Chris Hyzy: Thanks, everyone, for joining what is the second Street Talk Call of 2021. It feels like it’s the 10th Street Talk call given the chain of events that has unfolded since the first of the year. It feels like that will be the case for most of 2021, if not all, and perhaps in the new frontier year of 2022. With that as the opening statement, I thought we would focus more on the path forward versus what occurred. We’ll talk about what we call the concept of the input, the throughput, and the output before we get into the interview section of the upfront comments but in terms of the path forward, it’s important to kind of check your coat at the door and think about the great debates that are still out there, particularly in the input side of the equation we call the fundamental growth drivers or in other words, the areas of the pipes that feed into the broader economy we call again, those the inputs and there’s a lot of great debate around in the economy in general. Not necessarily, “Are we recovering?” but, “In what shape, in what manner?” in terms of what type of momentum. There’s still a great debate as to what the growth would be in the fourth quarter of 2020 once it’s revealed and in the first quarter obviously, some are out there suggesting potential for a negative quarter, some are discussing something called the mini recession, still others are suggesting that we are entering a phase of hyper growth and by the end of the year. What we’re viewing right now is a great delta between where the consensus is and where the ultimate potential conclusion is, which is a much higher growth rate than what the consensus believes, so there’s a great debate surrounding the economy in general and it’s more or less about the robustness of the economy in a post vaccine type of aggregate 12 month basis. Number two, same thing on profits in the corporate sector. We’ll be getting some of that starting this Friday where some of the banks report and then ultimately, gathering momentum throughout more financials and technology and industrials in the second week in consumer discretionary more or less in the third week so we’ll get a good feel for the fourth quarter but what’s most important again is the path forward. What do we see for 2021? In fact, as we work through 2021, what do we see for 2022? Because that’s what investors will be focusing on when they either revalue assets downward or upward in the coming months. Three, consumer trends. Four, jobs. Five, debts and deficits, and that’s not just long term speak, that’s actually short term speak when it relates to what budget reconciliation can offer in terms of potential policy changes around taxation and Jared Woodard, our guest, will touch a little bit more about that in just a few minutes. Six, cost of capital. What is the cost of capital in the household, in the private sector to help drive what we call operating leverage throughout the economy which we expect to be surprising to the upside? One of the basis for our more bullish outlook is the surprise that operating leverage can have in the household given the spending that’s going on from the federal government but also just to share liquidity out there in the corporate sector ultimately driving better job growth. Last but not least, policy – fiscal, monetary and the third one that you’re going to hear a lot more about in the coming months and years, and it’s societal policy. Exactly what do we do for the greater good? What do we do for the greater community and how that’s driven by both the private sector and the government sector working together to establish new norms, and that’s something that you’ll hear more about. Now switching over to the throughputs, that’s where you start to see this everyday whether you’re watching financial news media, reading about it, or potentially on these calls, that’s what we call again the throughputs. That’s where capital market debates come in. Is the dollar going to be soft? Is it flat? Is it going to be stronger? The great debate around that given the movement downward in the dollar in 2020 and what’s the next path forward for that. Yield curve – is it steep? Is it getting steeper? What do you view as steep between the long rates and the short rates or is it generally going to remain flat as we have seen over the course since really the credit crisis? The level of rates itself, both at the short end and long end. Factors in the markets, you hear a lot about that and momentum. You hear a lot about risk within the market. You hear about gaps. These are areas that throughout 2021 up ahead of what is the next normal, and we have to probably look away from calling everything the new normal but it’s really more about the next normal and factors in the market will tell us more or less the more insights about that. Style – value versus growth or is it both? Small caps, large caps, US, non-US, the level of credit spreads and also something you’re going to hear a lot about, and Jared has particular views on this as well, in terms of inflation expectation.
The view here is that the throughputs are what create the picture. The picture ultimately can be seen very differently depending on what eyes are looking at it. The inputs help create the throughput which is the picture and then here’s the more interesting aspect of all of this which is the output, and that’s where there’s great debate on portfolio strategy. What do you do as the picture’s developing between the inputs and the throughputs? What do you do in portfolios to be able to provide a clearer picture overall on the path forward? From our perspective, this is tactical adjustments. These are where your exposures are and where you have gaps. This is the sensitivities between different asset classes. What used to be a hedge in treasuries may not be a hedge. What used to be an income producing vehicle may not be an income producing vehicle like it used to. Where there was big risk in terms of volatility in the equity markets, does that risk come down? If so, where? Ultimately that drives your risk profile. Last but not least, this also includes how to invest. The how is just as important as the what. As we’ve seen a movement forwards passive vehicles and away from active vehicles, the question is is it better to have a mix? Is it better to just move towards one versus the other? In our view, it’s a mix.
So for the path forward, on the input side we see great surprises to the upside in the economy leaving ultimately that growth in the consensus is too low largely driven by operating leverage but mostly driven by the sheer liquidity, fiscal stimulus, and relief that we’ve long talked about. We also see the next big delta in profits. We think the consensus is still too low there as well, and that’s where operating leverage comes in in the corporate sector as expense management continues but at the same time revenue drivers and tailwinds begin to develop predominantly in the second half of the year. Those are the two biggest deltas in the inputs and we expect the great debate that’s still here in January to begin to fade as we get closer to the second half and obviously that’s driven by vaccine distributions.
Number two is the throughput. We believe it’s a steeper curve. Not necessarily a steep curve, but a steeper curve. We believe that cyclical inflation is coming, not secular inflation and the great debate around policy driven moves by the Fed will more than likely come in in 2022 versus 2021 but cyclical inflation, not secular. We think the dollar is relatively flat in the short term given interest rate differentials and also the fact that the US is likely to grow a little bit more than its competitors around the world at least initially but then the soft dollar comes back in as deficits and debt take over. Reflation of asset prices continues. It’s a magnet for where inflation traditionally would have been but this is where inflation moves into assets and that’s called asset reflation. We’ve already started to see some of that. We see a bump up in long term rates and we see factors like momentum and cyclicals beginning to work together, and that’s the whole argument. Not necessarily value or growth but it’s both. Last but not least, more frequent rebalancing will potentially be needed given the fact that people will be examining their risk budgets, particularly in the institutional space where we see significant base year. This year is a significant base year for rotation where fixed income has pressure on it particularly as rates back up and equities become the magnet of flows and that’s where we expect long term asset allocators to begin on the margin to move 2%, 3%, 4% over to equities from fixed income for longer term liability matching.
So what do you do? You increase cyclicals. We’ve increased small caps recently, lowered large caps slightly. We’ve increased again, cyclical positioning overall by adding to emerging markets and moving it up to a neutral from an underweight. Adding a little bit in small cap value as I said before to diversified growth versus value and on the sector basis, added to industrials, financials, and materials while keeping tech also at an overweight. So with all of this in mind, we asked Jared Woodard, the Head of the Research Investment Committee and ETF Research in BofA Global Research to join us. He wrote a really important report recently that highlights so many important factors throughout the inputs, the throughputs, and the outputs that we have mentioned and that came out just recently as of Tuesday. So it’s perfect timing to do a little back and forth with Jared here. Jared, welcome.
Jared Woodard: Thanks, Chris. I’m glad to be with you.
Chris Hyzy: We’ll start right out of the gates. We’ll hit the hardest question first that you had interviewed Ed Hill, Head of Policy, for us in Washington at Bank of America. You talk about the US elections and how the US elections will change policy or not. You want to take us through that interview that you had with Ed and some of the big summary points coming out of that?
Jared Woodard: Sure. Yeah. Ed Hill, our man in DC as it were, who’s very in touch with what’s happening in Washington and has great insight around what people are thinking and what the priorities are. So I asked Ed what the top priorities would be for the incoming administration and for the congress. He told me that number one is obviously going to be pandemic relief, supporting the economy, getting us out of this situation that we’re in. Once that’s resolved as the vaccine gets distributed, Ed told me that priorities one, two, three beyond that would all be around climate change and associated investments to deal with that and further on beyond that he mentioned some things like housing or the minimum wage or some other democratic priorities but I think it’s important to emphasize that within this discussion around priorities and what’s likely to come down in terms of legislation, there’s extreme limitations on what he thinks the next congress will be able to do. With the 50+1 majority being the vice president casting the tie breaking vote, senate democrats we don’t expect will be able to accomplish very much on changing laws, changing regulations, really to do anything except to pass budget reconciliation which is when the house approves budget and hands it off to the senate. That doesn’t require a super majority to break a filibuster, and so democrats with their 50+1 majority would be able to pass the budget he thinks. That presents really essentially two opportunities this year for congress to do something meaningful and even with that, the rules are very strict about what you can do in budget reconciliation. Essentially congress will be limited to changing their spending, changing taxes, and improving the debt ceiling and so that’s why so much of our focus is on the size and the composition of any new spending programs as well as questions around tax policy.
I’ll tell you, Chris, I know a lot of people are interested in what might happen on the tax front. Very understandable point of focus for a lot of investors and so we asked about several different proposals that have been floated over the past year. Some by the Biden campaign, things that people have discussed just to see what the odds were or what the constituency was in congress for some of these initiatives and I can take you through that very quickly. One proposal that you’ve heard people mention is the possibility of changing the incentive structure for 401K retirement investing. Ed thinks this is very unlikely. There’s a big constituency among moderate democrats to support and encourage people to save for retirement, and so they’re very unlikely to make some of the radical changes that have been proposed. On tax hikes more broadly, which is a big question especially upper income brackets, again, there’s really no visible constituency to raise taxes at this moment. I think Ed’s view and I think we’ve argued this in a [RIC] a few times in the past as well that the political calculus doesn’t make any sense before midterm elections. It certainly doesn't make sense when you’re still plowing your way out of a recession, and so Ed’s comment was he wouldn’t expect to see anything past in terms of the tax increases in 2021. Might not even get proposed until 2022 or beyond and even all of that would dependent on the state of the economic recovery and what’s feasible there. The last two proposals I would mention in terms of policy was discussion on whether the SALT, the state and local tax deductions that were changed under the Trump Administration, might get reversed. Again, there’s a point of something that could change but it wouldn’t be a priority either way. Ed thinks for congressional democrats the comment was simply they wouldn’t vote it down in a bill that was otherwise palatable but it’s also not something that they’re particularly eager to change. The last one, there was a kind of a floater of proposal kind of out in the wind of changing capital gains taxes so that you might have taxes on unrealized gains. In other words, you get taxed every year whether you sell or not. Some people had written in concerned about this. The comment was simply that this is essentially a half-baked proposal. Not to be too blunt but there’s zero chances of getting out of committee. So I think the overall message is more spending on the way to support the economy and I think very importantly, to support new forms of investment in the real economy but very little probability that we can see of aggressive moves in taxes.
Chris Hyzy: Great rundown. Now let’s switch to the second question that you highlight in the report. Some of which we talked about already but the consensus is our economic forecast coming out of BofA Global Research are slightly above consensus. Almost a full point actually, just about 80 basis points above the consensus already with the potential that we could see much higher real GDP growth and you touched on this in there how new fiscal stimulus could affect that outlook. You want to take us through that?
Jared Woodard: Absolutely. I mentioned two chances in budget reconciliation this year where you might see congress approve new spending. The first one would essentially be playing catch up from last year, and that could come up as early as February. Our economists had penciled in a $1 trillion package but I think there’s been some news/headlines overnight. I think Chuck Schumer had mentioned at one point $3 trillion. The Biden folks mentioned $2 trillion so these are all very big numbers obviously, but they’re all very positive in regards to short term economic growth and so our economists estimate that if you did see even just the $1 trillion package that they had kind of heard about over the next several months, that they’d tend to supervise their GDP forecast for this year up from 4.6% GDP growth to 6% or even higher. There’s a big effect that a lot of these proposals have and the simple reason is that with unemployment still 6% or 7%, effective additional support for people who are out of work. We’ve seen jobless claims continue to rise in recent weeks. These stimulus measures have played a huge role in preventing this recession from getting deeper than it is. So as this unfortunate round of kind of Covid infections and related unemployment continues, we think that the power of additional stimulus in the near term can be really significant but I want to mention too that second in the fall. Second budget really reconciliation opportunity. I think it’s just as important because here, you have the chance for the first time in a long time I think, to tackle some of the big issues that people in both political parties have been trying to do for quite a while, things like infrastructure, fixed asset investment, manufacturing, on shoring of production, more investment in research and development which we heard a lot about last year and these are all kind of the measures that wouldn’t have the same kind of immediate benefits in terms of instant economic growth that check for unemployed people might have but they also have much greater effects on long term productivity and so they can raise growth expectations further out in time. If you do see a bill come through later this year focusing on some of those big investment opportunities for the real economy, that could also really move the needle on both growth and inflation.
I’ll mention inflation. A lot of people are concerned that what one of these big budget deficits mean for future inflation? Are we going to debase the currency or lose control of inflation or things like that? The clear message, both from our economics and I think from a lot of big investors that we’ve spoken to, is the understanding that a lot of these measures are one time measures with regards to effects of people. They’re also plugging a gap rather than juicing the economy kind of beyond its natural output level. So the figures from our team is that the economists expect a bit of a bump to inflation in the first part of the year but that by the end of 2021 we’ll be averaging 1.6% inflation in the United States and that’s well below obviously the Fed’s 2% inflation target.
Chris Hyzy: That’s a major, major debate as I said before about the throughput inflation expectations and well said, Jared, in terms of filling a gap and that’s something that’s lost on a lot of people as to how inflation actually can be impactful or is it just filling a gap where you reset and that seems to be the case this time around with hyper support coming from the federal reserve to get back up to an inflation target that they’re comfortable with but we’ll see how that unfolds. That brings me to the third question. We’ve got two more for you. The third question is something that many of our clients own and we do talk about equities a little too much. So let’s talk about fixed income. Take us through how the recovery will affect fixed income considering the fact that many people have been dealing with not just low yields for the better part of say 12- 13 years but in some cases record low levels of rates. So take us through that.
Jared Woodard: Absolutely. Yeah. Well here it’s another one of those great debates as you mentioned and to get a little more clarity on what people are thinking about for interest rates and fixed income this year, I had a nice chat with Mark Cabana, who’s our Head of US Rates Strategy. His target for the 10 year bond yield, 10 year treasury note yield is 1.5% for the end of this year. Now we’re already at 1.1% today. We’ve already had quite a big move but he expects yields to continue to move higher and so to be very clear, that implies a negative total return for treasury bonds across the curve really almost any maturity really this year and that’s even before adjusting for inflation. Obviously, if you add in 1.5% - 1.6% inflation or something like that, you’re facing an even steeper climb when it comes to government bonds. This is something that we think that the rest of the fixed income market however can take in stride. So whether it’s corporate bonds or bank loans or high yield municipal bonds, there’s some other opportunities that we’ve written about in the RIC report and across research and across your team, Chris, I know where people can still pick up a little bit of decent yields with an understanding that at this point in the business cycle we’re a little less concerned about some massive wave of defaults or something like that than we are about finding opportunities that actually are worth the risks that you have to take of higher interest rates or dealing with inflation. I think there’s some opportunities still to be had but again, with eyes wide open that we expect higher interest rates and bond yields to affect treasures in a negative way this year.
Two more comments though from Mark that I thought were really great that I wanted to pass along. Mark focuses quite a lot on the short term funding market and the short term interest rate market. One of the things that they noticed last year was that the treasury department was gradually and kind of quietly increasing the sizes of their auctions and as a result, today US treasury has $1.6 trillion in cash on hand. That’s four times the normal amount that they usually carry. Usually it’s about $400 billion and so essentially what they’ve done is very internally pre-funded a lot of the fiscal stimulus that they anticipate would be needed. Again, if you hear some very big numbers coming out of congress about measures designed to offset the pandemic and people actually tend to worry, “Where’s all this coming from? How do we deal with it?” There’s a nice piece of good news hidden in there that the treasury department's already kind of taken care of that part of the challenge. The other point I wanted to mention on fixed income is that obviously if you’re looking at a higher rate forecast, higher bond yield forecast, it comes with the realization that for people facing at the moment record low or near record low interest rates, any changes or big decisions that they wanted to make when it comes to mortgages or housing, you may be facing a very rapidly closing window to get those things done at very low yields and so it’s something we’re thinking about.
Chris Hyzy: Yeah. The funding markets tend to drive a whole important framework and dashboard of the pipes that ultimately drive the yield curve, the level of rates, etc. and filters broadly into everything that everybody uses, which is something called the cost of capital, so good point on that, Jared.
Last but not least, again, this is a weekly call so we talk about weekly things many times but let’s take a look at the longer term. Within the area of the report that you talked about what does the recovery mean for stocks? You’ve touched on this buying the market at all-time highs in terms of what has an investor averaged. Now, I thought that was one of the more insightful portions. Take us through buying at the all-time highs and the network that your team conducted.
Jared Woodard: Well, it’s a simple question, but I think pretty counterintuitive to some of us. I know I was surprised when we did this little bit. We wondered what would happen if going back to the 1870s, that’s the earliest we’ve got for US equity markets. From 1871 to the present, if you wake up on January 1st, you check on stocks and how the year just ended, if the market was at an all time high and if you had said, “You know what? Markets are as high as they’ve ever been. I’m just going to cross my fingers and buy the market and see what happens,” we wondered what your returns would’ve been like because intuitively when stocks are expensive or record highs maybe that’s not the best time to buy. That’s kind of the intuition I think a lot of people have. What we found instead was the years after the market had just closed on a record high saw much better than average returns. The average return was on the order of 14% or 15%. All the other years when the market hadn’t closed that way, the average return was about 10%. It’s not just the average. Actually, if you look at the distribution of returns, which we did in the note, there’s a very visible right word skew to the upside with fewer downside years than in the ordinary regular distribution of equity returns. I think that kind of ties in, Chris, to the momentum factor that is so familiar to people from quantitative and factor investing but it certainly fits within our longer term framework for US equities and in global equities which is that there’s more upside potential here whether it’s from policy stimulus, from recovery in the business cycle, and associated profit growth or other catalysts. I think there’s more to be done in the market even if we do have some periods of volatility or even flat returns in some of the quarters to come.
Chris Hyzy: Well said, Jared. To wrap up, think about the path forward. It’s a combination of the inputs, the throughputs, and the outputs all of which have great debate. It’s what we do with the output. A lot of things that Jared touched on across fixed income, across equity, buying at an all-time high, what does it actually mean, what doesn’t it mean, ultimately what do you do with portfolio strategy in the context of changes to policy and changes to liquidity and the enormous amount of spending that is likely to still come from the federal government as the new administration takes over. So with that, that’ll stop the upfront comments for this week’s Street Talk call.
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