Economy & Markets Jul 26, 2021

Red Med Redemption

Michael Cembalest Chairman of Market and Investment Strategy for J.P. Morgan Asset & Wealth Management

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Red Med Redemption: Politics, vaccination resistance and the Delta variant; US economic recovery update; big tech reliance on acquisitions to fuel growth; Investor Odds & Ends (NYC hotels, personal/corp/int’l taxes)

While US vaccine resistance is not the sole province of one political party, there are some clear ideological factors at work as illustrated below. Now that the more contagious Delta variant has become dominant in the US, some unvaccinated members of the GOP may reconsider resistance/reluctance to receive medically proven vaccines. Or maybe not: even though 95%-99% of recent hospitalizations involve unvaccinated people, an Associated Press poll found that 80% of unvaccinated Americans “definitely” or “probably” won’t get vaccinated. To round out the week, a conservative talk show host wondered if Florida’s Governor was being bribed or threatened after he encouraged Floridians to be vaccinated.

Higher reproductive number estimates for the Delta variant have prompted some to wonder whether the US or other countries will reimpose lockdowns. My sense is that it’s probably too late for that given the prevalence of the Delta variant already. The risk-reward of mRNA and vector vaccines seems pretty clear to me (see charts below), but to each his own. In any case, the bottom chart shows that vaccines are “working”.

For detailed CDC reports on foregone COVID cases, hospitalizations, ICU admissions and deaths vs adverse vaccine outcomes, for mRNA vaccines see here:

https://www.cdc.gov/mmwr/volumes/70/wr/mm7027e2.htm#T2_down

and for the J&J vaccine, see here:

https://www.cdc.gov/vaccines/acip/meetings/downloads/slides-2021-07/05-COVID-Rosenblum-508.pdf

Note the low pass-through from infection to hospitalization and mortality in the UK. I’m optimistic about this, but some of my colleagues believe it’s too early to draw conclusions. More importantly, the UK has vaccinated 95%+ of its age 65+ population. In the US, the same figures are 10%-15% lower depending on the state you’re looking at, and even lower in certain counties. In Missouri and Florida, COVID hospitalizations among the vulnerable (almost all unvaccinated people) are almost as high as they were last winter.

In the prior note, I wrote that I did not expect lockdowns in the US irrespective of how bad the Delta variant gets. I still expect that to be the case; if most unvaccinated people still refuse to be vaccinated, how could a governor justify locking everyone down to protect them? In any case, here’s an update to US recovery metrics we follow. US manufacturing and services are still firmly in expansion mode, CEOs are very confident and plan to do a lot of hiring, retail inventories are at their lowest levels in 25 years relative to sales, and there’s still a lot of pent-up spending potential relative to actual consumption. The negatives: prices for homes and consumer goods have risen so much that consumers may now slow down their purchases, which when combined with the Delta variant, has prompted a rollover in “COVID recovery” stocks.

Reliance of the big 4 tech/social media stocks on acquisitions to fuel growth

We will discuss this in more detail after Labor Day, but given the impact of these stocks on the broad market, an anti-trust revival might curtail these kind of acquisitions. It’s too soon to tell since we have no idea which (if any) proposals from the House Judiciary Committee will be enacted as legislation or implemented as an Executive Order. But this is one of the more important political questions to consider as we head into the fall, since as shown below, the market expects little to no impact of anti-trust regulations on the big 4’s earnings.

Investor Odds & Ends: S&P earnings, NYC hotels, and the latest on personal, corporate and int’l taxation

With a quarter of S&P 500 companies reporting, 88% have beaten consensus EPS expectations and 86% have beaten consensus revenue expectations
The US CBD office utilization measure we track on our virus portal is at 50% for Texas cities but only 20%-30% elsewhere, among the lowest of all recovery indicators. In NYC, direct+shadow+sublet space has increased by 40 mm sq ft to 80 mm sq ft, compared to 25-35 mm sq ft increases after prior recessions
A distressed hotel fund just bought the 725-room Lexington Hotel at $255k per key, which is a little more than half of what the seller paid for it in 2011. Permanent closures of nearby hotels (Omni Berkshire Place, Roosevelt) and new rules designed to slow NYC hotel development appear to be part of the fund’s investment thesis. NYC’s hotel industry is still in an “economic depression” according to the American Hotel & Lodging Association, with revenues down 67% vs 2019. Other cities in the AHLA hotel market depression list: Seattle, Boston, Minneapolis, DC, Chicago and San Francisco
We don’t know how the tax landscape will change since the negotiations over the infrastructure and “human capital” bills are ongoing. But as a placeholder, consider the following: Biden’s original proposal included a 28% corporate rate on domestic income, no deferrals, and a 26.25% GILTI minimum tax after eliminating the exemption for normal returns and eliminating the commingling of foreign tax credits across countries (effectively moving back to a worldwide tax system); new higher taxes on oil & gas; a new SHIELD tax on foreign entities operating in the US; no commingling of foreign tax credits across countries; a cap on like-kind exchanges; full unification of capital gains and ordinary income tax rates for HNW individuals; and forced realization of capital gains at death
We now believe that the negotiations are headed for a 25% corporate tax rate, a GILTI tax of 15%-19%, partial commingling of foreign tax credits, and possibly a minimum book tax of 15%-20% which we estimate would have a negligible impact on S&P 500 earnings; an increase in capital gains to 28% instead of full unification with ordinary rates; and a possible doubling of the SALT deduction from $10k to $20k. There’s a long way to go, but it is notable how different the possible outcomes are from the original proposal
There’s a lot of talk about an international agreement on a minimum tax rate. However…how would this actually work? It falls apart considerably if countries do not accept a binding and universally applied definition of income, which means countries would have to agree to unify tax treatment for opportunity zones, R&D credits, drilling expenses, bonus depreciation, LIFO vs FIFO for inventory, bad loan write-offs, orphan drug credits, etc. Otherwise, countries would STILL be able to engage in tax competition with each other and have effective tax rates below the minimum level. This could take years to sort out and implement

In case you missed it: 2021 Eye on the Market archives

Hydraulic Spacking: SPAC review (February)

Future Shock: 2021 Energy paper (May)

An investor’s look at China: new risks and regulations (June)

Food Fight: 2021 private equity review (June)

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Red Med Redemption

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FEMALE VOICE: This podcast has been prepared exclusively for institutional, wholesale professional clients, and qualified investors only, as defined by local laws and regulations. Please read other important information, which can be found on the link at the end of the podcast episode.

MR. MICHAEL CEMBALEST: Good afternoon, welcome to the late July Eye on the Market. This one is titled Red Med Redemption, which you’ll understand in a minute. Topics for this week are the issues around politics, vaccination resistance, and the Delta variant. Also want to give you a quick summary of a US economic recovery update and then some quick advance comments on something we’ll cover more in the fall, which is big tech reliance on acquisitions to fuel growth and the potential for the House Judiciary recommendations on antitrust to derail some of that.

So there’s a couple of charts on the first page that the podcast is not going to do it justice. Vaccine resistance is not the sole province of one party; we know that. But when you look at the data, there are some very clear party-specific factors at work here. The first chart looks at the vaccination rate as a function of the liberalism or conservatism of the Congressional representative, and there’s a pretty clear pattern here where, that shows where the red dot GOP cluster has significantly lower vaccination rates. And then also a chart, some of you may have seen something like this before, but we run a county-specific cluster on the Trump share of the 2020 vote and vaccination by county. And there’s a pretty clear trend there as well.

So look, I mean it is what it is. And the shoe fits here, and so the big question is will some members of the GOP reconsider their resistance or reluctance to receive these vaccines? So far, even though about 95 to 99% of recent hospitalizations involve unvaccinated people, an Associated Press poll found that 80% of unvaccinated Americans plan to stay that way. And I thought this was fascinating. A conservative talk show host actually wondered if Florida’s governor was being bribed or threatened simply because DeSantis decided to step out and recommend that more Floridians be vaccinated, which is kind of remarkable.

The reproductive number for this Delta variant is pretty high and poses substantial risks to the vulnerable population of unvaccinated people. I don’t think lockdowns make sense, in large part because I think it’s too late for that. You’re already looking at 80%-plus prevalence of this Delta variant in the US and a bunch of other Western countries, and I don’t think lockdowns would be able to control it anyway.

To me, the risk/reward of the mRNA and vector vaccines is pretty clear. We have a couple of charts in here that show the ratio of foregone deaths and long-haul COVID cases relative to the Guillain-Barre, which is a very severe neurological disorder. How many cases of that would you expect per million compared to deaths in long-haul COVID if you don’t get vaccinated? And a similar-looking chart for the mRNA vaccines, and there the myocarditis and some of the other things that young people have gotten is generally treatable. And there the ratios are similarly high in terms of the foregone COVID outcomes from vaccination are many, many, many, many multiples higher than the chances of getting an inflammation condition.

But people can view this data in any way they want, to each his own. And it looks like this vaccine resistance is going to be pretty difficult to break through. In the UK, pardon the squeaking, that’s my dog playing with a toy, in the UK, the pass-through from infection to hospitalization and mortality has been very low. In other words, infections have spiked enormously, whereas hospitalization mortality hasn’t moved that much at all.

I’m optimistic about this. Some of my colleagues believe it’s too early to draw conclusions. But the main issue is that the UK has vaccinated 95% or more of its population over 65. In the US, the same figures are about 10 to 15% lower, depending on the state you’re looking at. And in some of the counties, it’s much lower than that. And you can see for yourself the impact of those lower vaccination rates. In Missouri and Florida, the COVID vaccination rates amongst unvaccinated people are almost as high as they were last winter, and they’re still rising.

So look, I think the situation is the Delta variant is spreading. There is a very large cohort of people that are protected in the United States and parts of Europe. I don’t think that most governments, either federal or local, are going to lock down large components of society and impose mobility restrictions to protect the unvaccinated, particularly since most of them are that way by their own choice.

So in any case, here’s an update on some US recovery metrics that we’re following. US manufacturing and services are still firmly in expansion mode. CEOs are very confident and plan to do a ton of hiring as well as capital spending. There is a lot of pent-up spending potential relative to actual consumption. We measure spending potential by looking at taxable income, transfer payments from the government, increases in housing wealth, increases in financial wealth. And so potential spending is still running, is still much higher than actual levels of consumption. And retail inventories relative to sales are at their lowest levels in decades. So there’s a lot of pent-up activity still to come. The pace of US growth may slow, but it’s slowing from a very fast pace to a still pretty fast pace as we head into the fall.

The big negatives are prices for homes, cars, and other consumer goods have gone up so much that there’s a bit of a consumer strike that may hit. Consumers are now signaling through various surveys that they don’t think it’s a good time anymore to buy certain household durables, cars, and houses. And so that may take a chunk out of growth simply because demand is being destroyed. And because of that, there’s been a rollover in some of these COVID recovery stock baskets. Those are the kind of things that I expect will pick up again once we get through the fall.

And then again, the biggest challenge for the economy right now I think in some ways is how sticky wage inflation is going to end up being. I think consumer price and goods inflation will rollover, but the wage inflation numbers look pretty sticky. The latest statistics I was looking at show some of the highest nominal wage growth that we’ve seen in 25, 30 years on a percentage year-on-year basis. Now that’s a good thing. Wage growth does level out some of the economic inequalities and wealth inequalities, and all things being equal, it’s a good thing. The only challenge is it’s inconsistent with super-accommodative monetary policy from the Fed. Those two things don’t go together. And at some point, there’s going to be a reckoning for the Fed in terms of how they deal with that.

There’s one last topic that I wanted to briefly mention, and that has to do with the potential for a serious antitrust revival. Right now, the House Judiciary Committee is talking about a whole bunch of things. What actually gets passed into legislation or enacted as an executive order is still very unclear. So it’d be premature to make a lot of substantial portfolio decisions based on things coming out of the Judiciary Committee.

That said, we do need to pay close attention to this. The top five firms, Apple, Microsoft, Amazon, Alphabet, Facebook, account for 25% of US market cap, by far the highest level since the late 1980s and around double the market cap of the top five firms even in the 2000 bubble. So this is a very concentrated market, substantial outperformance of a lot of these mega-cap names versus the rest of the market.

And they’ve also been driving, they’ve been the primary driver for margin expansion, at least in terms of the overall tech sector. If you look at operating margins for the S&P 500 just for consumer discretionary staples, healthcare, and industrials, those numbers have actually drifted down. So the margin story is really all about information technology and communications services. The markets are expecting the pace of earnings for the big four to continue at roughly the same pace that they’ve been growing over the last decade, and that’s when we have to start asking questions. ‘Cause when you look at acquisitions in new sectors versus core businesses for Facebook, Amazon, Apple, and Google, the ratio is roughly either two to one or three to one in terms of new sector acquisitions versus original core business. So any material change to antitrust legislation or de facto policies could have a big impact on the valuation of these companies going forward. So we’ve got a few charts, got a couple of charts in this Eye on the Market, a lot more that we’ll be discussing about all of this in the Eye on the Market after Labor Day. But I did just want to mention that, bring that to everybody’s attention.

The primary purpose of this week’s note is really just to discuss the Delta variant. I’m seeing some modeling that suggests that whatever happens, this Delta wave will be over in the US by the middle to the end of October. So hopefully that’s correct, but we’ll have to see. So thanks very much for listening, and enjoy the rest of your summer, bye.

FEMALE VOICE: Michael Cembalest’s Eye on the Market offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of J.P. Morgan Asset and Wealth Management. Michael Cembalest is the chairman of Market and Investment Strategy for J.P. Morgan Asset Management and is one of our most renowned and provocative speakers. For more information, please subscribe to the Eye on the Market by contacting your JPMorgan representative. If you’d like to hear more, please explore episodes on iTunes or on our website. This podcast is intended for informational purposes only and is a communication on behalf of J.P. Morgan Institutional Investments Incorporated. Views may not be suitable for all investors and are not intended as personal investment advice or a solicitation or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research. Please read other important information, which can be found at www.JPMorgan.com/disclaimer-EOTM.

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Red Med Redemption

Red Med Redemption: Politics, vaccination resistance and the Delta variant; US economic recovery update; big tech reliance on acquisitions to fuel growth; Investor Odds & Ends (NYC hotels, personal/corp/int’l taxes)

Reliance of the big 4 tech/social media stocks on acquisitions to fuel growth

Investor Odds & Ends: S&P earnings, NYC hotels, and the latest on personal, corporate and int’l taxation

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Red Med Redemption: Politics, vaccination resistance and the Delta variant; US economic recovery update; big tech reliance on acquisitions to fuel growth; Investor Odds & Ends (NYC hotels, personal/corp/int’l taxes)

Reliance of the big 4 tech/social media stocks on acquisitions to fuel growth

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