Monthly Partner Memo – May 2021

May 01, 2021 | Paul Chapman


Thankfully, in Canada we are finally making some progress on vaccinations. I hope that most of you have received or at least booked had the chance to book your initial shot.

Thankfully, in Canada we are finally making some progress on vaccinations. I hope that most of you have received or at least booked had the chance to book your initial shot. A massive thank you to New Brunswick and Newfoundland/Labrador for sending health care workers to Ontario to help.


Friends & Partners,

Thankfully, in Canada we are finally making some progress on vaccinations. I hope that most of you have received or at least booked had the chance to book your initial shot. A massive thank you to New Brunswick and Newfoundland/Labrador for sending health care workers to Ontario to help. 

Let’s get right into it this month – the market seems to defy many people’s expectations, but many are  finally starting to accept the fact that there remains continuous liquidity being pumped into the system, and the economy isn’t about to fall off a cliff. The Fed remains historically dovish and supportive of asset markets (despite the rebound in economic activity), and a steady decline in COVID-19 cases in the U.S. continues. Record-level easy financial conditions have led to indiscriminate asset inflation, floating all boats. There remain risks as always, but the main pillars supporting markets remain intact – massive government stimulus, historic Fed accommodation, vaccine progress and a continuing economic rebound. So, despite concerns around inflation, taxes, sentiment and timing around when the Fed starts letting off the gas, the outlook still appears relatively supportive for assets. But we need to be cautious, because timing pullbacks is impossible, and it won't take much to get a pullback as the hype surrounding the re-opening economy eventually starts to fade.

So let’s assess some of the risks:

US Corporate and Capital Gains Tax Increases – A Significant Market Risk?

In short – not really.

President Biden unveiled his Made in America Tax Plan recently, which proposes an increase in the US corporate tax rate to 28% from 21%. Though this is unlikely to pass through Congress in its current form, the prospect of higher corporate taxes has caused some heartburn for the markets. But historical market performance data indicates that changes to the corporate tax code should not be feared – calendar years in which tax hikes went into effect have historically coincided with double-digit S&P 500 price returns and stronger US GDP growth, on average. And tax regimes don’t have any meaningful long-term impact on broader market performance historically.

Biden also proposed an increase to the capital gains tax for high income earners (unsurprisingly). Looking at similar situations in the past, a hike could cause some investors to sell some equity positions sitting on sizable gains, but the potential downward pressure on equity markets from these selling flows would likely be short-lived as these sellers eventually buy back positions to restore their allocation back to previous levels.

The exhibits from RBC GAM below show the historical maximum capital gains tax rate in the U.S. and the performance of the S&P 500 before and after increases in the tax rate. At a high level, and without considering prevailing economic fundamentals at the time of previous tax increases, equities tended to experience some choppiness in the lead-up to the implementation of the capital gains tax hike, but weakness was by and large transitory. 

The Hot Topic of Inflation – It’s Definitely Here, But Will It Persist?

I’ve been noting for months that inflation expectations and yields were likely going to pick up, and that this puts some bond holdings at risk. So far this is playing out, and most bonds are down ~5% year to date. Ouch. These are ‘safe’ instruments that most people didn’t expect to ever lose capital on.

Inflationary signals are popping up everywhere we look. Composite PMIs are at or near all-time highs. Business spending is higher than pre-pandemic levels. Inflation indicators are rising everywhere and confidence surveys are surging to multi-year highs. I’m sure you’re feeling it first hand. Pent-up household demand has spilled into the real estate market (we just went firm on selling our house yesterday!). This has all led to a supply shortage, soaring home prices and depleted inventories of building materials.

Economic growth is surging, and GDP prints are big. Altogether, unemployed, underemployed, looking for better jobs and discouraged workers is 22 million. There's never been so much slack in the economy. As they come back into the workforce, they will drive spending, pay taxes and grow the GDP.

The US 5 year break-even inflation rate (a market-derived proxy for inflation expectations) has gone from an all-out collapse last March to breaking out of its historical range and hitting the highest level in nearly 13 years. Yet the Fed is still buying $120 billion/month of bonds, which is nearly 50% more than the $85 billion/month that occurred during QE3 (or “Quantitative Easing” from January 2013 through December 2013).

So is this inflation ‘transitory’? Are all of these pressures noted above heavily “front-loaded” in nature as the Fed believes? 

A number of the deflationary headwinds experienced since the global financial crisis remain – mainly, aging demographics and high levels of indebtedness. Many think that 9 to 12 months from now, much of the supply/demand mismatch should be back in balance—at least in the US. And that when the virus is under control, the economy could simply be back to where it was in 2019, with low growth, low inflation, low interest rates, and already-excessive debt that is now worse. 

There is no way to know for sure, and you may want to respectfully avoid anyone who claims that they have the answer. But we can monitor and position for some of these risks – this is what prudent portfolio management is all about. Going into a high growth and high inflation environment, we want exposure to companies with strong pricing power and operating leverage.

Investor Sentiment & Positioning Also Creates Some Risk

A near record-high percentage of global fund managers stated in a recent survey that they were overweight equities. Institutional investors are mirroring the same enthusiasm for exposure to common stocks as their retail counterparts. One year ago, expectations were dismally low. Today, more optimistic outlooks have radically re-priced risk upward. This transition will continue to be bumpy.

Investor complacency is illustrated by a host of sentiment measures. The concern is that that market volatility will be greatly amplified by the current record levels of margin debt and call-option buying. Investors have never been so levered. The result is a riskier market environment.

I’m a Broken Record Here, But Your Portfolio May Be Broken

I hosted an interesting event this past week with 3 of Canada’s leading alternative managers – Jason Mann from EHP Funds, Sal Malik from Anson North Star and Chris Rowan from NewGen Assets Mgmt. They did a great job of explaining how uncorrelated and well-hedged funds fit into your portfolio, especially in this environment where bonds are likely going to be precarious investments for the foreseeable future as rate and inflation rise.

So moving forward, your traditional stock/bond balanced portfolio (known as the 60/40 portfolio), is unlikely to offer a smooth and solid risk adjusted profile moving forward. This is not unlike the environment we saw in the mid part of the century when we were essentially in the same boat as we are today.

Chris Cole of Artemis is sharp, and he puts it very succinctly: "Unfortunately, with history as a guide, investors expecting the gains of the last 40 years with a traditional portfolio will be massively disappointed. The global economy is entering a period of change whereby deflation or manufactured inflation will destroy wealth to eliminate debt… collective Recency Bias is leaving most blind to the problem. Suppose history rhymes, and at some point in the next twenty years, we face a global crisis in servicing the historic levels of leverage. In that case, global deflation or stagflation will wreak havoc on traditional retirement portfolios. Wealth and savings will be destroyed, and many pension systems will become insolvent or require multi-trillion-dollar bail-outs by the government. None of this will be free. YOU will pay for it, either through higher taxes or loss of purchasing power due to higher inflation. 2020 was not the climax but merely the first act of this epic Greek Tragedy.”

But We’re Going to be OK, I Think…


This is a momentum driven market we’re in. The plumbing of this market means that pullbacks or corrections (even 10%-15%) can appear out of virtual thin air, simply because of the pile-on effect of algos, HFTs, etc. – it’s the way it is when the world is awash with liquidity chasing returns. But active portfolio management (i.e. smart stock pickers) will continue to outperform. In Q1 2021, almost 33% of the S&P 500 constituents beat the market by more than 10%, suggesting it is not just a few names that can make or break a portfolio. Moreover, in Q4 2020, 37% did the same. In this context, it is less about the index and more about the stocks within it. Index/ETF investing has had its day.

Vaccine production is surprising to the upside, stimulus is full throttle, the Fed remains as dovish has as ever, ‘excess savings’ are set to be spent as the economy opens up, stimulus cheques are flowing into the stock market, very easy year-over-year comparisons are making for some eye-popping growth numbers, and volatility remains subdued. However, the taper tantrum of 2018 could pale in comparison to a real rate tightening cycle. We need to be positioned for these risks – you will never time a pullback perfectly. Minimizing drawdowns is vital to long-term capital accumulation since large drawdowns at any point in an investor’s life have long-lasting consequences – it takes a much bigger gain to make back a loss. This is an environment we’re built for.

Wealth Management Alpha

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Socially responsible investing is any investment strategy which seeks to consider both financial return and social & environmental good to bring about positive social change. Many advisors aren't discussing responsible investing with their clients – the 2020 Responsible Investment Association (RIA) Investor survey found that 75% of respondents wanted their investment adviser to inform them about Responsible Investments but, only 28% have been asked about these options. We make it a cornerstone of our practice to offer our clients specific portfolios geared to those who wish to invest with impact. Our solutions are designed to generate competitive risk-adjusted returns with a view toward integrating environmental, social, and governance (ESG) factors into each investment.

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