Market Update Q1 2021: A Year Of Two Bridges

First Republic Bank
February 18, 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, everyone. Good afternoon. And thank you First Republic clients for joining us for our quarterly market update. It's my pleasure to host Christopher Wolfe. My name is Mike Selfridge. I am the Chief Banking Officer at First Republic Bank. And joining me, as I mentioned, is Christopher Wolfe, the Chief Investment Officer of First Republic Investment Management. Chris oversees the research and strategy for our Investment Management group, which is now $195 billion in assets under management. He is an influencer in the world of economics, in money management, you may have seen him on a number of television shows or in various periodicals. So it's always a pleasure. We do this every quarter, as I noted. Today, our theme is, a Year of Two Bridges, and we'll explain what that means, but Christopher, welcome, always great to host you. I will have many questions for you, but I think I'm going to divide this into a little bit of past, present and future. And I think I want to start with you just in terms of 2020, maybe a recap. Obviously, a very challenging year for everyone. I had pulled some of the words that trended from the "Washington Post" readers to describe 2020, words like, exhausting, lost, chaotic, surreal, relentless. It was a difficult year. And yet from the market's perspective, Chris, if you looked at the data, quite interesting, starting back to March, big dips and then recovery. So, maybe, Christopher, just starting with a recap of 2020, before we move forward.

Christopher Wolfe - You know, I like your analogy, Mike, if we were doing this at Christmas time, I think I would have used the ghost of Christmas past, Christmas present, Christmas future, would have been a good analogy. But you know, for where your question starts, which is a recap for 2020, it's really a couple of things. One is, some basic lessons, particularly around the fed and stimulus. And it's always good, at least historically, over the last 75 years or so, when the two policy arrows, monetary policy, that's cheap interest rates, and fiscal policy, lots of money getting pushed into the system, are pointing in the same direction. And guess what? In 2020, after the COVID crisis, those policy arrows were definitely pointing in the same direction. So, markets in a sense, were rescued by those policy decisions, the additional programs that the fed put in place as well as the CARES Act and then an additional stimulus booster shot at the end of the year, another 900 billion. We're talking about another trillion plus in 2021, so when we get to that, boy, is there are a lot of stimulus in the system. That was the biggest story after COVID in 2020. Now, COVID did a lot of things and it also revealed that the prioritization on safety has economic consequences, and they were pretty dire in many parts of the economy, particularly hospitality, that still has not recovered. So, what we saw, was a stock market, responding to those arrows, but the real economy actually fumbling along as we had disparate responses in different States, no national strategy.

And I think the idea that lockdowns had other effects, including psychological effects that remain to be tallied in 2021, are all part of that word flow for 2020 around the "Washington Post's", exhausting, tiring, et cetera. What it did though, is it left markets in a state of expectation. And that's really about 2021, expecting more stimulus, expecting the ability to commune coming back in 2021 as part of the story around why earnings might rise a lot in 2021. So, 2020 really had this stimulus story driving almost everything. And what that did, is it made returns for those willing to undertake those risks or even just stay committed to a long-term strategy, relatively positive. I think the biggest takeaway though, is at the end of the year, once it became clearer post the election that there would be a broader sense of reopening based on the vaccines, we saw some big rallies in what you might call the cyclical areas of the global economy, emerging markets, smaller U.S. companies, smaller companies in Europe, just really put the pedal to the medal and were up extraordinarily high, double digit amounts, small caps in the U.S., for example, up more than 20%, their best quarters since going back to the 1930s. So, it was really about those stimulus, really about the stimulus and ultimately about the expectation of what 2021 will bring.

Mike - Perfect, Chris. So let's now look at you, you've done a lot of research and you've come up with a thesis, called, a Year of Two Bridges. You know, we're sitting here, every time we sit here, I feel like it's a new high for something, but here we are. And I'm going to get into many questions on the markets, whether it's equities, bonds, alternatives, for our viewers, I would ask you, after about 30 minutes I'll take your questions. Just tee those up in the Q and A button that you see on your screen there. And I will get to those as best I can. Chris, we're hitting highs in the stock market. We're hitting highs in real estate. We're hitting highs in oil. We're hitting highs in Bitcoin, which I do want to get your opinions on Bitcoin. But let's talk about 2021 and what it means, a Year of Two Bridges, from your research and perspective.

Chris - So, we published a note late last year and have been continuing that progress, in terms of updating clients. And I think really the opportunity here, is to understand that two things really need to happen in 2021. The first is the vaccine bridge, that's the healthcare bridge, if you will, as vaccines need to be more widely distributed and we need to be in a place where that we observe really what we're seeing going on in Israel, for example. They're using the Pfizer vaccine. They just completed a study of over 400,000 folks that had been inoculated. And what they're finding is that, immunity is starting to rise, or at least the vaccine's working, rise at a very rapid clip. Now, small country, they've vaccinated at least 35, 40% of their population with two vaccines and more than, I think, 70 at this point with at least one dose of the vaccine. So, that is incredibly encouraging. And I would call that healthcare bridge, is being rapidly built around the world. Particularly when you look at a number of economies, at least in the developed markets that are now purchased enough vaccines to cover, vaccine doses to cover their population. Now, the other piece of the story though, is this stimulus bridge, and the stimulus bridge, is all about what the government's likely to do. Hey, cheap money and a lot of additional support through additional CARES Act type stimulus. So why is this important? Because as the stock market has responded, as I mentioned earlier, to all of this stimulus, it's expecting something.

It's expecting with the stimulus, we won't see a lot of bankruptcies. It's expecting that, as we commune again, we're going to see a huge resurgence in a lot of the areas that were hit the hardest. So, not just in the U.S., but actually around the world. And what's important about that, is when you that kind of resurgence, there's typically a pattern that it follows. Because companies coming out of the shutdowns, whether they're driven by a recession or driven by a kind of policy decisions, when they recover, they recover in a tentative way, meaning, sales might come in really strong as people come back together based on the vaccine. But companies will delay their hiring, and that typically means that they're going to have an acceleration of their profits going into 2021. And if things continue this way, certainly into 2022. So, I think markets are building off this story that both things are true. The healthcare bridge is built very soon, and that the stimulus story, not just in the U.S., but globally, is going to be a very powerful tailwind throughout the balance of 2021.

Mike - Chris, thank you. I want to break those two bridges down. So let's start with your healthcare

Chris - We need them, let's just not break them down.

Mike - Well, let's build on those bridges. How about that?

Chris - Great.

Mike - Well, it's just interesting, you noted Israel. So, here we are today, I believe worldwide, we've had first dosed vaccinations of about 176 million, United States, we're standing at 38 million first doses, 14 million second doses. Israel population, I think 9 million people, probably a few months away from herd immunity. Statistically, what are you seeing in terms of, you mentioned cases going down, but also some mortality rates for those that have been vaccinated?

Chris - Yeah, they're absolutely dropping. In some of the recent press reports, have actually got down to single digits. And in some parts of the population, below single digits, like a 10th of a percent kind of thing. So that is incredibly important, because as you do things like reduce mortality, the precursor to that is reduced hospitalization. You stop overloading the hospital and healthcare systems, which is absolutely a necessity in the U.S. And while things are coming down in the U.S., I think the case in Israel shows how rapidly things can come down and how much we can return to expectations that our healthcare system doesn't get overburdened and ultimately can handle a lot of what may still be a potential for another surge if we're not moving fast enough, in terms of the vaccine distribution. So I would say, the outset, the news from Israel is incredibly encouraging, and it really should set the bar for as getting as much vaccine out as fast as possible. That's really the answer.

Mike - That's encouraging. So, let's assume the first of your bridges, healthcare, gets resolved and we get herd immunity sometime in maybe late summer, fall. That's good news. Second bridge, stimulus. It just feels, last year, I think the United States pumped in about $3 trillion of stimulus. We've got a trillion, six to a trillion, nine, on the table today, you have central banks that have increased their own balance sheets by almost 70%. So in the United States, the Federal Reserve balance sheet is now standing at 7 trillion. I think globally, all central banks add up to probably 25 to $30 trillion. Lots of money, lots of stimulus, maybe just your perspective on what that means for 2021. And then I'll get into the, maybe what are the consequences of that down the road?

Chris - Well, it's one of the things that creates a dependency, but an anchor point really for markets to do relatively well in 2021. All that stimulus is going to do a couple of things in our view. Number one, is it will stave off a raft of bankruptcies that you could have anticipated, had we done nothing. And that's important, because that changes the overall risk premia, the credit profile, and some other financial jargon. It essentially means that people should be willing to take a bit more risk, because the government's taking some of that off the table. That's one. I think the second thing is that, we're going to be laying the foundations for inflation over the long term with all of this stimulus. Think about it this way, is all that money printing is going to end up somewhere. It doesn't mean that it's going to see immediate inflation, but the idea that there's lots of extra money sloshing around in the system, is either going to need a lot of rules to control it, that's like what Japan did in the 1990s, or it kind of leaks out. Where is it leaking out? In all sorts of places. As M1 and M2, those are measures of money supply moving around in the economy, direct currency and then currency and deposits, et cetera, have skyrocketed up in 2020 and continue in 2021. The leakage has shown up in all sorts of places, like Bitcoin, like equities, like a lot of anticipation that we're going to get back together again. So, there's a really powerful story behind all of this stimulus, that is anchored in terms of supporting markets, supporting higher valuations, at least for the very near term, as the risk expectations have come down because of all of that government money.

Now, here's the last piece, I think that's important about all this stimulus. The reality here is that a lot of the stimulus needs to continue flowing through the economy. And right now, it hasn't really kick-started just yet. We haven't seen enough hiring, enough of that money kind of recycling. There's a measure of this recycling of money in the economy, called velocity. And until we get back above one, like every dollar in the economy is kind of moving around at least one more time, it's going to be really hard to talk about inflation. Number one. And number two is, the inflation story, historically, over long periods of time is always based on scarcity. And we're not scarce a lot of things right now, we're just not using them. Whether it's hairstylists, chairs, cruise ships, or kind of restaurant capacity, all the equipment is still there. So, we didn't get rid of the equipment, it's just really what we're likely to see through this program, is a lot of change in ownership potentially, but the capacity to do all these things, these services that have been shut down, is still there. So, not going to see a lot of inflation in the near term, I think is the key message, but the groundwork for the longterm and how we control all that money, is really going to be important.

Mike - A couple of, quite a lot of questions, in fact, around inflation, in fact, that the bond market is starting to react a little bit, at least the long end of the curve. And you look at 10 Year Treasury has gone up in recent weeks. I think today it's touching about 1.28%. And we can talk about, we'll get into interest rates, but, so you don't seem that concerned about inflation. But again, you look at all the stimulus going into things, prices, equities, real estate, et cetera, economies, you mentioned the money supply. M2, I believe for the United States, is up 26% year-over-year. That's a lot of money going into the economy. How is it that it, is inflation just more of a tail risk down the road, that you're ignoring for now or don't think it's a risk or it's more of a maybe a 2023, '24 event from your perspective?

Chris - I think it's a longer-term story, it may be 2023. I think the reality is, we need to see a lot of capacity change. It's not clear that we're going to see a lot of that in the very near term. So one of the kind of counter-balancing effects, is the more that there aren't bankruptcies because of all the stimulus, the more the assets and the other things that were in place, the restaurant itself, et cetera, are likely to easily come back online. So the capacity to do those things and provide services to the hospitality sector, is likely to remain relatively high. I think the inflation story, for everyone's benefit, really has a couple of faces to it. At least in the last several months, what's happened is, goods inflation, the stay at home kind, buying a new dishwasher, reroofing your house, you know, all those kinds of things, is actually picked up a lot. But the travel, go around and do things inflation, called services to a certain degree, cruise ships, hotels, hospitality has really collapsed. The two have just kind of intersected nicely in 2020 and the average hasn't done a lot. So our expectation is that, as you get people communing, getting back together again, the hospitality industry picks up, you'd see services inflation pick up a bit. I think the real question is, what happens to goods inflation? And I think with all the money in the system, we could see a fairly big deal of pent up demand kind of bursting through the system a little bit. That may be a head fake more than anything else and our expectation is that we'll see that taper off, as a lot of those assets associated with service businesses, stay in place and service inflation probably moderates a bit.

Mike - So, Chris, I'm going to play the role of one of our clients, I'm sure on the line right now, who will disagree with you and thinks inflation is coming around the corner. How would you invest if we were to see a fairly sizable or significant rise in inflation?

Chris - Well, I think if you were expecting a rise in inflation at this point, you're probably, even though they're somewhat expensive, you might want to look at treasury inflation-protected securities, because a lot of what you'd be betting on, is that the policy that's currently being adopted in the United States and around the world, is a mistake. And typically tips respond well to policy mistakes, and mistakes is a strong word, but policy misses, I guess, is the way to think about it. If you thought that the energy story was actually very important and energy prices have rallied a lot, the cold snap in the United States, not withstanding, you know, West Texas screwed back above 57, getting closer to 60 bucks, you'd actually just buy energy or buy oil. That's kind of the second phase of inflation. First would be the policy side, second is energy. And then last, is kind of the good old, you know, stuff that we're all used to, slow creeping inflation, 2%, kind of the lubrication in the system, as former Chairman, Alan Greenspan talked about it. And really real estate does pretty well there, because inflation kind of slow and steady over long-term, is captured in what's called, rent rolls. So, interestingly enough, you have to think about inflation maybe in a bit more parsimonious way, a bit more segmented way, in order to kind of think about what's going on here. And those three things may be opportunities. I think the energy one, maybe not so much, but the other two, certainly.

Mike - I'll come back to energy. Let's talk interest rates. So, it's interesting now, I think when we first started this, I don't think the yield curve was inverted, but certainly it was two years ago and today it actually looks with the tenure going up, not bad. You've got the fed funds rate at zero to 25 basis points. As you mentioned, the tenure at 128 basis points. So, you've got a bit of steepness in the yield curve and that's actually the sign of a good economy. So how are you reading the tea leaves on the yield curve today? And then what is your prediction for interest rates on the short end from the fed perspective for the next year or two years?

Chris - Yeah. So, I think we're reading the interest rate curve as it is, which is, it's still below the rate of inflation. So that's called, negative real yields. That's a problem. That's not normal. You're supposed to earn from your bonds, at least the rate of inflation, and that's not possible, at least everywhere in the developed markets actually. So, why is that important? Because it tells you that there are other factors at work that are helping to keep interest rates very low, whether it's the rules put in place around how banks need to protect their capital and their profits, which means they tend to recycle it by buying U.S. treasuries, as an example, in addition to other things, number one. Number two is, there are, I think for many clients looking for opportunities to have a balance of safe and risky assets, you know, the opportunity to add treasuries, even at these levels where they feel comfortable. And then there's some things going on in mortgage markets and hedging and a number of other things that really create a fairly robust level of demand. Not the least of which would include foreign governments, looking at U.S. treasuries and saying, "Gosh, mine are negative and those are positive," or at least foreign investors, "How does that play out?" And so, you've seen a little bit of demand from that. So, the story of the yield being below the rate of inflation is a pretty powerful one.

That's going to stay with us through the balance of this year, we think, and then well into 2022, tied to that inflation story. It's a big risk though. As a point in time, when bond investors start scratching their heads and going, "Why am I getting less than inflation?" They may, as we saw in the 1990s, the bond vigilantes go on strike and they may just sit and wait, until they get better yields. That's going to create a bit of volatility in the bond markets, but our expectation based on what we see today, what we understand the policy to be, and I'll just touch on that in a moment, is that yields probably stuck in this reign somewhere between one, one and a half, through a good part of this year. There's an outside chance that we could see 2% by the end of the year as that bond vigilante story might come back in. But the feds indicated that they're likely to keep the front part of the interest rate curve pretty still. They're not going to move around a lot. Now, I don't mind the forecast that some are putting out there, that the fed won't touch the front end of the curve until 2024, even later, that sounds silly. The fed is a group of noted thinkers, at least about how policy and economics work. It seems far more likely that if the facts and circumstances change, they'll change their minds and change their policies. So, to the extent that maybe some things have been unanticipated, say there's something going on with the way our trade with China's working, for example, or there's something around how the tax code may change in the next couple of years, that changes spending dynamics in the United States or hiring dynamics. I could see the fed responding to that. It would be silly to believe that they will just sit back and wait. It's far more likely that when the facts change, their actions will change. And I think the reality is that we're going to see at some point in the next few years, the potential for the fed to hike rates, that's a ways away. But the bottom line is, the fed will be responsive. And I think for now, a lot of the rules in place keep the yield curve kind of at a lower level below the level of inflation.

Mike - So, it looks pretty good. What are your predictions on the Gross Domestic Product for the United States this year?

Chris - You know, it's likely to be a wild ride. If we see this 1.6 trillion or more, stimulus put through, I think two things happen. One, is a lot of Wall Street economists will chase up their forecast and revise up. You could see five and a half to 6% GDP, which is a boom time in the U.S., at least with respect to the way GDP math is all calculated. It may not feel like that to everybody. The reality is the numbers will say for a variety of reasons, mostly related to government spending, that GDP was up big in 2021 if that stimulus package is passed. And I think there's a high probability of that. So, that's kind of the first thing. I think the second is, to the extent we see fewer bankruptcies, et cetera, we're likely to see with that lower risk premia, a little bit more risk-taking behavior. It's probably good for equity markets, but you may see a whole bunch of other things go on as well. Remember all those assets for cruise ships and restaurants that are still in place? I think we're going to see a lot of turnover in this space, new owners, maybe lots of roll-ups, acquisitions, et cetera, as those are still productive assets. And if they're unlikely to go bankrupt, I'm sorry, unlikely to see, sorry, let's back up. If we're likely to see the vaccine drive us communing again, then the assets become that much more valuable. So, I could see those two things helping to propel markets.

Mike - So, Chris, I want to sort of look at maybe your thoughts on structural issues with the United States. And one of the things I picked up, just to give you a perspective of how large the CARES Act was. Three months of the CARES Act, the deficit increased by more than the deficit increase in the last five recessions, that goes back to 1972. That was a lot, a big deficit increase. So here we are, I think our U.S. national debt, that's in total, stands at maybe 27 trillion. We spend six and a half, we earn three and a half, so we've got this $3 billion deficit every year. It's more like four and a half trillion dollars of a deficit. But really, what concerns do you or the markets have about the debt that keeps piling on to the United States balance sheet?

Chris - A lot, I think is the short answer. This is not a great situation. It leaves most world economies, the U.S. included, exposed to another type of shock to the system. Typically, shock absorbers include, the policy response from the fed, hey, lower rates, things are bad, we'll help you through it, or you spend deficit spending. And I think what we're learning are two things about the way debt and deficits and crises are handled. One is, they become very political very quickly, meaning the debt and deficit are a political issue rather than a financial issue, at least for the near term. I think it's when things settle down over the course of the balance of this year, and even in 2022, we're likely to see how do we address the ballooning deficit, and more importantly, the debt. There is no math that works without some combination of higher taxes and/or lower spending. There just isn't. Well, there is, if GDP grew at like, nine and a half or 10% for, you know, five or six years in a row, we could probably grow our way out of that. There were some folks that think if we can just generate enough inflation, we'll inflate our way out of that, but that has some pretty dire long-term consequences, mostly for the dollar and the way that we think about global trade. So I don't think that's the best answer. So there's some other combination of redistributive tax policy, higher taxes, across a number of fronts and potentially lower spending. Why is that coming? Because at some point, the U.S. treasury debt profile becomes an issue, in terms of, it's very short right now. And as long as interest rates are short, the U.S. Government doesn't pay a lot of interest on that debt. And we're up to 500, some odd billion, at least on a net basis.

But by the time that gets to seven or 800 billion, and Mike, you said it, if we have a three and a half or $4 trillion budget, yikes, that's a lot of money going to something that you can't really change. It becomes like a fixed expense and that will crowd out other things. So, that may come a little sooner than anticipated, but a lot will depend on kind of where treasuries, Secretary Yellen and Fed Chairman Powell, take things around the interest rate story. And while there's a lot going through the system now, we could be in for some rude policy choices by the end of 2022 and the early part of '23.

Mike - Yeah, I'll get to politics and policy. Just lastly, there's a famous economist out there, kind of looking at the U.S. consumer, 70% of our Gross Domestic Product is the U.S. consumer. Consumer household net worth is at an all time high, it's $133 trillion. The savings rate of Americans is now 14%. I think historically that's more like 8%. A lot of pent-up savings, balance sheets, and we can get into the inequality of what this pandemic has done for households. But it just feels like, as one economist said, we're about to unleash the biggest increase in pent-up demand globally, not seen since the 1920s, at the same time stimulus hits, so we may supercharge something that could be supercharged. What would that mean for the next couple of years and even decade?

Chris - Wow. People don't talk about this, but we'll mention it. That's a pretty meaningful upside risk. It's, you know, there's fires burning already, because of the stimulus, things are starting to heat up. But you pour more gasoline on it and you may get, depending on how you do it, you may get a much bigger fire here. And in some ways that's not a bad thing, but I think in other ways there are some long-term consequences of it. So, I think that the very near term issues with respect to all of the stimulus, we've got to get through this. We've got to get the vaccine. We've got to get the ability to commune again, because so much of the global economy is anchored on being able to commune one way or another, like this Zoom call, we're communing, just not in-person, but many things, with respect to not just the U.S., but the global economy, require in-person communing, not everything can be done on the Zoom. So that's important, because the vaccine is just about to start accelerating over the balance of 2021. And we're seeing not just the U.S., but Germany, France, we're seeing China, we're seeing everybody throw additional money the system trying to face off against the same problems. Now, one point about some of the data that you cited, Mike, you're exactly right, that there's a lot of inequality in it. It's the top 5% doing all the savings, really.

And the issue is that the checks that are coming through, the kind of CARES Act, too, et cetera, are all to ensure that those making under a certain amount, 75 or even 50,000, can pay all their bills, can ensure that the companies that, you know, they're startups or whatever, can actually continue to function. That is absolutely critically important, because the pent up demand story needs to be broad. It's not like somebody with a billion dollars is going to buy 50 lawnmowers. We need a lot of people buying one lawnmower, we don't need one person buying 50. So, that's really the story here, it must be a broad recovery, not just kind of at the high level with the numbers, with just a few folks accumulating most of the wealth through the stock market. That's the

Mike - Thank you, Chris. Switching to politics and policy, talk a little bit about what you might expect with the new administration in tack, the Blue Congress and changes to fiscal policy, and perhaps some of the policies that might relate to things like, trade with China, for example. So just some perspective on what tailwinds or headwinds we might see in the next few years.

Chris - So, the trade story is an interesting one, no big changes so far, is kind of the quick update, but the reality is, some of the issues that the Trump Administration was dealing with, the Biden Administration will have to deal with as well. Most of it relates to things like, intellectual property, cyber warfare, intellectual property theft, and cyber warfare. That's not all of them, but that's a very large piece of it. If you read some of the news reports today, you're talking about China, withholding rare earth metals for the U.S.. Things are heating up, they should be dialing down there. They're not going in the right direction, at least in the very near term. I think the expectation's that it's all going to be fine in a year or two, might be a bit misplaced. Yeah, things have been on a rocket ride outside the U.S., mostly because there's an expectation of markets recovering, but we do need to be very sensitive to kind of what the policy and political decisions may be. I think at the margin, the arc seems to be bending. If you listen to some of the top consulting firms out there as we do, the arc seems to be bending towards maybe there's an opportunity for a detente between the U.S. and China later this year, but there's a lot that needs to happen between here and there. In the meantime, markets responding really just to the two arrows of monetary and fiscal and monetary stimulus. I think beyond the trade story, it's pretty clear at least from our perspective, you're going to see some form of higher taxation.

As I mentioned earlier, the idea of higher taxes and lower spending. There's no math, you can't cut your way all the way back to where we need to pay the debt. And you can't tax your way either, it's going to have to be both. So that's an expectation, I think markets are adjusting to. And if you're talking about some of the early proposals, you know, corporate tax rates rising, 25 seems to be the number that a lot of folks who are on Wall Street are settling on, You're talking about higher tax rates for individuals. There's some chitter chatter about carried interest in the like. There's a number of things that are going on with respect to potentially around the state taxes, et cetera. Our firm has published a number of items around this. Our financial planning team has been all over it. So the idea, I think for most of our clients would be, it is time to prepare. I think, as we're in February now this year, the process of bringing the taxation packages to the U.S. Congress at this point is likely to be messy. There's something called reconciliation and we don't have to get into all the weeds on how that happens. That's likely to be difficult, a lot of horse trading will happen in order to get different aspects of any package through Congress. So, I think the second piece of that puzzle is that, our expectation at this point, if stimulus is first and then kind of taxation is second, that's going to be a second half of the year kind of thing. And it will be hard, not impossible, but hard to actually retroactively apply all the tax changes in 2021. It seems to be if history is a guide, that if there are going to be bigger tax changes that are likely to happen next year, something that should be considered in the planning discussion, I think, for anybody looking to adjust their portfolios and their wealth in this environment that we're likely headed into.

Mike - We have a number of clients in California, on the East Coast that were unfavorably impacted by the changes in SALT, that is a State Local Income Taxes, do you foresee any changes with the Biden Administration on SALT, that might actually allow for more deductions for these households in these States that are not getting it right now with state and local income taxes?

Chris - So, I wish that were true, but it does not seem to be on the table at the moment, what seems to be on the table is just a higher level of deductions, overall from 10,000 up to 28,000, less limitations around it. And you know, the opportunity really then is, I think for folks in, you know, California, New York, New Jersey, Connecticut, you know, the areas where SALT taxes can matter a lot, is to really think about being fairly aggressive in managing tax liabilities. I think expectations for SALT to return this year should be modest at this point. They're not zero, but they should be modest. And it may be that there's a lot of other things that need to happen between here and the end of the year. The biggest thing that's going to drag on it, is in the second CARES Act package that's being proposed now, there's over 350 billion in direct aid to States. So if they're already getting that money, then the SALT story is less compelling from the state perspective, if you're a state treasurer, et cetera. So, there's a little bit of give and take around all of this. We're going to likely see some of the, I think wrangling of that evolve over the course of just the next several weeks.

Mike - Chris, I want to shift to equities and evaluations, then I'm going to go to the audience for the Q and A, that's stacking up, a lot of good questions. But just looking at the stock market again, all time highs, your perspective on, is it fairly valued, overvalued, undervalued? What are the indicators? I think I learned from you, is the Buffet indicator, and that's his simplistic formula of taking the U.S. market capitalization of U.S. stocks divided by the dollar value of the Gross Domestic Product. And I think if it's zero, effectively one-to-one, it's fairly valued. The .com meltdown just before that happened. I think it hit 160%, today, it's 180%. So, by that indicator, you might say that things are a little overvalued, but I know you have many other metrics, so would love to get your perspective on equities, predominantly U.S., but if you've got an opinion on international equities as well, we'd love to hear that.

Chris - Yeah, if you just do some quick calculations you can probably explain 40, 45% of the 180 from all the stimulus that's recent. It's just really been a big push through the system. So it does make some sense, but I think, at least if you compare the Warren Buffet metric to history, it's not in a good place, it's in a terrible place. I think the other things that we look at, there's a panel of data that we review from operating leverage, to cash flow metrics, to earnings metrics, to kind of what a balance sheets look like. What are sustainable profit margins? And a number of other factors. It's hard to say that the U.S. is in a bubble. I think it's much easier to say that we're extended and there's a lot of expectations built into the stock market. But that makes sense, because that operating leverage story means that earnings could be up, if things continue on this path in 2022, by something like 15 to 20%. You're going to see some big pops in earnings. And just to give you a quick sense of what operating leverage looks like, it's the change in your operating income for the change in your sales. That's a very simplistic way to look at it. It's more detailed than that. But for some industries it's two-to-one, for every 1% growth in sales, you get 2% growth in operating income. For some other industries with high fixed costs, like energy, sometimes it's nine-to-one. So you can see these really big moves in earnings or operating income really, in very short time periods, based on the factors we talked about earlier, the stimulus, the idea that there's a hiring lag, you're covering your fixed costs, et cetera, pent up demand. So you could get a lot of earnings growth going into 2022.

And I think the market sussed that out to a meaningful degree. I think the other piece though, is outside the U.S., some of the hardest hit areas may recover the most, because they have the most room to run. There's really been a favor of the U.S., think at home strategy over the last several years, that's worked incredibly well. But I think at this juncture, we're in a place where there are meaningful enough discounts on the order of 30% or more for markets outside of the U.S., for a lot of similar companies, for example, that may benefit from similar dynamics, all the spending that stimulus, the kind of the return to communing and frankly, their economies, particularly in places like France and Germany have been harder hit, because the lockdowns had been more severe. So, and I think there's an opportunity to just change the thinking a bit, rather than stay at home all the time. It's time to look a little bit more broad greater perspective. We've seen growth rates in markets like Japan and parts of Europe actually revived relatively strongly. So, I know took your question in probably a couple of other places, but that look beyond your own borders message, I think is a pretty powerful one. Particularly, if we're going to normalize trade, in some ways with, you know, some of our former strong partners, Japan and Europe, as well as change some of those dynamics, while leaving China still a little bit in the penalty box. I'd expect those economies and those markets to benefit.

Mike - But as you're setting the strategy for our clients, you're still viewing equities as an important aspect of asset allocation.

Chris - Absolutely. So, look, you may have an overvalued or an extended market with a lot of expectations, but relative to everything else, can't beat inflation with bonds, cash doesn't help you. You really can go to alternatives, you know, parts of the commodity markets look somewhat interesting. I think they're extended as well. But a lot of the things I mentioned earlier, remember the bankruptcy's? Lots of kind of credit stories and alternatives look interesting, some of their alternative real estate, you need to be qualified for many of the types of exposures and the risks that are in these things. But it's really an opportunity I think for most investors to broaden their horizons, because it's been the past, just kind of one thing, buy the U.S. large cap market and just close your eyes and you've done really well. Now's the time to open your eyes, because things are changing.

Mike - That's great. Chris, taking from the Q and A from the audience a lot of questions around crypto. So let's talk about Bitcoin. I think last I checked, it was pushing 50,000 per coin.

Chris - Yep.

Mike - I believe there's 21 million coins out there, 18 and a half million have been mined. I'm going to guess the market capitalization of Bitcoin is a trillion or more. What are your thoughts on crypto, either as an asset class or even as a stored value of money in the future, when we buy and sell goods?

Chris - Boy, everything I think I've said about crypto in the past might, might be at one point in time, either really right, or really wrong. So, being aware of that and kind of where we are today, I guess I'd offer the following. The first is, I think in our view, what's driving crypto, is really the scarcity function. Mike, to your point, you know, 18 million have been mined, there's another 3 million to go, if you kind of look at the way the algorithm is designed for Bitcoin. And for those of you who know this, sorry for rehashing, if you don't, it is important to know that Bitcoin can be lost. It can be forgotten, passwords, because remember, you have to access it with a password. And the reality is, there's not ever going to be 21 million Bitcoin. There might not even be 18 million by the time we're done, because so much has been lost, forgotten, or just kind of taken out of the system. So that's important. So, it's even scarcer than most people think or is likely to be scarcer. The way I think about valuing something like Bitcoin, is very hard, because it's like valuing a computer network. Metcalfe's law, for those of you familiar with it, is all about the connections that a network has. And as long as it's a non-zero, non-trivial value to each connection, the more you make, in terms of connections, the greater the value in some way to think about it. There's a number of academics that have posited this theory. I tend to agree with it, but it's not clear to me that 50,000 is the right number. I know some folks have called for 400,000, but at that point that's a real kind of scarcity premium and it is an expectation from my perspective that Bitcoin would take over the monetary system to a certain degree in the U.S., but also globally.

I think that's pretty challenging to do. There's a number of structural reasons for that, but maybe the most important is, I don't think there's been in the history of the world, any government that willingly gave up their ability to tax or pay their own debt in their own currency. So, I'd expect the flurry of rules between here and that point, as a way for central banks ultimately, to reclaim some land in this giant kind of wild west frontier around digital currencies. We like the digital asset story, there's a lot of interesting things going on here. Central bank digital currencies are coming, they're coming fast and you're likely to see digital payment forms sprout rapidly. Here's the thing about it though, every ecosystem, at least in the world for digital assets and digital payments, is different. Thousands of new companies have sprung up in Singapore, in Canada, the United States and China and Japan and Taiwan, all the ecosystems are different to a degree. So what's important about that, is they all need to be connected. And if you think about this five years or maybe 10 years from now, you know, we may not care what goes through the connections, the plumbing, the plumbing is the valuable piece, but it could be a Bitcoin, it could be a share of Walmart. You might pay for your next car in the next five or 10 years in, I don't know, 82 shares of Walmart, something like that. So, because it's all ones and zeros, once you digitize everything. I think that's the bigger message that we're heading towards. In the meantime, I think with all the stimulus, the leakage we talked about earlier, you're going to see a lot of price volatility, and it's kind of the only signal that I think a lot of folks are using at this point to make judgements about whether or not Bitcoin or Ethereum or other things are important. That said, we respect that there is a lot of interest here and are feverously working to ensure that we have opportunities to have deeper discussions around digital assets more broadly, but crypto in specific with clients.

Mike - That's great. It's interesting you mentioned, I think there's a pretty infamous story about there, after 10 misses on a password, Bitcoin or the blockchain behind it, will reencrypt your password. And this unfortunate person has given up eight of his 10 passwords and he's trying to get the $220 million worth of Bitcoin that's out there. So to your point--

Chris - It's more now, it might be 350 million.

Mike - Exactly. So, Chris, a couple of questions around real estate, just your thoughts on real estate as an asset class. I know that's a broad category, I guess I'd break it down into, you've got single family, multifamily and office. On the single family side, what we've seen in the business is, really quite a white hot market in suburban areas, vacations, second home, obviously with the pandemic people want space, low rates allow them to afford that. Multifamily, they can seize up a little bit, rent's down in some of the big markets, but more importantly, the story really around office and the question was specifically around tech workers, specifically in areas like San Francisco, moving to Austin, Colorado. You've got a lot of sublease square footage on the market in San Francisco. I think for the first time in history, Downtown, San Francisco, sublease surpassed direct leasing opportunities. So, this is a bit of a problem and it hasn't shown up in the numbers yet. People are still paying the rent on the office side, because they're on leases for a couple more years. But if you go to some of these city centers, there's not a lot of people moving around. So, maybe just broadly real estate and then specifically office, as you're looking at it for investment opportunities.

Chris - So, I think we're on the cusp of a sea change, you know, prior to 2020, something like 90 plus percent of all the tech jobs in the country were created in just five cities, three of which were in California. One was in Washington and one was in Boston, there were none In Texas. With the giant movement that we're seeing here, and by the way, I have news for you, the desirable parts of Austin, where everybody from California wants to move, despite that nonsense in San Francisco, you know, except Gate and a few other places, they're very expensive. So the cost of living isn't that much different. The reality is that it's an average and people look at averages. There are whole bunches of swaths of areas of Austin that aren't all that expensive that dragged the average down. So why would I bring that up? Because I think the averages can be deceiving. And Mike, you give a good example of some of the things going on in the Bay area, the averages might foretell doom for the peninsula, for, you know, the Bay area. And I just don't think that's exactly where things are going to head. You know, prices have a way of correcting. There's a lot of interesting things about California, from climate to all the tech brains that are still there and companies that want to be there. Policy does matter, so what Governor Newsom decides to do will play a role, I think in how these things continue to evolve. You know, but our expectation around the real estate story, as you mentioned, white hot in a lot of suburban markets. Office markets in some cities are set to cool, but a lot of these spaces have alternate uses.

It could be that you see larger opportunities to reconfigure floors, reconfigure the opportunity from a kind of just pure office to something else. I could see a lot of offices converting or a number of them, to mixed use or other types of opportunities. So that's one piece of the puzzle. I think the other that we're talking about in real estate, is kind of logistics and the opportunity for speeding up delivery times with a lot of locations nearer to where people are. Now, the challenge is when everybody moves to the suburbs, you need lots of warehouses in the suburbs or your delivery times go up. When things are dense, everyone's in the city, delivery times can be a little bit shorter. So, we're going to see second tier airports, for example, and a lot of kind of unused space, we think around those areas start to perk up, particularly as folks have been moving. I think the last piece of that puzzle on real estate, you said, housing, multi-family, et cetera, multi-family still looks pretty interesting. You know, if you look at the income strata in the United States, the top quarter, top 25% or so, have actually seen their incomes recover post COVID and actually they're now ahead of the game. So those folks looking to spend, that's your white hot suburban markets and your vacation homes, but you're actually starting to get that next 25% almost back to even as well. Remember, we have a very large proportion of the workforce, a hundred million plus, that are still employed.

And so, that kind of positive side is seeing those two folks, two cohorts actually do reasonably well. Where the real challenges lie though, is everybody kind of in the 75,000 and below income strata, that's the place where we're likely to see a lot of challenges and it's why we need the, I think a lot of the stimulus story, in order to help get those folks through a difficult period. That's not a political statement, but that's actually a statement about how you think of the economy overall behaving, getting back to communing. So why would that be important? Because that could lead to additional housing demand, particularly as you start to recoup that both in suburbs, but I think more importantly in the cities, with prices coming down, there's likely to be a bit more opportunity.

Mike - Chris, you said ahead of the game and there's a question from Nancy on GameStop. So, it might be a little unfair, but you know, obviously these meme stocks and it's more about the, you know, the democratization of information and the boards like Reddit and Discord, that have allowed mass communities to come together and effectively make positions on stocks. So, do you foresee more regulation as it relates to stock trading and the things that have happened more recently with the meme stocks?

Chris - You know, I don't know how you regulate Reddit or some of these other chat rooms, even 230E is kind of got some limitations and that's kind of the code, you know, part of the code used by tech companies to basically allow them to have lots of different free speech types of output coming out of their ecosystems. So, why would we bring that up? Because if you think about the market, Reddit just might be a layer up on the top, where people talk to each other, like the phone or, you know, screens or whatever. The next layer, if they decided to do something, it's called the execution layer, and that's like a broker dealer, a brokerage house, you know, that you would know. But the bottom layer, kind of the dark layer, or at least the layer you may not see all the time, is the clearing layer. Somebody's got to make sure all the money kind of ends up in the right places, and that clearing house layer, was really what helped kick off the challenges around GameStop and some of these other companies. Because the clearing house said, "Oh my gosh, this looks really risky." It does. And we need more money from you brokers, because we don't know what's going on. It looks crazy, or it looks very volatile. We want to be safer, because we're the bulwark of the system, we've got to be working all the time. So, in order for us to be safe, we need more collateral from you, the brokers, and, you know, folks like Robin Hood, Webull, and all the other things that are out there, had to put up additional collateral.

So, that changes what they can do. If they have to put more of their own money somewhere else, then they've got to be more careful about how many transactions they led through. So it has a cascade effect. Right now, it's worked relatively well. I know there's a lot of folks upset about the things that had happened, but the reality is, financial system is functioning like it's supposed to, when things get riskier, you demand more collateral. Hey, that's how finance works. So, I think where we are is a place that we're going to see potentially with all the stimulus money coming through the system, more of these things. But frankly, we need more investors in the market. So the opportunity then, I think is to find a way to keep bringing investors in, but not having so much regulation. It turns a lot of folks off or turns them away to markets. And that's always a delicate balance, but I see those two things coming together through 2021.

Mike - Chris, a question from Scott here, and there's a couple of themes around this. Do you see alternative investments is presenting an attractive opportunity over the next one to two years? And also some thoughts around the IPO market and SPACs, if you're involved in those areas?

Chris - So, alternatives. Broadly speaking, private anything, or things that you might call hedge funds or commodities or options, all those types of things that aren't just a simple buying a bond or buying a stock. The answer is yes, mostly because they offer different risk characteristics, different return profiles, and the value of diversification in a portfolio is going up, not down. So, kind of the cost of being wrong, if you concentrate in something that you're just sure is so awesome, but doesn't turn out to be. I really mangled Mark Twain's quote there, but this doesn't turn out to be, is so high now, think GameStop, that it really pays to be far more diversified. And while stocks and bonds are doing their thing, reality is there's lots of interesting opportunities in other parts of the markets, not just in the U.S., but globally. So, yes, we would be going in that direction around alternatives. Interestingly enough, in alternatives, it's mirroring public markets, but with some liquidity difference, there's private credit, private public credit, there's, you know, private equity, public equity, there's private real estate, there's public, you get where I'm going. This kind of mirroring function, means that there's a natural, I think mental model from most clients that are qualified to do these things to be able to have a conversation about what the thing you're investing in might look like.

And I think it's really going to help for firms that have, you know, a strong research capability to distinguish, because there's lots of me too investments out there at this point, and you really have to pay attention and be selective around them. Now, I think the other thing you mentioned, you know, beyond alternatives, was SPACs. So, SPAC stands for special purpose acquisition company. For those of you that read Charles Kindleberger's book, I'm just going call it, "The Madness Of Crowds". It's really not the title of the book, but it is. SPACs are just like the south sea bubble company for which a charter was written that says, "We don't know what we're doing just yet, "but give us the money." That's kind of what a SPAC is. Okay, that's a little glib, but it gets to the idea that there are two things going on that are powerful for SPACs. The first is, there's just not that many U.S. public companies. We need more. We went from 9,000 or so, that you could easily trade in 1995, down to like, less than 3000, roughly, that you can trade easily. There's lots of tiny companies out there, but if you're a bigger investor, you need to be able to kind of have some liquidity and boy, do we need more bigger liquid stocks. The market's been so narrow and so focused. So, in one way, SPACs aren't a bad thing. And the challenge is that, there's all sorts of folks now tying their brand, their names, their experience, but it's not clear that all the companies that are private that should come public are going to do that. So, there's some risks of some bad decision-making that may come about in 2021, as SPACs look to their frustrated investors saying, "When are you going to make some money?" And they make maybe a deal that they shouldn't have made or if they were more patient.

So, just like these investors should be, I would suggest that anyone looking at this space also needs to be patient and thoughtful, you know, around that. The recent performance suggests as much, there's been some big pops and then these things have tailed off a bit. But I think they're going to be around for 2021 and could present some interesting opportunities, but patience is required.

Mike - So, Chris, we're wrapping up here, but I just want to leave it on your kind of high level thoughts on the tailwinds and headwinds for the economy as we look forward for the next couple of years.

Chris - Well, I think 2021's not going to be so bad, when we look at the end of it, because we'll be facing the end of this year, looking into 2022, I think with a better healthcare picture globally. I think we're going to have a little bit more normalized trade relations. Certainly one step, we may be facing higher taxes. I think that's a very high probability as well. But I think we can get used to that with all this stimulus in the system. Given what history has taught us, there's a lot of gearing, a lot of operating leverage in the system. I think you'd be looking at 2022 probably a little bit better. So, that kind of outlook, I think is reasonably constructive. I think at this point though, it's a little bit more like the consensus. I think everybody is starting to follow on to this train at this point. So a lot of folks looking for volatility, you know, jerking around tax policy or some other big changes in the market, in order to buy the dip. I think we'd advise just being very patient and staying with your long-term strategy, rebalancing. I think for folks that are sitting on cash on the sidelines, there's no time like the present, not because you want to pile in, but just get started. I think the story here is one, where given the return on capital that we're continuing to see in the U.S. and the recovery that we expect outside the U.S., you're going to need that return on capital to stay ahead of inflation over the next several years. And that's really the key.

Mike - Well, Christopher Wolfe, Chief Investment Officer of First Republic Investment Management, I always appreciate your insights and perspective. This has been great. If any of you as clients would like any further research or insights from Christopher Wolfe, please contact your wealth advisor at First Republic or your relationship manager, and we will get you connected. And there's lots of great information that will give you more detail on any of these topics. But with that, Christopher, I want to thank you and wishing everybody a great day and great week.

Chris - Thank you.

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