FOURTH QUARTER ECONOMIC OUTLOOK
October 27, 2020
US & World Economy
As we come upon the 2020 Presidential election, I have a feeling it will be as memorable as the rest of the year has turned out to be. So my advice: hold on for the ride, there are more fun times ahead.
As we navigate this profound market recovery that is primarily supported by monetary policy, we are setting aside all emotions and intending to wait for outcomes. A foot in the sidelines is fine for the time being and a good defense is of the greatest importance while positioning ourselves for offense.
Our US economy has likely emerged from one of the deepest yet shortest recessions over the last century but it is imperative to remember that this recession was not the result of a financial institution malfunction like the Great Depression or the Great Recession but rather was caused by a natural disaster. And fortunately, the US came into the pandemic from a stronger position than much of the world in that we had a better economy, our credit was still highly rated and our interest rates were higher, giving the Federal Reserve more elbow room. From this point, however, we foresee a slower recovery and greater volatility than we have experienced since March as we need clarity on fiscal policy and virus containment to move significantly further. Economic output may not reach its 2019 levels until late 2021, early 2022. This is partly because consumption drives nearly 70% of the US economy and with the virus restricting the operations of many service-oriented businesses and high unemployment reducing households’ ability to spend, the largest driver of US GDP is impaired and unable to contribute at the summer’s brisk pace.
Worldwide, European economies have bounced since their March lows as well but have not kept pace with the Monetary stimulus the US has deployed. They started from weaker economies, low and sometimes negative interest rates, volatile government turmoil and often lack of agreement on policy and relations. This resulted in overall weaker local currencies making their import reliant economies recover slower. Emerging markets rely heavily on Europe yet their advantage comes from their growing middle class.
However far it feels we’ve ballooned our debt, the mandate of all Central Banks is to provide financial stability in the present. By far, the US is still the most attractive debt issuer in the world and the US Fed is under great pressure to retain our image of strength and security so it is highly unlikely we will see negative interest rates. Ultra-low rates are here to stay but even so, like any business or consumer is advised, oversized debt on a balance sheet will limit growth for years to come.
Low growth means achieving investment returns gets harder and harder but as professional investors, it is our job to design diversified investment models to support enough growth to keep you ahead of inflation without taking undue risk. Already, real yields in the US are negative as the nominal risk-free interest rate is lower than our rate of inflation (yes, we don’t have much inflation to speak of but the 10 year US Treasury only yields about 70 bps) so you can’t rely on the 60/40 investment protocol. Even Jeffrey Gundlach, the reputed Bond King, says now is the time for “massive diversification” and recommends allocating equal weights to equities, real assets like gold, cash and fixed income to confront the range of outcomes that lie ahead. Furthermore, he said fixed income could be substituted for cash as their returns are virtually the same. It is daunting to think of how massive pensions, municipalities and endowments are to achieve their contractual outlays in years ahead and we already see that they are allocating more to stable cash flowing real estate and equities.
The Value of Financial Planning in Uncertain Times
Although our world continues to struggle through the COVID crisis, domestically we face a perilous election and an uncertain future. In the span of the last two decades, we have seen dramatic shifts in both fiscal and monetary policy that have resulted in real-world changes that have affected every American. From the dramatic change in interest rates from 6.74% in 2000, to .25% today, to the Tea Party in 2010 and despite subsequent austerity measures we now have a federal deficit of 17.9% of GDP—nearly double what it was at its previous peak during the Great Recession. For anyone looking to invest their money, develop a retirement plan, or build a business, the importance of developing a Financial Plan has never been more imperative. As we must constantly adjust our strategies to the differing economic and legislative environment, we can still plan around the ever changing variables and develop a path forward.
As another example of the dramatic changes that can occur, in 2000 the Federal Estate and Gift Tax Exemption amount was $675,000 per person. Today it is $11,580,000 per person and in the last 20 years every estate plan has seen a swing in strategy. When the exemption amounts were lower, Irrevocable Life Insurance Trusts (ILIT) were often an incredibly popular strategy to separate assets out of one’s estate. The proceeds could be passed on tax-free to beneficiaries or even used to pay the Estate Tax due upon a donor’s death, a strategy to avoid fire-selling hard assets like real estate. As it stands today, the strategy for many wealthy families has been engaging in gifting strategies to move significantly more wealth to younger generations without paying any gift tax. Gifting strategies are excellent at not only lowering a donor’s estate today but also for providing the opportunity for those assets to grow even further outside of Estate Tax and maximizing the future legacy.
Yet, based on current tax law, the higher estate and gift tax exemption will sunset on December 31, 2025. Starting January 1, 2026, the exemption will return to $5 million adjusted for inflation. This is before any of the stated objectives of a Biden administration that is opposed to waiting until 2026, immediately are looking to raise revenue by reducing the Estate and Gift Tax Exemption limits. Additionally, Biden’s tax plan proposes to eliminate the step-up in basis rules that currently apply to inherited assets which would impact both higher- and lower-earners potentially facing a significant and problematic tax bill on inherited assets.
Thus Financial Planning and a strategy shift again becomes important. Life insurance could see renewed potential as a tool to provide liquidity and address the potential burden of increased tax liability. Other strategies to consider again may be continued gifting strategy throughout the owner’s lifetime, as well as considering the use of Grantor Retained Annuity Trusts (GRATs), Charitable Lead Annuity Trusts (CLATs), and sales to Intentionally Defective Grantor Trusts (IDGTs).
Although the outcome of the election is unknown, what is known is that we will continue to face new challenges as a result of the COVID recession, the increased debt burden, and a low-interest rate environment. Regardless of what Financial Planning you’ve done in the past, we encourage you to reach out to us to create or update your plan and ensure your current Investment, Tax, and Estate strategies continue to match your goals.
Why Emerging Markets Deserve a Second Look
Often, many investment managers tend to overlook Emerging Markets (EM) and instead focus on Developed Markets (DM). This may occur because of the often under-informed assumption that EM nations are potentially unstable, or that EM markets are over-weighted in commodity intensive businesses. There may also be the concern that EM markets heavily depend on net exports and that EM nations tend to be crisis-prone with more often occurring sovereign defaults and currency crises. However, despite these cautions, there is opportunity in investing in an economy that is in a growth mode versus focusing only on value economies which are often slow growth or even stagnant. With the current regulatory and macroeconomic issues facing Developed Markets, we believe that investors should give Emerging Markets a second look.
In the sphere of Emerging Markets, EM Asia may present some of the best investment opportunities. Countries within EM Asia, specifically China, South Korea, Taiwan, India, and Malaysia, are experiencing structural changes – new government policies, economic reforms, technological innovation – that are setting this region on the path to be the engine of global economic growth.
EM Asia has been generating growth rates that are large on both an absolute and relative basis, surpassing rates seen in Developed Markets like Europe and the United States. These high growth rates are largely a result from EM nations shifting from export-oriented manufacturing with low wages to higher-paying service-oriented businesses. China’s economy is now over 50% service-driven and that figure is expected to rise. Economic, political, and social reforms as well as the growth of a middle class with higher disposable incomes have also added to the high (yet sustainable) growth rate found in this region. China is expected to be the largest contributor to global GDP growth over the next five years followed by yet another EM Asia nation, India, as noted in the graph below.
At Optivest, we also see the innovation that is happening in China/Hong Kong, South Korea and India as a central component of our investment strategy. Innovation is occurring rapidly throughout all sectors of the EM Asia market. South Korea and China are leaders in electric-vehicle (EV) technology. Ninety percent of electric cars over the next five to ten years will be powered with batteries that come from these two countries. Another investment opportunity that we perceive within China is their expanding healthcare focus. China’s population is roughly four times larger than the population in the United States, and cancer and chronic diseases are on the rise. As a result, China has accelerated R&D in effective therapeutics and treatments, resulting in a biotech boom. As of today, the market capitalizations of many healthcare companies in China are small compared to peer companies in the United States and Europe. Given China’s healthcare innovation, addressable market and growth prospects, their future is promising.
Furthermore, the rising middle class in EM Asia is leading export-driven nations to shift to a consumer-based model. It is because of this domestic consumer-based market that lead us to believe that trade tensions between the United States and China should not be a concern when considering investment in the region. China and some neighboring countries with the EM classification are becoming less reliant on the U.S. as they produce more goods and services domestically. We expect to see an unprecedented increase in consumption in healthcare, banking and finance, communication services, and information technology as their middle class expands. For those who choose to capitalize on the opportunity, we believe that EM Asia will be a significant contributor of global growth and investment opportunities. As a result, expect to see the addition of a new Emerging Markets actively managed fund in the Optivest models in the near future.
Beyond our normal scope of our long standing support to many charities our Board has deep involvement with, the Board of the Optivest Foundation is directing support again this year to the Optivest office to adopt local families at Christmas time. We look forward to shopping, wrapping and delivering Christmas presents and grocery gift cards to our neighbors who might feel a heavy burden at the Christmas holiday. I think we have built our own tradition after seeing the smiling faces and feeling that we are really able to bless and love our neighbors.
Alpha (beyond average market returns) will now come from active security selection and emphasis must be given to credit analysis. Passive investing will inevitably expose investors to zombie companies. Expect mandates to not be fully invested at times setting up for tactical nimbleness to take advantage of dislocations ahead.
There are good times ahead for investors who have prepared for the risks and opportunities ahead. Beyond the pandemic and the election, the low-interest rate environment and likely negative real yields for years to come will drive the unprecedented and massive $4.3 Trillion currently held in money market funds back to the markets seeking returns from the only places it can safely be sourced – actively managed equity funds, stable cash flowing real estate and private lending to high credit borrowers when banks won’t be able to lend because they find themselves laden with defaults, loads of lower credit borrowers and diminished spreads.
We are excited for the future and we look forward to guiding you to achieve your long-term goals.
Leslie, Matt & Ryan