuring” classification on loans so that banks can continue to work with borrowers without incurring capital charge penalties. This has limited forced sales so many of our travel and leisure-related properties have been able to conserve revenue while making lower or no cash distributions which should end as the world returns to normal life activities.

Estate Laws on the Mind – Taking Action

by MATT MCMANUS, M.A., CFP^® Senior Wealth Advisor and COO

As the new administration begins to unfold its legislative agenda, the prospect of tax and estate laws changing again has become a real possibility. Although major legislation would likely require an unheard of modern bipartisan effort, the laws will change even with Congress in gridlock. Now is the time to consider reviewing your estate plan.

The estate and gift tax exemption is the amount that an individual can transfer to another individual tax-free either during their lifetime or at death before a 40% transfer tax is imposed.

In 2017, the Tax Cuts and Jobs Act (TCJA) raised the base amount from approximately $5 million to $10 million per person. That $10 million base is adjusted annually for inflation and today stands at $11.7 million per person.  The TCJA also doubled the amount of exemption that may be rolled over, or “ported,” from one spouse to another at the death of the first spouse.

However the law itself created limitations and the increased exemption amount is temporary and scheduled to sunset, or revert, to $5 million per person (adjusted for inflation) as of January 1, 2026.

The sunset provision also created a question as to whether gifts greater than the inflation-adjusted $5 million exemption made between 2018 and 2025 would be subject to estate tax if the donor died after January 1, 2026.

On November 26, 2019, the IRS issued final regulations confirming that individuals who take advantage of the increased gift tax exclusion or portability amounts in effect from 2018 to 2025 will not be adversely impacted when TCJA sunsets on January 1, 2026. The final regulations also provide a special rule that allows the estate to compute its estate tax credit using the greater of the basic exclusion amount applied to gifts made prior to January 1, 2026, or the basic exclusion amount applicable on the date of death. A similar special rule applies to an exemption that is “ported” to the surviving spouse.

As a result, individuals planning to make large gifts between 2018 and 2025 can do so without concern that they will lose the tax benefit of the higher exclusion level once it decreases after 2025. Similarly, spouses who have the benefit of additional, “ported” exclusions made in this period will continue to have the benefit of those ported exclusions after 2025.

The regulations set out a “use it or lose it” benefit. If an individual dies after 2025 and did not make gifts between 2018 and 2025 in excess of the sunsetted exclusion amount in effect at his/her death, the excess exclusion is lost.

Future legislation being discussed by President Biden suggested during his campaign that he would support legislation that would reduce both the estate and GST tax exemptions to $3.5 million per individual and would lower the lifetime gift tax exemption to $1 million. President Biden has discussed other proposed legislation, favorably proposed by Senator Bernie Sanders, that aims to place annual, aggregate donor limits on gifts to certain types of entities such as irrevocable life insurance trusts and certain pass-through entities such as family limited partnerships.

Top Estate Tax Rates: 1914-2018

In addition to reduced transfer tax exemption amounts, several Democratic tax reform proposals have suggested returning estate tax rates to historical norms. In the 1940s, the top estate tax rate was 77 percent, and under 2001 federal tax law, it was as high as 45-55 percent. As a result, we may well see an upward adjustment in the estate and gift tax rates.

Of course, future legislation is all speculation, and if they are able to pass an update to the law there will be compromises. That being said, the assumption is President Biden will not push any tax legislation until 2022 which gives us 2021 as a deadline to fully employ any estate plan or gifting strategies now while the exemptions are high and we have some measure of assurance that any prior gifting will be grandfathered in.

If you have any questions or are considering taking action please let us know and we can coordinate a Financial Roundtable discussion with your CPA and Estate Planning Attorney during your next Financial Plan update.

Portfolio Management

by RYAN THOMASON Associate Portfolio Manager

IS VALUE POISED FOR A COMEBACK?

One of the most notable features of the post-Great Financial Crisis period has been the secular outperformance of Growth vs. Value. Rotations have occurred over the past decade, but they have always been short-lived. As we move into 2021, we have witnessed yet another rotation into Value. Will this finally be the moment that famed-value investors and hedge funds are correct that the trend has reversed? Or will it stay the status quo?

The bulls for Value cite a myriad of reasons why 2021 will be remembered as the year that Value reigned supreme over Growth. Some argue that the divergence of valuations between Growth and Value has never been further away and that a reversion to the mean is imminent. Furthermore, Value companies are trading below their historical valuations while Growth companies are trading above their historical valuations. Now that the U.S. is rolling out vaccines across the country, we should also expect economic activity to return to normal levels, which would provide a boost to the economically sensitive Value sector. Lastly, we are in a period of historically low-interest rates that are expected to remain low for some time. This puts pressure on fixed-income investors to find yielding assets. While there are many different options to explore, defensive value stocks with meaningful dividend yields could help those investors reach their income goals.

Why would Growth continue its dominance? The three main drivers for why Growth has outperformed Value are low rates, low inflation, and low economic growth. These trends continue today and are expected to continue, with long-term consensus growth expectations, nominal GDP growth, and average sales growth declining. This means investors are willing to pay more for companies that they believe will grow strongly with a high degree of predictability. Many of these companies had stellar growth after the initial COVID market selloff as companies who had invested in their digital transformation saw their investments pay off with accelerated shifts in consumer and technological demands. With regards to high valuations as measured by the price-to-earnings ratio (P/E), many of these companies that are considered too expensive by some are the very companies that have innovated their products and services and are best-in-class in their respective fields. Given that the world is ever-more tech-focused, perhaps comparing forward P/Es to historical P/Es is not as straightforward as it once was.

Growth has not dominated Value because of investor preferences. It has to do with our economy shifting from a manufacturing-focus to a digital, technological, and asset-lite focus. This is the strongest theme that supports why we believe Growth still has room to run, as long as we continue to see the supporting factors of low-interest rates, low inflation, and low economic growth. In this shift from asset-heavy to intellectual property and intangible-heavy balance sheets, assessing companies based on price-to-book or price-to-earnings may not be as useful as it once was. This is another argument for why active management is so important in successful investing today. It requires taking a deeper dive into each company to understand how to value their intellectual property and intangible assets when there is no readily available market value. Those that correctly assess these companies and invest in them will be part of the extended bull-run of Growth stocks.