- We find the increased focus on corporate taxes to be a fair and necessary discussion to have, especially given the number of loopholes that corporates are currently benefiting from.
- Emerging Markets assets are not simply a reflation play – technology has a significant weighing in the EM’s major index and we should be mindful of this in the event growth continues to perform at the expense of the reflation trade.
- The compound effects of an emerging investor base, the increased untethering of business models from the physical realm, and the extension of cheap capital mean investing principles might be adapting to a future that will look nothing like the past.
On Corporate Taxes
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:
- Increase the relatively historical low level of taxes paid by corporations – from the 50s to the 70s, many corporations paid about half of their profits to the federal government (they pay almost half that now). We’re definitely not arguing for 50% taxes, but an adjustment from current levels would make sense.
- Go after all that income (read offshore) that currently sits in grey areas around the world that governments are not collecting.
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:
- The UK’s Chancellor is also tabling ideas for higher taxes.
- Blocks such as the EU are calling for a coordinated effort to prevent companies from finding loopholes via tax-lite jurisdictions.
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:
- The first is the declining US corporate tax take despite an increasing share of profits within US GDP. It is estimated that 20 per cent of the US tax burden has shifted from corporations to individuals since 1945. It is an unsustainable trend, and arguably one of the reasons for the decline in the economic wellbeing of the American middle class.
- Second is the continuing use of tax havens by US corporations. Approximately 60 per cent of their income is now recorded in such places, and is therefore largely out of reach of the US Internal Revenue Service as a consequence.
- Third, due to massive underinvestment in the IRS the rate of audit of US corporations has fallen by at least 50 per cent in the last decade. The chance that US tax cheats might get away with their deceptions has increased considerably.”
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:
- 55 of the major US companies, with a total of $40 billion of US pre-tax income, did not pay any federal tax in 2020 (yes, we realize $40 billion of pre-tax income is like throwing a bucket of water on a forest fire when the US ran a $4 trillion deficit last year…but it’s the principle that we’re discussing here).
- More than a third of corporate tax cuts flows to the top 1% of the population, and less than 70% flows to the top 20%.
Emerging Markets’ Tech
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:
- Starting in 2014, we had seen a global bust in commodities and an industrial profit recession due to the surge in the US Dollar (which decreases demand for commodities) and a mini currency devaluation by China in August 2015 (which decreases Chinese imports, a key driver of commodity prices).
- The global slowdown prompted a then-record injection of credit by China in the first quarter of 2016, a policy relent by the Fed, and an alleged G20 accord in Shanghai, to halt the rise of the US dollar.
- More importantly though, whilst the MSCI EM Index (EEM US) and the Commodity Index (CRB) declined in lockstep into the 2016 lows (as one would expect if one believed EM to be a commodity play), during the recovery phase, the commodity rally quickly ran out of steam, whilst emerging market equities continued to rally in tandem with the NASDAQ.
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.
Don’t Reject Tech
As we’ve said many times over, the current reflation trade has been driven by dollar weakness rather than global synchronized growth. Consider this:
- The US dollar weakness behind the reflation trade has primarily materialized against the Euro and North Asian currencies. Emerging markets currencies, which would normally outperform during periods of true global reflation, have struggled to find a bid.
- The Dollar Index (DXY) has been bouncing off the bottom of its six-year range (a headwind to the US Dollar-driven reflation trade).
- US fiscal policies have ignited growth prospects for the US economy. The US 10-year yields have regained nearly all the lost ground versus European and Japanese equivalents. When will Central Banks react?
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?
A Permanent Shift in Investing?
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.