REPORT: "POTENTIAL CHANGE OF LEADERSHIP FROM US AND GROWTH STOCKS TO INTERNATIONAL AND VALUE STOCKS IN 2021-2023”

BOSTON, MA – 09/28/21 – Vitaly Veksler, CEO and Portfolio Manager at Beyond Borders Investment Strategies, LLC (BBIS), published a report titled, “Potential Change of Leadership from US and Growth Stocks to International and Value Stocks in 2021-2023”. The leadership change would happen after a historically long combination of underperformance of International and Value stocks. International stocks, which include stocks of developed countries and emerging markets, underperformed US stocks for eleven years. Value stocks underperformed Growth stocks by even longer – fourteen years. 

To read the full report in PDF format, please Click Here
 
The Setting: The initial catalyst for the stock leadership change would be the Quantitative Easing (QE) tapering in 2021 and ending in the middle of 2022. These policies stimulate economic growth by lowering interest rates and infusing freshly created money into the economy. While in modern history, the QE policies were first introduced in Japan in 2001, the US Fed has started using them in response to the Global Financial Crisis in 2008 and used the policies through the end of October 2014. During the new round of the QE that started in response to the COVID-19 pandemic in March 2020, the Fed has been purchasing the Treasury bonds from the banks. The banks have been using the cash they were receiving from the Fed to extend loans to businesses and consumers. And since interest rates have been reduced by the abundance of money in the economy, valuations of most stocks went up. The impact was especially pronounced for Growth stocks, which are more sensitive to discount rates that depend on the Treasury yields impacted by the Fed rates. Generally, Growth stocks’ valuations benefit from very low rates more than Value Stocks. Since the US stock markets are Growth heavy, they outperformed stock markets of many developed countries and emerging markets, the majority of which have a much higher weight of Value stocks in them.
 
The Primary Catalyst: As the economy recovers from the pandemic, the QE policies that are akin to economic medicines are no longer needed. High inflation is a dangerous byproduct of the QE policies. In 2021, we have seen that inflation rates increased far above the Fed’s 2% target. In August 2021, for example, Consumer Price Index (CPI), which measures consumer inflation, and Producer Price Index (PPI), which measures business inflation, increased to 5.2% and 8.3%, respectively, over the August 2020 levels.
 
In his September 22 press conference at the end of the September meeting of the Federal Open Market Committee (FOMC), Jerome Powell, the Fed’s Chair, indicated that the Fed may start tapering the QE policy of purchasing assets (i.e., Treasury bonds) in 2021 and end the program entirely by the middle of 2022. Mr. Powell also indicated conditions that the Fed is thinking about starting raising interest rates. He stated that half of the FOMC members believe that these conditions may be reached by the end of 2022. So, the Fed may start raising rates from the ultralow range of 0-0.25% at the end of 2022 or, more realistically, in 2023. The rate liftoff would be another catalyst for Value and International stocks to outperform Growth and US stocks. The weight of Growth in US stock market indices is high.
 
Catalysts for the Potential Future Outperformance of Value vs. Growth Stock Markets: Potential catalysts may help Value stocks outperform Growth stocks over the next several years.

1. QE tapering that would lead to higher Treasury yields that may not support expensive valuations of Growth stocks, prices of which may fall, but may result in higher prices of Value stocks in such sectors as Industrials and Materials, but, especially, Energy and Financials
2. Outright interest rates’ increases that would be positive for Value stocks and especially the ones in the Financials and Energy sectors;
3. Increases in revenues and profits of companies in the Energy, Industrial, and Materials sectors due to potentially large-scale construction around the world, and those in the Financials sector that would benefit from the borrowing by the companies in the first three sectors. All four sectors include predominantly Value stocks:

• Rebuilding of corporate supply chains in the wake of the COVID-19 pandemic;
• Moving of some manufacturing facilities out of China;
• Potential adoption of the $1.2 trillion US Infrastructure Bill; and
• Possible adoption of the $3.5 trillion Democrats Budget Reconciliation Package that includes    some construction in it.

 
Catalysts for the Potential Future Outperformance of International Markets vs. US Markets:

1. The end of the COVID-19 pandemic makes markets outside the US, the world’s largest “safe haven” market that during crises attracts investment inflows from all over the world, more appealing;
2. Potential sentiment and valuation reversion have historically made Value stocks more attractive than Growth stocks during recessions and recoveries. Once again, International stocks may outperform because the weights of Value stocks in the International indices are higher than in the US indices; The rebound of the economic growth rates in countries that were heavily hit by the COVID-19 pandemic may improve investment sentiment around them;
3. Lower valuations of many countries’ stock indices vs. the US stock market valuation may make these markets more attractive to investors. As of August 31, 2021, stock markets of 40 out of 49 countries in BBIS’ investment universe (all countries that have single-country ETFs) had lower valuations than the US on the GDP-to-Market-Capitalization ratios (i.e., Warren Buffett Indicator). Importantly, we compare all country valuations to their own histories rather than to other countries’ valuations – all countries have different risk levels, and riskier countries would almost always have lower valuations than less-risky countries;
4. The same four construction-related catalysts may lead to the increased demand for Value companies in the Energy, Industrial, Materials, and Financials sectors as these sectors are more represented in the International rather than US indices (see points four points in Item 3 in the previous section);
5. The US Dollar (USD) may potentially depreciate due to the following seven groups of problems. Some of these problems may also impact market valuations of the US market directly (not via the USD depreciation)

---------- 1) Rising Attractiveness of International Assets When COVID-19 Pandemic is Mostly Over:
---------- 2) Boost for international currencies due to rising US consumption and higher US trade deficit;
---------- 3) Rising US government deficit and debt;
---------- 4) Potential tax revenues on the wealthy and corporations may disappoint and could make the US tax base even smaller due to the capital flight;
---------- 5) High US inflation may not be transitory as the Fed expects (Domestic Causes of Inflation):

• Historically high money supply far exceeding the country’s ability to produce goods and services has led to inflation that may continue in the future; and
• Minimum-wage increases in 24 states can exert upward pressure on the above-minimum wages and all wages above them in these states and on the minimum wages in the other 26 states.

​---------- 6) US & Global Inflation May Stay High Due to Supply Chain Disruptions, While Demand for Goods Stays High (Partly International and Partly Domestic Causes of Inflation):

• China’s Zero-COVID policy may continue to create a bottleneck in the global trade system;
• Covid-19 may wreak havoc in other important manufacturing countries (i.e., Vietnam);
• Freight rates may continue to stay high due to the unpredictability of factories’ closures and the shortage of containers;
• Upcoming negotiations between ports of Los Angeles and Long Beach with Trade Unions may lead to lasting cargo handling slowdowns;
• New climate regulation rule that would require ships to sail at lower speeds to cut emissions is likely to add to the shortage of containers and ultimately to inflation through increases of goods’ prices; and
• Finally, the shortage of truck drivers may continue to exert pressure in the US for reasons ranging from the relative dearth of younger people in the generations following the Baby Boomers to the lack of desire by potential drivers to drive in the civil unrest or high crime areas to the lack of potential applicants’ confidence in their ability to pass the drug test after marijuana was legalized.

---------- 7) Potential draconian new banking regulation provision in the Democrat Budget Reconciliation Bill, which would require banks to provide information on all transactions in the accounts that had              annual inflows or outflows of $600, can backfire spectacularly for many reasons

• The proposed legislation is basically not written (its current length is only one page and six lines), and if adopted “as is” would give the Treasury Secretary too much power to write whatever she desires without any oversight by the Congress and Senate;
• The groups that would be mainly targeted for the tax gap enforcement are not the same in two different Treasury’s documents about the provision – but both groups (small and medium business owners and the Top 1% of income earners) contribute above their weights to the US economic growth, and frequent indiscriminate audits against their members would slow the economic growth;
• The language of “The Case for a Robust Attack on the Tax Gap” report, written by the Treasury’s Deputy Assistant Secretary for Economic Policy, stirs up negative emotions against the Top 1% of income earners as tax cheats. It ranges from unfair to blatantly wrong and may convince some honest people in the Top 1% not to work as hard to get out of the group. This would lead to lower economic growth;
• The adoption of the provision could accelerate capital flight from the United States that started after the 2020 elections. It is dangerous because as warmer waters make hurricanes bigger and stronger, the lack of domestic investors makes crises more intense and last longer;
• Intrusive regulations may lower demand for the US Dollar in foreign countries leading to the USD depreciation and potential weakening of its status as the world’s top reserve currency. The US’ attractiveness as a destination for storing money for wealthy foreign investors may diminish;
• In its quest to get unpaid taxes from wealthy tax evaders, the IRS may turn into Big Brother from a police state masterfully depicted by George Orwell in his famous “1984” novel. The Treasury’s goal behind the provision is to find wealthy tax evaders and make them pay the taxes. But to find several percent of tax evaders, the provision would intrude on the privacy of the overwhelming majority of law-abiding citizens. It would collect data on accounts of all other but the lowest-income Americans. If the provision passes, the IRS will gather information on inflows and outflows of pretty much all citizens, including hundreds of millions of middle-class and even lower-middle-class families, which the IRS would have no actual reason to do;
• The comprehensive IRS database would become one of the most valuable targets for cybercriminals and spies. If profit-seeking cybercriminals hacked the IRS’ bank account database, their pitches to potential victims would become more convincing after they mention all of the victims’ accounts with inflows to and outflows from them. The database would also open a whole new avenue for collecting data to foreign intelligence agencies that could use the data from the government officials’ accounts, for example, to make these officials do things against the US national interests;
• A giant regulatory wave that the current administration has unleashed will likely slow the US economic growth the same way it happened during the Obama-Biden era. Flashback – The Obama/Biden administration’s regulations cost was equal to combined individual and corporate income taxes in 2016, its final full year in power. While the number of regulations increased, the economic growth slowed significantly. The US GDP grew by just 1.6% per year on average during the Obama/Biden term (2009-2016);
• The annual tax gap may be dramatically lower than the IRS estimate of $600 billion. The provision is based on a debatable theoretical background. The paper that the “Attack” report is based on was criticized by US Treasury’s and US Congress’ economists for using methodology that “tends to overestimate total [tax] underreporting, overstate true top incomes, and allocate too much underreporting to the top of the distribution.” Additionally, making long-term forecasts of tax gaps based on past estimates for 2011-2013 (8-10 years ago) may lead to imprecise tax gap results in 2021 and beyond. Also, the tax gap in 2017-2019 may be smaller because tax compliance increases when tax rates are cut; and
• Finally, even in the best case, the provision would provide the US government with a minimal financial benefit but would cause a big fight within the society. Even if all current Treasury officials’ estimates are correct, which we doubt for the reasons described above, the Treasury will collect $460 billion over the next decade as forecasted in The American Families Plan Tax Compliance Agenda. It is only 0.16% of the projected total 2022-2031 GDP of $287,702 billion. An almost $80 billion investment in the IRS over the next decade would further reduce the financial benefit of the provision. The tax revenue collected as a result of the provision would increase the projected total 2022-2031 GDP by just $381 billion, or all of 0.13%. In our opinion, the financial benefit from the provision is so minimal that it would not make it worth implementing a measure that may add to the simmering internal societal conflict and capital flight that has already started in earnest after the 2020 elections. In our view, the provision exemplifies a saying, “Some wars are not worth fighting.”
• In addition, we believe that the provision would most likely increase capital outflows from the US, turning the provision’s impact on the US economy from almost zero to negative. It is worth remembering a famous lesson from Aesop’s tale, “The North Wind and the Sun”: “Gentleness and kind persuasion win where force and bluster fail.”  After World War II, the US economy became a leader and a magnet for people and capital from all over the world, not because it had a byzantine pyramid of inflexible and punitive laws and regulations, or was a country where citizens were forced to comply with these laws and regulations by the regulators. Instead, the US economy started to prosper because of its business-friendly laws and regulations that most people considered fair and gladly chose to comply with. 

Risks to Our Forecasts

1. The Quantitative Easing’s Tapering, a major catalyst for the Financials and other Value sectors, may be delayed;
2. The Budget Reconciliation Bill may be more expensive than its already shocking $3.5 trillion tag, and it may have many negative surprises inside that can impact the US productivity for decades (as the provision on accounts with $600 flows);
3. The US Infrastructure Bill, a major catalyst for the Materials, Energy, and Industrials sectors may not be adopted;
4. The COVID-19 pandemic gets from under control: investors may move the capital to the US and several other safe-haven countries; and
5. After the mistakes-ridden US military withdrawal from Afghanistan, US’ rivals and enemies may think that the country’s allies may be attacked. A military crisis can spur capital Flight to safe-haven countries

 
Best regards,
Vitaly Veksler, CFA
CEO & Portfolio Manager
Beyond Borders Investment Strategies, LLC
[email protected]