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Analysis of Federal Reserve’s Latest Moves

SEC Approves First Bitcoin Futures-Backed ETF

Insights on Supply Chain and Labor Woes

Potential Tax Implications of Infrastructure Plan

Employment and Price Stability

Wyett Addresses Growing Inflation Concerns

Is Inflation Just Around the Corner?

Consumers Coming Back

Your Questions Answered

Matthew Stephani

Matthew Stephani, CFA
President
Cavanal Hill Investment Management


With capital gains tax rates potentially increasing in 2022, will that have an impact in the markets (i.e. selling pressure towards year-end)?

 

On the capital gains tax rate, proposals have ranged anywhere from raising it to 28% to as high as the highest marginal tax rate, which could approach 40%. Those proposals seem a bit draconian, and the range of potential outcomes is quite wide. It’s also important to remember that different administrations lead to different tax policies, so any policy change this year may be temporary or reversed in future years. We’ll just have to keep an eye on this as it is clear that at least the initial proposal that was put out there is going to have a difficult time getting passed as proposed. So, the chances that the worst of the tax outcomes becomes a reality is somewhat low at the present time.

But, as far as selling pressure on stocks, I’m not sure that would exist. Let’s say you sell your stock because you want to take advantage of the lower capital gains rate this year relative to next year. Once you sell, what do you do with the proceeds?

Investors would have several options to consider once they sell stocks to take advantage of the lower capital gains. First, you could consider the low-risk savings account with virtually no yield as one possibility. Then, you’ve got your medium-risk bonds with rates that offer minimal returns – the 10-year Treasury only yields 1.3%. Finally, you have your higher-risk equities where returns have been historically most attractive. In this scenario, I still think equities would look relatively attractive, given the alternative opportunities in deposits and bonds. So I don’t know that raising capital gains tax rates would have a dramatic effect on equity markets as that market would still appear attractive when compared to these alternatives.

More Questions Answered

Expert: Steve Wyett, CFA | Chief Investment Strategist, BOK Financial

From my lens, I don’t think the Fed is going to tighten lending. In fact, the most recent action by the Fed was to loosen some of the requirements on the systematically important financial institutions (SIFI), which freed up money for them to pay out more in the form of dividends and stock buybacks. One of the key differences as we come through this pandemic as compared to past economic downturns is our financial system is well capitalized and flush with liquidity.

Financial institutions in general are going to be looking for ways to increase lending activity as we move over the next couple of years. A key part of our outlook for sustained economic growth is the ability for new companies to go into business and gain access to capital. Last year, as the pandemic related shutdown occurred, banks were required to place billions of dollars in loan loss reserves as a cushion against expected losses. As the economy recovered it became clear loan losses were going to be materially less than earlier expectations. Hence many banks are now releasing those reserves back to income and their overall capital position remains above regulatory minimums.

In summation, we do not think the Fed is going to be in a position to restrict lending as we go forward.

Expert: David (Dave) Maher | Manager S.V.P. International Sales & Trading, BOK Financial

The crackdown in China is political in nature. Specifically, the crackdown is on Chinese companies listed in the U.S. This is likely in response to criticism here in the U.S. about some Chinese large tech firms amid worries about security issues. I think that this could impact investment, certainly in Chinese tech companies. These actions remind investors that China is a communist regime and doesn’t need to go through the same processes that we do here. China can crack down and make wholesale change spur of the moment.

Expert: Steve Wyett, CFA Chief Investment Strategist, BOK Financial

This question highlights an interesting dilemma for the Fed – of their own making – as they have become very prescriptive in their communication around monetary policy. From our lens, the thought of seeing a taper tantrum increases if the Fed would do something that the market was not anticipating. We saw a little bit of that at the most recent FOMC meeting, when we saw their “dot plot” – a measure of the individual FOMC participant’s views on interest rates – change fairly significantly from one meeting to the next. Some FOMC members moved forward their anticipated date for expected interest rate increases leading 10-year Treasury notes to move up to 1.7% rather quickly. It has since reversed a lot of this upward move as Fed Chair Powell, and others, tried to clarify the “dot plot” is not a forecast. But I think this highlights the risk of taper tantrum is there if the Fed does not effectively communicate what they are doing. As long as the path towards tapering occurs within our expected timeframe, and as long as we don’t get any huge surprises from an economic standpoint, I think the chances of a taper tantrum like we saw some years ago are low.

The Fed feels the price increases that we are seeing right now – which are really driven by this peak stimulus and reopening of the economy – are more transitory in nature, meaning that they aren’t going to last very long. Transitory itself is not a definitively defined term. We don’t know what that means; is it three months, is it six months, is it a year? That’s the debate. We need to see that economic growth continue as there is going to need to be a handoff from this stimulus-led recovery that we saw coming out of the pandemic to a private sector-led expansion that then can last for multiple months.

The Fed has started to talk about how they are going to begin to reduce the amount of monetary accommodation they are providing. Importantly, this does not mean the Fed is tightening in any way, they are just going to be somewhat less accommodative. While there are some FOMC members that seem to think we need to start raising rates as early as 2022, we find that to be highly unlikely as we would not expect them to start raising interest rates until they complete the tapering process. Our thought is that it is going to be 2023 before we see any interest rate increases and depending on how this handoff from the stimulus-led recovery to the private sector-led expansion goes, it might even be a little bit longer than that.

The Fed will be stepping back – we want that – as we want the economy to be able to operate without needing this extraordinary amount of monetary accommodation.

Expert: Matthew Stephani, CFA | President, Cavanal Hill Investment Management

Regarding equities, if you look at a chart of equity returns, there is really no place you could have been in equity markets in the last quarter, three years or five years that would have had a negative return. As interest rates drop, there is currently a discount rate on future earnings. Think about a company that has a lot of earnings projected for 2030 but not a lot now. Those 2030 earnings are being discounted at a much lower interest rate. That propels growth stocks in the short run. This doesn’t necessarily mean that growth is over-valued relative to value, it just means that the interest rate environment is low. We think that there are better opportunities in cyclical stocks rather than defensives, but rather than playing that out domestically, we think the opportunity sits in Europe. Why?

When you look at the European market relative to the U.S. market by sector, 44% of EAFE stocks are in the industrials, energy, financials and materials sector. Only 26% of the S&P 500 are in those four sectors. So, we like the international market not only because it has a little cyclical bend to it, but more importantly, think about what is going on with the vaccine. As I mentioned previously, Europe looks to be behind the U.S. in its recovery and the emerging markets are behind Europe. If these markets grow their GDP as the U.S. did in the first quarter, there’s a lot of opportunity for investments in some of these cyclical sectors that have more of an influence and more of their customer base in Europe.

Expert: Matthew Stephani, CFA | President, Cavanal Hill Investment Management

If 60/40 is your right investment objective, and it fits your risk tolerance profile in a five to 10-year timeframe, I wouldn’t make any changes. There’s nothing in the market that would lead us to think that we need to materially alter the makeup of the portfolio at this point in time. That being said, we do like international equities right now, not only because those markets have more cyclical exposure, but more importantly, because of where they are in terms of the vaccine. We got to the point in the U.S. where vaccines were readily available throughout the country in the April/May time period. Europe looks to be about two to three months behind us, and then the emerging markets look to be three to five months behind Europe.

So, while the U.S. hit 6% GDP growth in the first quarter, most of the rest of the world – with the exception of China – printed negative GDP growth in the first quarter. What is likely to happen as the second and third quarters move along, and as Europe and then the emerging economies continue to vaccinate their citizens, is that the recovery in GDP broadens to include these international markets. As a result, investments in international equities may benefit. We are not negative on U.S. stocks, but rather equal weight U.S. stocks with a tilt towards international as the recovery that has already started in the U.S. moves into Europe and the rest of the world. Of course, this is all contingent on vaccines and what is going on with the Delta variant of the virus, so we are watching those things very closely. So if a 60/40 allocation fits your risk tolerance profile for that time period, I wouldn’t be nervous about leaving it as is. Just stay in touch with the advisor who is monitoring the market and your portfolio.

Expert: Brian Henderson, CFA | Executive Vice President, Chief Investment Officer, BOK Financial

Yes, this chart shows that Europe has seen unprecedented growth when it comes to their savings rate, just as we have seen here in the U.S. Europe’s recovery was pushed back a bit due to a COVID case surge in the first quarter of 2021. That led to negative GDP growth and elongated their recovery, putting them back about a quarter or so behind the U.S. So, there’s a lot of pent-up demand in Europe. While they didn’t have the open checkbook like we did here with lots of stimulus checks, they have core savings and their savings rates are very high, just like they are here in the U.S.

2021 Mid-Year Economic and Market Outlook

Our investment management team discusses key insights for the back half of the year in this video series.

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