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2021 Outlook: A Year of Two Bridges

First Republic Private Wealth Management
January 14, 2021

Watch a 2021 market outlook discussion with Christopher J. Wolfe, Chief Investment Officer of First Republic Private Wealth Management. 

Read below for a full transcript of the conversation. 

Christopher Wolfe - Okay, good afternoon, everybody. Thank you for joining today. My name is Christopher Wolfe and I'm the chief investment officer for First Republic Private Wealth Management. We really appreciate you joining our 2021 outlook discussion today. We've titled it "A Year of Two Bridges". You'll see why a little bit later, but they're going to focus on the two things that we think are driving markets this year. The first is the healthcare solution. The second is going to be the stimulus solution, and those things have a bearing on markets that we think will be important. Now, before we start, we have a quick housekeeping note. I'll be taking questions at the end of the discussion. In order to submit the questions during the session, if you'd like, you can use the Q & A button at the bottom of your screen. Now, let's begin. 2021 wouldn't be much, given that we're only just a couple weeks in, if we didn't take a moment to review what happened in 2020. I'm going to share a few slides today, nine really, nine or 10 or so, to talk a little bit about not only what happened in 2020, that'll take a few minutes, but more importantly, what we think is going to be developing for 2021. But in order to begin that process, let me share some slides now. Okay. So, let's begin with a review of 2020. It was a year of surprises.

There were quite a few of them. Who would have thought, if you look at the chart contained on this page, that we would end up in a one-year view, those are the bars in gold, with some stupendous performance coming from equities after the COVID disaster throughout the year, but most importantly, the effect it had on the economy and markets in the first and second quarters and then lingered throughout the year? In fact, some milestones in 2020 were pretty important. We had the best quarter for small cap stocks, in at least recorded history for small cap stocks, in the last quarter of 2020. We had some of the strongest performance across value sectors for example, really on the back of expectations that there would be much more stimulus coming. Now the December story is actually a pretty powerful one and we think emblematic of what investors are expecting for 2021. And that year of two bridges comes into play now.

The first is much more stimulus. So despite the 900 billion passed in December, we think there's at least another trillion coming in the first part of 2021. And there's potential, given the light blue wave that we recently wrote about in our "Week In Review", there is potential for additional stimulus as the year evolves. Now that's the first piece of the puzzle, but the second thing that helped propel markets in the last quarter of 2020 was the announcement of not just one, but as many as five different vaccines that may be available in 2021. And in fact, the first inoculations were given in December of 2020. And those two things, the bridges for 2021, which were laid down in December of 2020, or really the fourth quarter of 2020, are what we think is going to anchor market performance and risk appetite overall in 2021. Now, the rallies that we saw in 2020, the pro-cyclical, and that's just a fancy way of saying the smaller companies, the ones that are more sensitive to economic growth, not just in the United States, but globally, started in December. But we think that there's room, for a few reasons I will show later, for that to continue into 2021.

Importantly, most of the performance that we saw, and not just in the United States on a cyclical basis, carried around the world, and what we saw were markets outside of the US also participating in this year of two bridges rally. Now not to be left out, we saw a strong performance on the fixed income side because one of the key takeaways when you see a lot of stimulus coming through the system is that you stave off to a certain degree bankruptcy risk. And in fact, you make a gap between bankruptcy and solvency. So whether or not your assets are bigger than your liabilities, and then whether or not you can pay those bills, as long as that gap is wide, then risk appetite tends to actually pick up reasonably strongly. We see that in things like credit spreads that come down, interest rates that remain relatively low, and ultimately, there'll be a cost for that.

But this basis for the two bridges in 2021 really began in 2020, and we see that continuing throughout the year. Let's talk a little bit about why that might be. So, to put things in a fine point, there are really five key issues that we think investors should be focusing on for 2021. And just to take them in order. The story, the central view that we espouse is that there is a sustainable growth path in the United States, but it's dependent on those two bridges. It's dependent on a successful rollout of the vaccine throughout the year. Our expectations are that we could see as much as half the country inoculated by the middle part of the year, maybe even a little bit later, but that is a, would be a tremendous performance, in terms of getting the ability to commune to start to come back, because that's ultimately one of the key drivers for economic growth, that ability to commune.

The second piece is the stimulus. So while we're waiting for the healthcare bridge to continue being built throughout the year, the stimulus story needs to take place as well. And that's not just a one-and-done, as we learned in the latter half of 2020, it is something that needs to be sustained, at least for a period of time during 2021. And that bridge is really to help ensure that the employment story picks up in a meaningful way, going through the remainder of '21 and even into '22. Now that's just the US story, but it's actually a story for around the world. We think the recovery paths around the world are likely to vary quite a bit, but ultimately the policy alignment, the healthcare bridge and the stimulus bridge, is likely to be, in our view, consistent globally. So the story of reopening is one that may take a series of steps throughout the year in the US, but beyond that, it will be taking steps, not just in '21 but in '22, in other economies.

Out of all of this, with all the stimulus that's likely to be in the system, a global financial system, over the course of the next 12 months, you know, there are building expectations around inflation. Our view is at the current time though, we're unlikely to see strong inflationary pressures in at least in the near term, let's call it through the balance of '21 and maybe into 2022. And a lot of that has to do with the way central banks around the world are controlling short-term interest rates, but also how money is circulating in the economy. And I'll share a slide on that. But our view is that we don't see a lot of inflationary pressures just yet, that interest rates should be relatively low for short-term, and they'll creep up a little bit on the longer term.

We call it "the Cheaper and Steeper Bond Market for 2021". Outside of that, we think that markets may continue to reward, with all the stimulus in the system, a lot of the non-traditional investments that we see starting to develop. There was, a year of the SPAC might be what you call 2020. And SPAC stands for Special Purpose Acquisition Company. It's where you create a company and then you go buy and trade it on the public stock exchanges. It's called a SPAC, and you use the funds that you raise to go buy a private company and drag it into the public domain. There were a large number of those this year, and that kind of creative financing, as some of the rules had changed in 2020, is likely to persist in 2021. Now, our base case is that these rounds of stimulus and the vaccine rollout are all likely to take place in the first half of next year. But I do want to stress something. There is a high degree of dependency on these factors coming into play and remaining in play throughout the year. Should either one of them change, whether it's changes to the way the vaccine rollouts are working, whether it's new variants that may be resistant to the vaccine, in terms of the healthcare bridge, we would be forced to reevaluate some of our more constructive views for 2021. Now, the other side of that is we also need to see the stimulus story continue to play out. Recognize that money is not free, but the reality here is that keeping that gap between bankruptcy and solvency very wide in 2021 is going to be important in our view for risk appetite. The wider that gap is, the more likely we are to see reasonably positive returns out of equity markets, not just in the US, but globally. So that's our base case for our 2021 outlook.

Let's talk a little bit about some of the details. So as we mentioned, the idea of a COVID or a healthcare bridge being a critical part of 2021, I think is exemplified in some of the charts that we're showing here. On the left-hand side are hospitalizations and mortality that we've seen rising rapidly in the United States. Other countries around the world following similar patterns in terms of slope, just not to the same degree. The United States is among the top 10 worst-performing, in terms of COVID at this point. But we think the vaccine story could change that. It's important because this rising slope really puts a lot of pressure on the incoming administration to ensure that the deployment of vaccines is happening, happening as quickly and effectively as possible.

Now, part of the rationale for this deployment, as I mentioned earlier, is that as vaccines come about, the opportunity for humans to go back to communing, to communing, to gathering, to meeting, to going out, to having dinner in a restaurant, to going on cruises, all the things where there are, that essentially stopped in the COVID environment, is important. On the right-hand side of this is the unemployment data globally. Now, what's important really as a takeaway, is that we've lost several years, in many cases. And in some cases, like the US, we've lost more than five years of job gains through the COVID shutdowns, and they all haven't come back yet. So, there is a long way to go, in terms of labor market improvement.

And as I mentioned at the outset, the dependency here is on stimulus to get us through that period, but also on the deployment of vaccines, because the jobs that were lost will be lost permanently if we're not able to commune again in a meaningful way. So the story for investors is really in 2021 around income replacement. So how do we bridge the gap between not having a stronger employment situation and having enough capital in the system, enough spending capital in the system, in order for things to continue working smoothly and for GDP growth overall to continue to be propelled ahead? Now, on the left-hand side are some measures of personal income. You can see that the gold line is excluding transfer payments. That's things like social security and the like, as well as transfer payments from states. And what you really see on the top line, that gold line, is what the income story looked like in actuality.

So, what you see is that there was a very strong response, as true incomes, the gold line dropped, they were substituted by the income provided by stimulus checks, et cetera, during the period of COVID. Now they've waned quite dramatically. And what that's left is given that the job data hasn't been so strong, the actual income numbers are waning off a little bit. And part of that story is anchored in the chart on the right. If you look at income across wage groups, we just divided it in three, but you can divide it any way you'd like, it generally tells the same story. What we're seeing is that the job recovery that has taken place to a degree in the economy post-April of 2020 is working out incredibly slowly for lower wage jobs. So $27,000 a year represents an interesting cut. That's something like, ooh, 14, 13.50, $14 an hour or so. There's a call for minimum wage to go to $15 an hour. Now, this is important when you look at this wage data around how we think about two things. The first is inflation, and the second is how does GDP growth evolve in 2021?

And what you need to think about is that gray line, those low wage jobs, are about half of all the jobs in the United States, about half, a little more than that, 52% or so. The middle wage jobs are about 30%, 35%. And all the remainder are the higher wage jobs, above 60,000. So why is it important? Because the higher wage jobs have largely recovered, but there is a lower proportion of people in that universe. The middle wage jobs have not fully recovered. They're down somewhere between four and 5%, relative, in terms of employment, relative to where they were. But all those lower wage jobs, the service industry in particular, have been so sorely hit and they have not recovered. At the margin, this is where we need to see that recovery. Back to my point earlier about communing. So if we're in a place where the service industry revives, I'd expect to see those lower wage jobs, and the aggregate income for the entire country, continue to pick up.

Now, that'll be an important point. It will be a good problem at that point, should we have that, a good problem for the fed because that could be one of the leading indicators for inflation. Now, why would I mention that? Because the next story around economic trajectory for 2021 isn't just about healthcare help and stimulus helping to bridge the employment challenges, but it's also about what's going on, with respect to this stimulus story, and how it's starting to build some potential inflationary pressures. On the left-hand side of this page, the idea is really about if there's a lot of money in the financial system but it's not moving around a lot, it's very hard to have a lot of inflation. It's a concept called money velocity, how often does a dollar move around in the economy, and that's that green line in the left-hand chart. And it's been falling drastically, at least over the last 20 years or so, and really collapsed in the COVID period, it has not revived.

Another way to say that is people are saving more and spending less. So for folks worried about the gold line, look at all the money the fed is printing. Well, it really won't matter a lot until we see that velocity number pickup. Until all that money starts moving around the system in a much faster way, it's going to be really hard to tell a story of runaway inflation. We're a way away from that. Why would that be? Well, if you recall the chart I showed previously, around where the job growth is, until we get the vaccine and we can commune again, and get the service industry restarted, we need a lot more of those service industry jobs actually being paid and spending the money that they earn. That's where the velocity will pick up. Our view is that's not, at best, until much later this year, and more likely a 2022 story. I think there's plenty of time to consider how to position bond portfolios in light of that. As I mentioned at the outset, this really contributes to a view of a cheaper and steeper yield curve throughout the balance of 2021.

Now on the right-hand side is something that's also almost as important as the velocity of money story. And that's where does the capital come from in the economy if it's not coming from the consumer side? And one of the things that happened over the last 10 years, post the global financial crisis, is that banks became much less levered. And one way to look at that is to look at their deposit base. That's the gold line, it skyrocketed. Banks are in a much better financial position, broadly speaking at the industry level, than they were at any time prior to the global financial crisis, at least the 20 years prior. So why is that important? For those expecting a similar repeat of the global financial crisis, that seems extremely unlikely. Now, part of that story is that even though banks are flushed with deposits at an industry level, there just hasn't been that much lending. Why? The rules have changed making it harder.

Many banks have gone up in quality, in terms of their lending, and that's left a lot of the credit opportunities to be fulfilled by a lot of nonfinancial entities. Think private equity investments or hedge funds, types of investors that will look at some of these other opportunities. But if we're having kind of in the base case not a lot of money moving around in the system and not a lot of lending to help propel that, again, my point would be very simple. Very hard to see a lot of inflation percolating in 2021. Now, that might leave us though with I think a slightly different story around where things should go in our central view. And in our central view, the idea is that the healthcare bridge and the stimulus bridge really start that process of reopening the economy. And from that reopening, going back to the communing.

We expect to see, as the year progresses, and certainly by the latter half of the year, barring some major changes in the way the COVID variants come out, or some changes in the vaccine deployment, barring any changes to the stimulus bridge or to the healthcare bridge, then the reopening story is the central one for 2021. What that should do in a reopening world is it should argue for portfolios at a minimum being more exposed to places that are more cyclical. Now, what does that mean, cyclical? Cyclical is when it follows the cycle of the economy. People use fancy terms like reflation, or an insurgent, a resurgence of growth.

The reality here is all the stimulus that's likely to filter through the system, if it is successful, which we anticipate, staves off bankruptcy, so we don't have a lot of challenges around that, and helps to keep that, keep that consumption story moving along well in 2021. From a stock Mark perspective though, things may behave a little bit differently. In the last several years, the best place to be has actually been US equities, and more narrowly, US equities that pay dividends and have really good balance sheets. A lot of folks hiding in those companies and frankly, they've done pretty well. Now, as I mentioned at the very outset of our talk, the idea was that as the vaccine was deployed and lots of stimulus starts to roll through the system, the stock market, a forward-looking anticipator of what may happen, is really going to look for this opportunity set to say, number one, probably less bankruptcies, that's good for my risk appetite.

I should take more risks. Number two, there's a lot of stimulus in the system, that may help spending and revenue growth as the government steps in to do what unemployed consumers are not doing at the moment. And ultimately, what that may lead to is that cyclical performance doing well in 2021, after years of not doing so well, relatively speaking. We got a taste of that in the fourth quarter with the big surge in smaller companies and the big surge that we saw in more value or cyclically oriented companies. Now, the graphic we're showing you helps to give some context for those commentary. So on the graph, there are six bar charts, split into two colors, and those bar charts we've just broken down in a simple way to highlight how much exposure of the index, they're all listed on the bottom, is cyclical, meaning follows the economy much more closely, and how much is more defensive. Think of it like healthcare companies or things that have stable revenues no matter what. So ones that move with the economy more tend to be on the right-hand side, the right three. MSCI EAFE, which is the index of a lot of markets outside the United States, the Russell 2000, which is an index of smaller companies, and the Emerging Markets Index. Look at how much greater proportion of green cyclical exposure that a lot of these areas have.

So part of our advice to clients, starting really in the fourth quarter of 2020, but remains to this day, is to be rebalancing, considering how to rebalance portfolios to capture what we anticipate to be some of the cyclical strength over the balance of 2021. That's not to say we won't expect bumps along the way. We're starting 2021 with a massive amount of bullishness in markets at this point. And that bullishness means that a lot of things have been bid up. But we think it's warranted. If the central case, which we're advocating for, is that a healthcare bridge and a stimulus bridge get us through 2021, then we think the performance of equity markets will reflect that. Are all the gains in? We don't think so. Are a good piece of them in? Probably. But it doesn't mean it's too late. It means there's really an opportunity to look for rebalancing portfolios and gaining additional exposure around either more non-US stocks, for example, some of the smaller companies, for example, or even more towards emerging markets. So this story around reopening in two bridges has a direct impact then on portfolio positioning.

Now beyond that, I'm going to share a little bit more about non-US markets. Part of our strategy over the last several years has been very simple: stay at home, stay in the US, stay with big companies. And that's generally a good strategy. And over the last couple of years, what you've seen is this, on the left-hand side of the charts shown now, is the profit margin story for non-US companies, the Europe, Australia, and Far East Index. That's that gold line, which has collapsed over the last several years. And it's kind of meant that non-US equity markets had been a bit of a dud. They've had okay numbers, but it's really meant because the green line on the top, the US profit margin story through the use of technology, we've used the term robots for people, really US corporations have been very nimble at managing and protecting their profit margins.

But we're at a place now where the gap is so large that if we get to a return of a bit of growth, a bit of reopening, even if it's later this year, in markets, we're likely to see some meaningful improvements in the profit margin story of markets outside the US. Doesn't mean the Us won't do well. We think they're just maybe opportunities that look a little bit more compelling. And it's one of the reasons that we advocate for rebalancing away from the stay-at-home-only strategy and much more of a, "Hey, where are there opportunities outside the US as well?" On the right-hand side as you can see, markets are starting to suss this out, at least the growth story. As I said, we're facing 2021 with a massive amount of bullishness, or a very large amount of bullishness built into markets. And what you see is this forward price earnings ratio is a valuation measure by which you can, you know, gauge how investors are anticipating how much growth may come through the system, and that gold line, the S & P 500, good old US companies, there's a lot of good news being built in. Now, on the chart on the left, with high profit margins likely to turn back up, US companies can deliver. But if you look at the discounts that you see from some of the other indexes, particularly Emerging Markets, or Europe, or, you know, even just kind of Asia more broadly, there's some meaningful discounts.

And if that profit margin story turns up, there's likely to be some very strong earnings acceleration, if not in 2021, maybe more towards the end of '21, but maybe well into 2022. And that's important. The stock market is a discounting mechanism. It's going to look ahead and it's going to anticipate some of these good news, good news points that we're talking about here. So the story is really one around rebalancing the equity exposure in our view. Now, let's spend a little bit of time on the alternative assets story. I think it's one of the more compelling ones, I think, for many clients to consider where they're qualified and have an opportunity to have a conversation with their wealth manager. There's a number of things that we think are developing as meaningful trends in 2021, but ultimately, they come down to a couple of things. They come down to the deployment of technology in new and creative ways. We continue to anticipate that to accelerate through 2021 and beyond, whether it's things that as I mentioned, the green hexagon here, the deployment or the growth in digital assets. Some of you might hear that as cryptocurrencies.

Other of you might hear that as content for media. But everything being digitized means that they may now be able to assign a value to them. And once you can assign value through, something for you techies called "Metcalfe's Law", the value of a network is in relationship to how big it is and how many nodes of connection there are, you have an opportunity to consider a new way to look at assets and potentially asset allocation from an alternative standpoint in 2021. Now, the other things that we think would be important, at least for the story around where we're going to look for themes and trends in alternative assets, credit dislocation. So even though the feds we think are going to do a reasonably compelling job at managing the gap between solvency and bankruptcy, there's still likely to be some disruptions throughout 2021. And we think private companies are likely to be best positioned to capture some of that. That dislocation story is one that's probably for smaller industries, but could continue to still show up in many of the service industries that we think will struggle for at least the first half of the year before picking up a little bit in the second half. Now, I mentioned SPACs a little bit earlier, Special Purpose Acquisition Companies. We don't think that's a trend that's going away.

And even though large amounts of capital are being raised, there are some very large private companies that are actually coming through the system. And really the trend behind all of this is liquification, liquefying assets that were heretofore illiquid. It it's a boon for private equity companies that get to liquefy their investments. It's a boon for investors in the public markets that otherwise wouldn't get access. And the real trick here is to find the right valuation level. So, all SPACs aren't created equal, but it is an interesting trend, this liquification, which is really the key part of it that we continue to see on the back of the big stimulus and on the back of what we think will be a return to reopening in the US economy. Last piece I think we want to emphasize, given that we've long been strong investors in real estate is the story for 2021 may become a bit more focused. Broadly, real estate has done incredibly well for those knowledgeable about the industry.

Capitalization rates have come down so much that in some areas it can be relatively challenging to make, you know, very high returns. That said, there are still some trends. Let's call it the Amazon-fiction of retail and the demand for logistics. Think of that as warehouses near airports, and trucking and distribution and delivery facilities that will continue to be in demand as people shop from home for a much longer period of time. We also think the multifamily story around real estate still has a lot of room to run, particularly in real estate markets that are not only recovering, but are continuing to expand in certain parts of the market based on migration inside the country. So, some of the stories around the alternative asset space for us look pretty compelling. You'll see opportunities from our firm over the balance of 2021 along some of these lines where we're trying to capture some of these critical themes. Okay, well, no discussion about 2021 would be complete without talking a little bit about the risks. Now, in December of 2020, in our "Year Ahead" piece, we published a number of our forecasts where we thought things may end up in 2021, in S & P, and the midpoint around 3,900, with a wide range around it.

A 10-year bond close to 1 1/4%, maybe a little bit higher. Boy, we're creeping up on that right now. We thought GDP growth could be as high as 4 1/2%. We made a number of those forecast elements. And to the extent that a lot of the politics that have played out in our last "Week in Review", we talked about the policy decisions being more important than the politics. We don't anticipate at this point a lot of other extreme events to derail us from the central scenario because so much, as I mentioned at the outset of our discussion today, is dependent on stimulus and on that healthcare bridge. But it doesn't mean the world is riskless. In fact, there are large numbers of them, ones that we can see and identify maybe somewhat priced into markets. The harder ones to see and identify, we just don't understand yet and we'll have to analyze them as they come along. But some of them that we think are important to understand, because of the dependence I mentioned, are the pandemic recovery takes longer because the vaccine rollout continues to get bungled, or there are some challenges around it.

There's all sorts of news reports right now, indicating that those challenges are starting to percolate up. And there's actually been a response by the federal government to say all the doses we were holding in reserve; we're now going to launch out there. We've just got to get people vaccinated, even with the very first dose. I think that's an important shift and it represents a mentality and an intensity on getting things back to the reopening that I think the current administration has just started to underwrite and the incoming administration, for certain, will underwrite in a meaningful way. What that should suggest is that we get, as I mentioned at the outset, something like half the population inoculated, or at least vaccinated, somewhere by the middle of the year, maybe just a little bit later than that. That would be an important milestone for us to have greater confidence around the return to communing and the idea that the service sector could have an element of recovery. Now, we don't know a lot about virus mutations.

They've already started to percolate through the system, but very hard to forecast those kinds of things. But it is something that we'll be watching very closely as a risk, particularly as once vaccinated, there's subsequent and follow-up testing that will be going on to understand whether or not the protection is afforded against certain strains, all strains, and for the duration of time that it would be afforded. I think the second piece around what we're looking at for 2021 is policy failure. And that would come in the back of gridlock. Despite what you may have heard, political gridlock is not good. It's bad. The common wisdom there, in our, view is misplaced. There has been a longer history in this country where political compromise has actually developed programs that benefit a large number of people. Think of the old age survivorship and disability insurance, what we know is Social Security and Medicare, the OASDI. Think about New Deal. Think about a number of programs that required compromise. It is important that we think about it in that light.

A compromise going forward is going to be something that the country can rally around, or different parts of the divisions within the country can rally around. Gridlock just represents a status quo function, which is keep your divisions, you stay over there, we'll stay over here, and not a lot gets done. We need policy actions now. Why? Because we're seeing markets are dependent to a degree on stimulus, not just on monetary side, but increasingly on the fiscal side. And that requires working together. So, gridlock and back to infighting would be a bad result in our view and something that will cause us to do some reassessment on where we're headed for the economic growth, but ultimately also for markets.

The other thing is we have seen in the past central banks overreact to inflation scares. Right now, we think the US fed is leading the way by indicating that we're going to use average inflation. We're going to let inflation run for a longer period of time. We're not going to hike rates. It's giving a sense of complacency to the bond market about the fed will keep short-term interest rates pinned at a very low level for a very long time. I recently saw a forecast out to 2025. That's a little silly. The fed is unlikely to be that nonresponsive for so many years. Our view is that some of the pressures that are building, remember that money supply chart, very high at this point, are likely to be addressed with the fed that will become more responsive, particularly with learned folks, like potentially Janet Yellen to be confirmed as the new head of Treasury, and Jerome Powell remaining in his seat. We think that they will let the facts determine their policy rather than we're never going to change it, which I think the market would be mispricing.

That said, the US fed leading the way gives us some confidence that most central banks will not overreact to the inflation story, and ultimately kill off any type of recovery from the COVID, from the COVID shutdowns. And finally last but not least, but probably the most important, is the tensions with China have not abated. It is unlikely that President-elect Biden is going to change anything meaningful, with respect to China policy, at least in the next several months. There's much more of a domestic story that he needs to address. There's much more of a story around Europe that needs to be repaired. And I think from that standpoint, we have some lights of encouragement, but tensions that worsen with China, to us, argue for reassessing the overall risk profile. As we've seen a number of not only incursions, but rising cybersecurity threats that come out of these tensions. It's absolutely crucial that we start to reset some of those relationship elements. Right now, we think we're in an okay place because there's likely to be no further aggravating actions on either side, at least for the time being. And from that perspective, we think the risks are worth monitoring but not overreacting to at the moment.

So this brings us to the end of our formal remarks. I want to say again, thank you everybody for listening. We'll turn now to some of the Q & A items that have come in, the questions that have come in. So I'm going to take those as we go through our screen. I'm going to stop sharing and just go back to the questions. Okay. So, I have a few of them that are listed here. So let me try to tackle a few of them. And I'm going to group some of them together, if we've been asking them together, then hopefully we can answer them. So the first one is: What are the most likely tax reform changes we should expect? So, I didn't spend a lot of time on that because some of that remains to be determined. It is unclear how the new 50-50 Senate split will work. In the prior incarnations of 50-50 Senate splits, you had Tom Daschle and you had Trent Lott agreeing to share power, maybe a little bit of what we would now look at historically as a gentleman's agreement. It's not clear how things will work here. And to the extent Democrats make it much more of a power move, I think it will be increasingly challenging to find compromise.

That said, what the Biden-Harris plan and proposals typically have focused on are changes to both personal taxes, as well as corporate taxes. So I'll give you a couple of expectations, which are really just our base case, but I want to not put too much confidence in them, but I do think there are likely, if there is compromise in Washington. So the first will be marginal tax rates likely to go to the 39.6% up from 37%. That'd be the first. I think the second is there's likely to be some limitation on deductions. So if SALT does come back, there'd be some limitation deductions. Current talk seems to be around 25 to 28%. So, some deductions back would be good, but not enough as an offset, particularly for high wage-earners. And we're likely to see some additional taxation measures beyond that, but largely the income tax story's going to be around deductions and marginal rates, particularly for high income earners, over 400,000.

So a re-orienting of some of the brackets as well. So in the personal side, higher taxes for higher earners seems to be the case. The corporate side is similar, where there are likely to be some forms of alternative minimum tax or minimum book taxes, as they're being labeled in the Harris, Biden-Harris proposals. The corporate tax rate, at least at a marginal level, is likely to move higher. It was 28% before it was knocked down to 21 under President Trump. It's likely not to get back all the way to 28, some range though between 24 and 27 seems likely. The market seems to be betting on 25%. And what I would stress at least around tax proposals is that they are unlikely to all be affected in 2021. They are much more likely to be something for 2022. So that's a likelihood, it's not a guarantee. And really, that's anchored on two things. One is the priorities that President-elect Biden has placed on getting vaccines out and getting the country back to a place where we can commune again, that's important. And so, that's going to dominate a lot of the agenda, and potentially an additional impeachment may as well. So the tax story is something that's likely to be, if it's going to be driven by compromise, which we anticipate, something that will take a while and as a result, likely happened much later in the year.

Here's the key to that. The leader in the year it happens, the less likely it is to be retroactive. So I think our current expectations at the moment are that there's a later in the year set of tax changes that will likely be in effect for 2022, likely I say, but that remains to be seen. It is a touchy and sensitive subject, something we are watching very closely. Should indication shift, we will immediately be back with clients around that issue. Okay, let's talk a little bit about cryptocurrency become a viable investment. So it's a great question there. I think for some, cryptocurrencies are already a viable investment as they think about it. I think there are three issues that we consider around the crypto story. So the first is the regulatory environment. It's one that seems to be changing quite a bit. There have been, for those that follow this closely, a number of announcements over the last several weeks and months, particularly related to things like fraud, accounting, securities issues, et cetera. So that's important when you think about cryptocurrencies and whether or not they're securities and ultimately need to be regulated.

Some areas of the cryptocurrency market are not yet, are not absolutely clear just yet. So that's one, and we'd anticipate additional changes around the regulatory environment in 2021. Number two, I think for many of the interesting ways that folks are investing in this space, cryptocurrencies, the vehicles that you often end up having to choose are not always the thing that is underneath them. And that's a fancy way of saying that you may look at something that looks like it owns Bitcoin or some other type of currency piece, but the reality is it might actually, for a whole bunch of legal and regulatory reasons, behave very differently. So what's important about it is you have to know what you're investing in. And I think we, from our perspective, continue to do work around this topic because many of the structures that we see for investing here are somewhat challenged. Doesn't mean they can't go up in terms of price, but we care about managing those risks. I think that's the last piece of the puzzle here. I think the volatility story around cryptocurrency, the risks around it, is not likely to lessen at all in 2021.

There are a number of initiatives that many central banks are making around digital currencies. So a more formal way that you would think about transferring capital money across systems, et cetera, and kind of the simplest way to think about it is the cryptocurrency ecosystem, at least as it's currently understood, and there's many other uses, is a transactional one. There's a buyer and a seller. There's some piping, plumbing in the middle. That's actually pretty valuable. And then there's a thing that goes through the plumbing, Bitcoin, Ethereum, whatever, whatever it is. It may be less important about what goes through the plumbing than how many plumbing nodes and networks are connected over time. As things become ever increasingly digitized, that opportunity set is likely to continue increasing. And I would suspect that the digital asset story, one that's much bigger than just cryptocurrencies, is probably the place that you'll see is definitely the place you're going to see more from us in 2021. Okay. Let's go through a couple other of the questions that are here. Slide two, bullet point four.

That's very precise, that's great. Non-traditional investments. Is it fair to think of them as tech-related investments? Yep, that is one answer. From our perspective, non-traditional is a nice catch-all that is really about managing liquidity. So investments that aren't that liquid, as something that we would think about as not being so traditional. But it could also represent a lot of different things. Some folks collect muscle cars, some folks collect microscopes, or they trade them from the 1800s. Reality is there's a whole bunch of things there, some of which were not qualified to analyze, but maybe experts clients are, but nonetheless can be considered in some cases in that non-traditional space. Where we have insight or expertise, we'll continue to share that and demonstrate that I think with clients. So yes, in the tech space, we do have both and yes, you will see some of that in 2021. Okay, we talked a little bit about Bitcoin, and we'll go through a few other. So do we see the dollar behaving as a currency? How do you see the dollar behaving as a currency over the next year? So, that's a really good question.

Conventional wisdom, which we share at this point, is the dollar is likely to be a little bit weaker. Part of that story anchors on the fact that things that have been hit the hardest, that's Europe, that's Japan, that's the pro-cyclical story, may actually recover the most. And capital, at least if it still moves freely around the world, which we anticipate it will continue to do so, it's likely to move to the places where there can be some of the higher returns. Now, we've seen that, for example, in Bitcoin. Bitcoin is an example. It kind of moves in, moves out very rapidly, but we think on a longer-term basis, if you're starting from a pretty low level, a discounted place for say European equities, we're likely to see that kind of continued pressure. Hey, I'm going to just reduce some of my exposure in the US, add some exposure into Europe. And that means you're going to sell some dollars and buy some euros. And at the margin, that adds a little bit of pressure. Does that mean the us dollar is likely to fall in a panic-type way? No, we don't anticipate that.

Janet Yellen is confirmed as the head of the Treasury and Jerome Powell remains as Fed chairman, which we anticipate both items. Then the real opportunity here is for confidence to be regained in the dollar and the dollar to arrest its slide and be much more tapered through the balance of 2021. So that, from my perspective, argues I think reasonably well for really opening the doors for investing outside the US, because over the last several years, with the exception of 2020, the dollar has been a headwind. It's been a big challenge to invest outside the US because the dollar keeps going up and it makes the returns from the markets, you're investing outside the US look a bit worse. Our expectation is that the dollar is less likely to be a feature of returns, at least over the near term. And from that perspective, we get to focus more on the fundamentals, and then that's a good thing. Okay. Great question about how overvalued in this market. Well, it depends on the metric. Or it depends on the ruler that you use. If you use the Warren Buffet ruler, we're at 150% of GDP. So the market value to the GDP of the economy, now that's comparing an apple and an orange, but the reality is it's a metric Mr. Buffett likes to use, and boy, is it relatively high. But it kind of makes sense, given all the stimulus that's in the system and how much deficit financing we're doing, we're gassing things up quite a bit. And oftentimes what happens is even if you start from a high place in markets, they can still go higher.

At least in the short-term. There is at least a very strong mean reversion tendency in most markets, so if they start from very high levels, they tend to kind of average back. Now, one thing that supports though a little bit higher levels is that story I mentioned a little bit earlier in the discussion. That was a green line. That was the profit margins of US companies. They tend to be higher. We tend to use more technology and we tend to have much more variable costs. US companies tend to remain profitable through more of the economic cycle than our counterparts outside the rest of the world. So, there is some justification for having US markets be more expensive or more richly valued than other markets and that makes some sense to me. I think the other story here is that valuation is very rarely an indicator of a crash. Very rarely also is an indicator of a wild bull market. It's just a condition of the markets.

Now, from our perspective, we have a multitude of metrics we look at, whether it's a price to earnings, price to cashflow, price to free cash flow, enterprise value to EBITDA, all kinds of financial terms for saying, yeah, US markets do not sit in cheap territory. They sit, on average, somewhere between half a standard deviation and one standard deviation expensive. That's not scary territory, but boy, you have to be thoughtful about how you allocate your assets in an environment like that. Over one standard deviation, or closer to two, you really have to pay attention and you want to be very aggressive in managing the risk. At this point, though, with a little bit of overvaluation, I think you're okay to continue in the central scenario of the vaccine and the healthcare, and the stimulus bridges in 2021. Okay. Some other questions about emerging markets. I'm going to put a couple of them together. So the idea about China entering the MSEI Emerging Markets Index and how has that changed? Well, I think without getting into all the technical details there, Morgan Stanley Capital International, the big index provider, reconstituted many of their indexes, really to make China a much bigger part over the last several years.

That's done two things. I think it's made the opportunity for most clients when they look at investing in emerging markets, say through exchange-traded funds, just buy one thing and go home because it's cheap. They've made that an interesting opportunity, but I think from my perspective, and certainly from our research team's perspective, it's meant that the opportunity to go beyond the index, look either inside of China or across the regions, who benefits from a China that's recovering from COVID much quicker? Is it that Philippine markets? Potentially, they have. Is the Vietnamese markets? Potentially. Is it Japan? Yeah, that's actually been a big revival. So the opportunity I think is not just an allocation by a single thing, meaning an exchange-traded fund and then not look at it, but actually to look beyond that index. So, China coming into the Index has made it much easier to have that discussion of do I need to go beyond, because increasingly, when you're buying an exchange-traded fund, you're buying a lot of China, and you can do that other different ways. Doesn't mean it's a bad thing, just means that you're concentrating. It's a little bit like buying technology indexes in the United States. Some of the smaller technology indexes are actually just two stocks, Microsoft and Apple. And that might be fine, but you have to know what you're buying. That's really the key. Okay. So a couple other questions I think, and we'll get to them.

Okay. So, what do we see happening with interest rates? If inflation remains relatively low, suggests continued low rates, even though they're historically very low and how does that affect mortgage rates? I'm going to leave the mortgage rate out for a little bit because you know, banks determined those policies there. But I do think the interest rates story is one that's likely to be a bit noisier in 2021. The arc of reopening, or the arc of the economy bending towards reopening, in our view, is likely to do a few things. The first is it will likely as job growth returns a little bit, start to put a bit of inflationary pressure in there. And guess what? The bond market is sussing that out. How do we know? Because we have had 10-year bond interest rates go from 90 basis points, less than 1%, all the way to one and close to 1 1/4% in a very short timeframe. That's a big move, a really big move in bond land. It's a little bit in stock land, but it's a big move in bond land. And I think what really the market is starting to tell us is that things are getting a little bit better, at least with respect to some of the data. The vaccine certainly helps that and that there's an anticipation that some of those trends will continue. Our view though is that given that the vaccine rollout's likely to take a meaningful period of time, even though Operation Warp Speed was successful in getting things done in December, it has not been successful in kind of meeting some intermediate term targets. And it's likely we only get half the country vaccinated by the middle of the year.

That's likely to keep some pressure on the job creation, the consumption story. It'll still create demand for stimulus, and it probably keeps interest rates at a bit of a range. It's called one to 1 1/2%. As I mentioned at the outset, we made some forecasts that you know, we thought it'd be at 1 1/4 at the end of this year. But I think at this point, you know, we're going to stick with that forecast, but you know, subject to revision depending on how the job market evolves in 2021. So our expectation is that the fed will keep short-term interest rates very low, and that the yield curve is going to be pretty steep. And that means the difference between longer-term bonds, 10 years, and shorter-term bonds, say fed funds, is likely to be pretty big. That's a good thing for bank profitability, just generally speaking but it's also something that's a bit more normal in terms of the interest rate environment. That's also a good thing.

What is not a good thing just yet is that interest rates are still below inflation. Inflation's running in the two range and interest rates are only in the one range. So we still have this weird land of negative real yields, or yields after inflation. Our expectation is that will continue in 2021. And that will also I think for a number of other reasons, keep some pressure on rates from rising too fast, too high, too fast. So our expectation is there will be a steep yield curve, short rates near zero, 10-year bond, one, 1 1/4 range, at least to the first part of the year, maybe higher in the second half. And that's really, I think the story here. Very hard to see 3% 10-year bond yields, just to be an outside forecast in 2021 without some meaningful pickup in inflation. And frankly, I think that would only come from two things. One would be a really good problem, which is we start to see a lot of job creation and consumption and all the pent-up demand starting to come out, or a bad reason, and that would be some massive loss of confidence in US policymakers.

I discount the bad reason for the moment, but I think the good reason would be something that we'd want to evaluate. That would probably argue much more for owning equities, even to a greater degree, than it would be for fixed income. On the mortgage side, it would probably also put some upward pressure on mortgage rates because it would ultimately get to that spread that banks make from borrowing versus lending. Okay. Capital gains tax preference. I should have answered that in my tax story. So, one of the other tax items is related to what capital gains tax rates may look like. And so the opportunity, or at least some of the proposals that have been put out on the Biden website are to tax capital as income. Inherently, that makes some sense, if you're going to raise money. I think for folks this would affect, it doesn't make any sense. The reality is there is likely to be some proposal around capital gains taxes moving higher, over the period that I mentioned earlier. Tax negotiations carry in 2021. Then 2022 is really the point at which we start the tax clock. If that's the case, very hard to see the capital gains numbers moving higher for anybody making under 400,000. I think the pledge that Biden, as President-elect Biden has made is not to change taxes for under 400,000. Much more likely that above 400,000, if you make that, then your capital gains may be taxed at a higher rate.

So, we would anticipate something like that being on the table for tax changes in 2021. And I appreciate somebody highlighting that. I should have mentioned that. Okay. All right. So, thoughts on markets seem to be indifferent to the events in Capital last week. Do you see this changing? You know, I think three things are going to come out of all of this, but let me start with what we wrote last week. The events were heartbreaking. Un-American. Not something that we would have been anticipated and given the culture of our firm, not something that I think is supportable in any way. However, markets, to the questioner's point, make a really good distinction between what affects them, which is policy and what doesn't affect them, which is a lot of politics. And last week didn't create any meaningful policy changes just yet, save impeachment. Now what it may do, and this is my second point. So that's the first point, markets we'll look through this. And as one of my colleagues reminds me, markets don't care about your emotions. They care about everybody else's emotions collectively, but they don't care about your individual emotions, no matter what they are. But the second point is important, because collectively, the emotions in Washington are relatively high and that could drive some policy changes, whether it's related to security, whether it's related to how we think about voting laws, those things may or may not affect markets.

Likely it's very little, if they do it all, but it is something that we're going to watch relatively closely. I think most importantly though on the second point, it's likely to affect the way that there is or is not compromise in Washington. That's the critical piece here. I think that needs to evolve and it's very hard to speculate on this point. The third thing though I think that does come out of the events that have transpired and we've seen it already has been a large number of news reports about what political funding looks like. For those of you that are familiar with Citizens United and Companies Are People, Too, and all those kinds of things that have transpired over the last 20 years, the idea that corporate funding changes as a result of this could be a meaningful factor for future elections. That said, corporate funding historically only ever taken pauses, they've never just stopped. So, I think it remains to be seen how this third point plays out, but it's something we, again, we'll watch carefully because I think to the extent that there is backlash or repercussions around corporate funding, those are likely to evolve in just the next several weeks. Okay. We're coming up on time here. So I'm going to just take one more, one more question here which I think is a very good one, and it's: Could you please comment on a healthy short-term correction?

Boy, I wish we had one and that's not a flippant answer. Markets go through periods of up and downs over the course of any cycle. And to the extent you have a one-way market, up up, up, up, up, it should concern an investor. It doesn't follow patterns of history. It tells you that something else is swamping the fundamentals. And in this case, it's probably the stimulus. So to the extent, a healthy correction maybe associated with higher interest rates, maybe we've gotten that view wrong, because the economy is recovering a bit faster, and oh gosh, the cost of money is changing, so I've got to change my discount rate in my evaluation mechanism. I think the bottom line there is yes, a healthy correction is not something we'd be afraid of. There are unhealthy corrections. Think about some of the things that have transpired in markets that are very speculative. I think the up 20%, down 20% movements in some of the speculative investments, maybe a little bit like Bitcoin, those are a little challenging to understand.

But a broad stock market correction that's down in the 10% range, I don't think is something we'd be afraid of. We'd look to continue rebalancing portfolios. I think it would come on the back of something like the COVID bridge or the healthcare bridge taking too long to build, or the rest of the world actually suffering under other COVID variants, those are meaningful challenges. And by the way, the bridges we're talking about aren't just US bridges. Every country in the world is going to have to build bridges like that. And to the extent, the healthcare bridges for most other economies are going to take a while to develop, the longer they take to develop, the more likely we are to have periods of corrections in this pro-cyclical story that we're talking about. So, that dependency I mentioned is really the key here. Any change to the stimulus program or change to the healthcare program, those bridges really, is going to help determine how fast, how deep a correction may come. But I think at this point, we'd use it to rebalance because the underlying mechanics, remember that profit margin story for US and kind of the recovery story here, still look meaningfully good.

And as long as there's enough stimulus in the system to keep that gap between bankruptcy and solvency relatively wide, then we'll be in a relatively good shape. So with that, we've just come across the five o'clock hour. I'd like to say thank you everybody who joined me. Hope you enjoyed the presentation. A replay of the discussion will be available and if you have any questions, we'd encourage you to contact your wealth manager. Thank you for choosing First Republic for your wealth management needs. The entire First Republic team is here to support you and your family across your financial needs at any time. That will bring our presentation to a close. Thanks everybody for your time and attention.

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