It has been an interesting year for the markets. With Evergrande making waves in China. Political drama in the U.S. over a possible government shut down and a capital gains tax dominating our headlines. And that's just the beginning.
In Episode 8 of 2021, Glenn Royal and Natalie Picha wrap up this year's 3rd quarter and discuss a possible year-end rally in the markets.
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Welcome to RHP Market Talk. I'm Natalie Picha...Glenn Royal:
...and I'm Glenn Royal...Natalie Picha:
And together with Michelle Jones, we're the founding partners of Royal Harbor Partners Wealth Management. Also joining us today, is our investment analyst Jason's Strzyzewski. There is a lot going on in the markets right now, a lot of data to digest, from the fed meetings to the wrap-up of the third quarter of 2021. And we just want to hit some of the headlines and the highlights and look forward, as we wrap up the rest of this year. So, Glenn, you and I, as is usual here, there's always conversations and crosstalk about what's going on in the markets. And I think that one of the big headlines, has been the Evergrande story and what that's going to look like. Is there going to be a spillover from China into the U. S? What do you think?Glenn Royal:
Yeah. Evergrande has certainly got our attention this week. It reminds you....some folks who are trying to take it to that Lehman moment when Lehman was so deeply embedded in the global financial system with counter party risk and all these things that when it fell in 2008, it took down the global economy with it. So, we've made that natural connection, right ? This is the same thing that's going to happen. That China is going to be the culprit this time. Rather than seeing this as a Lehman moment, I think people should probably look at this as a WorldCom moment. And those of you remember back in the Enron days, the WorldCom, which was fraudulent activity that happened, that took down that company. I think this is going to be more company specific . You are starting to see actions by China, that come in and kind of ring fence the damage , injecting capital into the system. But I believe because property development has really driven the growth of China. It's one of the internal dynamics. It's gotten so, housing has become extremely unaffordable and in China. So, this may be a way the Chinese Communist Party tries to address this issue of housing affordability, by just letting Evergrande implode. But ring fencing, collateral damage that may come as a result of that. So, I don't see it as a threat to the U. S . or the global economy. But we're certainly watching our eyes in case things should change. But right now, it's been more of an interesting show. You know, China, you know , just before this and the property casualty market, they were going out to the technology industry. And so, that left and right, Tencent, Alibaba, all this is they're trying to reign in. And I think the point to make is, China is not capitalist . The Chinese are Communists that use capitalism as a tool, or it's a way of life, or Western economies. That's kind of something, a thread in here, of understanding that we're all trying to where the east meets west. And you're trying to understand how they're operating right now, but they're operating as Communist, not as capitalists. Right?Natalie Picha:
Right. So, the spillover is going to be at least contained, to some degree.Glenn Royal:
We think so at this moment. You know , that's the general talk on the street.Natalie Picha:
So, another big headline and topic this week, was the fed meeting. The taper tantrum rate, hikes, the timing, the balance sheet of the fed , all of those things are kind of coming together. I think I really liked , what you mentioned , in a meeting earlier this week about the Fed's balance sheet being an $8 trillion balance sheet and what that looks like for tapering.Glenn Royal:
Yeah. And so, you know, we go back to prior to 2008, the Fed's balance sheet ran about $750 billion. I mean, it, wasn't what it is today, 2008 caused that to explode , up to about 4 trillion today, it's 8 trillion as a result of the pandemic and their responses. The process for the fed to start to, you know , stop filling the punchbowl and kind of in this party has already been laid out in 2008. The markets know what exactly what, how the approach the fed is going to do. And so they're telegraphing that. So there's no surprises. And part of while you're seeing this thing kind of calm and the market up today S&P is up one and a half percent , it's because the fed has done a good job at telegraphing. What their expectations are going to be and how they're going to unwind this. Timing gets to be a little question now with inflationary pressures. I think what's interesting to me is that the fed has always focused on inflation. As long as I've been in the business. They've always tried to fight the inflation front. This time they've shifted to that average inflation targeting, going to let inflation run north of 2% or to get the 2% average. We've been way south of that for decades. So, that is a big change away from , you know, focusing on inflation to focusing on full employment. So, they're going to take the error on the side of inflation, running a lot, because they think they can get a hold of it. And part of the tools they'll use. So, that's the question that we have every day right now is, Jason and I as PM's in here, is when does this fed have to move? So they are announcing that they're going to end tapering. Let's talk a little bit about that. Right now, the fed purchases, $120 billion a month of both treasuries and mortgage backs. They currently have expanded the Fed's balance sheet to 5.4, right about 5.4 billion in treasuries and 2.5 Billion of mortgage backed securities. They're gonna start tapering at the amount of 15 billion a month. All that simply means is they're not going to purchase 15 billion. The fed has been buying. They're going to reduce their buying by 15 billion a month, until they ended the tapering part in sometime mid-year, next year, their purchases. That $15 on an 8 trillion balance sheet. This is pocket change. It's a lot to us. But for the size of that, that we're talking about, it's going to have very little impact on the market. Now, the next step would be, and the really hard decision for the fed is when do we lift off interest rates? When did we start raising the federal funds rates? Inflation is going to answer that right? There's some talk. Now you're single bit of hawkishness and federal reserve governors. There's the hawks on there. And the doves. The doves want to keep rates low through end of 23. The Hawks are now starting to point to an end of 2022, move. 2022. So, you may see some little bit of moving in there. But I'm not the next step. So you go through the taper, then the fed goes through the fed rate hike. And then the next step the fed is going to do, is as though , instead of reinvesting their $8 trillion balance sheet. They're going to let the bonds mature as the cash comes in, they send it over to treasury and they just pare that thing down. That's all going to come. The fed announced that, hey, we're looking to normalize fed policy, however , we're willing to be accommodative should conditions change . So, they've sent a pretty good signal the market is being received well. Now you're seeing bond yields move up to date pretty sharply. It's a day lag. But treasuries, we were 1.3% of the 10-year. We are at 1.4 today. That's a pretty big move in one day.Natalie Picha:
Yeah. And you shared a chart with us earlier of the S&P 500 , the price to earnings ratio overlaid with the U.S. 10 -year treasury and made the comment, the cost of capital is coming down. PE is expanded and the rising rates are going to have the opposite effect. Right? That's where we're going. That's what we are seeing.Glenn Royal:
Yeah, yeah. That's exactly what you're going to see. Rates eat into that PE multiple and so discount factor and a present value analysis that you just plug into the form of higher rates bring prices down. Yeah, for the fed to kind of move towards this liftoff . What we're looking for is the fed to get, where they're comfortable, that we've got a 4% unemployment rate. That we're the 2% average inflation targeting, is within check. And the outlook for inflation doesn't exceed 2%. So, there there's some markers they're using in here before they start the move. But , I think what that, that multiple, you know, the issue with the price earnings multiple is it feeds into future returns. So, if I start with the high multiple, it pulls down my forward returns. So, that's kind of the setup that we have here. We talked earlier, I know we put out a little flash report relating, you know , the PE multiple was at 30 it's come down about 26 times is that earnings growth has continued and prices have come off a little bit. We still see that earnings to be supportive of the PE multiple, low inflation supportive of that. So we probably are in a position where the multiples are going to stay high rich , as we continue to kind of to move forward to this. I want to talk a little bit about the setup that we have going forward with this multiple, as result of it. You know, these big secular bull markets, they start out with the early stages of really strong earnings growth. Boom. But , you know , we let's go a bit . These secular bulls are long-term, embedded bull markets. We've had three in recent modern times. We had one at post- World War 2, which was 1945 to 1968. Then we had one from 1982 to 2000, which was after the big hike of inflationary years in the seventies, set up for a disinflationary, deflationary environment, off we went. And then , also you have to have , a low of starting valuations, right? To start these bull markets. Well, that's not where we are with PE multiples. And the last thing you also, you want to see as rising profit margins. Those are all kind of the recipes for us to have these big secular bulls. We are kind of the opposite of that right now. Right. We are starting with interest rates that are very low, that are starting to go higher. We're starting with very high valuation levels. And we have profit margins that are really the best we've ever seen. So it's hard to see margins improving from here. So you may start to see margin pressure, particularly from labor. Right? We're seeing the wage demands and things of that nature. It's kind of bleeding into that. So, what that implies is lower future returns. And so, this year, we think, you know, we're up 18%, you got the possibility the S&P at 4,700 to 5 ,000 this year. And let me tell you why I think we, the set up for a year-end rally is in play right now. And that it's a setup where we have the corporations that buy stocks are currently in a blackout period. They're not able to buy their shares back in front of earnings. We're about to have the third quarter earnings come out here in October. So you have a big, big purchaser of stocks, that's on the sideline. Outside of that, I had 2 trillion just in the United States alone, in excess savings, of money that people didn't spend the last few years. You know , government programs and then savings of that nature. So, there is a lot of investor firepower underneath this market that may unleash as we go into this fourth quarter on earnings growth and all these good things that we're talking about. It's just the set up , gets a little bit cloudy as we move into next year. So, bull markets, in my experience, they tend to end on kind of moonshots, just really strong lifts. But I've also seen, too many charts where the decline mirrors the ascent. If I get a sharp rally, I can get a sharp sell off. So, I'm not saying or suggesting that happens, but those are just things to be wary of. If we get a big bull in the year end, we would likely be lightening up into that. Particularly on high valuations and facing the rising rates.Natalie Picha:
Okay. Well, you know, on top of all of the things that are happening in the market right now, as we kind of return back to some sense of normal, after this pandemic and the recovery. We've also got the conversation going on in congress right now about potential tax law changes. And we're getting some of those calls here at the office. They're hearing the headlines about maybe the capital gains rate going up and things like that. How do you see some of that playing out as we finish this year out in terms of putting pressure on the market?Glenn Royal:
You know , the thing that we were pleased to see in the market, that wasn't as bad as we had feared. The proposals on tax. So you hadn't seen a big sell off in the market as a result of it. And , you know, earlier talks are much, much higher. You know, all the deal with the state taxation, all these different things that they were proposing. So, what's kind of come out is a little bit more palatable. However, anytime you raise taxes, that's going to impact the earnings of the market. So, we're looking for this year, 2021, to end about $202 per share and earnings for the S&P 500. That was up 42% growth over last year, right ? All that stimulus. Everything that was lifted up. But as we go forward in 2022, we're only looking for about a 9% increase in running step to $220 a share in earnings. I go out to 2023, another 9% increase in earnings, which puts us at $240. That's where the rub is. How much of that earnings per share is going to be hit by this tax increase? Could we lose all of next year's expected earnings growth, because of the tax increase? Returns , S&P earnings from $220 down to 202 or 205. That's possibly the outcome. I think that we can work through, it because this wasn't too onerous of a tax bite. But there'll be a period of adjustment as we go through that, for sure. You know, the debt ceiling, all these different things that they're doing right now in congress. Yeah . It's an interesting time for investors, with politics right now.Natalie Picha:
Yeah. I thought it was interesting. The debt ceiling drama, you were sharing a story with me earlier , about how that kind of came about , and what that looks like that really, it is just political drama. More or less.Glenn Royal:
Yeah. Can you imagine the U S not paying its bills? And not paying its debt ? I mean, that's, we all have to say this. If we went to that position and we actually weren't able to pay, make a payment on, on our treasury debt. That would be had extreme consequences in this market. You're looking hard down. You're looking at a big, big sell off. A global impact. So, the consequences of them failing to act, are far too great. Even politicians understand that if they're playing games or whatever they're doing with this. It would be catastrophic. So, what we will see is the brinkmanship of politics. Today, I saw the Biden administration is telling federal agencies to prepare for a shutdown. So, here we go. We're going in that dance. The treasury has tools. Resources. They're not telling you the exact date, because they don't want politicians to know. They're screaming. They've written editorials in the Wall Street Journal, all that about the need to pass the debt ceiling. But, there's a period somewhere in October. So, we still, we don't know the exact day, but if they shut down on September 30th, we still have the ability to fund for a period of time in October. So, the markets are going to be aware of that, with expectations, just like the last several they've done, that they'll come back to the table and resolve it. And you know , there may be high political theater on this one. They always are.Natalie Picha:
Yeah. Yeah. It's just another thing that we kind of keep our eyes on.Glenn Royal:
You have to. I mean, it does feed through and I, of course I tell clients all the time, they get caught up in this, you know, 80% of that is just posturing and garbage. Don't listen to it. They're just saying things, to try to be relevant or whatever, but you do have to pay attention because 20% of that could have an impact on your portfolio.Natalie Picha:
Right. Right. Well, I think that we've covered a lot of ground here. A lot to think about. Markets have certainly been different this year. I mean, it's a post pandemic world , and we're still in recovery. Do you have anything else you'd like for us to share?Glenn Royal:
A lot of this is supply chain related issues, and the COVID, the Delta Variant that came along. And, what's going to continue to help our recovery, is the vaccine push in some emerging and frontier economies. The poor nations of the world. And you're seeing that now. We've had five and a half billion doses of the vaccines administered globally right now. There's still plenty of parts of this world that hasn't received any vaccines. I think Africa, off the top of my head. So, we have to see that continue to push. And you are starting to see the developed nations. The richer nations, start to push vaccines out. That's going to address the issues of logistics. The fed cannot. Monetary policy will have nothing to do with logistics. That's a structural issue, not a financial issue, right? We're starting to see signs, as that starts to log jam. You know, long beach, all the different ones start to, you know, you get that going again. That's, that's going to be a positive. I think that feeds into the fourth quarter and perhaps this year-end rally. As the underlying impact of normalization of supply chains, it's going to extend for a while. We know that well into next year but it's moving. I saw this week where there's been several new LNG liquified, natural gas ships that have been received that have just been made. You're starting to see the whole LNG industry, you know, increase their ability to move gas, to foreign countries. It's breaking up in different areas and we're seeing some positive signs, but it's still problematic. But I'm, encouraged by it. I think that all feeds into this year end rally, with all this money coming in. A still extraordinarily accommodative federal reserve. And you look at stocks, and I look at everything else out there. And I say, hey, there's this Tina concept, which is, there is no alternative to stocks. Rates probably stay low for a few years, before we get that li ft o ff. It 's g o ing t o c ontinue to feed equities, which will stay richly valued and will continue on. But going forward, that's one thing I want to talk about. I talked about these shifts going forward. I do want to close with this, is what's worked for us in the last decade, plus 2008. Growth over value. U.S. over International. You know, I don't know if that's going to be the set-up going forward. This little inflationary kick that we've got, has the ability to change a few things at the margin and get us out of this position where, you know, the Fed has been the only game in town. Now we've moved towards fiscal spending by governments and more the normalization of how that all should work. So, you know, there's a lot on the table right now. It's not the same setup we've had the last two years. But I think there's still...I'm optimistic. I think we'll be able to continue to have a good equity market for the next decade. But we're going to p er haps be taking opportunities where companies are presenting. You know, I could see more of a stock pick ers mar ket, than an index market. I know we've been saying that forever. But, this is a different paradigm shift that we're having here. And, I just, it's something that's on the radar, that I'm mindful of. It 's kee ping me up at night. Are we shifting leadership? And if we're doing so, we have to be prepared in t he portfolios to accommodate that.Natalie Picha:
Right. Well, thank you Glenn , for your thoughts. It's always a great conversation. Thank you to our listeners for listening to Royal Harbor Partners Market Talk. At RHP, we're passionate about planning for your financial future. We are devoted to our relationships with multi-generational families and for the creation of successful legacies. Through our one-on-one conversations, we can help you navigate your personal wealth management and investment journey. How different will your life look with the right advice? Call us today, or visit our website, www.royalharborpartners.com to start your conversation.Disclosure:
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