Why I’m (still) bullish US Equities

I’m a big fan of Ark Invest and the work of Cathie Wood and Brett Winton. I regularly trawl through their research pieces to formulate my view on the markets and to guide my investment ideas.

This is a brief summary of my learnings and general conclusions from Ark’s most recent, ‘In the Know’ series. These views are my own and whilst I reference Ark’s research, I am not associated with Ark Invest in any way. If you found this helpful, please subscribe as I continue to build out this blog as a forum to share my learnings, thoughts and market ideas.

Headline Inflation numbers are skewed

There’s no doubt about it, money supply in the economy is rallying sharply and is on an upward trajectory. This is being fueled by Central Bank Easing (Fed purchases of securities) and Government Stimulus measures. Normally, this leads to higher inflation (increased supply of money means higher prices of goods and services). This is a popular narrative, especially as we start to see strong economic data feed into reports

US Money Supply is at record highs

Nonetheless, inflation reports this year are going to be skewed towards being more frightful, than accurate. This is because inflation is typically reported as a year/year comparison (to account for seasonality). Last year, we saw major deflationary effects in the economy (people couldn’t spend money, so prices fell and the economy sank into a severe recession). This leads to a ‘basing’ effect where now that we start to see this process reverse, the year/year reports start to look abnormally high (especially compared to the Fed’s 2% Target Inflation Rate).

Inflation data on a monthly basis avoids the same basing effects, and as of yet, we are not seeing any major inflationary pressures creep up in the economy (more on why that’s the case, below).

US CPI Inflation (Monthly)

Higher Corporate Income Taxes are not going to tip this market over

Government spending is beyond anything we’ve ever seen before. Federal Debt as a % of total GDP is ballooning. This should be a cause for concern because at some point, all this money needs to be paid back, through higher taxes and/or reduced spending.

Federal Debt is Approx. 130% of GDP

What is harder to know however is when it needs to be paid back. This is a function of political incentives, where we are in the economic cycle and how hard it starts to get for the Fed to start servicing this debt load. My view is that for the next 6 months at least, the market continues to ride the gravy train. This is because the new administration is still setting out their political agenda, forward GDP forecasts are being revised higher and debt service payments remain at historically low levels – so there is not an immediate need to balance the books.

With that being said, there is a lot of talk about Corporate Income Taxes (‘Corp Tax’) having to increase to fund this debt, eventually. The current administration has proposed increasing Corp Tax by 7% (from 21% to 28%, at a Federal Level). Firstly, I don’t think a tax hike of this scale ends up happening. Secondly, even if we did see some increase in Corp Tax (at a Federal Level), I think the effective change for most corporations would be muted because of relocation incentives between states. More on this below.

Corporate Taxes only make up for about 7% of total Government Revenues (Incomes Taxes are around 50% of revenues, on the other hand). Therefore, even if you assume a 33% hike in the tax rate (28% vs 21% and assuming zero elasticity in revenues, this only increases government revenues by around 2%, at most). So this is hardly making a dent on the overall fiscal balance.

Corporate Income Tax only accounts for 7% of Govt Revenues

More importantly, compared to other Advanced Economies (OECD), the US already has above average (Effective) Corp Income Taxes (26% vs 23%). A 7% increase would certainly put it in the running for the highest Corp Tax Rate out of the bunch, higher than France (32%), Germany (29%), Italy (29%). Optically, I struggle to see this happening as it’s not a position any major economy wants to have (let alone a broadly fiscally conservative, free market oriented, USA).

Even if we were to see some increases in Corp Tax at a Federal Level, there is a huge disparity in state level Corp Income Taxes which will mute the net impact on Corporations.

For example, a relocation from California to Florida, reduces the top rate of Corp Income Tax by 4.4%. Move from New York to Texas and you cut this by 6.50%. This explains why intra-US company relocation is at all-time highs (compounded by pandemic related shifts to working from home). Companies like Goldman, Telsa and HP are leading this charge and won’t be the last. Ark Invest are also considering the same.

Sizeable difference in State Level Corp Income Tax

*Texas does not have a Corp Income Tax. Instead, it has a Gross Receipts Tax (applied to revenues before cost deductions) which is not a direct comparison.

So long story short, Corporation Income Tax hikes are a red herring. The tax hike proposals are overly aggressive/ambitious and the reality is that this probably doesn’t mean much for what businesses end up paying. This likely mutes any resulting impact on stock prices (though it does make real estate investments in Texas/Florida look very compelling).

Significant (deflationary) economic tailwinds

The savings rate in the US remains at historically elevated levels (above 13%). This speaks to the amount of overall pent-up demand in the economy as people have been stuck at home for so long (and for many, receiving stimulus checks they haven’t been able to spend).

US Savings Rate at historical highs

Over the next couple months, we are likely to see the savings rate trend progressively lower; especially as more restrictions are lifted across the US and people have more places to spend their money. This will continue to drive GDP higher (70% of US GDP is made up of consumption).

However, to off-set the inflationary impact of this higher spending, we are seeing very encouraging signs in the labour market of deflationary forces playing out. Whilst we’ve seen employment rebound, we’ve also seen working hours increase at the same time, as firms extract more labour (productivity) from their existing workforce.

We are likely only at the cusp of these productivity gains in the workforce. Ark identifies five key platforms of technological innovation which are likely to drive further productivity gains and resultingly deflationary forces in the economy. These are: Robotics, Blockchain, Artificial Intelligence, DNA Gene Editing and Energy Storage. The breakthroughs in these areas are already at key inflection points and should spur a period of rapid economic growth with (positive) productivity led deflation in the economy.

US Treasury Yield Saga is likely over (for now)

One final thought is how quickly and efficiently the market has managed to shrug off fears of rising 10 Year US Treasury yields.

The 10-Year Treasury Yield nearly doubled in three months, which is a huge move in a relatively tame bond market. The narrative was that inflationary pressures seeping into the economy were being reflected by the bond market (as investors sold 10 Year Treasuries), and as a result, growth stocks in particular were being sold off (due to future cash flows now being discounted by a greater amount). FWIW, I don’t agree with this view and I explain why in my previous post.

Nonetheless, over the last couple weeks, we’ve seen a large reversal in equities with no news in the bond markets. Most growth stocks are up ~20% off their lows and the Nasdaq has rallied 7% from March lows, and is now at all-time highs. This is despite the 10 Year Treasury yield stabilizing around 1.6% (which is still 3x higher than the Aug 2020 low).

One interesting theory Ark posits here for this is that many investors overlooked the SLR requirements the Fed was planning to change for banks at the end of Q1 2021. From April 1st, the Fed removed the temporary relief on capital requirements for Banks, which had allowed them to exclude their holdings of US Treasuries, from their reserve requirements. (The theory is that by allowing banks to exclude Treasuries from their reserve requirements, they would have more cash to lend out and thereby kickstart the US economy). As this waiver was coming to an end, banks were forced to sell their Treasury holdings to meet the stricter reserve requirements. Since this has come into effect, we’ve seen a pull-back in bond market volatility (and a stabilization in yields). Given the Central Bank has a vested interest in keeping yields low/stable (which such a high debt load), I’d assume this stability is going to be enforced one way or another and therefore, I think we’ve likely seen the end of the yield saga for now.

Conclusion

In sum, I have a lot to be bullish about in this market. I expect to see some scary headline inflation numbers which surpass the Fed’s 2% Target but the reality is that the US economy is heading for a sharp rebound from a terrible 2020. So long as we continuee to see real productivity gains driving economic growth, I’ll ignore the noise and continue to be (levered) long equities.

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