Research Bulletin – September 14, 2021
The Research Bulletin for September 14, 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.
I am often asked about the deficit spending and the seemingly rocketship trajectory of debt accumulating on the U.S. government’s balance sheet. Is it a pending disaster? And my answer has been eventually, yes. But with historically low interest rates, debt servicing tends to be where policy makers and some economists are focused. Begging the question: can the Fed ever really raise rates?
Cornerstone Macro hosted their Virtual Macro Conference this week. One of the most interesting panels entitled Deficits, Debts, and Fiscal Policy Implications featured Douglas Holtz-Eakin, President of the American Action Forum and former Director of the Congressional Budget Office and Charles Seville, Senior Director, Co-head Americas Sovereign Ratings, Fitch Ratings. In July, Fitch downgraded its outlook on the U.S. to AAA, outlook: negative. One of the reasons? The U.S. government’s inability to govern in a bi-partisan manner.
The biggest take-away was the chart below, which gives me pause. Currently, U.S. debt as a percent of GDP sits at 107.6%, a steady march over the last ten years when debt sat at 95.8% of total GDP and approaching the WWII era high of 118.9% of GDP. More important than the current level is the trend in spending coming out of Washington. The current “human capital” bill that the Democrats are planning to pass (in some form) on a partisan basis in reconciliation adds trillions of dollars of spending on top of the trillions of dollars in incremental (COVID inspired) spending in 2020. But that is only half the story—the $3.5 trillion Build Back Better Plan, following the $1.3 trillion American Rescue Plan—bill vastly expands the social contract without doing anything to solve the funding problems for Medicare and Social Security. Stay tuned.
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?
Don’t let upcoming volatility scare you out of the market.
We have discussed our expectation around a correction. In the last two Tengler Reports, I have written about bad policy coming out of Washington. We are about to see that as the House intends to announce the Buy Back Better reconciliation plan on Monday (or thereabouts). During a recent Strategas Virtual Policy Conference with Dan Clifton, I took note of the following two charts.
The most analogous period to today is September of 2013. Check out the chart below. The similarities are uncanny. You can see that stocks corrected and then were off to the races. We have said a correction will be a buying opportunity. We still believe that, and the chart below reinforces that view.
The Washington cohort just doesn’t think like the rest of us. As presidential poll numbers decline, their legislative agenda becomes more ambitious. We expect to see the reconciliation bill announced Monday or Tuesday. Spending will be robust, but since the spending is spread over ten years, we will not see the stimulative inflationary growth we’ve seen from recent stimulus (though we expect inflation to be stickier, longer than the Fed is anticipating—we have written extensively about how wrong the Fed has been on inflation for the last decade), rather if the Build Back Better bill follows the blueprint laid out by the Biden Administration, corporations will see significant tax increases (likely to shave $10/5% of S&P 500 earnings in 2022), and the economy will absorb a fiscal drag of about 8%. As we have written, growth is slowing, and we have been repositioning our portfolios accordingly.
Interestingly, the draconian estate tax proposals are unlikely to stick. Still too soon to know, but it is likely the step-up proposal will not be included (super important for everyone but especially small businesses and farms), though the estate tax is likely to be raised from 40% to 45% and the lifetime exemption to be phased down to $7.5M-$8M from $11M today.
We may have Senator Kyrsten Sinema to thank for the moderation of the Biden Administration’s estate tax proposal. According to Dan Clifton of Strategas, Senator Sinema is a self-proscribed champion of small business. During a recent Congressional recess, the Senator, who interned at a California winery—was one of the biggest opponents to the current proposal. She apparently understands the ramifications for small business and landowners. Encouraging to us. But hang on—we should know a great deal more in the next few weeks.
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 Since joining Laffer Tengler just over one year ago, we have generated modestly good returns and have been very successful versus our competitors with similar strategies achieving a 6th percentile rank according to the eVestment database. In the first half of this past year, this was due to our optimism in the resilience of the global economy, the progress on a vaccine, and unprecedented fiscal and monetary support by governments and global central banks. In the latter half, our approach has proceeded with quite a bit more caution, due primarily to the speed and strength of markets’ recovery. Valuations are at historic highs and the supply of debt at negative yields is at a historic peak. To illustrate just how challenging market conditions have been as of late for fixed income investors, I came across a very descriptive twitter thread from earlier this year included below:
It’s a snoozy Friday and bonds have been moving basically sideways for a couple of weeks here, so I haven’t had much to say. That range on 10yr yields is <6bps wide.— Guy LeBas (@lebas_janney) January 22, 2021
(Incidentally, I think “sideways” is path of least resistance for while).
Mini-thread. 1/x pic.twitter.com/qoXdl8mt6Z
The thread continues, “I’m not sure what catalyst breaks this balance, but it’s probably a few months off, and my bet is the next move will be for somewhat higher rates. So what do we bond PM-types do when rates move sideways for a while?
We look for non-directional source of return, which fall into three broad categories:
- Short vol
I’ll go through each quickly.
- Carry is just the income generated by the yield of an instrument, often adjusted by financing cost. For example, the 30yr UST has a yield of 1.86%, financing is 5bps, so your carry is 181bps. Higher risk bonds generally have higher carry.
- Short vol is selling options to collect premium. You can do this explicitly in listed ED/UST options or in OTC swaptions depending on your mandate. Or you can buy option-embedded bonds like MBS. Not a lot of juice in short rate vol right now, but it’s something.
- Roll-down is the income generated by the passage of time over and above carry. It’s created when a bond goes from being discounted at a “x” yr interest rate to an “x-t” yr interest rate, where it is the passage of time. this is actually the most interesting to me at the moment. Roll-down is best when and where the yield curve is steep. The curve is steepest between the 5-7yr points with a yield differential of 33bps (17bps/yr) and 7yr USTs carry 71bps/yr.
In a unch rates, 7yr UST total returns will run ~88bps/yr. DV01, a measure of risk, on a 7yr UST is $670/mm; divide the two and the expected return/risk ratio on 7s is 0.13x. compared to 10s at 0.12x and 5s at 0.10x, and 7s are best prospect in flat rate scenario.
So that’s how at least one PM is thinking about allocating rates capital for the short term.”
from Stan Rogers, Senior Portfolio Manager
News/Earnings of note:
The new issue calendar began to show signs of life following the official end of summer. A total of 5 deals were priced for proceeds of $3.7 billion. Sea Ltd, a Singaporean company, comprised the bulk of this amount with a $2.5 billion convertible bond. While these deals did not fit in our strategy, it is a positive development for the asset class.
Broadcom (AVGO), our last remaining holding to release earnings, reported positive Q3 results. Revenue and earnings were above expectations, and the company raised revenue guidance for Q4. Management made positive comments regarding momentum in their product portfolio and an improving enterprise demand environment.
We exited the CenterPoint Energy (CNP) 7% mandatory convertible preferred position. It matures/converts on The proceeds from the recent CNP.B sell were reallocated to the purchase of NiSource (NI) 7.75% mandatory convertible preferred. At purchase, this security has a 7.3% current yield and a 20% conversion premium. Trading on a mid-70s delta, it will provide a +20%/-15% return on a +/- 25% move in the underlying common. S&P rates the security BBB-, has life until 3-1-24, and out-yields the underlying common by 3.8%.
International Flavor & Fragrances (IFF), 6% mandatory convertible preferred was sold. The security mandatorily matures/converts on 9-15, and we exited the position prior to this date.
from David Jeffress, Portfolio Manager
We are fully hedged in our Equity Hedge strategy, and as of this week, we hold put option contracts against over one million shares of the SPY exchange-traded fund. Some of these contracts will expire before the end of the month, with the balance set to expire by mid-October if they are not monetized. Any liquidation in these contracts would likely begin to happen if the S&P 500 were to fall back towards the 4,000 level.
As of Friday, September 10, the S&P 500 has fallen for five straight days while remaining within 2% of its all-time high, which is unusual. Interestingly, while the S&P 500 as an index remains resilient, a growing number of individual companies have already experienced a 10% correction from their recent highs (as illustrated in the chart below from Morgan Stanly by way of Bloomberg).
We remain optimistic that the equity markets will continue their ebullience as we head into the fourth quarter, with market fundamentals remaining extremely supportive, but the contracts we have accumulated allow us to remain fully invested across our equity strategies while still being mindful of the potential for a meaningful sell-off in equities.
from Jonathan Berkowitz, Securities Analyst
The Global Revolution strategy has utilized exchange traded funds (ETFs) to build a portfolio that offers global diversification of green infrastructure, emerging technologies and energy with a particular emphasis on metal miners that produce the materials necessary to achieve planetary decarbonization.
When creating the portfolio, we concluded the metal miners would benefit from the increased demand and decreased supply of metals needed as the world transitions to clean energy and green infrastructure. The chart below proves we were right, with the exception of iron ore and silver. The price of iron ore has decreased 27% over the last month, due to China’s decreased demand and increased supply as the country continues to release reserves to help curb commodity prices. Silver has been inversely correlated with the dollar and has yet to diverge based on its contribution to the production of solar panels and solar cells. Overall, the surge in critical commodity prices has been spectacular.
The overarching goal of Global Revolution is to have an overweight position in copper and equal weighted positions in gold, silver, palladium, iron ore and steel. Copper is a key ingredient for the planetary decarbonization theme (transportation electrification, power decarbonization and infrastructure expansion). We have analyzed our metal exposure since inception and have seen a major shift in holdings within the exchange traded funds causing unintended and unwanted overweights in specific metals. Happily, we caught it quickly and have made the decision to move into individual securities. This will give us the ability to act quickly if needed in dynamic market environments and to target our exposure precisely.
We have developed a tool which allows us to determine our exact metal exposure per security based on the percentage of total revenue. By knowing the exact breakdown by security, we can set specific guidelines to achieve a targeted overall metal exposure for the entire portfolio.
In order to reduce our exposure to gold, we are selling our positions in the iShares MSCI Global Metal and Mining Producers ETF (PICK), the iShares MSCI Global Gold Miners ETF (RING) and the iShares MSCI Global Silver Miners ETF (SLVP), which recently added significant exposure to gold. The Aberdeen Standard Physical Palladium Shares ETF (PALL) will be trimmed to maintain proper palladium exposure.
The initial change will include nine mining companies; Freeport-McMoRan Inc., Vale, Steel Dynamics Inc., Southern Copper Corporation, Reliance Steel & Aluminum Company, Cleveland-Cliffs Inc., Wheaton Precious Metals Corp., Pan American Silver Corp., and Turquoise Hill Resources. The benefit of shifting away from ETFs and into individual securities is that we can get away from over diversification and consolidate our positions in high quality names. A 12-Factor Analysis has been completed on all new positions.