Category Archives: Macro

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

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).

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.

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.

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.

*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).

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 1^st, 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.

Calling the markets turbulent over the last couple weeks is an understatement. Many new investors have not experienced drawdowns this large and based on the numerous emails/DM’s I have received, this seems to be leaving many bewildered, angry and scared. Instead of writing a specific stock recommendation, this week I’ve taken a step back to think about my high-level views of the market and the lessons I have learned as an investor.

Below are six guiding principles which I have found to be true and below each, how I intend to reflect these in my investment decisions.

Quick Recap: Current Market

The stock market is forward looking. We made new all-time highs during the peak of COVID-19 and now, as the economy shows signs of improvement, the stock market is showing signs of weakness.

The reason for this is because coming out of the pandemic is going to put upward pressure on prices (inflation). The bond markets are reflecting this through higher long-term yields on treasuries (as long-term bonds are sold in anticipation of more inflation). As cash flows and rates start to creep higher, this is resulting in (1) a rotation away from companies that don’t make money into companies that do and (2) is leading to a sell-off in equities, as markets expect an end to the accommodative policies of central banks.

Unfortunately for policy makers, you’re caught between a rock and a hard place. As markets price higher inflation in the future, it makes the cost of current (government) debt more expensive. But if policy makers increase interest rates now (to off-set fears of inflation in the future), it increases the chances that we end up risking the economic recovery we’ve only just started to see signs off.

#1 Productive assets yield the highest returns.

Stocks should form largest % of my invested asset base

Over the long run, productive assets yield the highest returns. Stocks are by their very nature, productive assets, as they are literally pieces of a business. Examples of non-productive assets would be Housing, Bonds and Gold. Over time, stocks have outperformed all these other asset classes. Arguably, some stocks are more productive than others (due to the underlying nature of their business), but short of having your own company, stocks are the easiest entry point to a highly productive asset base for the new investor. Resultingly, I believe stocks are the most efficient means of making long term returns.

#2 Revenue Growth is the biggest driver of Stock Performance

Invest in companies with pricing power

What the single most important driver of the price of a stock? You might think it’s metrics like P/E ratios, Profits or even Cash Flows. In fact, the biggest driver of long run stock performance (1990-2009) is Revenue Growth. Intuitively, if a business cannot sustainably sell its product, then everything else goes out the door.

The companies that have a natural advantage will have pricing power and large Total Addressable Markets (TAM). This is what is considered a “business moat”. Margins and Profits are not important in the short term, as if a business can sell its product (at scale), then there will undoubtedly be ways in which it will be able to monetize this in the future. Meanwhile, multiple compression is just the markets way of reflecting herd behaviors as we swing from optimism to pessimism and should not be a consideration for investment decisions (more on this below).

#3 The long-term market P/E ratio is ~20x which implies a 5% yield

Assume 20x P/E in long term forecasts/price targets

Despite the media headlines around rising long term rates, the market has actually been positively correlated with rising rates over the last decade. This makes sense if you consider that long term yields rising generally reflect a more optimistic view of the future, and therefore, businesses should be doing better (all else being equal).

But there is something more interesting about this relationship. Even in periods where rates have been declining (such as in late 2019), we have not seen widespread multiple expansion. Or in other words, the market has consistently priced between a 10 to 25x earnings multiple on stocks (periods where it rallied above this such as in 2008 and 2020 were skewed as earnings were based on trailing 12 month averages). Another way to look at P/E ratios is as an earnings yield. A 20x P/E ratio reflects a 1/20 Earnings/Price Yield or in other words, a 5% return. So in other words, investors in the stock market already have an implied earnings yield/discount rate which is factored into investments despite what treasury yields are doing, and it’s around 5% (or a 20x multiple). This is the level I will use to model stock price targets in future blog posts.

#4 When inflation becomes a problem, you’ll have time to trade it

Don’t rush into inflation/deflation based trades

I was duped into the inflation trade during the on-set of the pandemic, as Central Banks everywhere, started printing massive amounts of money. My analysis was too simple (even though I was able to make a bit of money on my Gold hedges) and since then, Gold has underperformed the rest of the market.

The reason for this is because a critical part of inflation is the Velocity of Money (that’s a measure of how quickly money is circulating in the economy). This is often neglected and hardest to predict. During the onset of the pandemic, we saw the opposite of inflation (deflation). Why? Because people were not able to spend the money they received from governments. Today, even though much of the US is open, we’re yet to see increasing inflation. Why? Because a large proportion of the money being printed doesn’t end up flowing through to ordinary people (it sits with banks who then recycle this money into treasuries). It is this velocity of money that guides inflation expectations and thats extremely difficult to predict.

The second aspect of inflation is its impact on the stock market. Again, this is a more nuanced relationship, as valuations have actually been pretty supported around a 0-4% inflation range. It’s when inflation starts to break outside of these bounds that valuations start to be negatively impacted. This leaves a wide range for inflation before it starts to creep into stock market performance and make a material impact to your portfolio.

My learning here is that inflation is a bit like the monster under the bed. It’s scary and dramatized but frequently misunderstood. When inflation truly becomes a problem, there will be time to trade it and it will be obvious. Until then, better to ignore the media frenzy around it.

#5 The traditional business has a debt problem

Technological disrupters will prevail in most industries. Old fashioned businesses are value traps

When looking at the inflationary/deflationary effects circulating in the economy, I came across an interesting video by Cathie Wood from Ark Invest. She makes some great points about the worrying levels of corporate debt in the economy. Debt to Equity values continue to remain elevated as many companies have taken the last decade to spend money wastefully (through share buy-backs and dividends). Ultimately, they are in for a hard reckoning here as traditional business models in many industries are due to be challenged by technological breakthroughs.

Some of these breakthroughs that I’m looking at are 3D Printing in Manufacturing, Robotics in Logistics, AI in Insurance and E-commerce. The only solution here is that these incumbants will need to re-structure their balance sheets and reduce prices to manage their debt loads but at the same time, will have their business models disrupted by new entrants who are smarter and more tech savvy.

#6 Don’t fight the Fed

Never take the other side of the Fed in any investment class

This is a common saying in the market. The Federal Reserve is the single biggest buyer of assets in the US economy and has an unlimited amount of resource to solve problems (literally, they can just print more money). If at any point in time in modern US economic history you had bet against the Fed, you would have lost.

Historically, the Fed has been able to respond to liquidity crises with ease. In the past, when yields have increased at a rate which has threatened the Government’s ability to maintain its debt load, the Fed has been able to artificially bring yields lower with remarkable efficiency.

The Fed is facing an issue right now with regards to long term treasury yields rising. In fact, the Budget Office estimates that a 1% point increase in yields would cost more than 10x the US annual Defense Budget in interest payments over the next 9 years. I don’t know ultimately how this plays out but with such high stakes and given the historical effectiveness of the Fed in getting what it wants, I expect this to be swiftly dealt with as soon as it becomes a meaningful problem. Indeed the Fed is already sitting on $1.5tn in 1-5 year Treasuries (which could be sold for 10yr + Treasuries to bring long term rates lower).

Conclusion

Markets can be extremely volatile and I have found it easy to get caught up in the minutae without taking the time to think about the overall objectives and view that I am trying to reflect. I hope by reading these principles you are encouraged to think through your own view of the markets and the lessons you have learnt so as to have a better game plan to handle swings during the trading day.