Friday 7th May, 2021
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Markets have suffered a correction this week amid concerns about the scale of the coronavirus outbreak in Asia and Latin America (where the pandemic has been rampaging non-stop). And the drawdown only intensified on Thursday after President Biden revealed a more aggressive (and progressive) tax plan than many on Wall Street were expecting. The S&P 500 has already shed -1.2% for the week (ahead of the Friday open), while most European, Asian, and EM indexes have seen similarly large declines. At Bedrock, we have been cautious of sky-high stocks and frothy market conditions for some time and have positioned portfolios accordingly. If there is now going to be a double digit sell-off, it would come as no surprise to us. Indeed, the warning signs have been flashing for some time already. For example, on Friday last week, the price of Dogecoin, a crypto currency set up as a joke, rose another +110% in a single day (and briefly had a market cap of c.$50bn). This is not normal – or rational. That being said, we do not believe that the Fed or the ECB will allow a big decline in traditional asset markets while the real economy is facing the strain of pandemic policies. As such, while short-term volatility is long overdue, our medium-term outlook is for risk to continue to rally as we (in the developed world at least) exit restrictions this year.
Turning first to the pandemic, then, Asia is getting worse – and quickly. In the North, Japan is facing a big increase in cases and with the Olympics now just three months away. To stem the tide of infections, the government (of what is the world’s third largest economy, remember) has been forced to declare a state of emergency and new lockdown restrictions in several prefectures including Tokyo. Whether this will be enough to flatten the curve seems doubtful given how little locally specific half-measures have worked elsewhere. Meanwhile, India is fast becoming the global epicentre for new infections. As we write this letter, >300k cases of covid-19 are being diagnosed in India every day and an infectious new variant is taking hold across the country. The steep rise in hospitalisations in particular is pushing India’s rudimentary health system to the brink of collapse – and the peak of this covid wave is nowhere yet in sight. Nevertheless, given the poverty in which so many Indians live, the government fears the economic and social costs of an extended lockdown even more than the virus itself; and, so, with no good options left, India is for all intents and purposes preparing to ride out the virus and accept the consequences. India’s predicament should serve as a grim reminder that the pandemic is far from over even if the sun is starting to shine in the US and Europe. And a similar fate could befall much of the EM world soon if vaccines do not get distributed quickly. Most developing countries suffer from a lack of monetary and fiscal space to dampen the economic effects of social distancing and lockdown policies, and also have large informal labour markets (and small tax bases), a relatively tiny number of ‘tele-workable’ jobs as a share of the total, poor health infrastructure for distributing vaccines, and crowded and unsanitary housing in cities. The only positive for EMs is that demographics are favourable. This is why the IMF predicted in its latest Global Economic Report that while the economic fallout from 2008 was felt most heavily in the DM world, the events of 2020 and 2021 will reverberate much more in the EM world. In light of this, a level of caution around idiosyncratic EM exposures is warranted, and a diversified portfolio is the best answer to an uncertain world.
The other market-negative news this week was the announcement that President Biden is planning to double capital gains tax for high earners (i.e., those on >$1m per annum), and in the process eliminate favourable tax treatment of carried interest for private equity funds and hedge funds. The proposed tax changes will be introduced (perhaps as early as next week) as part of the President’s American Family Plan, which is the second leg of his vast infrastructure spending package (now worth >$3tn). Coming on top of the c.$2tn in fiscal stimulus pushed out earlier in the year, these proposals are quite something. How the two components (i.e., tax and spending) each change growth and productivity dynamics in the US will determine if the policy is a success. Clearly, the US could do with new roads and bridges, and ‘greening’ the economy is necessary to meet long-term climate change commitments (a key priority for the new Administration). However, markets have been very focused on the additional spending in the Biden programme and rather less so on the tax implications. Analysis suggests that the higher tax rates that Biden has proposed will more or less reverse the Trump tax cuts in 2017 – and markets flew after that reform bill passed. If enough Democrats back Biden on tax, investors will have good reason to be concerned. Notwithstanding that, however, where will these concerned investors go? The vaccine rollout in the US is bringing life back to major cities across the country, even as the streets of Paris and Rome empty out. The developing world, as discussed above, is nowhere near the end of the pandemic saga – and the worst is probably yet to come. Even if corporate and capital gains taxes rise in the US, the medium-term impact on US assets is likely to be outweighed by the rapid re-opening of the economy and the absence of ‘better ideas’. So once the weaker hands are shaken out, and the dust has settled, we do not anticipate the US starting to underperform. Uncle Sam is never one to bet against.
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