If It's Not One Thing, It's Another
Markets started the third quarter on a strong note but mostly gave up the gains and then some, especially in September. Throughout the quarter, concerns mounted on several fronts: continuing COVID-related supply chain issues; slowing economic growth as a result of those issues; inflation; China's real estate debt market, along with its posturing toward Taiwan; and, finally, the threat of the US defaulting on its national due to partisan brinksmanship in D.C. And, yet, despite all of those worries, the third quarter ended about flat, with many broad equity categories in the red and few in the black. YTD returns are still quite robust due to a strong first half.
Before jumping into a few summary comments on the last quarter, it's worth a reminder that so much of the current news cycle—nay, every news cycle—is of the perennial variety: the actors change from year to year, decade to decade, but the never-ending refrain of worry that we endlessly scroll past—inflation, interest rates, economic growth prospects, national security threats, and inter-party political squabbling—are often of little-to-no long-term import. And, yet we scroll.
That acknowledged, here are a few short comments on some of the more significant economic themes of the past quarter.
Diminished Growth Projections
US GDP grew 6.5% in the second quarter. This would have been spectacular in normal times, but 6.5% was well below the 8.5% recovery rate that many analysts expected. The Q2 miss was primarily due to the continuing impact of COVID on supply chain issues (especially computer chips) and economic activity. These issues have diminished consumer activity in many categories due to lack of available goods, lengthy delays, and the resulting high prices. Unfortunately, the problems will take a while to be be resolved.
Unemployment numbers have recovered but more slowly than hoped for—again due to knock-on COVID impacts. All of this has led many analysts to reduce their full-year growth expectations by ~20% relative to earlier estimates. The good news is that the economy has surpassed its pre-pandemic level, although output is still below what the trendline growth would have been had we not suffered through last year's recession.
US inflation has been a worry since this spring's April and May inflation prints (about 4% and 5%, respectively), and most of the high inflation we are now experiencing is likely due to COVID-related supply chain issues. Unfortunately, even if COVID were to be magically wiped from the planet tomorrow, it would take some time to reestablish the complex rhythm between suppliers, manufacturers, and transporters and repair and replenish the supply chain. Remember, though, that many of the high headline inflation numbers we've seen these last six months are based on the artificially low base numbers of 2020 when we were in the thick of the COVID shutdown. If we look back over 24 months, using 2019 as a base, the two-year average headline inflation is closer to 3.3% per year on average. Yes, that's higher than the 1.5% to 2.0% rate we saw during much of the 2010s, but it's hardly catastrophic. Forward-looking bond market projections put 10-year inflation expectations at 2.4%, very much in line with the Federal Reserve's long-term target.
Like inflation, the China topic has come up in a few conversations over the last month or two. Three things are going on in China at the moment: 1. A dramatic increase in the government's exercise of its power over private capital and money flows and a move away from western-style capitalism; 2. The Evergrande/Fantasia Group Chinese real estate debt crisis; and 3. Increasing tensions between China and Taiwan, with China becoming increasingly aggressive in its efforts toward unification.
Regarding the real estate developer debt crisis: given the high degree of control the Chinese government exercises over banks and other key economic actors, it would be surprising for them to allow a Chinese-style Lehman Brothers event to play out. Even if such were to occur, it’s unlikely the impact would be as globally systemic.
With respect to China's changing approach to their management of private capital and the Taiwan situation, the outcomes of these situations are entirely unknowable. And, even if we could ascertain the eventual consequences, there is no way to know the timing thereof or fathom what the global economic impacts might or might not be. As such, there is no basis on which I could imagine formulating any coherent investment policy around matters where both the outcomes and timing are so variable, and that's all I have to say on that topic.
The US Debt Ceiling Negotiations—or, if you prefer, Kabuki Theater Comes to Washington
Dire, ridiculous, and yet utterly predictable. This play comes to town every few years, with the last National Tour quality version being 2011. The outcome has always been the same: drama, wailing, rending of garments —and eventually a resolution by the adults in the room just before the bus drives over the edge. As an aside, the US government has defaulted in some fashion at least four times: 1862's Civil War "demand notes" default; 1933 and 1968 when the US defaulted on its promise to redeem gold bonds or silver certificates, respectively, for in-kind metal as previously promised; and President Nixon's 1971 decision to default on our obligation to redeem foreign-held dollars for gold as previously agreed to under the post-WW2 Bretton Woods Agreement.
Lastly, a Quick Update on the Pending Tax Law Proposal
Last month the House Ways and Means Committee released its proposed version of the American Families Plan, which contained numerous changes from the plan initially proposed by the Biden Administration. It remains to be seen what a final, passable bill might look like, but the Democrats are bitterly divided over what should be included and at what cost. I imagine the prospects for this bill are tied in at some level with the debt ceiling negotiations. While we wait for clarification, here is a summary of some of the key proposals that may affect our clients:
- Beginning in 2022, the top marginal income tax rate would return to the pre-Trump tax cut rate of 39.6% for single taxpayers with taxable income over $400,000 and married taxpayers over $450,000. This was scheduled to happen automatically beginning in 2026 with the currently legislated tax-rate sunset provisions.
- The unified estate and gift exemption may fall from today's $11.7M per person to about $6M per person, with no proposed change to the estate tax rate structure (40% for gifts or estates above those thresholds).
- Effective for transactions occurring on or after September 14th, 2021, a new top capital gains rate of 25%, up from 20%, for married taxpayers with income over $450,000 and singles over $400,000.
- Roth conversions of non-deductible/post-tax contributions to an IRA or a company retirement plan (so-called "backdoor Roth conversions") would no longer be allowed.
- Lastly, there would be an income limit for pre-tax Roth IRA conversions, with married taxpayers above $450,000 and singles above $400,000 no longer eligible for any Roth conversion.
On a positive note, the step-up in basis for assets inherited at death had been on the chopping block in the original proposal by the administration but looks likely to remain in place under the currently proposed legislation. Although these proposed changes are the result of negotiations between President Biden and the Democrat-controlled House, it remains to be seen what the final legislation will look like and when any proposed capital gains rate increase would ultimately be effective so stay tuned.
There are encouraging signs that the spread of the Delta variant is slowing, with national trends showing a decrease of about 20% in new cases and hospitalizations over the last 14 days and closer to a 30% decline over the previous 30 days. While I'm sure we all hoped we'd be mostly beyond COVID and its far-reaching impacts by now, there is good reason to be optimistic that the next six months will look much better than even the last six. In the meantime, I hope you are enjoying Fall weather wherever you are. I have long thought the eight weeks between mid-September and mid-November are the best two months weather-wise in Colorado, and this year is not disappointing.
As always, we sincerely appreciate the opportunity to be of service. Please let us know if there is anything we can help with.