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Third Quarter 2021 Client Newsletter

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Throughout the past three months, we’ve seen signs of a slowing recovery and budding signs of market anxiety. So, this quarter, we will review the basis of those two developments and contemplate the coming shifts to economic growth, policy and confidence.

Additionally, recent developments in China have graced the front pages of business and general news publications alike. We’ll try and help you make sense of the events, as well as their potentially wide-ranging implications.

As always, we are constantly integrating these developments into the management of your account. If you have any questions or concerns, please let us know.



The Transition(s) – Going from Great to Good, isn’t all Bad.

Do you remember the last really, really great trip you went on? Or maybe a distinctly memorable celebration with friends or family?

Seriously. Take a moment. What do you remember?

Happy thoughts, I hope.

Ok, now recall the moment that your vacation/event concluded and life went back to normal. Maybe it ended when your return flight landed, maybe it was when you went to pick the dog up from boarding, or maybe it was the drive home. Despite everyday life being at the very least O.K., do you remember it feeling… like a letdown?

That feeling, that letdown, is where markets are at this moment.

After a stimulus-fueled post-COVID recovery, economic data, monetary/fiscal policy, and consumer/investor confidence are all in the process of getting accustomed to some sense of normal again.

The good news: at this point, the normal we’re headed towards doesn’t look so bad.

The bad news: transitioning from great to good will take time.

The Data

When an economist or analyst invokes the old adage that “Trees don’t grow to the sky,” they’re typically talking about the fact that growth can be fickle, especially at extremes.   In this case, it’s an apt way to frame economic growth in the United States.  The rapid rebound from the COVID recession left heads spinning.  Never had so much money been spent in such a short period. In our last newsletter, we reviewed the successful recovery to pre-COVID growth trends.  While those trajectories are not yet in danger of failing, the pace of growth is starting to slow.  

In the United States, the late summer and early fall have brought renewed COVID distortions and supply chain disasters. Of the 31 domestic economic indicators we track, 26 have stalled after setting a peak in 2021, many in just the last few months. While that sounds extremely negative, let’s look at regional surveys of current business conditions for some context.

Many of the regional activity indicators have peaked. Some have even entered downtrends. However, the majority are simply signaling that the economy has reverted to its 5-year average (white horizontal lines). Softer trends could continue and result in outright negative readings - but it seems a bit early to draw that conclusion.

The National Federation of Independent Businesses (NFIB) conducts an in-depth monthly survey of small businesses. Their questions span hiring plans, inventory satisfaction, pricing circumstances, and general business conditions. Like the regional surveys above, general business conditions have deteriorated recently, but conflicting data abound beneath the surface.

Capital expenditure plans, hiring plans, pricing initiatives, and employee compensation responses are at or near multi-decade highs. Hiring and capital expenditure plans for small businesses form the bedrock of our economy, as they represent investment in future growth.

On the other hand, companies are scrambling to raise prices and wages. Put it all together, and fewer and fewer business owners are answering in the affirmative when asked if it is a “good time to expand.”

An unwillingness to expand capacity, especially in supply-constrained industries, would be an untimely development in our battle with inflation.

The struggle with price inflation and margin compression is also impacting large, publicly traded companies, albeit unevenly on a sector-by-sector basis. Over the last few months, we’ve seen disappointing reports from Nike, Sherwin Williams, and FedEx.

 Nike: Matthew Friend – EVP, CFO

“Previously, I had shared that we were planning for transit times to remain elevated for the balance of fiscal ’22. Unfortunately, the situation deteriorated even further in the first quarter, with North America and EMEA seeing increases in transit times, due primarily to port and rail congestion and labor shortages. Additionally, several of our factory partners in Vietnam and Indonesia were required to abruptly cease operations in the first quarter. As of today, Indonesia is now fully operational. But in Vietnam, nearly all footwear factories remain closed by government mandate.”

 Sherwin Williams: John George Morikis – Chairman, President, CEO

“Let me begin by framing my comments with some key themes. First, demand is very strong across the majority of our business, and we are aggressively pursuing growth opportunities. Two, while industry supply chain constraints are continuing to impact production and sales, nobody has more assets and capabilities than Sherwin-Williams to keep their customers in paint and on the job. Three, we are aggressively combating raw material inflation with significant price actions across each of our businesses. We will continue to do so as necessary.”

FedEx: Rajesh Subramaniam – President, COO

“Labor shortages had two distinct impacts on our business. The competition for talent particularly for our frontline workers have driven wage rates higher and pay premiums higher. While wage rates are higher, the more significant impact is the widespread inefficiencies in our operation from constrained labor markets.”

Despite margin pressures for the companies above, they are all still expected to post profit growth in their current fiscal year. And in the aggregate, corporate earnings have never been higher. It’s the path to even higher earnings where the question marks live.


The Policies

Fiscal Policy - (Administration and Congress)

With Congress bickering over whether to pay the bills we’ve already accrued or to potentially re-imagine portions of the tax code and social safety net, there is no shortage of action in D.C. We won’t wade into the debate on what ‘should’ happen; instead, let’s review the coming shift away from ultra-supportive pandemic policies.

The federal budget deficit represents the annual amount the United States spends over and above tax revenues.

Before most of us knew what a coronavirus was, the U.S. government was running annual deficits of about $1 trillion – yellow circle. In response to the pandemic, an incomprehensible amount of money was spent. The annualized deficit from March of 2020 to September of 2021 was just shy of $4 trillion per year – blue line.

Now, there shouldn’t be any surprise that pandemic level spending is entirely unsustainable. But how much of a transition towards fiscal austerity should we expect? Will deficits go back to the ‘old normal’ of about $1T/year? Or will deficits remain structurally higher?

The Congressional Budget Office (CBO) produces a budget based on current spending projections (not including the proposed spending plans that you hear about in the news). Their baseline expectation is that we’ll revert to annual deficits in the $1.2T/year range – purple line.

Presidential Administrations also publish budgets. And while Congress rarely implements them, they do give a window into policy preferences. Based on the Biden Budget from May of this year, the average annual budget over the next ten years would be roughly $1.3T/year.

Monetary Policy – Federal Reserve

Supply chain bottlenecks, higher wages, and commodity shortages are driving inflation. And inflation is pressuring a policy shift at the Federal Reserve. The pivot away from aggressively accommodative policies is catching some off guard, but should we expect an outrightly restrictive posture soon?

As you’ll remember, the Federal Reserve uses three main tools to influence business conditions: short-term interest rates, asset purchases, and forward guidance. The first two are objective and measurable, while the third is a bit subjective.

In their current configuration, asset purchases and interest rate policy have never been more extraordinary.

Based on the median projection of Federal Reserve Regional Bank Presidents and Federal Reserve Board members, the Fed’s policy rate (blue line) will reach 1.75% at the end of 2024 – note that Federal Funds before the pandemic was an entire percentage point higher. Remember, lower rates = more accommodative financial conditions.

The Federal Reserve Balance Sheet (green line) has grown more over the past 18 months than most economists could have ever imagined. And the Fed is still buying more than $100 billion per month of Treasuries and mortgage-backed securities. The expectation is that the Fed will purchase fewer and fewer securities over each of the next nine months until their net monthly purchases reach $0 per month. At that point, the balance sheet will no longer increase in size. Note, though, that the balance sheet is unlikely to contract anytime soon.

Historically speaking, sub-2% interest rates and a $9 trillion balance sheet is undeniably an accommodative environment - even if it is slightly less generous than where we stand today.


Confidence – Consumers and Investors

The broad support consumers received during the most acute phases of the pandemic saved the economy from experiencing a 2008/2009 style retail recession.  In the aggregate, government support payments actually exceeded lost W-2 employment income. On an emotional level, however, consumers have yet to recover.

The University of Michigan, The Conference Board, and Langer each collect survey data on consumers’ finances, willingness to spend, and outlook for the future.

Despite record household wealth, the cleanest credit scores in a generation, and a rapidly decreasing unemployment rate, consumers have yet to reach 2019 levels of comfort/confidence in their financial position. Further, we’ve seen outright deterioration in each dataset this year. Negativity is centered around inflated prices and the unavailability of big-ticket items such as autos and homes. The worsening condition of the consumer psyche is among the most concerning of all the data retrenchments we’re watching.

Investor confidence can be measured in several ways, some more valuable than others. Survey data is noisy and short-term. Fund flows can be wildly contradictory depending on the security type in question (ETFs vs. Mutual Funds). To us, the best way to assess investor confidence is to ask: 1) How much equity (stock) do people own? and 2) At what price are they willing to own that stock?

When it comes to the aggregate household allocation to U.S. stocks, the concentration has never been higher.


Additionally, the price at which households own those stocks is nearly the most expensive on record.

While additional worthwhile considerations to investor confidence include the outlook for interest rates, inflation, taxes, and expected future growth, we’ll save those for another time. Suffice to say, investors own a great deal of stock at lofty prices. Investors have yet to reassess their confidence broadly.


No matter where you look, seasons are changing. But just as the shift from summer to fall needn’t be anxiety-provoking, neither must the transition from great data to good data. As always, we’ll continue managing our portfolio exposures to match the changing circumstances.

China: Corporate Debt and Common Prosperity 

Late last month, China’s second-largest property development firm failed to make an interest payment to bank lenders. It’s by far the largest example in a string of debt defaults and restructurings by Chinese companies in recent years, as the state has slowly rolled back their implicit backing of government-affiliated firms. China Evergrande Group, together with its more than 2,000 subsidiaries, has sizeable investments in electric vehicles, internet and media production, entertainment, and the food industry, in addition to its flagship homebuilding operations. All told, the Group’s assets total roughly 2% of China’s annual gross domestic product. But Evergrande’s size has largely been fueled by debt - their liabilities sum to more than $300 billion.

The Group’s scale and relationship with banks and other institutions has stirred fears of a Lehman-like crisis in China should Evergrande fall into bankruptcy. The pain from such a collapse would be felt by more than just banks. Evergrande employs 200,000 people and hires another 3.8 million every year to develop properties. More than 1 million people have placed deposits on homes that have yet to be finished, and 70,000 individuals have bought interest-bearing wealth management products backed by the company. The situation puts the Chinese government in a difficult position: allow the firm to collapse and risk both financial turmoil and a fallout in public support ahead of next year’s National Congress of the Chinese Communist Party, or bail them out and risk stoking the moral hazard that helped create the country’s corporate debt problem in the first place.

Further complicating things is that the Evergrande crisis can be traced, in part, to the Chinese government’s efforts to rein in housing prices and curb credit issuance in the real estate market. Earlier this year, they unveiled a new ‘three red lines’ policy that limits debt growth for developers like Evergrande. Coupled with rising interest costs and falling property prices, Evergrande’s inability to raise new debt worsened a liquidity crunch, forcing them to sell assets and discount homes even further to try and shore up cash. So far, their efforts haven’t been enough.

The three red lines policy is just one piece of President Xi Jinping’s renewed focus on ‘Common Prosperity’. Whether to pursue the Chinese Communist Party’s long-stated objective of an egalitarian society, or simply to shore up popular support before seeking an unprecedented third term next year, Xi has resurrected the Mao-era slogan and spearheaded a wide-reaching crackdown on China’s rich and powerful in hopes of reducing wealth inequality.

Here are just some of the recent actions taken by the CCP to cut powerful businesses and their leaders down to size:

  • Jack Ma, the billionaire co-founder of e-commerce company Alibaba and its financial affiliate Ant Group, publicly criticized the Chinese government’s regulatory approach in an October 2020 speech. He scolded the system for being outdated and stifling innovation. Beijing responded by canceling Ant Group’s imminent IPO on the Shanghai Stock exchange, ordering Ant Group to overhaul its business, and launching an antitrust probe into Alibaba. Ma, a celebrity in his own right, has hardly been seen or heard from since.
  • Meituan, China’s largest food delivery company, is under investigation for antitrust concerns surrounding exclusivity agreements with merchants.  In addition, a summer ruling ordered online food platforms to ensure workers earned the local minimum wage. CEO Wang Xing has kept a low profile since he posted poem on social media deemed critical of President Xi earlier this year.
  • The $100B private tutoring industry was caught by surprise in July when Beijing banned companies that teach school curriculum from making profits or going public. They’re also restricted from tutoring during weekends or holidays. Publicly traded companies in the space lost more than half their value overnight.
  • China’s leading ride-hailing service, Didi Chuxing, announced an IPO in the United States and within a week was under antitrust investigation. Didi went ahead with their IPO anyway, but days later came under more pressure. The Cyberspace Administration of China (CAC) launched an investigation over data security concerns, prohibited Didi from registering new users, and removed their app from China’s app stores. It’s been rumored that Beijing could take the company under state control.
  • Over the summer, Chinese officials described video games as ‘spiritual opium’, then imposed a rule limiting children under the age of 18 to no more than three hours of video games per week (one hour each on Friday, Saturday, and Sunday) and an additional hour on holidays. In addition, regulators announced they would slow the approval process for new games and have warned against games that ‘misrepresent history’.
  • Technology conglomerate Tencent, already impacted by the gaming restrictions noted above, was ordered to give up exclusive music rights as part of an antitrust investigation. Regulators also blocked a merger with a rival live-streaming site. They, along with other tech powerhouses Baidu, ByteDance, and JD.com, have been fined this year for various past actions now judged to be monopolistic.
  • Stock regulators are preparing rules that would effectively ban foreign IPOs for Chinese internet firms that hold personal data from at least 1 million users. In other recent data security legislation, China has implemented new rules regulating the transfer of data across borders, cloud computing services used by government affiliated firms, and collection of consumer data by technology firms.
  • Banks and online payment firms have been restricted from using cryptocurrencies for payment or settlement – unless they’re using the digital yuan developed by the People’s Bank of China. Fund managers can’t invest in cryptos either, and Chinese institutions are prohibited from exchanging cryptocurrencies for fiat. The PBOC even plans to prosecute exchanges based outside country if they offer crypto services within the mainland. Bitcoin mining, which uses large amounts of energy, was targeted by provincial level governments after Vice Premier Liu He called for a crackdown on the practice in a May release from the Financial Stability and Development Committee.
  • Huarong Asset Management is an asset management firm majority owned by the state that was created to help manage distressed debt for commercial banks. Chairman Lai Xiaomin instead turned it into a speculative trading firm, and heavy losses required a government bailout in 2020. Lai was executed in January on charges of bribery, corruption, and bigamy. Just last week, Chen Feng and Adam Tan, the Chairman and CEO of HNA Group, were detained by police. HNA racked up debt with more than 80 acquisition since 2015, but is now under court-led bankruptcy after it was unable to pay creditors.
  • The CAC derided ‘chaotic celebrity fan culture’ and vowed to stifle the distribution of ‘harmful information’ in celebrity fan groups and to shut down problematic discussion channels. Sites are prohibited from publishing popularity lists, and talent shows can no longer charge fans to vote for their favorite acts. Film stars Zheng Shuang and Zhao Wei each ran afoul of Beijing and have suffered the consequences – Zheng was probed and fined by tax authorities, and Zhao’s films were removed from Chinese video platforms.


The regulatory barrage has spared few industries, if any. Health care, short-term housing, private investment, high-frequency trading, and even cosmetics, have all faced increased scrutiny in the past year. The impact on Chinese equities – especially Chinese tech stocks - has been pronounced, with the Nasdaq Golden Dragon China Index falling by more than 50%, its largest decline since 2008.

It all comes amid a Chinese economy that’s expanding at the slowest rate in decades and showing no signs of accelerating. Industrial production rose at a 5% annual clip over the last 2 years, downright mediocre relative to historical trends. Inflation-adjusted retail sales are nearly flat:


COVID deserves some blame, of course. Lockdowns hampered local demand, but more importantly, worldwide supply chain disruptions amid the pandemic have changed the way businesses think about product sourcing. In the years before COVID, tariffs and national security concerns had sparked a renewed interest in domestic production. The pandemic was tinder to a young flame. Inventory shortages and shipping delays have favored those with centralized supply chains, and technological advances continue to erode the labor cost advantages of overseas manufacturing. In short, globalization has given way to localization. The speed and scale at which the transition takes place could have severe implications for the world’s largest exporter.

There are issues on the home front, too. China’s disastrous one-child policy from 1979 to 2015 has resulted in a rapidly aging society. According to estimates from the United Nations, the country’s working age population has already peaked. 

Economic growth will be difficult to sustain without an increase in birth rates, but potential parents – most of whom have no brothers or sisters – already face the financial burden of caring for their two elderly parents. The idea of having several children, too, given elevated home prices and the rising cost of education, is often an unwelcome prospect. We’ll have to wait and see whether the CCP’s aggressive campaign for ‘Common Prosperity’ succeeds in improving middle class wealth and turning the demographic tide.