“One hot mess” seems to be a prevailing theme as we collectively face multiple challenges. In response to recent economic events, we recently made some relatively modest allocation changes by decreasing stock exposure. The main positive is that we continue to experience economic growth in a low-interest-rate environment. Moreover, the probability that Congress will pass additional fiscal stimulus with the infrastructure bill should continue to support that growth. So, while investment risks have increased (after a remarkable recovery from March 2020), we are not dramatically decreasing exposure to risk assets (stocks). We have not observed a sustained flight to investments that tend to do well in a crisis, such as long-term treasuries, gold, or even the Japanese Yen. We would expect to see this confirming information in the markets to signal that further de-risking action was necessary.
China and Emerging Markets
As the second-largest economy globally, Chinese equities comprise the most significant part of the emerging markets stock index. Emerging market stocks seem to be excellent values due to pricing and growth rates relative to the United States markets. However, political risk is high due to Chinese government crackdowns on technology stocks combined with the potentially overleveraged real estate sector. In addition, the Evergrande crisis and likely bankruptcy mimic some characteristics of the Lehman Brothers collapse in 2008. Therefore, we think it is prudent to reduce emerging markets allocations at this time. Hopefully, China will be able to implement corrective action and policy to avoid a financial meltdown, which would affect not only Chinese equities but also equities around the world.
COVID Delta Variant Economic Effects
COVID outbreaks boil down to math. Unvaccinated individuals with COVID are nine times more likely to be hospitalized than vaccinated individuals who have a breakthrough case. In addition, over 99% of deaths are in unvaccinated individuals. There has been a resulting drag on the aforementioned economic growth, mainly from individuals reducing exposure to crowds at places of business or travel. Nevertheless, barring another variant outbreak, there is some good news given current hotspots are clustered in highly unvaccinated populations. One takeaway could be any current slowing to economic growth will likely pick up in 2022, which bodes well for stocks.
Tax Increases
Nine months have passed since the Biden administration took office, and at this point, it appears many fears about tax increases were unfounded. The likely changes, if passed through reconciliation, are more modest than initial proposals. Nonetheless, we do expect the following changes:
- Increased corporate taxes on earnings over $10,000,000 from 21% to 26.5%.
- Increased maximum capital gains taxes from 20% to 25%
- Increased top individual income tax rate from 37% to 39.6% along with a 3% surtax on individual taxpayers with Adjusted Gross Income above $5,000,000 (filing jointly). The tax also applies to trusts and estates with income over $100,000.
- Decreased ability to fund Roth IRAs
- An inability to fund retirement plan accounts if balances are over $10,000,000 along with new increased required minimum distributions on those same high balance accounts
The proposals contain many more details. So, besides paying a little more tax, most of us will not experience significant changes, but we will be in touch with you when the final details are known. In any event, increased rates kicking in at various income levels increase the need for tax planning, particularly on sales of assets with capital gains.
Inflation
Social Security benefits may increase by 6% in 2022. Many industries are experiencing shortages, and businesses are having trouble finding enough workers. Inflation is real, and while we expect it to ebb into 2022, it is nearly impossible to predict the base level accurately. As a result, we continue to be very wary of making longer-term commitments to fixed income securities, even though shorter-term safe investments have yields lower than inflation.
Stock markets have had a very good run since March 2020. However, many asset classes peaked earlier this year and have been in an up and down pattern ever since. So, while the outlook heading into 2022 is good, market risk has increased. Nevertheless, the markets tend to perform well from November-January, and we will be looking to identify opportunities to participate as long as current problems do not escalate.