Spring in the Step

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April has brought good cheer — at least in the United States. Despite ominous signs that Covid-19 has not yet loosened its grip, analysts and investors agree: growth is coming. Policymakers in the US are intent on assuring a strong recovery, that helps all Americans, including those often left on the sidelines. Remember — even with a jump in payrolls in March, official numbers show America is still 8.4 million jobs short of pre-pandemic levels. The Fed plans to keep the liquidity taps open for as long as it takes to bring back those jobs. Of course, the Fed has not given up the other part of its dual mandate — anchoring inflation. But Fed Chairman Jay Powell last week reaffirmed — yet again — that this central bank will tolerate some rise in inflation on the way back to full employment. Even bond traders gave him a tentative thumbs-up last week — and equities took off again. The prospect of higher corporate taxes to pay for President Biden’s ambitious infrastructure plans was not enough to dent optimism — at least not yet. Eyes now are on earnings reports this week.
There are still reasons to tread carefully. Unexpected inflation — as a result of the government pushing too much stimulus into the economy — and a consequent tightening of monetary policy remains a concern for investors. As we described in last week’s letter, RockCreek expects an uptick in inflation but not one that escapes out of the Fed’s control. With government stimulus set to continue, the impact on the real economy from higher rates will likely be offset by the fiscal boost.

April has pointed to three other important issues for investors. First is the coronavirus. Many people now believe that the worst is behind us. That may be right, but the latest data show the virus is far from beaten. As long as it continues to circulate widely in some parts of the world, a return to “normal life” is not assured anywhere. The second issue is connected — divergence. We have noted throughout the past year that low-income communities have been hit hardest by the Covid-19 recession. A global recovery is now underway. But new forecasts from the IMF last week showed the recovery is also going to be unequal. Low-income communities in rich and poor countries are set to have less vigorous growth, in part because vaccinations will not reach them. The other reason for slower growth in some countries is their more limited room for government stimulus. Contrast that with the United States: President Biden’s $2.3 trillion infrastructure proposal is bold and ambitious. Will Congress go along, and who will pay? That is the third issue of the week.
Observations and takeaways for investors:
Divergent recoveries — will the world come together to help?

For decades, emerging and low-income countries have grown more rapidly on average than developed markets, narrowing the gap in living standards and lifting hundreds of millions out of poverty. The last global recession hit jobs and output in North America, Europe and Japan while emerging markets continued to expand, albeit at a slower pace than pre-crisis. Today’s pandemic economy is different, with greater costs falling on lower-income countries as well as on lower-income groups in developed markets. The Coronavirus Recession is estimated to have thrown 95 million people into severe poverty in the past year.

The IMF’s calculations of living standards around the world tell the story. The poorest countries are expected to suffer a 5.7 percent average annual decline in living standards, due to the pandemic, over the course of 2020-2024. Emerging markets are projected to fare somewhat better, with an average drop of 4.7 percent, notwithstanding rapid growth this year in China and, more notably, India. Advanced economies, other than the US, are also forecast to experience a decline in living standards compared to the pre-pandemic path. But the much smaller 2.3 percent average annual hit to the incomes that are already much higher in developed markets will be easier to bear.

As the reality of divergence sinks in, there is a growing effort to push for an international response to help emerging and low-income countries pull through. As RockCreek founder and CEO, Afsaneh Beschloss has argued, international cooperation is needed to finance a transformational climate action plan together with a more robust approach to combating the pandemic. Additionally, Senior Advisor Caroline Atkinson called for increased vaccine diplomacy to ensure a more inclusive recovery for all. With the blessing of the new US Administration, finance ministers from around the world agreed last week to create an additional $650 billion SDRs of global liquidity, through the IMF. In 2009, major countries agreed to an SDR allocation of just $250 billion. But, unlike then, there is no agreement today on boosting IMF or World Bank resources. The infusion of SDRs helps, but the bulk of it will go into the foreign exchange reserves of countries like the US (and China) that don’t need the money. Emerging markets apart from China would receive about $212 billion, while the poorest countries will get just $21 billion. Hopeful poverty campaigners are pressing for better-off countries, including the US, to divert their SDRs to others more in need. But that is unlikely to happen. Congressional approval is not needed for the IMF to create the $650 billion SDRs: one reason that the US Administration has backed the idea. But using the money to fund any new loans or grants would require Congress to sign off — so far, an unlikely prospect.

Covid-19 continues — luckily scientists have not stopped working

One area where the US has come through is Covid-19. American medical and scientific innovation — powered by government money as well as private sector ingenuity and international collaboration — was crucial in the development and manufacture of safe and effective vaccines. Less well-known is the US support for the global effort to provide cheap vaccines to the rest of the world, through COVAX — a joint enterprise between GAVI and WHO. Congress approved $4 billion for this effort late last year. More finance, and contributions from others, will be needed to assure that poorer countries can afford to vaccinate their populations. More crucially, it has become clear in recent days that the global supply of vaccines is falling far short of what is needed.

Production is expected to ramp up in the second half of 2021. But vaccinations are not likely to be fast enough to halt a worrying surge in Covid-19 cases — in rich as well as poorer countries. Parts of Canada last week joined major European countries in re-imposing lockdown restrictions as cases surged north of the border. Vaccinations so far have reached fewer than one in five Canadians — better than in Europe but far behind the US and UK. Globally, new daily infections are now averaging more than half a million a day, up by 60 percent in just six weeks. The surge is powered in large part by new and more contagious variants that are infecting younger people — who are more likely to be going out and about and less likely to be vaccinated.

Worldwide, it will take time to bring production and distribution of vaccines into line with needs. Africa has received only 2 percent of vaccinations administered around the world so far, according to the WHO. COVAX expects to supply enough to low-income countries to vaccinate 20 percent of the population this year and the Africa CDC is targeting 35 percent — still far short of herd immunity. India, the world’s biggest vaccine manufacturer, has halted exports for the time being in the face of rapid worsening in infections. The UK, with the best vaccination record among major countries so far, will be forced to slow the pace of inoculations as it loses supplies from India. Concerns about the safety of the Astra-Zeneca vaccine — the cheapest and most widely available globally — have already contributed to the dismal vaccine record in Europe in Q1. One good sign: a big increase in supplies in Europe is expected in Q2, which should enable major countries to ease their new lockdowns.

Coronavirus cases are rising in the US, but so is the pace of vaccinations. Here, the main concern will be whether enough Americans agree to the shot to bring us to herd immunity. Last week brought the news that in at least one state — Mississippi — vaccines are going unused, reflecting vaccine hesitancy among many living there. Nationally, polls suggest that getting immunizations to the 70-90 percent range needed for herd immunity will require an effective campaign to persuade other reluctant Americans. New lockdowns or government restrictions remain unlikely here. But a rush to spend on personal services, hospitality and travel may be slower in the face of continued fears of infections.

Bottom line: it will likely be months, if not years, before vaccines are distributed widely enough to be sure that the world as a whole has reached “herd immunity”. Dangerous variants can develop in that time and new booster shots will need to be developed and distributed. The focus on scientific innovation in health will remain crucial.

Emerging market equities: can they shrug off Covid-19 and continued divergence?

Emerging market equities continued to rally last week mostly in growth sectors such as technology while value sectors, including energy and financials lagged. Markets have turned their focus to the expected strong Q1 earnings, especially in North Asian countries. All eyes will especially be on TSMC’s Q1 earnings report coming out on April 15. Sitting at the nexus of China-US tensions, a global demand-supply mismatch for semiconductor chips, and with a stock that has sold off more than 10 percent since the highs in February, TSMC earnings are highly anticipated. The Taiwanese government realizes what is at stake, to the point of prioritizing water usage in favor of semiconductor manufacturers, and at the expense of its farmers, in the middle of one of the country’s worst droughts in decades. We are paying particular attention to TSMC’s US expansion plans as a sign that the company sees continued outsized demand for its product suite.

Tensions between the US and China have led to warnings from some foreign policy experts in America that increasing conflict between China and Taiwan should be viewed as a possibility. The Biden Administration is continuing to loosen the long-held restrictions on US-Taiwan interaction. On the ground in Taiwan, Chinese aggression is viewed more as a normal part of life and not likely to alter in the near-term.

Outside of North Asia, the situation in Brazil and India remains precarious on the public health front with markets unsure of how to react. Indian cities and towns have begun to declare new lockdowns in reaction to the renewed rise in Covid-19. No one expects a return to a drastic national lockdown as was imposed a year ago. But unless this second wave peaks and subsides relatively quickly, it is difficult to see how the country will meet consensus expectations of 10 percent GDP growth or higher in 2021. Markets have so far wobbled more than corrected, but we are in a race against time.
Brazilian markets remain volatile though unlike India, new cases in Brazil have peaked along with hospitalization rates. Brazil is currently vaccinating 1 million per day with a goal of increasing to 2 million per day in the near term. The Brazilian government — aware of the risks the pandemic still poses to the economic recovery — announced a fresh round of stimulus, replenishing the so-called Corona voucher program. Markets are also trying to discount the ever-discordant President Bolsonaro, who increasingly finds himself torn between populist rhetoric and a popular (among investors) finance minister trying to stick to orthodox economic policy.
Unsurprisingly, given the mixed picture across many emerging market countries between Covid-19 and economic prospects, flows into EM equities decelerated last week. But they were still positive, marking a streak of 28 weeks of inflows for a record $119 billion. However, signaling divergence, flows were positive in Asia ex-Japan markets but turned negative across EMEA and Latin America.

Infrastructure is coming; higher taxes too

No one expects President Biden’s infrastructure plans to be blessed by Congress as swiftly and completely as the $1.9 trillion Covid-19 relief bill that passed last month. The American Rescue Plan Act of 2021 was almost unchanged from the Administration’s initial proposal. But an important ruling by the apparently all-powerful Senate Parliamentarian makes it likely that Biden will get much of what he wants. The American Jobs Plan — as the infrastructure bill is cleverly named — can be passed with just a simple majority, under the budget reconciliation procedure. As Republicans have come out against the proposal, which includes much that is not traditional infrastructure, the parliamentarian’s decision gave it more than a fighting chance.
Infrastructure and public investment are good for growth. But the corporate tax increases proposed to pay for them will hit company earnings down the road. That is a feature and not a bug. The President and his economic team believe that the politics, as well as economics, favor some reversal of former President Trump’s tax cuts. While business cheered the 2017 cuts in corporate taxes, these did not lead to the hoped-for revival in investment. Overall, the notion that the cuts helped wealthy Americans and did little for average families seems to have stuck in the minds of voters. The Administration is also moving to undercut one argument — that higher company taxes hit competitiveness — with a global proposal to make it harder for multinationals to avoid tax at home by moving profits overseas.

For investors, the key will be whether higher taxes or faster growth win out on earnings. Growth-oriented companies in the technology and consumer sectors stand to be most impacted by higher corporate taxes, yet are on a rebound in recent weeks as inflationary concerns eased and bond yields leveled off. The market seems to be ignoring the implications of an increase in corporate taxes given lack of clarity on the details in the final legislation. Assuming Biden’s 2020 plan is fully implemented, higher corporate taxes could reduce S&P 500 earnings growth by as much as 9 percent in 2022, according to Goldman Sachs strategists. JPM global market strategist David Kelly is somewhat more bullish. He predicted higher taxes would cut into earnings by about 5 percent next year. At RockCreek, we expect that a compromise with moderate Democrats makes a rise to 25 percent rather than 28 percent in corporate tax quite likely, with the higher global minimum also negotiated down somewhat.

Investors will need to be mindful of the potential effects of higher corporate taxes that may come at the same time as a combination of higher interest rates, increased wage pressures, and decelerating economic growth. The US market’s current 22x forward earnings multiple might start to look expensive within that context. The road ahead may be bumpy as more details emerge on the corporate tax front and investors grapple with the implications.

Despite what may lie ahead, US equity markets rallied again last week, offsetting, for now, any concerns of higher corporate taxes. Technology, consumer discretionary and communications sectors led markets higher while energy gave back some of its year-to-date gains. Equities were also supported by treasury yields, with the 10yr rate falling 6bps to 1.66 percent during the week. This recent rally in rates is quite mild considering the magnitude of the year-to-date move higher in yields, but the action in the past few weeks may at least signal a stabilization. This recent fall in nominal yield has been accompanied by a move lower in real yields. The move in real yields has driven the dollar 1 percent lower in April. The Greenback remains at its strongest level since October 2020, however.
RockCreek Update
Last Friday, Afsaneh Beschloss appeared on Bloomberg’s Wall Street Week with David Westin to discuss opportunities in infrastructure, short-term market corrections, and vaccine rollout in emerging economies. Watch here.

At the Bretton Woods Committee 2021 Annual Meeting, Afsaneh Beschloss joined a panel to discuss how countries can accelerate their transition to a green economy, the role DFIs can play in mobilizing capital, and innovative climate financing solutions for emerging markets. Watch here.

Team RockCreek

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