The loose fiscal policy narrative drives through the center of today’s global financial markets, but the developments of the tax narrative highlight a partially contradictory message: fiscal policy will not be that loose after all. (the government giveth, and the government taketh)
The case for higher taxes that is being made around the world is simple: current spending needs to be offset, debt needs to be repaid and wealth needs to be distributed more evenly. With that, the lowest hanging fruit is to:
The proposed increase in corporate income tax from 21% to 28% would lead the combined US corporate tax rate to reach in excess of 32% (up from the current level of just under 26%), which would make it the highest in the OECD. It is unlikely that the US will be alone:
On a global level, tax increases are quite hard to implement as they rely on transnational cooperation (hence why we’ve seen Janet Yellen calling for a global minimum corporate tax rate). Without cooperation, and especially in a more digital world, tax increases usually lead profits to move to more favorable jurisdiction, and this leads to a global tax rate race to the bottom which resembles the worst possible game theory outcome for governments. (Anyone else find it funny that when global governments ‘work together’ to fix prices or collect taxes we call it ‘transnational cooperation’, but if individuals or corporations do it, we call it ‘collusion’?)
As recently reported by the FT: “The US’s change of heart [with regards to corporate tax law] reflects three realities:
Corporates have little fault in this – they’re simply taking advantage of the legislative loopholes that exist under the current system – but that doesn’t mean the corporate tax discussion isn’t a fair and necessary one:
For the last 20 years, emerging market equities have been considered a play on commodities as the MSCI Emerging Market Index seemingly moved in tandem with copper.
Whilst this is the prevailing narrative concerning EM assets, we must acknowledge that the nature of emerging market equity is changing. Consider this:
The reality is that internet and semiconductors are the largest two sectors in the MSCI EM benchmark, accounting for 32.5% of the index. The four largest stocks are Taiwan Semi, Tencent, Alibaba, and Samsung. This means that the MSCI EM Index is less about commodities and more about tech than one would tend to believe.
Whilst this is still clearly a far cry for the NASDAQ (technology stocks make up 48% of the index), we should still apply the same principles to the emerging market space as we do to the US market. Emerging Markets are increasingly differentiated, and rather than place all EM stocks in the reflation camp, we should view them as growth and cyclical opportunities as we do the US market.
Now, back to the present. Despite the blockbuster data from China over the last couple of months (coming off the pandemic lows of Jan-Feb last year), emerging market equities have given back much of last year’s outperformance, after only a small bounce in the US dollar. China’s economic rebound, which tends to drive commodity assets higher, has not had a significant impact on emerging market equities over the last year.
If central banks eventually decide to move against higher yields (Yield Curve Control), and thus reflation, the cyclical side of EM (commodities) should feel the impact, but tailwinds for EM tech stocks will remain strong, especially if the US’s fiscal impulse is not replicated by other regions (China appears to be tightening already after last year’s record credit binge).
In summary: watch the EM tech and Nasdaq correlation.
As we’ve said many times over, the current reflation trade has been driven by dollar weakness rather than global synchronized growth. Consider this:
Stronger USD and stable or declining bond yields would again favor the US tech trade, which has seemingly worked for the better part of the last decade. The possibility that 2020 was an air pocket no different than what December 2018 was (except for scale and fundamental drivers) is becoming a real possibility.
What if, after the incredible year of 2020, all we end up with is larger mega-caps, continued US outperformance, increased dominance of passive, secular stagnation and no sign of real inflation? What if, nothing, really, fundamentally, changed?
It should be clear that the framework for investing in equities, in the US at least, has evolved and maybe even fundamentally changed over the last few years.
Is the divergence of US equity performance from underlying profits part of a secular change in the investing landscape? Or is this simply another short-term extreme that will mean revert, different only for a short period of time?
In favor of this secular change (as opposed to transitory change) is the emergence of a fresh generation of investors that is vocal in their preference for companies embedded within the digital age with the potential for scaling their businesses through the explosive growth opportunity of the network effect.
The digital age has created a new opportunity for corporates to tap unprecedented growth potential, whilst a new wave of investors has been able to disintermediate the traditional gatekeepers of investment and strike out on their own (read VCs, SPACs, and direct listings).
Why shouldn’t the principles of investing change? Profitability (read as cash flow positive) has been the cornerstone of modern finance, but this was encumbered by limitations on the collection and dissemination of data (thanks a lot Ben Graham). Access to this data was then monopolized by sell-side institutions that cherished the principles of profitability as the basis for investment. However, today’s neural networks embrace the possibility for growth, long before any profits can be registered.
In waiting for profitability, we may be missing the investment opportunity, especially in a world of relatively low-cost financing to inject into a corporation’s capital structure, creating a longer, pre cash flow breakeven runway for the company to scale and attract investors.
Current profitability might still be relevant for old economy companies, which rely heavily on physical assets that are being rendered obsolete by the digital age. This old economy group of companies is being disrupted and disintermediated like never before. What if the market is looking further ahead (it can now because of low-cost capital structures), and discounting the shrinking terminal value that these kinds of businesses will generate in the world of tomorrow?
Today’s tech companies trade with an emphasis on their future growth opportunities, rather than profitability, and so far, investors have been rewarded for taking this approach. COVID pulled a new generation of investors out from the shadows at a time when boomers are tending toward divestment of a lifetime of savings as they progress toward retirement and beyond.
Boomers were the first generation who implemented the mass adoption of saving for retirement. Perhaps, we are simply witnessing the first truly generational shift in investing methodology as a result of an increasingly more technological market (where growth is exponential and not linear) and the retirement of the old type of investor (sorry Ben Graham). Rather than being a radical departure from what should be, this could represent the natural order of new investing principles that take into consideration what will be.
We know that policymakers have facilitated the emergence of this shift, but what will its level of permanence be? It is highly unlikely that policymakers will now abandon their newfound zeal for intervention. COVID was the catalyst for a shift toward yet more intervention which is starting to embrace (but not yet implement) the concepts of Modern Monetary Theory such as Universal Basic Income.
Unorthodox policy has altered the availability and value of capital and helped accelerate and concentrate change. Capital has been made readily available to companies that can rapidly disrupt and disintermediate in a rerun of the capital made available to those ‘dot-com’ businesses twenty years ago.
The real test for these new investing standards might be inflation, and how this increasingly digital world will adapt to it (yes, it’s a bit paradoxical to be discussing inflation in the same sentence as tech, a historically deflationary theme). It might be that if inflation does return (still a big if), investors will decide to migrate towards the crypto universe instead of buying gold. It might be that, if and when inflation happens, the world will react to it through asset allocation decisions that have no historical precedent, and thus very little data to build any kind of reasonable model to make a forecast. Time will tell, but one thing seems to be sure: we’re in the midst of a significant change in the way financial markets work. And that is not necessarily a bad thing.