A Hundred Days of Change…

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As President Biden closes in on his first 100 days in office, much has changed. The global economy is expanding rapidly. Vaccines are being rolled out. And markets have mostly been cheering, even as Covid-19 continues to lurk or even, as in India now, to continue to wreak havoc.

Investor enthusiasm for the President’s rapid-fire fiscal plans dimmed somewhat last week when the administration unveiled tax increases to pay for them. But before coming to the economy and markets, it is worth noting two other events that engaged the President’s attention last week and hold promise for needed change. The first was Derek Chauvin’s swift conviction for murder, and the widespread relief that greeted the news. Chauvin’s killing of George Floyd nearly a year ago set off global protests against systemic racism and inequality. Those problems will take a great deal more time and work to resolve; however, this was one step along the way. Secondly, the (virtual) Leaders’ Summit on Climate hosted by President Biden and joined by 40 world leaders, including China, underlined the global recognition that we all need to act to reduce and eventually eliminate carbon emissions. Corporations and investors increasingly recognize the need to confront these two enormous challenges. Last week marked progress.

Businesses are still finding their way of expressing social — or political — views. Witness the fierce criticism by some politicians and analysts of companies’ statements and actions in protest of Georgia’s new voting laws, all while many employees and other stakeholders lauded the protests. Climate commitments are now less controversial. Indeed, investors, non-profits and corporations large and small competed last week to announce different variations of net-zero emissions targets and other climate standards.
Meanwhile, unsurprisingly, equities markets last week gave a thumbs down to the latest fiscal policy news from the US. Mostly, investors have liked the rapid changes made so far. Markets largely welcomed the massive fiscal boost from the March $1.9 trillion American Rescue Plan, inflation fears notwithstanding. Promised infrastructure spending is also attractive. But last week brought further news of how the US Administration would like to pay for at least some of this spending: by raising taxes on wealthy individuals and corporations. At RockCreek, we were not surprised. We expect compromise with Congress will reduce the headline numbers for both capital gains and corporate tax rates, but investors should be prepared for higher US taxes, in particular on wealth and — over time — on major corporations, including but not limited to Big Tech. This should not crimp recovery, given the policy support from the central bank and government. But it puts a premium on stock selection. So too does the uncertainty regarding Covid-19.
Observations and takeaways for investors:
A stock pickers market…looking for themes

As vaccines continue to roll out and summer rolls in — at least in the US — investors are looking across sectors for the smartest investments in a recovery scenario. BEACH stocks — Booking, Entertainment, Airlines, Cruise Lines, and Hotels — unsurprisingly, continue to interest investors as they look to capitalize on a reopening.

Since October 2020, (prior to the Pfizer vaccine announcement) an equal-weighted basket of 29 BEACH stocks has risen over 60 percent, compared with a 29 percent return for the S&P 500. While an impressive run, there may still be room for these stocks to rise. Since the end of 2019 BEACH stocks are still underperforming the S&P 500 by around 20 percentage points. Some of these sectors may catch up to the broader market as the economy reopens. But for some, the road ahead may continue to be rocky for a while. Airlines have been some of the biggest laggards since the beginning of the pandemic given high operating leverage and in many instances, financial leverage. Balance sheets deteriorated as airlines were forced to increase their net debt to finance operating costs in the absence of revenue. While airlines were able to secure low rates, companies are still in a precarious position without sustained revenue. Many investors are betting that revenue will pick up as newly vaccinated families take to the skies for a dose of normal over the summer holidays, although long-distance foreign travel may have to wait for better news on Covid-19 overseas. And business travel is not expected to grow back to pre-Covid levels any time soon.

The US travel market may differ this summer from International trends. Slow vaccination progress in many countries outside of the US and continued tight border restrictions in many countries, including the US, are dimming prospects for some International travel. Focusing on US airlines that derive as much revenue as possible from domestic routes is wise. A prime example is Southwest Airlines, which not only derives all of its revenue from domestic routes, but historically generated strong pre-tax ROIC and has actually strengthened its net debt position during the pandemic.

Travel by cruise is another laggard with more challenges to resolve. Cruise line companies are already lower-margin businesses with significantly larger debt loads, and while people may be getting comfortable with the idea of being together with strangers in a confined space for a few hours, a few days may be another matter.

Hotel stocks have generally fared better since the onset of the pandemic, but still lag the S&P 500. With an expected uptick in travel this summer, revenue should be strong. Related stocks such as Disney and Booking have exhibited strong data in the recovery. While Disney Parks and Experiences accounted for about 40 percent of revenue pre-pandemic for Disney, they are currently about 37 percent below 2019 levels. However, the company successfully diversified into other business lines including most notably Disney+. Stocks like Disney provide not only exposure to the reopening trade but a longer-term digital play. Booking is another stock to watch with a profitable online travel platform and a strong financial position to benefit from a recovery.

Equity markets are ripe this year for stock pickers as valuations are compelling for longer-term investors across sectors that have been largely ignored during the pandemic.

Unfortunately — not yet time to bid Covid-19 goodbye

Vaccinations are reaching Americans at a pace that we could hardly have dreamed of three months ago. On average, 2.86 million doses per day are now being administered. But, depressingly, the virus — and variants — are still alive and kicking among us. Pharmaceutical companies are shifting to develop booster shots, perhaps to begin as soon as this fall in America. In addition, some limited efforts continue to produce lower-cost vaccines and improve delivery systems in low-income countries that do not yet have access. That means that Americans are not yet welcome in many other countries and, reciprocally, our borders remain largely closed.

Vaccinations continue to roll out only slowly across the border in Canada, where an untimely opening of parts of the country seems to be the reason for a second deadly wave. Far more deadly still is the situation in India. Just weeks ago, many were celebrating the success in combating the virus. Now, hospitals are overwhelmed. People, including in the major cities, are dying because of lack of oxygen supply. And with India the biggest manufacturer of vaccines globally, this will spill over worldwide.

Although Covid-19 continues to impact recovery in developing countries, investors in certain markets seem to be looking through the latest cases. The pandemic is hitting Latin America hard: 40 percent of worldwide deaths have been in Latin America, although it has only 8.4 percent of the world’s population, and nine countries — including the six largest in the region — are among the 20 emerging markets worldwide with the highest death toll. Nevertheless, Latin American equities led the way last week, with Mexico and Brazil in particular outperforming. After a terrible 2020 and a poor start to this year, Latin American equities have seen renewed interest as domestic investors seek to capitalize on record low valuations in a continued search for yield. Communications services, materials, and IT names are strong, led by the newly merged Televisa-Univision juggernaut, iron producer Vale, and information technology specialist Totus. Latin American equity performance has coincided with an improving public health situation. Both hospitalization and mortality rates have come down. Vaccination rates remain stubbornly low but new supplies should begin to address the situation.
The good news in Latin America has been overshadowed elsewhere in emerging markets by the rapidly deteriorating public health situation in India, and ongoing tensions between China and the US. For a region that was supposed to benefit from the global economy opening it has been a lackluster 2021. The rate of new cases and deaths in India has tragically reached new highs. The country’s health infrastructure is at a breaking point and the Modi administration is struggling with solutions. Indian equities ended lower on Friday to record weekly losses, with most sectors except for healthcare stocks, tumbling.
Chinese equities were flat for the week with investors hesitant amidst President Xi comments at the annual Boam Forum reiterating its red-line stance on Taiwan and the fear of PBOC policy tightening. Year to date, Chinese equities remain significantly behind the rest of emerging markets.

Elsewhere in Asia, South Korea recorded its first weekly loss in five weeks. Only Vietnam and Taiwan seem to be bucking the trend — perhaps a reward for their exceptionally well-run virus containment strategies (and in the case of Taiwan, semiconductors). Stalling Asian equity markets may be temporary as the factors driving optimism for the region at the beginning of this year remain. Similar to Latin America, we expect equity investors to treat this as an opportunity to rebalance in emerging markets and maintain a mix of beneficiaries from a global recovery and defensive names. A weakening USD and dovish Fed policy continue to provide support for the region’s equity markets.

Emerging markets flows decreased this week but were still positive, extending the inflow streak to thirty weeks totaling $124 billion. This is the largest USD inflow and longest in terms of weeks. Unsurprisingly, Latin America and Emerging Asia saw net inflows whereas EMEA markets continued to see outflows.

Whither Central Banks, now that economies are on the mend and consumers, may be worrying about inflation?

Nevermind Covid-19. Economic recovery is clearly here. Data for the service sector (Markit PMIs) showed expectations jumping to record highs in the US, UK, and Australia and rising in France after strong manufacturing PMIs. Even Japan is up on that measure.

This does raise a question for central banks. When should they call time on the extraordinary measures of the last year — and decade — to support economic growth and combat disinflation? And how can that be done so as to avoid spooking markets? The Bank of Canada started the ball rolling last week with a gentle tapering of asset purchases, which were well signaled in advance. The move was interesting given Canada’s deteriorating public health situation and threat of more restrictions on activity. Central Bank governor Tiff Maklem, who has also spent years in the Finance Ministry, did not appear to hesitate.

South of that border, the Fed continues to hold steady, even as inflation concerns continue. The next few months will be a critical test of how well inflation expectations are anchored. Will consumers and businesses be taken unawares by the uptick in price increases that experts and analysts, including at the Fed, see coming? And how much will strained supply of key inputs — notably semiconductors but also some parts of the labor pool — add to costs? With European inflation still very low and German rates still negative, there is less pressure on ECB President Lagarde to tighten. And the cost of premature tightness in the past is still top of mind.

About those taxes — spend first, tax later

The outcry from businesses and companies against proposed higher taxes on capital gains, as well as big business, was loud last week, but it has not been uniform. There are a number of reasons for that. Companies’ widespread use of the 2017 tax cuts to buy back shares and boost dividends — rather than invest in new capacity — weakens the economic arguments against higher corporate tax rates. More fundamentally, some corporate leaders recognize that taxes on profits have fallen to record lows. They can see the case for raising corporate taxes to help pay for needed public investments. High incomes from capital gains for corporate leaders and shareholders may also be exacerbating employee and stakeholder concerns about inequality, and contributing to political division. America’s economic strength depends on political cohesion and trust in the system as well as the flexibility and innovation that the nation is famous for.

At RockCreek, we see a compromise corporate rate of 25 percent as likely. A rise in the minimum tax on overseas income is also plausible, although winning international agreement will require all of Treasury Secretary Yellen’s skill. Smaller, domestic companies — who tend to pay a higher tax rate than larger, and often more profitable businesses — may be quietly sympathetic to boosting taxes on multinational companies. But expect fierce opposition from some others, who will argue that higher taxes on income earned, or allocated, overseas by high-income investors and multinationals will damage competitiveness. Sheltering income from tax this way continues to be big business, despite a growing push-back on tax havens by major countries over the last 25 years, and particularly since the global financial crisis. Multinational companies, including — but not only — Big Tech companies, have managed to keep tax bills down by arbitraging across international regimes. Profits and profile have not stayed low, however. Steadily rising public ire may now push major countries to agree among themselves on how best to tax such companies — and how to put pressure on some smaller tax havens.

Bottom line: compromise on proposals for higher taxes on capital gains and wealth is likely, just as for the corporate tax rate. But investors should prepare for some increase. The reason? A shift in domestic politics.

Democrats in Congress, encouraged by President Biden and by broad popular support so far, are following the “tax and spend” route that they have traditionally been accused of — but with a twist. This time, the spending is coming first and the taxing later. Traditional fiscal conservatives, naturally, do not like either the expanded government role from more spending, or the higher deficits implied by the infrastructure spending kicking in before the full impact of higher taxes. And the new spending would be on top of last month’s $1.9 trillion Covid-19 rescue plant.

But there are a growing number of economists who support this combination of higher taxes with a more expensive safety net and higher investment in jobs and people as a way to promote a stronger American economy. A leading economist made a strong case last week that this domestic shift is more important for middle-class Americans than the focus that both this Administration and former President Trump have put on protecting traditional domestic manufacturing. Adam Posen, President of the Peterson Institute for International Economics (PIIE) pushed back vigorously on the widely-held view that most middle-class American families have been hurt by a US economy that is too open to wide-scale immigration and to overseas competition from the likes of China. Instead, Posen argues, the data show that the US economy has become more closed to imports, foreign investment, and immigration this century, as governments have focused on stemming the loss of manufacturing jobs for “traditional” workers — “men doing heavy work on big stuff” — who are a small minority of non-college educated workers. Restrictions on trade, including tariffs, ignore the costs of reduced competition and productivity growth for all American families and the interests of the 86 percent of non-college-educated American workers who are not in manufacturing. This is not the conventional view of competition from China. Nor is President Biden likely to look kindly upon foreign competition that apparently saps “good jobs” from America. But there is more support for the notion that America has under-invested in lower-skilled workers and in families whose basic needs — from food to shelter — are scarcely met in today’s economy.
RockCreek Update
As we look ahead, the world economy is increasingly affected by climate change. RockCreek participated in various events related to Climate Action Week. Last Friday, RockCreek Founder and CEO Afsaneh Beschloss moderated a conversation with David Marchick, COO of the International Development Finance Corporation, on the agency’s expanding climate-related investments.

At RockCreek, we continue to engage with policymakers and to invest in the transformation towards a more sustainable future for our partners and the communities in which we live and work. Over the past two decades, RockCreek has invested in and published research regarding the nexus between financial markets and sustainability.

Since RockCreek’s inception, we have deployed over $5.5 billion in impact and ESG strategies and companies, recognizing early the return and impact potential. We are a signatory to Net Zero Asset Manager Initiative, joined UN PRI in 2010 and were a founding member of the IFC Operating Principles for Impact Management. RockCreek has been a plastics-free office since 2016.

“There has never been a more critical moment than now for investors and asset managers to collaborate and signal the shift to net-zero by insisting on transparency and bold action,” said Afsaneh Beschloss.

Team RockCreek

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