A Year of Two Bridges: Markets, Inflation and Policy Update

First Republic Bank
April 23, 2021

Watch a market update and discussion featuring Christopher J. Wolfe, Chief Investment Officer of First Republic Private Wealth Management, and Mike Selfridge, Chief Banking Officer of First Republic Bank. 

Read below for a full transcript of the conversation.

Mike Selfridge - Well, good morning, good afternoon everyone and thank you for joining us today. This is our quarterly update and it's my pleasure to host the Market Update with Christopher Wolf. My name is Mike Selfridge, I am the Chief Banking Officer at First Republic Bank, and as I mentioned, Christopher Wolf, he is our Chief Investment Officer of First Republic Investment Management who oversees the research and strategy of our Investment Management group, which as of the quarter we just released, is now $218 billion, which is extraordinary, Chris, great quarter for you and the team. Christopher's an influencer in the world of economics, in money management and many of you may have seen him on TV or published in many periodicals. Just a reminder, if you would like to ask questions of Christopher, I will go through mine and I will get to yours as soon as possible. I know we have a lot of them. So Christopher, great to see you, and it's always great to do a market update. Happy Earth Day from yesterday. for the backdrop there. Actually, First Republic is proud this month to be sponsoring the planting of 100,000 trees with the National Forest Foundation, so I'm always happy to do our part. Christopher, maybe I'm going to start with just kind of where we were. I think we've rehashed these through 2020, we've been doing this since the onset of the pandemic, but we did this in early February. I'd like to recap sort of what what's transpired since then, but one thing that you've always been consistent with starting back in October of 2020, was a year of two bridges, and that theme seems to be spot on. So before I ask you to assess your report card of yourself and your performance, why don't you remind the audience what a year of two bridges is and why that's so important looking forward?

Christopher Wolfe - Yep, Mike, thanks for that and I appreciate the kind words. The year of two bridges was really to underscore how important it was to have both the healthcare bridge, that was the vaccine and a stimulus bridge, which is both monetary and fiscal. So it's all the support that's being poured into the economy from the government, and there's a cost for that, which we'll get to later, but we didn't see a way forward in 2021 or even beyond without those two things working, I think really, in a very paired and shared way, this year and knock on wood, it's actually worked out that way. I think that was fairly straightforward, and from that perspective, most of the bridge work is the scaffolding certainly building, the decking is being laid, so I think we're actually in a very good place to propel the economy, at least to the balance of this year and into 2022, and we'll get into that a little bit. So, right now we're in a relatively good place for the economy for those two bridges.

Mike - That's good, but we've got work to do in building those bridges.

Chris - Yeah.

Mike - Chris, just kind of looking back to the last time we did the Market Update, I guess I would summarize it perhaps as better, higher, steeper.

Chris - Yeah.

Mike - So better, higher, steeper, better consumer strength, consumer savings, to your healthcare theme, US vaccinations. The last time we did this, we were at 38 million Americans that had the first dose, today worth 135 million, we're almost pushing 50% of the us population with the first dose. Higher, your GDP estimates from early February to now and steeper, the yield curve is actually steeping a little bit, that's a sign of a good economy. So let's have you give your report card as to what went as you expected and what you might've changed looking back a few months ago? Well, I think to put it simply, I think we're somewhere in the B+, maybe we can stretch it to an A- in terms of how we came out with some of the expectations and predictions that we had. First part of the year was about a couple of things. One, GDP growth that was at least going to be 6%, which when we did it, was above consensus and we're busy, been trying to raise those estimates with all of the new stimulus coming down the pike. There's a small, very small chance that we actually had GDP in the 10% range in 2021, very small chance. It's much more likely between eight and nine, given what we're seeing, some of that's still politics, but we misjudged how strong things would be with the stimulus package, but nonetheless, kind of on the right track, number one. Number two, the bond market, the story here was, I think right on in a couple of ways. One no big inflation fears have really manifested. Yes, the yield curve got a little bit steeper, but we're not talking about inflation of three, four or 5% runaway style that would have really propelled the bond market much higher.

In fact, our expectations of inflation probably has a bit of volatility through this year and probably quiets as we get into 2022 and beyond, much more akin to where the fed sees it, but this year is going to be pretty noisy. There's some very important effects that will happen. I think we were spot on there. We were a little behind on the bond market forecast, it's just been so volatile. We thought rates would kind of stay in the 125, 175 range, but we've had to move that up, the real rate function, meaning the rate after inflation has actually been getting smaller and smaller, and I think at some point we probably have either zero or positive real rates somewhere in the next 18 months. And I think the last piece where it's been right on is the equity markets. I think we've been talking about adding more exposure in client portfolios that is geared towards the reopening the economy, or economically sensitive things. That looks like value, it looks like smaller cap. It looks like some of the places that have been hit hardest, although they're still dealing with a lot of issues, with the exception of Britain in some cases, we're likely to see those areas actually recover quite a bit. So, I think we're on consensus around the earnings numbers and if you look ahead to 2022, I'll put a first number out there, it could be 200 plus, and there's an outside chance, outside chance that you could see even after the taxes that we'll see on corporate earnings, somewhere in the 215, 220 range, small chance but nonetheless, markets will kind of build in the story of, what could go right? And I think that's what's been helping propel things higher in 2021.

Chris - I think it's hard to get a lot of things right given some volatility, especially the bond market. I think-

Mike - You're a bit of a harsh grader, a B+, not the my colleague, I give you an A, because I've managed expectations. So I want to start with gross domestic product. Last time we spoke, 5, 6% GDP this year, to say an outlier chance of 10%, I've seen plenty of great economists come in at 7, 8, 9, 10% GDP, what is changing to drive that kind of growth in the gross domestic product for the United States?

Chris - Simply put, it's all the stimulus in the system. We're talking about, if you remember your old economics equation, C plus I plus G minus net exports, C is consumer, I is investment, G is government spending, and then it's an X minus M, which is exports, net exports. But in reality, what's happening is the vaccines are taking hold consumers coming back. They're in our view, something like 85 to 90 plus percent the way back at this point, so I don't know how much more is left there in terms of gas in the tank. We'll see some, but it's really this G function, government spending, which is just going haywire. We're talking about very large amounts of spending that are actually moving through the system as we speak, and there's likely to be more, at least around the government spending as it feeds the corporate side on infrastructure, for example, later this year. That's going to have a longer tail and gives us some encouragement that 2022 GDP isn't just going to fall off the cliff after 2021. So what we're seeing is all those stimulus checks and additional stimulus packages really gear up to push that G number much higher, and that's really where a lot of this is coming from, the combination of consumer and government spending, it's very hard to stop.

Mike - I like that. So gross domestic product equals C plus I plus G plus X minus M, but- But I want to break down to C plus I plus G and let's start with the G piece. The pandemic stimulus, I think is now cumulatively topped just over $5 trillion and you've got a new potential infrastructure and social spending plan in the works right now. How much gas is that putting in the tank and when is this going to, or should it stop?

Chris - Well, the second question is really hard to answer, so I'm going to move that to the second part of the framing. But I think the first part is there's a lot of gas in the tank. One of the things that we've observed with the stimulus checks is that actually in the latest round, there's been a higher proportion of those stimulus checks that have been saved. So money that saved really around some concerns, I think consumer confidence hasn't come back as strong as we would have expected. There's still some risks around COVID, I think that's keeping a lid on things. There's still a number of social issues going on in the country that I think also are keeping a lid on things, but as confidence returns, we expect some of that savings to be depleted, not all of it, but some, and that's going to help propel consumer growth as the year goes on. So there is more gas in the tank, simply put. I think on your second part, the should, that's a really difficult question to answer, because at this point, I think it becomes really a political question. The idea is that we're going to spend a lot here, we're going to raise the national debt to unprecedented level, or almost unprecedented levels. We're going to have ballooning deficits again in 2021, likely some in 2022, and if you were just thinking in a very simple world, how do you pay for all this? You say basically that the economy would have to grow at about 8 or 9% for a number of years for us to start to get on top of all this, and frankly, that's just not in the cards. So we're going to think about maybe a period of interest rates that are really low over a long period of time and we kind of finance our way out of this and all the extra growth that we get in the years coming, coupled with things like redistributive tax policy, ultimately gets us to a place where the debt load can be manageable, but it's going to be a bit more risky, I think, politically and as long as the debt doesn't matter, at least for now, things can work. It may matter, and it's likely to somewhere in the next 18 months.

Mike - I want to come back to that, we've got a lot of ground to cover, we're going to go over debt, deficits, inflation, interest rates, equity market valuations, and of course, Bitcoin, a lot of people always want to know your thoughts on Bitcoin.

Chris - Sure.

Mike - So let's maybe focus on the C part of that GDP equation, the consumer. Consumer confidence is up, it's not quite at the pre-pandemic levels, but it's close. The savings rate, as you mentioned, I think is double compared to historic levels, and then, this pent up demand, this communing you mentioned, I think Disneyland opened their first and second day ticket sales on April 15th and the system crashed, and when they finally got the servers back up, the tickets sold out in a matter of hours. So I don't know if that's any indication, but it does feel like there's a ground swell of consumer optimism, consumer communing, whether it's cruises, baseball games or Disneyland, just kind of your thoughts on this representation of which is 70% of our gross domestic product.

Chris - So economists have coined the term revenge spending to get to this. "I've been cooped up so long, I'm going to treat myself, I'm going to do a number of things that really help create a burst of consumption activity." So part of the story is that the first quarter actually is likely to have very, very good GDP, but the second and the third quarter as well, remember that kind of savings still being pent up, and then Disneyland, good example, there were online waiting for concerts, cruises, all the things that as we talked about earlier, you were prevented from doing because they required communing, humans to be together. And as restrictions are lifted and you can see it in certain states, restaurants come back in a hurry, a lot of different businesses that depend on communing come back in a hurry. So when they come back in an explosive way, I think Disney is just giving its brand, a very good example of that. That's one reason to be hopeful around the sustainability, at least, for the balance of this year in not only GDP and economic growth, but I think ultimately, in the job creation story, because there's a little bit of a fetal feedback loop here that as we get more of those services coming back in an explosive way, well, by golly, they've gotta hire people in order to be able to manage all of the stock-outs or shortages that you're going to see in terms of labor, service people providing all of these opportunities, I think, for people to spend their money.

Mike - The one sticking point has been the unemployment rate, and since the last time we met, it was 6.3%, it's 6%. I think, full unemployment still yet to be determined by the fed, whether that's three, four, or 4 1/2%, but there's also potential there, and as I've talked to some clients that own things like restaurants and hotels, they're actually having a hard time getting people back because they're on stimulus checks. So is this yet another boost to the economy as people do sort of migrate back to full-time unemployment or employment?

Chris - Yeah, I think so. There's likely to be a bit of a lag. There are a number of service industries that will have to grapple that hotels, cruise lines, for example, because the stimulus checks are likely to filter through the system, and given that they've been saved at this point, they may hang around the effects of kind of stalling out labor force growth may hang around for a little bit, but ultimately, they're going to get either saved or spent and then there's not likely to be another giant stimulus program for consumers at this point, given the job openings and a lot of the data that we see out there. One thing I think though is important is that you're seeing in many cases, whether it's state initiatives or even corporate initiatives, minimum wages are moving up a lot. So, folks worried a little bit about consumer inflation, I think, rightly so as we think about consumers being paid $15 an hour 20, 30 in some cases, but the opportunity I think here is to look beyond that and not just at the kind of the consumer based inflation, but also where's the capacity? We still have lots of capacity to meet many of the service demands. None of the cruise ships that I'm aware of were actually put into yards and dismantled, there's still lots of cruise ship capacity. So things like that as an example, means that there is an opportunity to meet this without creating spiraling runaway services inflation, which I think some people fear. We just don't see it, there's lots of capacity still in the system.

Mike - So I will come back, I want to dig deeper on your thoughts on inflation and debt and deficits. Before we do, let's sort of look to 2022. Federal reserve has still been very accommodative on interest rate policy, monetary policy. They're keeping rated at sort of near zero to 25 basis points. How do you sort of project the fed actions over the next, I don’t know, this year and even 22, 23?

Chris - Well, there have been two big changes based on the commentary from chairman Powell. The first is that expectations as recent as just the end of last year were for the fed to stay on hold well into 2023. So think about that. End of 20, people were expecting three years of the fed to do nothing, plausible back at the time, but the vaccine story has ramped up so quickly, it's changed a lot of the dynamics around how the fed may have to respond and what the market has done, this is surprise number one, is really for-shortened that period of three years down to about a year and a half, maybe a year. And you're looking at kind of the forward markets pricing in a rate hike coming somewhere in the next 12 to 18 months with a reasonable high probability. Now, the fed to their credit, has said something to the effect of, "We have two priorities, price stability, and employment, we're going to favor the second one, employment for as long as we can get that number that's really high right now." By the way, the total number is 18 million plus of folks still either underemployed or unemployed, you gotta get that number way down, even kind of below the 10 numbers. So you'd need months and months of six or 700,000 jobs being created in order to get that number down, and that's just going to take a while. So if you're the fed and you're prioritizing job creation, you'll probably leave rates lower for longer, and I think that's kind of the other piece of the puzzle, is the fed is just really being very strongly committed to that lower for longer story. But I think there are some pressures that are building, that will get to 2022, where they may have to at least signal that they're going to be hiking or at least managing expectations, particularly if inflation numbers kind of perk up here, and here's why this is a concern.

If you look over the last 35 years or so, producer inflation, this kind that's good for businesses, at least some of them, and overall good for profitability, has seen a huge spike up. I mean, we're talking 6, 7, 8%, it's runaway, but it's good, at least for producer prices. There's never been an instance in that period where producer prices don't rise that much and it doesn't drag CPI with it. So we're going to get some inflation volatility as the year goes on. That'll translate in the bond market volatility but I think the trick is to look at it and assess whether it's volatility or there's the beginning of the new trend. Has capacity really come out of the system? because that's where you get inflation when you're out of something or there's something that's scarce. So to say it in another way, if 50 cruise ships we're putting the yards for dismantling, we might see inflation in food prices, I'm sorry, it's not food, in cruise prices, they rhyme, food and cruise. Anyway, but where we are today, and I think our estimation is that we're not going to see that translation of prices be permanent, price increases be permanent. It's much more likely given the excess capacity that can be called online to be a bit more transient, and a good example of that is the airline industry. Right now, you can fly coast to coast for 200 bucks, $250, there's a lot of planes parked in the Arizona Desert. So even though planes are more packed these days, and you're going to see an increase in fares, as fares go up and capacity runs out, guess what? They're going to bring planes back and pilots back. So there'll be a capacity matching story so that a year from now, it would be very unlikely to see coast to coast economy tickets at $2,000. That's just not, given what we understand about how capacity and airlines manage things, and all industries do this, not something I think you should expect.

Mike - Let's talk a little bit about inflation. So as I hear you, this year looks really good, but we've got unprecedented stimulus, we've got monetary stimulus, fiscal stimulus, we have a consumer who overall in the United States has an incredibly strong balance sheet, it's up pre-pandemic, increased savings, pent up demand that we talked about, potential unleashing of more people being employed, put in the economy and we could talk about your thoughts on the velocity of money, but there's been a significant increase in the money supply. It all feels like it's just brewing, and now you've got an accommodated fed, and I know that the fed will always look at data, but if it goes through 2022, it just feels like, could we overshoot this? And as inflation of your thoughts recently, I think a consumer price index, we just saw the largest increase since 2011, producer price index is up somewhere in the four handle range, month over month on an annualized basis. So are those warning signs for impending inflation? And as you stir all this up in the Punchbowl, what's your prognosis for the potential of inflation down the road that's quite significant?

Chris - Short answer, they are warning signs. Our expectation is inflation is going to be rising through the year as I mentioned earlier, but I think what I was trying to get at in the prior point was, is it going to stay that high 3, 4%, over a long period of time, and we don't expect that? That said, the fed has talked about a willingness to tolerate that kind of inflation on a temporary basis. I will tell you this, the bond market will not like it one bit. That's where we think the bond market volatility comes from and you could see bouts of the 10-year bond, for example, rising quickly towards 2%, or even above that, not sure that it be sustained unless the inflation reading becomes much more embedded into the system, and we just don't see that yet. I think beyond the numbers that you're talking about, there is reason to be concerned. I think what it does though, is it shifts your thinking. I think there's a naive response that most folks have and that is, "Uh, inflation up, bond prices down, bond yields up, all bonds bad." And that's not a great answer, not because it's self-serving, but mostly because what it should do, same thing with the equity market, is to shift your thinking from just buying the average of something like an index into something that's more specific. So think about what else will be happening in this environment, we expect redistributive tax policies and our team and the Financial Planning team has written a fair bit about this from what we expect for hired personal and corporate tax rates, the limitation of many deductions, et cetera, and what that will effectively do is raise tax rates, I think, for a number of a number of individuals potentially on this call. So, why would that be important? Well, when you put those pieces of the puzzle together, that's likely to help manage the revenue stream for government and government spending, it's also likely to curtail a little bit some of the consumer-based inflation that you might see in the system, and I think when we put all those pieces of the puzzle together, it is a reasonable view to share what the fed has shared, which is, yeah, we're likely to see inflation have a bout of volatility through the balance of 2021 because of the stimulus, but over a longer period of time, say 2022 and beyond, unlikely to be sustained unless we see wholesale reductions in capacity to serve or capacity to manufacturer, and that's just not happening.

Mike - Some of our audience is putting some Q and A, and some say runaway inflation, and whether that's true or not, I don't know, but if we did start to see significant inflation down the road, how would you position investments today? What are the things that would be attractive to you to hedge against inflation?

Chris - I think any precursor for inflation is going to be a couple of things. The first is I think we can observe inflation, the things we buy, for example. If you're remodeling your home, the cost of the dishwasher, either in terms of time and delays or buying a new car, certain types of cars are actually quite delayed at this point, or if you're building a home that lumber prices have gone absolutely ballistic. There's a number of reasons for that, but it would be easy to misread kind of given the recency bias, meaning whatever I saw recent must be the entirety of the inflation picture. The issue is the government measures things differently. They use something called owner's equivalent rent, to measure inflation. I'm sorry, I'm digressing, but this is important. Why hasn't CPI picked up a lot? Well, partly because all the suburban home price increases that we've seen have been offset by all of the rent decreases in Manhattan and San Francisco and other places. So there's a wash and housing prices are a big component of inflation, and so while they've moved up a bit, the runaway story here I think would really come on the back of something I mentioned earlier, we'd have to see wholesale closing down of capacity, so wholesale closing down of, say, apartments. And while we don't have enough housing stock, generally speaking, we have enough apartment stock in some areas, and if you're looking at the deals in New York and San Francisco, is great examples, they are really good. Three, four, five months free rent, wow, that's a pretty good deal, even if the list price is very high. So why would I bring this up? Because the story I think around inflation is really anchored on capacity and the assets for many of the industries that serve consumers are still in place, there's still the barber chairs in the barbershop, there's still the cruise ships that we talked about, et cetera. They just might change owners, but the capacity to serve is still relatively strong.

It's very hard to talk about runaway inflation, doesn't mean it couldn't happen, because I would never say never. A case where there's a loss of confidence in the fed, a collapse in the dollar, and to the extent that there is much more hoarding behavior in the United States, and we don't see that yet. It's very hard to get us consumers to stop spending, but boy, that would be a bigger concern about whether or not there's runaway inflation, and you would see it in two data points. You'd see it, as Mike mentioned, in the velocity of money and while that's relatively low, it hasn't collapsed. And velocity would have to get below kind of 0.5, for those of you interested in that kind of stuff, to get really concerning and the head lower. And the other piece of that puzzle is when we think about propensity to consume. The reality is it's still very hard to make a living off $15 an hour, so to the extent that you make $15 an hour, you're spending all of it and there's a lot of those kinds of jobs available, so as those folks come back online, they're likely to spend, but they're not spending on very big dollar items, so.

Mike - Can I just drill down on that a little bit, Chris? Because if I look at the money supply of the United States, Euro Zone and China, I think it's up to, most recent statistics, I saw $71 trillion, it's up 20%, you have a lot of money in the money supply. That concept of velocity, so it's sticking on the balance sheets of and businesses, it almost sounds, and there's potential for that velocity to increase, which could further exacerbate the inflation story. Is that the way you're describing that?

Chris - Yeah, velocity is kind of a measurement after the fact. There's things before the fact like sentiment, job security, and a number of other features to the economy that would indicate we may have to have a higher level of concern about runaway inflation than we do now, it's just not hiring our priority list. So from that perspective, I think there's one other piece of the puzzle we should mention, it is a serious underestimation of Central Banks to consider that they... Well, it would be an underestimation if you didn't consider that they can change rules at will. The US Treasury and the us federal reserve have added 13 new programs post the COVID crisis. They added more than seven new programs post-global financial crisis. The opportunity to change rules so that we don't have an explosive or blow up moment or a collapsed moment because no government's really interested in that, I think is the one thing that is important to remember. There's a great story about Japan in the 1990s, they did something similar. In fact, the magnitude of what they did is still bigger relative to their economy and in terms of where we are, but what's important about that is they put a bunch of rules in place that the money didn't really leak into the system, and what that meant is that they printed money like a wildfire, and we still don't have inflation in Japan 30 years later, it's not there. And there's other aspects of that, cultural and a few other things, but the reality is if it were as simple as print money equals inflation, then we would have seen it in 100 other places by now and it's just not the case.

Mike - So I want to come back to that, because there's a concept, called a Modern Monetary Theory, I'll explain that and why you used Japan as a test case there, but really, I think what's on people's mind is the debt and deficit. So I think the US budget deficit just topped 15% with all this stimulus and spending going on. Historically, it had been more like maybe 4 or 5%, maybe 3. The debt now, I saw the Congressional Budget Office is projecting 2050, a couple of interesting things. One, that our debt will be 2x our gross domestic product. Here, they actually forecasted that rates on the long end, were going to be pretty low, like 2 1/2% 10-year treasury, which I find surprising they can make a 30-year projection. But essentially, the story here is I was a kid of the 70s, we didn't have devices and iPads. We played a game called kick the can.

Chris - I remember that.

Mike - So is this just a game of kick the can going on with the national debt?

Chris - The short answer is yes, to a degree, the longer answer, we don't have time for this, I'm going to do the middle answer, so the Goldilocks answer, which is we're entering or have been in an era, but we're entering a new phase of it, the era is called financial repression, first coined by Carmen Reinhart and Kenneth Rogoff about the post-global financial prices. What happens when you have too much debt and you can't really repudiate it, meaning, "Hey, I refuse to pay." or restructure it, it's very hard for the US to do that without other massive consequences. So you end up in this kind of repression/refinancing way and you can get a little conspiratorial with it, with the expectation that the fed will just keep rates low, but the reality is, underlying inflation, as long as it stays low, it makes a lot of sense that you would have interest rates very low. Technology and debt combined are massive disinflationary, meaning they lower the rate of inflation, and in some cases, outright deflationary forces, they push strongly against the consumer strength that we're going to see in the very near term, and it's kind of simple, at the end of the day, if you're busy repaying debt, you're not investing to grow. So you you don't get a lot of that benefit in terms of growth and recycling. And on the technology side, the technology deflator is often running between 5 and 10% a year, which means average prices drop 5 to 10% a year for goods, and you're seeing that continue to manifest itself as it translates into the services and the activities around it.

So, I think that it's realistic, but the probability around that outcome is probably shrinking a little bit. The more we pile on debt now, the more likely we already have got new phase, which has maybe more extreme outcomes, more extreme elements of volatility, because something we've touched on in other calls are also affecting markets and that's machines, machines just follow the rules, and if the rule said, "It was down today, sell it again." Or, "If it was up today, buy it again." You can get magnification of moves in markets that you may not expect. And that expecting that kind of action in the market like we're likely to face for the next 10 years is probably one of the biggest things that you can do to manage your personal expectations, manage the volatility and portfolios, and keep yourself in a good place to rebalance quickly and capture some of those moves because we're going to see a lot of those.

Mike - I know Chris, I'm going to ask you a question from Bill here, and it's always hard to make projections. He wants to know kind of your 5 to 10-year outlook of the worst case, so downside scenario. As bill says, any chance of the return of the insanity of the late 70s, early 80s?

Chris - My crystal ball is broken, so that's a good thing. Look, here's, I think the biggest challenge that investors face is that the range of outcomes that you could make in any kind of probability assessment, that's how we look at it, we kind of look at things in a base case and upside and a downside, is they're just getting more and more extreme, the distribution, sorry to be very statistical, used to be pretty tight, now it's really wide because a lot of things can happen in an environment that's overloaded with debt, that's gotten massive operating leverage, a ton of stimulus moving through the system. These are just heard of, so could something go really wrong? Well, you know what? The kindling is here for a conflagration, it really is, much like it was in 2007, where are the excesses in the system? And there's excesses of speculation in some parts of the market, there's excesses in the way that we think about capital kind of being tied up and accumulated. Technology has facilitated that, it's an age of hyper aggregation and proselytizing aside, I think the reality is you can't rule out an extreme downside case. What I'm encouraged by though, are two things. One history has taught policymakers a lot, guess what they all studied? "Hey, we shouldn't have done all those crazy policy things in the 60s because it really didn't help things and it confused the market players, and we didn't have a market solution." And we made it worse than the 70s with some of the policies that we had. It's not clear that what we add in the 80s or 90s were kind of all in the same vein, but we made some improvements that at least favored a more capitalistic approach. We may or may not be continuing to fulfill that type of a role in the way that we look at capitalism in this democracy, we may be in a place where a combination of redistributive tax policies and the like change the way that we think about how we look at capital and returns on capital, not just in the US but around the world, and there are other big changes that also to the extent that two folks don't get along, the US and China, the two elephants fighting in the forest analogy reviews. There's lots of collateral issues. So that sounds like I'm explaining "The Blob that Ate Cleveland" story, I think that's what it would take to get to an extreme downside, kind of a stagflation depression-ish, type of outcome and I put a rally low chance on that, mostly for two reasons, one the history piece I talked about, and two, the willingness and ability of policymakers to change the rules to avoid an outcome like that.

Mike - Chris, before I get into stock market, real estate, Bitcoin, I just want to close it on the macro, and you mentioned Japan and I love your thoughts. You mentioned this in the past, this concept of Modern Monetary Theory, which I think is a bit contrarian to Orthodox economics, but the suggestion is that as long as you are the world currency or the fiat currency, you can keep printing money, absent any significant inflation. You can keep printing money to finance your debt and deficits. Is this a widely held viewed by central governments?

Chris - I don't know that the version of Modern Monetary Theory that you've talked about, there's kind of a central viewpoint on it, is the one that I would say Jerome Powell, Christine Lagarde espouse. I think it's much more a reactive in terms of, what is the priority, how do we help a situation where it is very important for people to be useful to society working and all those kinds of things, and where a central bank can help is by not creating hurdles in terms of the cost of money. It's part of the idea of keeping the cost of money relatively low. But there's going to be a consequence for all this, whether it's growth will be lower than it otherwise would have somewhere in the future because we're busy paying debt. If there is some sea change in the way payment systems work by via technology and China takes a lead, it would be harder for example, in an MMT, Modern Monetary Theory world for the US to make seigniorage, it's huge benefit, seigniorage is when you can pay your own debt in your own currency. So there's a lot of things that we have to watch carefully, I would say, between here and the next several years, but for now, that is a political question, and I think it becomes the cudgel that one party is going to use either one somewhere in the next 18 months, around midterm elections and potentially in the next presidential cycle. That's going to be very important because I think the opportunity to understand how that might play out is going to be pretty crucial for how we see market return in a near term perspective, and that would include that 5 to 10 year window I mentioned previously.

Mike - Let's get into the stock market. Every time we meet, Chris, it's still up another-

Chris - To keep talking then.

Mike - I think we should keep talking. S&P is up from the last time we spoke, it's up and up and up in a year over year, it's up quite substantially. I brought up last time the Warren Buffet indicator where he takes his sort of basic view of whether the market's overvalued and he takes the total market value of US stocks, and divides by the dollar value of the gross domestic product. And if it's one-to-one, that's effectively a fairly valued market. In the dot-com meltdown, prior to that, it was about 1.6. The last time you and I met it was about two to one, and it's up even further now and maybe GDP lags a little bit, obviously in the print, but I think it's pushing like 2 1/2 to one. What are your views on the macro market today? I'm speaking predominantly US, but if you want to get into some of the international markets as well, feel free to do that.

Chris - Well, I think a couple of things, the first is you have a fundamental backdrop fueled by operating leverage, a historical lag in hiring, et cetera that should mean profitability for US corporates, is going to be pretty good. And as I mentioned at the outset, it could actually be really good in 2020, $200 plus in terms of BPS for the S&P 500 as an example at a base case, and there's an outside chance, but a pretty good one, you could see it higher than that, given all the leverage in the system. So why is that important? Well, you could say that in a world where the United States has the highest returns on capital relative to almost every other country, the highest amounts of operating leverage, which means they don't need much sales to get really good earnings growth, that gosh, you should pay up for that, in a what? A recovering stimulus fueled economy? Oh, that makes a lot of sense. So would you pay 20 times for that? That's kind of where we are today. So market's 4,100, something like that, 4,200 rough justice, so that's market kind of at 20 times earnings anticipating $200 in earnings next year, because I think everybody gets this year, they're looking ahead, the market's a discounting mechanism. So is it all built in? Nah, not really, but a lot of good news is, in some places there's more to go, A, because we think the operating leverage story and B the things that have been down the most, the value in the smaller companies, the ones that have been more aligned to how economic performance works are really ones that are set to recover the most, I think, if our expectations are accurate, that 2021 is going to be very good for the economy, and there's not a big drop-off in 2022, there's a slowdown, but not a big drop-off. So that suggests the stock market is not in a bad place, both relative to what the earnings power is and relative to the rest of the world. Remember, highest returns on capital and highest profit margins and highest operating leverage. Now that said, there are some rules that got some really big discounts, same kinds of companies in Europe at a 20 or 30% discount, same kind of end markets. "Okay, maybe I should take a look at that." And that makes some sense.

I mean, look, where we've come from in the last several years has been a stay-at-home strategy, and the US, the best place to be, and while we still favor that, it's just not to the same degree. It is time to be adding back more value, more small cap, more international, and we've been doing that in portfolios over the last six months or so, and we'll continue to do that as a function of rebalancing portfolios to be more global. The opportunities is set to finish the point, globally is looking more compelling as the two bridges globally are built, the COVID, the healthcare bridge and the stimulus bridge, because we talk about the US like it's the only place, it's a wonderful place, but the reality is everywhere else is going to go through this similar exercise of a healthcare bridge of some sort and a stimulus bridge of some sort.

Mike - I'm going to come back to the healthcare bridge, but just to... If the S&P earnings hit 200, I think the latest I saw was about $174 earnings per share on the S&P 500. So the good news doesn't yet appear to be baked into the evaluation of at least the S&P. There's still a little bit of room to grow. I'd love your thoughts on even when the market gets overvalued, you still find opportunities in the stock market, certain sectors, certain companies, what are your thoughts around being selective even if you feel the market is overvalued?

Chris - I'd love to be the person to take credit for this, but a very long time ago, maybe 21 years ago, I was on television with Jim Cramer and he said something when we were interviewing someone else, he said, "There's a bull market somewhere, and your job is to find it.", and he was pointing a finger at me, I said, yeah, that is our job. Look, there's an opportunity set somewhere in the world that I think represents a way to make a return that we'd want to talk to clients about. The question is whether or not it's appropriate, how much you put in, liquidity and a bunch of other factors, but the whole world doesn't rise and fall all at once identically in the same lane, being able to identify some of those different policy maneuvers, the kind of where the money's going and ultimately, kind of where the stimulus is going to have the greatest impact or all important elements of , trying to skate where the puck is going to be, rather than just riding whatever current wave that you're on. So, Mike, to your point, I think when we look out over the next couple of years, the earnings power, not just in the US is likely to be pretty decent. Companies are doing more with kind of similar or less amounts of technology. We're likely to see that benefit translate into other markets as well, so we're starting from very low in Europe and in emerging markets and in Japan as well, and our expectation is that as global growth kind of comes back, remember the US story isn't the only one, GDP in China first quarter was 18%, one, eight, 18. That's a huge number. Now, they have the same kind of stimulus flooding through their system, they're going to taper off, but the reality here is the stimulus story that we mentioned earlier that is likely to be a global story, is going to be a global story, and that's going to propel that reorientation of where earnings and revenues come from, and we expect to see that translate into stock price gains outside the US.

Mike - I love that there's always opportunity even within a compressing market. Jamie asked the question, do you think that the market is accounting for corporate tax changes in the estimates of future earnings?

Chris - I think to some degree, not perfect though, at this point. A, it's not a hard to know what the number is going to be, we went from 21% to 28. For anybody who follows corporate taxation, you know there's tons of loopholes and tons of ways that companies manage their what's called the effective tax rate, and in many cases, it's in the teens or in some cases, single digits, and that's important to understand, so until you have some other version that's hard-coded into the system, like a corporate alternative minimum tax, it's going to be very hard to talk about going from 21 to 25%, which might be a negotiated number, having a huge impact on earnings, maybe it costs the S&P 500 between 5 and 7% of EPS, that's what our Head of Equities, Doug Reid, is talking about, something along those lines. It could be a little more than that, but I think the reality here is there's so many other good features happening. Remember the operating leverage and the revenue growth that I think markets are accounting for some of this. What we can't account for at the moment is whether or not those kinds of taxation issues affect corporate investment, the remember, C plus I plus G, does it slow it down? Does it make it more focused on technology, for example? It may do that, or whether or not it cools investors' desire for even very high returning companies like in the US. That would move the PE multiple down a little bit, and that might make companies outside the US which already kind of pay taxes in that rate on an effective basis in the 20% range, relatively attractive or relatively more attractive at that point. It doesn't mean you should sell your US equities, it just means that the opportunity to rebalance away from US, is the majority of my exposure, I think is pretty compelling as we speak.

Mike - Before I get into alternative investments, I have to address Bitcoin because some of the questions are piling up on Bitcoin. You sort of look at this, I don't know if you want to call it an asset class. Now, there's 21 million Bitcoin in the world, 18 million have been mined, I think by 2040, they think all the Bitcoin will have been mined. There's a significant number that had been lost and still some challenges, and yet there seems to be a legitimate following here, 140 million, I think users. Andrew Yang in New York says he wants to make New York City the Bitcoin capital of the world. So there's a lot of legitimacy going on with Bitcoin. I'd just love to get your thoughts around that and digital assets, particularly as it relates to what you're doing at First Republic.

Chris - Yeah, so I appreciate that question. I would say, we're probably never going to be on the bleeding edge in a lot of these things, but we're not going to be on the tail edge either, so we're mid-flight with a number of opportunities. I think that we'll be able to talk to clients about it in the next couple of weeks and months, but I can say three things about the way we think about Bitcoin. One is, cryptocurrencies, more broadly Bitcoin is a cryptocurrency, it's the biggest one, but there are others there, kind of, and even behind that blockchain is something that we are big believers in. Actually, we have a paper out on it in the next week or so, where I'll talk a little about the ecosystem and some presentation materials to share. That's one of the things that I mentioned earlier, but it's important to kind of understand what's going on, where there's maybe the opportunity in a world of decentralized finance, that's what a lot of people are talking about these days and how that might play out. Our expectations has got a very long runway, It's not an all in done and that a little bit like the land rush that you saw in the United States in the 1840s, you're going to see a fair bit of that in terms of different spaces that companies are going to want to stake out. I'm fairly confident two things are going to happen in the next five years, number one, massive amounts of M&A, mergers and acquisitions. Lots of money's pouring into this space. The ability to start up a company is just costing close to zero, and you're likely to see anybody with a network or relationship start to capitalize on that. And that's what happens when you have effectively free money and lots of people looking for digital ideas that are transformative, and particular in finance, where you have a lot of opportunity to think about lowering the tax on the overall system.

I think the other thing that I'd say, at least more specifically about Bitcoin is we've been a little bit late and cautious around this. The regulators have rightly I think have been cautious as well. That first started out as other risks around terrorist financing, there's been some studies that say maybe not as high as they originally anticipated, and I think finally the last piece of the puzzle is the expectations it that I'm not sure anyone should share at this point that Bitcoin will take over as the currency of the realm. That's ridiculous. So I'm going to say that and I expect to get feedback, but is it going to be used as a collectible? It's trading on scarcity value? Is it a medium of transaction for something? Sure. The way I would look at it is there's along the following lines, Bitcoin and the crypto world, there are likely to be central banks that will not want to give up control of things like taxation, seigniorage, et cetera. That's your core center of payment processing and transactional systems, where central banks need to talk to each other and ultimately to other regional banking systems, because it's very unlikely that that system itself is going to be completely upended. How do we know that? Because governments change rules all the time, so that system's likely to be in place, although it will be challenged. The next concentric circle, I think, is around how you see some of these other types of tokens, stable tokens, a lot of the ecosystem that can involve transactions that are connected to the hub, but ultimately, may derive value from other things. Then the last piece I think, is more of the collectibles and things on the outside. They can still be used as payment, but I don't think they turn into the coin of the realm per se, but they're still going to be beneficial as transaction media, and opportunities to see that network grow are important. Now, here's why this is relevant. There's something called Metcalfe's law, and without getting into all the weeds, it's just kind of simple. The more connections and network has, the more valuable the network is and what are all the blockchain and Bitcoin , Is their networks. So if you have 130 million users and you go to 400 or 500 or 2 billion or 6 billion, in theory, the value of your network should get higher, so is that a case like Bitcoin should be higher? It's one version of why you could see higher prices here sustained by evaluation function that's associated with that. There's lots of reasons to be concerned, regulators could change their mind and et cetera, but reality is there are some very powerful opposing forces that are in play here and to the extent the SEC in the United States has a catbird seat in terms of thinking about how to look at investors opportunity set in a very liquid and very regulated way in Bitcoin through the use of exchange traded funds is likely to happen this year.

And I think at that point, you could see another upwelling with respect to demand around some of these things. I think that said, we're likely to also see periods where there's going to be challenges to these things from rule set. You've seen Turkey, for example, say, "Hey, no cryptocurrency, no Bitcoin, nothing." You're seeing China start to real in its expectations around non-central bank digital currency by saying, "Hey, Bitcoin and other cryptos are not currency, they're something else." So though that sounds a little dramatic, but I think that's emblematic of how governments start to think about things that threaten their payment in global financial networks. It's going to be, I think, an ongoing battle and the bottom line is very simple, I think you're just ready for a lot of volatility around the cryptocurrencies over the next couple of years, and some of it's going to be way to the upside.

Mike - And I know you and your team are doing a lot of research on Bitcoin and also blockchain, which offers a lot of opportunities in financial services, the blockchain technology. Chris, real estate, from the First Republic side, we've seen a lot of activity in real estate. We've seen very strong activity in single family residential, predominantly suburban vacation or second home markets. Overall, I'm sitting here in downtown San Francisco, we still have a lot of empty class A office buildings, but people are starting to, as you say, commune and come back slowly, multi-family and then industrial. And I know that's very broad, but some general thoughts on, because you oversee our alternatives platform, which is quite sizeable and these are investments in credit funds and private equity firms and areas like real estate. Anything you're seeing macro in terms of investing in real estate?

Chris - Yeah, I think there's three big trends here that are helpful. One is, there's a lot of folks that I think are going to be changing the way they think about work and working from home. That will continue to facilitate the Amazonification of second tier airports and kind of second tier places. Not that they're worse, just kind of they're not New York City, for example, or San Francisco, and so that's an interesting trend. We expect to see that continue for several more years in particular regions where there's lots of population migration, a lot of it in the South, in Texas as well as in the mid Atlantic and a little bit in the Southwest, so the climate is starting to be a bigger risk there. I think the second thing around real estate is that this expectation that the big cities in New York, San Francisco and others are just going to collapse under their own weight, I think is a little silly on its premise. A combination of kind of very cheap brands, I mentioned that a little bit earlier, alternative uses for many of the spaces that are there, I think are important to understand. You're starting to see different floors on buildings be converted to something else. You could convert some of these office buildings to apartment buildings, hey, we can solve a lot of compartment issues. The current owners may not like that, but the reality is there are many things you can do with these big cubes that have been planted in many of the cities. They don't have to be one thing, they could be some other things as long as there's reasonable zoning and zoning variance opportunities and San Francisco a little harder than New York. But alternate use is an important piece. The last thing I'd say about the real estate story from our perspective is that we're likely to continue to see a few areas see development. We do think things like multi-families, some of these seniors housing looks interesting, but we have to be way more selective.

There's a lot of money that's chased many of the deals that are out there, and at this point we're going to be very selective and really focused on things like population migration, where is that happening? Climate change, that's going to drive some of the migration and ultimately, how we'll think about that, and then finally, resource utilization. So there's some really awesome places in Texas, but there's not a lot of water there. So it's probably better to invest in the water pipeline companies, something that we've been doing the last several years than it is in the real estate company. It doesn't mean the real estate companies are bad, but you have to make a relative assessment of what's going on when you're driving off that population story.

Mike - Chris, we've got only a few minutes left, so maybe as rapid fire as I can do for you.

Chris - Okay.

Mike - SALT has come up as a question, that's not the spice that's state and local income taxes. I know the Democrats in New York are pushing Biden and his new package to say "Let's repeal the $10,000 cap." Any thoughts on SALT and the impact there on the blue States of real estate?

Chris - Yeah, it would be great for full repeal, but unlikely. I think, that's the opinion. I think that we're starting to see more and more across the consensus. The reality is that that the optics around that are challenging. It looks like a very wealthy land owner giveaway to some extent, although prior to it being removed, there wasn't that much about it. So the reality is some version of it may come through, whether it's a cap, like at 28% has been proposed, a couple of Republican lawmakers have suggested that there are ways to modify it and get some of the benefit, but not all of it, but then marry it with other things, whether it's tax hikes and other places, or transportation. Mitt Romney, for example, talked about a version of that tied to infrastructure spending. So, still in play, I think is the most important answer but unlikely to be kind of full repeal pre-2017, much more likely to have some set of modifications that I think taxpayers would have some benefit for. Does it result in kind of big upswing again, in property values in the suburban blue States? hard to state, but I don't think so. You've seen a lot of that game post-pandemic and last year in some markets, 20, 30, 40% higher if you're looking at some of the metropolitan service areas in terms of property prices off the low transaction values to similar houses priced just in the last month or so. So that data suggests that you've got a lot of that game back. In many cases, you're above where you were in pre-2017.

Mike - Another quick question here Chris, you touched on this, but it's the vaccine rollout, but more around the world, not the US as I mentioned, the last time we met, 38 million first doses in the United States now, now we're 135 million, and yet you've touched on we need a global vaccination plan. Any thoughts on how the rest of the world is doing with the rollout and what risk or benefit that might have on the global economy.

Chris - So aside from US, China, Russia, UK, and a few others, terrible, just terrible. I would fully expect at some point, and I'd expect an uproar about it. The US has to start considering how they share the vaccines that they have, either in stockpiles with other countries. The challenge around that is in most cases, they're controlled by states to the extent that states have to think about what their policy is and whether or not their population is vaccinated, that creates a lot of challenges and hurdles, but it could be simply point where the federal government just orders a lot less vaccine, even though Pfizer can make X or my Madonna can make X vaccine, if the US is no longer the biggest, highest paying consumer of them, then there's a chance for other nations to benefit. But US can't recover alone and nobody else come along, that's not a great scenario for global growth, number one, I don't think it's a great scenario for a sustainable US recovery. We need, elements of trade, we need elements of the world to recover to have a high confidence view that US growth can be sustained over a longer period of time. So I think that's going to have to change and I think we're going to see it somewhere in the next 18 months.

Mike - Last question, Chris, from Ricky, and that sort of ties into your thoughts on emerging markets and investing, and maybe tie that into one of those bridges, the healthcare bridge and the vaccine rollout in some of these countries, is that influencing how you're investing in emerging markets?

Chris - There's two things there and they're just really strong forces. One is emerging markets have mountains of debt, kind of like what we're talking about now, they've been living with for a long period of time and we've seen the volatility and the swings that excesses of debt can cause, but that said, they also have massively depressed valuations post-COVID to the extent that any kind of global growth starts to recover, and by the way, the world that comes back post-COVID is unlikely to be the same one that we departed from. There's just been too much political and diplomatic damage done between some of the biggest superpowers where the fracture, which is what a gentlemen named Ian Bremmer at Eurasia at calls G-Zero world, it's everybody kind of for themselves and it likely results in regional trading blocks, kind of more power within Asia driven by China, for example, or more power within Europe driven primarily by the European Union, but also to some extent, Russia. So why would that be important? Because that means the entire blocks, the regional blocks could actually have reasonably strong benefits, and if you're an investor, what you're not looking at is whether Procter & Gamble can make diapers cheaper in the Philippines and selling to China anymore. They're actually looking at whether or not diaper manufacturer number seven in China can do relatively well by outsourcing to the Philippines, in which case you'd probably have to buy a Philippine pulp manufacturer in order to be able to capture that trend, which is a very different way of thinking than what it used to be, "Hey, Proctor & Gamble, I have all my exposure." And the answer is no. The world that we're in with is G-Zero and as things cover, it's likely to recover in a bit of a bulkinized way.

That's important because it should change the way that you think about investing in emerging markets, despite the massive debt burdens, there's a path to growth forward for many of these economies, and that, when you have that growth forward, many of their markets, stock markets are tied to the economic growth, not just locally, but regionally. So to the extent we see those growth patterns emerging, they're starting now. Remember all the stimulus in the system, we'd expect some of these markets to benefit, and frankly, we've started to see it. Now, some of the markets are very small and going up quite a bit, but the reality is, that's just emblematic of kind of the broad emerging markets piece. Last point I'll make is, remember the fund manager recently, the idea that China's emerging market probably goes out the window in 2021, maybe 2022, it's not really an emerging market, it's just number two behind the US. Why are we calling that an emerging market? They have a lot of interesting things there. So, it's then may be that we have to think about investing in emerging markets in a very different way and the developed markets very differently as well.

Mike - Christopher, I know we're at the top of the hour, there's a lot more to cover and many questions from our clients. I just want to say if you'd like access to Christopher Wolf, his research, how he's positioning, please contact your First Republic wealth advisor, or your relationship manager, and we will make sure to connect you. But Christopher Wolf, the Chief Investment Officer of First Republic Investment Management, always make me feel a little bit smarter than when I came into this and I just want to thank you, so.

Chris - You're so kind.

Mike - I appreciate all you do. All right Happy Earth Day.

Chris - Thank you.

Mike - Thanks Christopher

Chris - You too.

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