BFT Financial

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BFT Financial Market Update: Q4 2020

Listen to the brief audio version or read the full overview below.

Twelve months after the first reports of a new virus started to show up and ten months after the start of a global pandemic, there is a light at the end of the tunnel. Vaccines developed by Pfizer-BioNTech and Moderna seem to have efficacy rates of around 95%. AstraZeneca’s vaccine, developed together with Oxford University, has shown an efficacy rate of 90%. Russia and China have also launched vaccines. The Russian vaccine, Gamaleya, displayed an efficacy rate of 91% based on 22,000 test participants. Such high efficacy rates are on par with the measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu vaccine.

If we combine the global roll-out of the vaccines with the typical cycle of previous viral pandemics, we could very well see a sharp drop in new Covid cases in the coming months. When effective vaccines allow everyone to live a normal life again, there will be a burst of economic activity of every kind. When this happens, it will unlock tremendous pent-up demand around the world. There will be party booms, travel booms, shopping malls will be filled with people and airports will be busy again.

The Covid-19 crisis is a natural disaster and historically, the impact of this kind of crisis on the economy and society is always “temporary”. This time is no different. The speed of the economic rebound since April has been fast and surprised many investors. Retail sales in the U.S. and Europe have not only clawed back all their lost ground but have made new highs.

Another reason for a recovery boom is that, although the Covid-19 crisis is a
temporary shock, it has caused structural shifts in policy. This will make the
recovery story very different from the post-2009 recovery. Back then, the world economy was plagued by a badly damaged banking system in the West, prolonged deleveraging, and a crash in Chinese investment spending. This led to a long period of low growth, sustained deflationary threat and a secular bear market in commodities.

A Roaring 2020s?

The 1918 Spanish Flu pandemic gave way to the roaring 1920s, business boomed, stocks roared ahead, and the world economy experienced unprecedented prosperity. Is there a chance that we will see a repeat with a roaring 2020s?

This is certainly possible as all the economic and monetary stimulus most likely has extended the economic cycle and the secular bull market by another few years.

The path is already well greased with liquidity, and the current economic backdrop bears some similarities to the 1920s. Back then, there were many game-changing new technologies and innovations such as electricity, the automobile, the telephone, radio, consumer appliances, assembly-line production and so on. These new developments played major roles in driving down inflation and stimulating growth, which led to rising profits and stock prices until it abruptly ended in 1929.

Today, corporate profits are recovering strongly from the recession last year and stocks are trading at a forward Price/Earnings Ratio (P/E) of 22, which is not low but also not overly expensive by historical standards, especially taking into account the much lower interest rates. This is not to mention the many important technological advances in recent decades.

Obviously, there are key differences between the 1920s and now. More than a century ago, Americans were younger, and the economy was more vibrant and growing faster. Today, the population is getting older, the economy invests a lot less and growth is much slower. However, these differences are not the reasons preventing a financial mania. There are already areas of speculation, but we must differentiate between pockets of speculation like stocks of electric car makers or bitcoin, and the general market. We are nowhere near a general financial mania yet.

If we get a roaring 2020s, when and how could it end?

We could see an extended bull market in risk assets until we see the next financial recession, which could be triggered by monetary tightening. Almost all previous asset bubbles were pricked by monetary tightening. If the Fed is serious about its forward guidance, rates are likely to stay low for a few years, which is the key reason why the market could run up a lot further and could lead to asset bubbles and financial manias this decade.

But be careful: policymakers can change their minds quickly and the risk to equity prices will escalate when the Fed is preparing to “normalize” policy again. However, this likely still several years down the road.

The world economy is recovering fast but governments and central banks are still worried about a “double dip” for the economy given the continued lockdowns and they will continue approving large economic stimulus packages. The U.S. has just agreed another fiscal package of around $900 billion, while the EU will push through its own €750 billion recovery fund.

Politically, the right thing to do is to give more money to the most affected people, but for the U.S. economy as whole, additional income subsidy might not be necessary to sustain the recovery. A large part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) expired at the end of July but the unemployment rate has continued to fall and the economy has continued to improve. Additional fiscal support in the U.S. or Europe will simply add more fuel to the potential spending recovery.

The Democratic wins in the Georgia senate races will also give the Biden-Harris administration more leeway to get larger economic stimulus packages through congress and investors do not need to fear a premature tightening of fiscal policy in the U.S.

Several European countries will hold elections this year or early 2022, which means politicians have very little incentive to stop the economic stimulus any time soon.

Fiscal policy around the world has been so far focused on giving out income support for people, but the emphasis could shift to rebuilding the economy. As such, infrastructure spending could be increased significantly from the U.S. to Europe to Asia, fueling a surge in construction activity. This could be good news for commodity prices. And indirectly emerging markets.

Our overall view is therefore that the global economy will strengthen in 2021 as the pandemic winds down. Inflation will remain low for the next 2-to-3 years before possibly moving higher by the middle of the decade.

Interest rates should stay low as long as there is no real inflation threat, and this is positive for equity markets. Right now, stocks are technically overbought and vulnerable to a short-term correction. Nevertheless, investors should continue to favour equities over bonds in 2021 given the likelihood that earnings will accelerate while monetary policy stays accommodative. If social instability in the U.S. would affect the markets in the short-term, we would be more inclined to buy the dip rather than sell.

Given the strong divergence in markets last year with large cap tech stocks accounting for most of the gains, it is not unlikely that we will see some mean-reversion this year and last year’s losers could be this year’s winners.

In 2021, international stocks could outperform US stocks, small caps can outperform large caps and banks and industrial companies can catch up to large cap tech. A weaker dollar will also help to make international markets more attractive.

Bond yields could rise modestly this year on the back of an improving economy, but the move is unlikely to be very large as central banks will want to avoid the situation that fast rising bond yields would hurt the recovering economy.

Investment grade bonds remain preferential to treasuries as we continue to view credit risk as a better alternative to rate risk. Given the rise in inflation expectations (which is not the same as inflation), inflation-protected securities may be attractive as well.

The US dollar will likely continue to weaken in 2021. The collapse in US interest rate differentials versus its trading partners, stronger global growth, and a widening US trade deficit are all bearish for the dollar.

Positive Risk In 2021

There is a ‘risk’ that stocks rise much more than investor can imagine and mega-cap growth stocks continue to lead the way. A liquidity tsunami is still in the making and major central banks except China are working in overdrive to print money and monetize debt. Next year, Quantitative Easing (Q.E.) will likely be significantly enlarged.

The U.S. Treasury will likely issue $2.4 trillion in new debt, and a large part of the new issuance will be absorbed by the Federal Reserve. This means that the Fed’s balance sheet will continue to grow, particularly if they try to keep bond yields down.

All this newly created money will not create inflation in the short-term, but it will flow into stocks, real estate and anything that has some yield, or into momentum plays like bitcoin.

In the meantime, there are captivating growth stories in the technology, biotech and clean energy space, which could easily capture investors’ imagination and generate more inflows into these sectors.

The price pattern of Facebook, Apple, Amazon, Netflix and Google (FAANGs) is very similar to the financial mania in technology, media and telecom in the 1990s. These mega-cap names are natural hot spots for investors to deploy large amounts of liquid capital. At the height of the last technology bubble, the average annual return for the S&P500 was 30% from 1996 to 1999.

Geopolitical Risks

Beijing has been the key source of negative shocks to risk assets in recent years. Policymakers in China are fixated on their Debt-Gross Domestic Product (GDP) ratio and have taken every opportunity of the economic recovery to hammer. Next to that China has taken a firmer stand regarding Taiwan and the South China sea and this has the potential to lead to conflicts.

The announcement from Iran that they will start to enrich more uranium will increase tension not only with the U.S. but also Europe.  The recent seizure of a South Korean tanker could be the start of more tensions in the Middle East.

Geopolitical risks could lead to sharp corrections in equity markets but are unlikely to unsettle the underlying economic trends.

Emerging Markets Transition to a Structural Bull Market

The current macro environment surrounding emerging market assets shares some similarities to what happened after the U.S. tech bubble bust two decades ago. Emerging market assets were battered by multiple crises in the 1990s and became deeply undervalued and under-owned. The Fed eased aggressively to fight the deflationary shock, which pushed down the dollar and released massive liquidity into the global financial system. This, together with strong Chinese growth, created a spectacular bull market in emerging market that lasted until after the Global Financial Crisis in 2008.

While history never repeats itself and it is overly simplistic to draw historical parallels, financial markets are subject to long-term mean reversion. The fact that emerging market equities have underperformed developed markets by so much in the past decade and are trading at much more lower multiples holds the promise of higher returns over the long run.

In addition, a few important factors suggest that the cyclical emerging market bull market has the potential to develop into a multi-year structural one.

First, the ongoing rally in commodity prices likely reflects more than just the Fed easing and a weaker dollar. Rather, it could be a sign of a demand-supply mismatch. On the demand side, China is full-throttle supporting the development of the country’s booming new energy vehicles (NEVs) industry, aiming to double its market share in auto sales in five years, which requires aggressive investment in related infrastructure. The country is also pushing development of “new infrastructure” such as 5G stations, high-voltage power grids, intra-city rail transitand data centers, all of which are commodity intensive undertakings.

In addition, China’s “belt and road initiative” has suffered a setback due to U.S.- China tensions and the pandemic but will inevitably continue to gain momentum in the coming years. The belt and road initiative is essentially a series of basic transportation infrastructure projects in developing countries financed by Chinese institutions.

Meanwhile, the U.S. under a Biden presidency will also likely push on infrastructure development, setting the stage for stronger demand for commodities.

On the supply side, a decade-long bear market in commodity prices has significantly reduced capital spending in mining.

Investment in infrastructure and clean energy technology is a trend that will continue in the coming years.

Portfolios

In previous years, we’ve been more inclined to tactically reallocate portfolios to meet changes in the economic cycle and market attitude. This year was a return to traditional rebalancing of portfolios and a harvesting of profits and purchase of lesser performing assets. The result, our portfolios have remained globally diversified and maintained have their weightings. As such, we have participated in the “stay at home” tech momentum and have benefitted from strengthening foreign companies as well. While value hasn’t kept pace with growth for some number of quarters it has been profitable and the past few trading sessions it has been the benefactor of a slight sell off in growth and big tech stocks. Should that continue we are positioned to benefit as well. Our attitude on bonds is reflected in our positioning; we are satisfied to collect the yield, albeit lowered, and not stretch for more than is realistic. Our risk exposure is derived from our equity positioning and shouldn’t be enhanced with a reach for yield.

Disclaimers: This newsletter contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no
guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

*Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred.  Returns do not include reinvested dividends.

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2020 Message from BFT Financial CEO Stephen Tally

There have been some interesting years, some challenging years, some sad years, and lots of really good years in my career as an advisor. This year has been all those things. The “good” comment probably sounds outlandish but be patient; I’ll get there.  

The Interesting Part

2020 was interesting from the perspective of a student on the market. Never in history has the market fallen so far so fast. Twenty-two trading days from peak to trough. Similarly, we had a meteoric recovery thanks in part to the tech industry’s ingenuity, whose products and developments kept the country open and moving. I don’t know how we could have managed this year without email and web-based communication technology like Zoom (which I hope doesn’t replace meeting face to face). We’ve not learned all of the lessons from this year (I doubt we’re even close), but we did galvanize some of the ideals we’ve believed in all these years: 

  • Know your risk budget and don’t overspend it 
  • News makes waves while fundamentals drive markets
  • Jumping off a moving roller coaster normally doesn’t end well   

The Hard Part

I don’t know many who haven’t had some amount of difficulty this year. It’s common, and I’d imagine that we could say that every year, but this year just seems even more so. Being isolated from one another is a terrible thing. Being quarantined is one thing, but COVID did more than keep us at home.  Our daughter contracted COVID early on, and the stress of her being sick with a virus that we knew little about and not being to see her and take care of her was terrible. Thankfully, she recovered in short order. Many didn’t battle COVID directly but were affected, nonetheless. Some lost jobs. Some lost businesses. The lucky ones struggled with working remotely for the first time. The even less lucky worked from home and became their children’s teachers.  

The Sad Part

For some, 2020 brought sadness that will not quickly wear away. You lost loved ones, and maybe you couldn’t say goodbye or have closure from a service or celebration of life. We all lost precious time – with aging parents, with family, and with friends. We’ve seen people struggle with isolation and depression and had little or no opportunity to help. Our places of worship closed. Our charities suffered.  Many simply did with less, or worse, without. We’ll heal, and with time and a cure, we will all be able to move past.

The Good Part

I recently said something about being positive, which made my wife chuckle. It’s easy to see me as negative if you don’t take a closer look—my career centers on risk analysis and reduction. I can’t afford to be naive or oblivious to what may go wrong. But it doesn’t mean my glass is half empty. It’s quite the opposite. I believe life is good, and things work out the way they’re supposed to. 

My life is filled with my Dad’s words – “You can figure it out,” “Just solve the problem,” “Work on it and it’ll come to you,” and his famous, “I can hit that shot.” That last one, not so much! I also believe that we are at our best when it’s the worst. I see more people walking in my neighborhood than ever before. I see parents in the yard playing with kids. What an opportunity parents have, albeit it may be a pinch at times.  

Never in my lifetime have I seen the entire world work to solve the same problem. I hope this cooperation continues to germinate. Quarantining has made me realize how truly blessed I am to have such a fantastic family and group of friends. I do miss them all so much. I miss all of you too. I’m lucky that you all are such a great bunch and a treat to work with. I hope we exit this time with a deeper value of one another, and a desire to be more engaging in a personal way and less of a technological way. A call is better than a text and not as good as seeing you in person.  

Personal Notes from 2020

Kelley and I bought a place in Fairplay, Colorado a couple of years ago. It’s in a high valley in the middle of nowhere. It reminds me of my childhood home on the ranch. We‘ve been able to spend much more time there than we’d ever thought. We’d drive up on a Saturday and plugin on Monday and work there for the week. Kelley is much better at working remotely than I. No matter the number of hours or tasks completed, if I’m not at the office at my desk, I feel unproductive. It’s silly, I know.

Our oldest daughter and her husband moved back after years of being away. Nine, to be exact. David finished his obligation with the Army discharging honorably as a Captain. Kelsey is teaching again but decided not to coach volleyball this year. She was previously the head coach at the Americas High School in El Paso. David started completely anew with JP Morgan as an investment banking analyst. I’ve yet to wrangle any of my kids into the business. They’re expecting their first child in February. He’ll be our first grandchild. Kelley has completely lost her mind, and I’m worn out from playing it cool. Again, silly.

Allie, our younger daughter, is the family COVID champion. It’ll be a cool story someday. She started working at American Airlines last fall as a price analyst. She was nervous for a bit but being the smart, hardworking employee she is, she’s not only retained her job but instead moved to the pricing group for Europe. She downplays it, but we’re proud to see her working her way up. If we can only get Auntie A to move back to the Ft. Worth side of the metroplex, all would be right.

I performed my third wedding ceremony this year. The first was my best friend Michael from college. The second my daughter Kelsey, and the third Stephen Walden and his bride Bailey. Little Stephen is the son of my best childhood friend, Todd (I’m big Stephen). It was such a fun experience. I’ve known Stephen since he was a baby, actually since before he was born; and to be a part of his growing family means something to me, I can’t quite put into words.  

2021 Resolution Goals

I’m not one to make resolutions, but I do always set goals. Maybe there’s a difference, and perhaps there isn’t. I haven’t sat down and made the official list yet, but I can share some things that easily make the list.

  • Spend more time with family and friends  
  • Focus on health.  I refer to this COVID filled year as “the taco season.”
  • Less TV
  • Explore more

In Parting

I really enjoy Christmas. I love the memories most. Being little, Mom and Dad taking us to Thorton’s department store to look at the window decorations, and then up the escalator to see Santa. Trying to stay in bed Christmas morning past 5:00. Adopting a family and giving gifts to others. Decorating the tree for the first time with my new wife and daughters. Getting gifts for the kids they really wanted, or better yet, things they didn’t expect and loved. Mexican food on Christmas Eve at Mom and Dad’s. I smile thinking about it all.

Christmas isn’t just about the celebration; it always brings me to my faith. My beliefs are fundamental to who I am. Know that I have lifted you all up repeatedly this past year, asking that you be protected, healthy, and unaffected. I’ve asked that for all of us. I’ve asked that we navigate not only this virus but the contentiousness of the election. I pray that you find peace and happiness. 

I wish all of you well, and what struggles you may have or have had subsided. It’s a season of hope. I hope we all have a great 2021!

Stephen

DISCLAIMER: The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of BFT Financial Group. Neither BFT Financial Group nor the author makes any warranty or representation as to the accuracy, completeness or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall BFT Financial Group be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither BFT or the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.

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Capital Gains Tax in a Volatile Year

While mutual funds are efficient vehicles for diversification, they’re sometimes not as efficient from a tax perspective. Investors often have questions related to capital gains, specifically associated with mutual fund activities. With 2020 being a volatile market year, here are the top three questions I’ve been asked and my insight into each.

Click or tap a question below or scroll to read the full list.  

What is a capital gain distribution, and why am I getting one if I didn’t sell any mutual funds?
How does a long-term capital gain affect me?
It looks like my investment went down in value. What happened?

“What is a capital gain distribution, and why am I getting one if I didn’t sell any mutual funds?

Mutual funds are required by law to make distributions of at least 90% of capital gains incurred each year. First, some background on buying and selling of mutual funds. When an investor purchases shares of a mutual fund, it is not the same process as buying stock shares. A mutual fund transaction does not occur on an exchange, like the New York Stock Exchange. Mutual fund shares are purchased directly from the mutual fund company. Alternately, when shares of a fund are sold, they are not sold to a fellow investor. They are sold back to the mutual fund company. The fund companies’ responsibility is to account for the inflows and outflows of their funds and to have sufficient cash to meet their obligations.

Capital gains occur when a mutual fund manager sells a position within the fund at a profit. Managers may sell positions for several reasons. For example, during the year, managers may trim positions because they have grown in value, to reduce overall risk, or the manager believes the investment no longer makes sense.

Also, mutual funds need to meet redemption requests daily. When investors in a mutual fund sell their shares, the fund manager may need to sell positions to generate cash to meet the requests. In a volatile year like 2020, the manager may sell positions, incurring a gain that they would have preferred to avoid. Generally, investors should sit still during bouts of volatility. However, rash investors often panic, sell, then run and hide. Mutual fund managers are forced to sell to provide the liquidity needed to meet the panicky investors’ redemptions. Consequently, all investors who hold those mutual funds may receive larger capital gain distributions that year than expected. It is essential to understand that capital gains go to every investor proportionally, not just to the investors that sold their shares.

Lastly, some managers implement a high turnover strategy. They find value in buying and selling stocks with high frequency, regardless of the tax consequences. Funds with high turnover generally have more capital gains distributions.

“How does a long-term capital gain affect me?”

It depends. There is no impact on the owner of qualified accounts, like an IRA or 401(k). However, it does impact the taxable income of non-qualified account owners. 

If you reinvest capital gains in tax-qualified retirement accounts, the distribution will immediately buy back into the mutual fund from where it came. Capital gains distributions not set to reinvest are paid out to cash inside your account. In essence, this is seen as a return of your invested money. No taxes are due on these retirement accounts until a distribution is made from the account, at which time they are taxed as ordinary income.

If your account is non-qualified, in that it does not qualify for preferential tax treatment, then you may have a tax liability for the year in which they occur. At this time, all capital gain distributions are treated as long-term capital gains, no matter how long you have held the investment. Generally, long-term capital gains tax rates are preferable to those of ordinary income. Please keep in mind that every investor is different, and I urge you to consult your tax professional regarding your situation.

“It looks like my investment went down in value. What happened?”

In this situation, it matters whether you reinvest capital gains or not. If you reinvest capital gains, when the mutual fund makes a capital gain distribution, the fund’s market value (the Net Asset Value, aka NAV) is reduced. Let’s use an example of a fund with a NAV of $50 per share and a capital gain distribution of $5 per share. The NAV declines by $5 to $45 per share. It may appear to be a decline in price; however, the total return of the fund has not changed. At this point, you will use the $5 per share distribution to purchase (reinvest) more shares of the fund at the new market price of $45 per share.

In the same example, if capital gains are not reinvested, the $5 per share distribution is paid in cash to your account. It is a return of a portion of your investment, not a reduction of its value. The remaining investment is valued at $45 per share and you will have the $5 per share value in your cash account.

Effectively, before the distribution, you had $50 of value per share owned. After the distribution, you still have the $50 of value, either in the mutual fund (after the distribution is used to purchase more shares) or as a combination of the fund worth $45 and cash worth $5 per share.

Timing also matters with capital gains distributions. In my experience, these distributions can occur on a Friday, and the corresponding reinvestment or cash distribution may not be reported until the next business day, Monday. This lag leaves a gap of a weekend for the process to complete.

Travis Crowell is a financial advisor with BFT Financial and is a graduate of Abilene Christian University with a degree in Financial Management.

Have more questions about capital gains, mutual funds, and how they may impact your financial goals? Contact us or subscribe to our mailing list to gain more insights into financial planning. 

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DISCLAIMER: The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of BFT Financial Group. Neither BFT Financial Group nor the author makes any warranty or representation as to the accuracy, completeness or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall BFT Financial Group be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither BFT or the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.

Disclosures:

Mutual Funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing in Mutual Funds. The prospectus, which contains this and other information about the investment company, can be obtained directly from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.

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The U.S. Election: It Is What It Is

Overnight more votes were counted in Michigan and Wisconsin, 2 states Trump won in 2016. Biden is the winner and now has a likely path to the 270 votes needed in the electoral college. Arizona (called for Biden by some, but not yet official), Georgia and even Pennsylvania may go his way. However, many of the states have razor thin margins and the Trump campaign has already filed lawsuits to challenge results and force recounts. Multiple states allow automatic recounts if the margin of error is sub 1% anyway. When all is said and done, including what is likely to be multiple trips to the Supreme Court, it is starting to look like Biden is the likely President elect. Trump still has paths to win, but it is getting increasingly unlikely, though not impossible.

However, the story is very different in the House and Senate. Democrats have gained 1 seat so far and there are 5 seats remaining. We won’t know the tally for some time (weeks actually, as there will be at least one run-off in Georgia), but a Republican Senate is increasingly likely. While the House will almost certainly remain under Democratic control, it was not a good showing with Republicans gaining 5 seats so far. In short, if Biden wins the Presidency, he will confront a less united House and a Republican Senate. This potentially means smaller stimulus plans, continued division on healthcare, and a lot of focus on 2022 mid-term elections. We will have to rely on McConnell and Biden remembering their work together in the Senate over the last few decades and hoping they can find some sort of compromise.

Despite many bold predictions of a ‘Blue Sweep’ in which Democrats gained (or re-gained) all Trumpian red territory of 2016 and then some, as of this morning it looks like only Arizona, Michigan and Wisconsin flipped from red to blue. Four states remain outstanding: Georgia, North Carolina, Nevada, and Pennsylvania. Democratic hopes for Florida and Texas faded early in the night on Tuesday.

The Republican and Democratic legal teams are preparing for trench warfare. Major legal challenges are highly likely and will delay the final outcome into December or even January. The first thing is to finish counting the absentee and mail-in ballots. Georgia, Michigan, Wisconsin, and Arizona are not accepting ballots after election day, so they will finish counting soon. Then all that remains is to see if any legal disputes arise that prevent the Electoral College members from being settled in these states, which is still possible.

Nevada will accept ballots by November 10 and North Carolina by November 12 as long as they are postmarked by election day. It is likely but not certain that Democrats will keep Nevada (~75% counted) while Republicans will keep North Carolina (~100% counted).

That leaves Pennsylvania as the biggest risk of a contested result. The deadline to receive mailed ballots is Friday, November 6, but a legal dispute is already underway as to whether the original November 3 deadline should be reinstated.

We won’t know what the final court verdict on Pennsylvania will be, but it would not be surprising at all if the Supreme Court ruled that ballots received after election day cannot be accepted. The constitution grants state legislatures the sole power of choosing a state’s electors. Each state passes its own election laws. The Pennsylvania state legislature clearly stated that ballots must be returned by election day. It was a court decision that extended the deadline. The Supreme Court could easily determine that a lower court does not have the power to change the deadline. But nobody will know until the court rules. The fact that Trump appointed several of the judges doesn’t necessarily mean they vote in his favor because they serve lifetime appointments.

Assuming North Carolina and Georgia have slipped away from Biden and that Nevada remains blue, the best-case scenario for the former vice president is a 290-electoral vote victory. That’s more than George W. Bush achieved in his two successful campaigns (271 in 2000 and 286 in 2004), but fewer than Barack Obama (365 in 2008 and 332 in 2012) and Donald Trump (304 in 2016). A win, of course, is a win. But if Biden is victorious, it will be under radically curtailed circumstances from what Democrats had assumed.

At the moment, we think a Biden win with a GOP Senate seems to have the highest probability. But the US election is not over yet. Trump still has a chance of victory by winning Pennsylvania and one other state. If the vote count does not settle the outcome clearly this week, a full-fledged contested election will emerge that may not be settled until December 14.

Risk-off sentiment will prevail in the interim, given the importance of the next economic stimulus package. What we know is that Republicans will very likely keep the Senate. This means gridlock is assured, which is actually positive for US stocks in the medium to long-term.

Biden Needed the Senate

The predicted ‘Blue Sweep’ didn’t materialize. That means whoever prevails in the presidential race, Mitch McConnell is likely to remain in charge of the upper chamber and that means that the American government will be divided or “gridlocked” for the next two years. As things stand, Democrats picked up two senate seats, Arizona and Colorado, but fell short everywhere else. They may even have lost a seat in Michigan. This leaves the balance of power at ~52-48 in favor of Republicans. In this case, Biden would be the first president in 32 years to come into office without control of Congress, another dynamic that would weaken claims of a strong mandate.

The Democrats’ anti-filibuster movement and its interest in expanding the Supreme Court and the Senate, or any other process reforms to maximize a new Democratic president’s power and influence, would be placed on pause. President Biden’s agenda would be defined by his ability to win over the entire Senate Democratic caucus, from Bernie Sanders to Joe Manchin, and then as many as 10 Republicans. Ultimately, Biden would have to deal with McConnell, who would undoubtedly reprise the role he played in the Obama era when he had no incentive to help Obama rack up legislative achievements.

For markets, this is probably the best possible long-term outcome. Historically gridlock offers more upside for the S&P 500 than a single-party sweep. However, there is risk that the short-term economic stimulus will be much smaller than the market wants in the case of a Biden win with a Republican Senate. If Trump prevails, he has more leverage to force the Senate to approve a much larger economic stimulus package before the end of the year. A Trump administration will also face gridlock because of the Democratic majority in the House. In his case, the gridlock is reflationary at first (good for markets) but problematic later due to continuation and likely expansion of Trump’s trade war focus.

A Biden gridlock is deflationary at first but the best outcome for investors over the long run as it will mean that a Biden administration cannot introduce sweeping new regulations on everything from healthcare to technology companies or fracking. And it is unlikely a Republican senate will approve any tax increases. History shows that a gridlocked government tends to be positive for the economy as a whole. On top of that, a Biden administration is less likely to start a global trade war than a Trump administration. Or at least take a more considered and diplomatic approach to it. Both are positive for the global economy.

It means that a potential Biden administration will have to govern from the middle and that the progressive wing from the Democratic party will have limited influence on policy. It seems that the United States is not yet ready for a more left-leaning government, despite many predictions to the contrary.

Market Impact

Now for the bad news, a contested election will lead to market uncertainty in the short-term. Mainly because it is now unclear when to expect the much-needed next economic pandemic stimulus and how big it will be.

So far, neither the election nor Ant Group’s Initial Public Offering (IPO) derailing have had a major impact on markets. All markets were up the last couple of days, basically reclaiming last week’s sell-off. We are likely to see continued uncertainty in the coming 1-2 weeks, but do not expect any major correction. Equity markets are comfortable with a Biden Presidency and a Republican Senate, so there may be some risk if recounts point the other way, but we do not expect such a move to be material enough to warrant a change in our outlook.

Over the next 12-24 months we continue to favour equities given the ongoing economic recovery, likely progress on Covid and other healthcare measures, and of course the potential for government stimulus in the US (especially now that any tax increases are likely to be constrained by the Senate).

Ant Group’s IPO

While the US election is the biggest news globally, Ant is Asia’s leading story right now. It seems that the IPO, due to be the largest ever globally, has been put on hold by the Chinese government. Ant is already the largest non-State-Owned financial player in China and going public would put it more squarely in the private and non-government-controlled camp. This is a continuation of ongoing conflict in China between the private sector (best embodied by the outspoken and fluent in English Jack Ma) and the Communist Party (firmly controlled by Xi Jinping).

There is lots of speculation that Jack Ma’s speech over the prior weekend about regulators holding back innovation in finance was the final straw for those in power in China. The IPO, scheduled for today in Hong Kong and Shanghai, was cancelled only two days before listing and after more than three months of reviews. This suggests the decision was made top down by Xi Jinping and the Communist Party, not by the many administrators who reviewed it in prior months.

Alibaba, Ant’s parent and major shareholder, dropped 8-9% in Hong Kong and NewYork on Wednesday. It is unclear how long the “regulatory” review will take and when the IPO will come back. We think that eventually the Ant IPO will go through as it is too important to be allowed to fail for both Shanghai and Hong Kong markets.

A New Wave of Covid Infections

Stocks rallied in the spring and summer on hopes that the worst of the pandemic was over and that fiscal stimulus would continue to prop up employment and spending. Now, both assumptions are being challenged. The number of coronavirus cases continues to rise worldwide. In both Europe and the US, the daily tally of confirmed new cases exceeds the March peak. The only saving grace is that the number of deaths has not risen by as much as many had feared.

While governments have understandably tightened restrictions to control the latest surge in Covid cases, they are unlikely to fully revert to the extreme measures taken in March. Back then, there was considerable uncertainty over how fatal the virus was, with estimates for the mortality rate ranging from 0.5% to over 5%. The latest research suggests that the true number is near the bottom of that range, and perhaps even below it.

Progress continues to be made on a vaccine. Close to 95% of professional forecasters surveyed by The Good Judgement Project expect a vaccine to be widely available within the next 12 months.

Ironically, the severity of this second (or third) wave of the pandemic will likely lead to even more economic stimulus than the market was expecting. Every developed country in the world has already run up deficits to finance economic stimulus. There is no politician in the world that is now going to stop spending. Especially with elections coming up in all the major countries in Europe over the next 18 months.

The combination of a vaccine and further fiscal support against a backdrop of ultra-easy monetary policy should be enough to lift global equities. While the near-term picture for stocks is uncertain, investors should remain invested in global equities.

Fixed Income Markets

A democratic Blue Sweep would have led to extensive fiscal spending the next few years. This is now much less likely to happen and that is positive for fixed income markets. Biden’s original economic plan would have likely pushed up U.S. Treasury yields.

Now that spending will be curtailed by a Republican Senate it is more likely that bond yields will remain subdued for longer. Which in turn is not only positive for bond prices in the short-term but is also positive for growth stocks as the discount rate will stay low for longer.

The U.S. Dollar

As a countercyclical currency, the US dollar is poised to weaken next year. Typically, non-US stocks outperform when global growth is strengthening, and the dollar is weakening. Moreover, a generous monetary and fiscal policy setting in the U.S. has eroded the dollar’s appeal as the country’s trade deficit widens. Furthermore, U.S. broad money growth stands far above that of other major economies. Compared with other major central banks, the Fed is more guilty of financing the public- sector’s debt binge. Debt monetization creates a real risk to a stable USD.

The expanding global recovery creates an additional problem for the countercyclical dollar. China’s role is particularly important in this regard as the nation’s domestic economic activity will improve further in response to the lagged impact of a rapid climb in total social financing. Likewise, China’s healthy recovery has lifted interest rate differentials in favor of the yuan. A strong CNY improves China’s purchasing power abroad and diminishes deflationary pressures around the world. This combination should stimulate the global manufacturing sector, which benefits foreign economies more than it does the U.S.

Portfolio Impact

For all 2020 we have maintained a neutral position on both our US and non-US equity weightings. The performance of growth stocks and the additions of a technology position and a healthcare position have been tailwinds for our portfolios. We do anticipate a rebalance in the near future as the aforementioned have appreciated in advance of their value counterparts. Post-rebalance, we believe we are well-positioned to profit from the economic outlook described above. Despite any short-term market volatility we might see.

Fixed Income Portfolio

Whether Biden or Trumps eventually wins, a gridlocked Congress will likely mean that bond yields won’t rise any time soon. Yields across much of the government bond universe in USD, EUR and JPY are close to 0% and are likely to stay there. With yields low and spreads narrow on higher risk bonds, our preference is to remain core in nature with an eye on duration and credit risk, specifically investment grade, being more attractive than rate risk.

DISCLAIMER: The views expressed in this economic update are those of the author and do not necessarily reflect those of BFT.  This update contains “forward-looking statements” that relate to future events, including future economic performance and plans. These forward-looking statements can be identified by the use of such words as “believe,” “think,” “intend,” “may,” “will,” “should,” ”expect,” ”anticipate,” “estimate,” or “could,” or variations of these terms or the use of other comparable terms. There are certain risks and uncertainties that could cause actual results to differ from those predicted in the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this update.

DISCLOSURES: Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.  There are risks associated with these types of investments and include but are not limited to the following:  Typically no secondary market exists for the security listed above.  Potential difficulty discerning between routine interest payments and principal repayment.  Redemption price of a REIT may be worth more or less than the original price paid.  Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.  Involves risks such as refinancing in the real estate industry, interest rates, vailability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.  This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value. The Nasdaq Composite Index is an unmanaged group of securities representative of the market capitalization-weighted index of over 2,500 common equities listed on the Nasdaq stock exchange.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred.  Returns do not include reinvested dividends.

By

Truths, No Matter Who Wins The Election

As we get to the back half of 2020 one thing we can say with complete and emphatic certainty – there’s been a lot of drama this year. I certainly don’t mean to downplay the severity of COVID-19. It is terrible. And, we continue to pay a dear price in lives affected both physically and economically.

We do have another bit of drama left to play out this year and it’s a doozy. The 2020 presidential election. To quote my daughter, “It’s a hot mess.”

I have no interest in promoting any political party in the course of my work or writings. Wealth managers should view markets and investing in an agnostic manner. We review the data at hand, and that may influence our decisions, but we have a lengthy view and understand that along the way parties change.

Be sure to put your feet in the right place, then stand firm.

Abraham Lincoln

This quote from Abraham Lincoln is a truth that gives staying power to our decisions and efforts. Sticking with truths, let me share some truths no matter who wins the election.

Markets have performed well under both parties.

The S&P 500 index delivered an average annual return of approximately 11% over the past 75 years, through both parties’ administrations. During that same period, the economy expanded by around 3%(1). Neither party can boast a superior economic or financial market performance.

We do not radically re-engineer the US economy. 

The biggest fear among investors is that a progressive candidate might make a radical change in the economy. Remember, all presidents also need control of the Congress. This checks and balances system resulted in the last two presidents getting one signature achievement before losing the House. And despite concerns about major policy changes, business investment and government spending have been remarkably consistent as a percent of GDP.(2)

The historical narrative is not always as you remember it. 

We often draw on the past to make decisions on the future, but we don’t always get the history right. Here are a few “surprises.”

  • Jimmy Carter presided over significant job growth. 
  • Under Reagan, income for those in the 50th percentile ranked by income grew by almost 20%. 
  • During Obama’s presidency, despite concerns that his policies would cause massive inflation, the US had one of the longest deflationary environments on record.  
  • Under Trump, capital expenditures have been below their historical growth rate, even in the aftermath of a large corporate tax cut.(3)

Monetary policy matters more.

For all the focus put on the executive branch I would argue the that monetary policy matters more. The adage holds true: Don’t fight the Fed. Historically, presidents have been hurt or helped by the Federal Reserve. Both Reagan and Clinton benefited from falling rates. Both George H.W. and George W. Bush were hurt by Fed tightening. Obama befitted from a benign environment. And Trump’s first two years found a tighter policy.(4)

Markets don’t care if you don’t like who’s president.

The market can do well whether you like the president or not. Some of the best returns came when the presidential rating was in the low range of between 36% and 50%.(5)

That means the market delivered some of its best returns when half or more of the country didn’t approve of the current administration. Still, it’s hard to discern any direct relationship between the president’s popularity and the health and overall performance of the economy.

This is, in fact, not the most vitriolic election. Really.

Let’s look at the media not playing it straight through a historical lens.  

Newspapers were filled “with all the invective that disappointment, ignorance of facts, and malicious falsehoods could invent to misrepresent my politics.

George Washington

Nothing can now be believed which is seen in a newspaper.  Truth itself becomes superstitious by being put into that polluted vehicle.

 Thomas Jefferson

And finally, you think the ire and nastiness today is at a new unparalleled high? Remember back when Vice President Aaron Burr and former Treasury Secretary Alexander Hamilton had a vendetta, they settled it on the cliffs of Weehawken (with dualling pistols!), ultimately resulting in Mr. Hamilton’s death. As long as it stays on Twitter, believe it or not, we’re on a higher level.

Sources:

  1. Invesco, real GDP data, S &P
  2. Fred-global financial data
  3. Bureau of Labor and Statistics, Bureau of Economic Analysis
  4. Goldman Sachs, Bloomberg
  5. Bloomberg

DISCLAIMER: The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of BFT Financial Group. Neither BFT Financial Group nor the author makes any warranty or representation as to the accuracy, completeness or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall BFT Financial Group be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither BFT or the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.

DISCLOSURES: The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.