The Research Bulletin for August 31, 2021 includes commentary from our Portfolio Managers and Head Trader. View online, or download the printer-friendly version.

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The Outlook for Equities
from Nancy Tengler, Chief Investment Officer

Economic Growth: We are expecting growth to slow which is not to say we don’t think the economy is humming along. As investors, we have to look ahead a minimum of six to nine months in positioning our portfolios. And, it is true, growth will slow in 2022. As we have said numerous times. It’s just the math. It is difficult to sustain the kind of growth we’ve seen in the economic bounce back of 2020. Still there is plenty of good news as the U.S. economy continues to chug along.

  • Onshoring momentum continues: 137 companies (so far) in 2021 announced U.S. onshoring with production coming largely from China then Europe and Japan. In 2020 250 companies announced reshoring to the US. This is kind of a gee whiz factoid but over the longer term, good for the supply chain. In AZ where I spend half my time, we are seeing massive buildings going up to accommodate foundries (INTC-2, TSM-1), server farms (GOOGL 750K square feet in Mesa) and distribution centers.
  • Inventories as measured by the ISM Purchasing Manager’s Index are at historic lows. New orders are up driving inventories to historic lows as supply chain disruptions make it difficult to obtain critical parts. Replenishing those inventories will drive economic growth in Q4 and into 2022.
  • Industrial production rose 0.9% month over month in July while capacity utilization rose as well. High tech industrial production took a breather in July—flat over June. But take a look at that chart. It’s breathtaking.
Source: Cornerstone Macro (8/17/21)

Higher taxes on the horizon. Democrats passed a budget resolution joining the Senate and setting in motion the budget reconciliation process to settle on the final price tag for the Biden Administration’s proposed $3.5 trillion “human capital” bill. One of the most closely watched and anticipated taxes is the capital gains tax. As proposed the bill calls for a dramatic increase to over 40% on investment gains. However, it seems more likely the tax will increase from 20% to 28% on incomes above a certain threshold. The bill, as proposed, calls for the tax rate to increase on incomes above $1MM but the murmur number is around $400K. Add to that the 3.8% Obamacare tax on investment income for joint filers earning $250,000 annually.

Finally, the outstanding question is “will the tax be retroactive?”. President Biden suggested the tax be retroactive to when he introduced the legislation in the spring. Our sources suggest the greatest likelihood is that the tax will be effective on the date when the legislation is introduced by the chairman of the Ways and Means Committee—likely mid- to late-September. Of course, no one knows and this is an educated guess but below is a table prepared by our friends at Cornerstone Macro outlining previous tax increases and their effective dates. Stay tuned.

Jackson Hole: I thought this was one of Powell’s better speeches. I am sure others disagree with me. I have been a vocal critic of how badly the Fed missed the ferociousness of inflation and has had to raise their near-term target. And I am sure others disagree with me there too. However, the message was clear (whether I agree or not ) tapering will begin prior to year-end. “Substantial further progress” (which was defined by the Fed in December as the threshold for action) has been made on inflation and progress has been achieved in labor market. Labor is still below the Fed’s definition of “substantial further progress”.

What has been missing from the Fed’s jobs assessment is the clear effects of supplemental benefits on the demand for jobs. We know there is huge supply of jobs ($10MM ish per JOLTS) but a lack of applicants or, supply. We also know that states which have ceased the supplemental benefits are experiencing significantly lower continuing claims. We wonder why the Fed has not noted that or considered it in their thinking about the employment picture. That said, it is clear rate hikes are not being tied to tapering and that the Fed will require full employment and a sustainable 2% level of inflation. Increasing spending on tech capex (and the sub-2% level a-cyclical inflation experienced over the last decade) are likely to put pressure on the 2% inflation target which makes us wonder if the risk to the Fed’s thesis is that after this inflation shock improving productivity will put pressure on sustainable inflation. Causing us to ask: will the Fed ever really be able to raise rates?

Bonds & Fixed Income
from Jason Weaver, CFA®, Head Trader & Portfolio Manager

Relatively quiet couple of weeks in rates with 10yr Treasury yields stuck in a 10-12bp band, first rallying on COVID delta concerns then selling off as Fed officials come out possibly supporting an earlier taper timeline as soon as later in 2021. Most political analysts are predicting a continuation of Powell’s leadership of the Fed (which we agree with), with Lael Brainard possibly becoming vice chair with the implication she is next in line post Powell era. This policy continuity should limit the potential for more uncertainty which should be a calming influence on markets. We expect some incremental information on the boards (not the individual members’) thoughts around taper timing and sizing at the conclusion of next week’s Jackson Hole Symposium—but ultimately any change will be measured, gradual, and widely communicated, in the possible hopes to avoid a 2013 “tantrum” scenario.

In credit, even noting the tightness of markets historically, we like our positioning as modestly aggressive which should perform well under a still-continuing recovery cycle, albeit a bit slower than we have seen to date. Our partners at Strategas Group report that leading up to the 2013 taper, high yield performed best of all asset classes, and during the taper local currency EM debt performed worst. Note – we have a significant position in high yield bonds as well as similar credit quality bank loans – both with very limited interest rate exposure and, we recently sold our local currency EM exposure.

Convertible Securities
from Stan Rogers, Senior Portfolio Manager

The primary convertible market began to show small signs of emerging from a summer slowdown with 3 issues priced for $2.3 billion in proceeds. Word on the street is that post Labor Day, the primary calendar will meaningfully pick up.

News/Earnings of note:
Illumina (ILMN) made a pre-emptive move to go ahead and close the acquisition of GRAIL, a cancer testing startup, ahead of European and US regulatory approval of the deal. The move could hinder relationships with regulators. Management indicated they made the move due to what they perceived as delaying tactics by European regulators, and stated that they did not have jurisdiction anyway, since GRAIL has no operations there. This news, coupled with potential earnings dilution in 2022, caused the stock to move lower.

Lumentum (LITE) delivered a strong Q4 report. Earnings and sales were above estimates, and the company also guided Q1up slightly. The guidance could have been more impressive, but management said that critical semiconductor components would hurt revenue. Margins also improved on better laser demand and seasonal strength on Apple iPhone ramp.

Palo Alto Networks (PANW) had a stellar Q4 report. Earnings and revenue were above consensus, and the company guided FY earnings and revenue higher. Billing growth accelerated reflecting a broad-based demand for security solutions. The company is also showing signs of success in transitioning to a subscription cloud-based model. The only negative in the report was a compression in operating margins, where op-ex increased as the company continued to invest in growth initiatives. The stock reacted favorably to the news.

Splunk (SPLK) announced a solid Q2, with earnings and revenue exceeding estimates. Cloud and license revenue growth were both strong. The company’s transition to a subscription model had hindered earnings in previous quarters, but this report shows the progress the company is making. Annualized recurring revenue and the number of customers provides comfort in management’s execution and future growth opportunities.


We exited the CenterPoint Energy (CNP) 7% mandatory convertible preferred position. It matures/converts on September 1, and we already received the final dividend.

Upcoming maturities/redemptions:

  • IFFT 6% mandatory convertible preferred. Goes ex on 9-11 and matures on 9-15 and will try and sell in this narrow window.
  • NI 7.75% mandatory is a replacement candidate for the CNP position.

Equity Hedging
from David Jeffress, Portfolio Manager

We continue to watch the VIX and wait for an opportunity to purchase VIX calls, essentially hedging not only the equity market’s downside, but also increased volatility. We had previously communicated to you that we were looking for an attractive price on the VIX before we purchased calls on the index, and that number was 12, later revised to 15. The VIX never did quite make it, dropping as low as 15.45 on 8/13 before briefly rising to 21.63 on 8/19 and then resuming its fall back towards 16. We will continue to watch and conduct our analysis on the relative opportunity between VIX Index calls and S&P 500 puts, which we continue to measure through the SPY exchange-traded fund.

As of August 2021, it has been 10 months without a 5% fall in the S&P 500, so hedging for drastic moves to the downside has been an exercise in both patience and maintaining our discipline. We will continue to monitor the situation and will report back with new developments as they come our way.

We are 80% allocated to put options on the SPY as of 8/13/2021 and have been waiting for an opportune time to deploy the remaining capital in the hedge strategy for the quarter to call options on the VIX Index, as we have done previously. The long-term trend on the VIX suggests that anything below 12 would be an ideal entry point. However, we pride ourselves in being flexible and have revised our target. Should the VIX stay at or below 15 in the coming days we anticipate making this final trade for the quarter.

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