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Market InSights:

Rudolph with Your Nose So Bright

Investing 2021

If you don’t recall the most famous reindeer of all, Rudolph, the Montgomery Ward creation possesses the special characteristic to guide Santa’s sleigh among a fog that would have otherwise canceled Christmas. Like Rudolph’s nose, I’m going to highlight a couple of macroeconomics bright spots that we like right now, that will surely support markets and guide us through the fog of 2021. Enjoy the holiday season and may you have a prosperous new year. 

Unemployment – I think it’s fair to say that the spike in unemployment (fastest spike ever) and the subsequent drop in unemployment (fastest drop ever) have given politicians the hyperbole they need, but the rate getting back to 6.7% means a couple of good things going forward. Firstly, the “easy to lose” and “easy to return” jobs were flushed out in the spike, and the jobs that could easily return have. This means that while each percentage point from here on out is going to be harder and harder, the headline risk of massive jobless swings has likely settled for now. Unemployment in the +6’s has been the recent peaks for prior negative economic swings. In 2003, we peaked at 6.3%, 1992 7.7% even the economic crisis in 2009 only saw a peak of 9.9%. So at least the unemployment figures have gotten back to “normal bad” and not “historically bad”. But here is the good news for 2021, from this point forward we will get positive headlines for employment. I think we have crested, the liquidity in the markets has helped, and near term the unemployment outlook is stable. This pandemic is different than a cyclical recession, this can be resolved as quickly as the damage was done, and for between 4-8 quarters we can see a routine and constructive print for joblessness. This will be a supportive series of headlines for markets. 

Inflation – Inflation will be a headwind for bonds and cash but will be constructive for some assets. Those invested in equities will see an increase in capital chasing the same number of assets. This inflation will be constructive for stocks and other hard assets from 2021 but will cut into the expectations for the buying power of dollars going forward. Expect long term dollar weakness. Additionally, we’re not alone, this pandemic is global and I anticipate every central bank to prefer adding liquidity to their economies over the risk of inflation. Expect countries that emerge from the pandemic quickly to see a major tailwind from global inflation, those whose course is slower and shutdowns longer to be hampered by it.  

Debt – Record low borrowing costs should tee up leveraged companies for success. This is absolutely a situation where “zombie” companies will be created, so investors should be aware of the health of companies they are buying, but long term, allowing companies that have been historically highly leveraged to restructure at amazing rates, or even granting companies that have healthy balance sheets more cheap capital to take on more cap-ex projects for the at least a decade or more will be supportive for the market on the whole. As I write this, the 2-10 spread is .8%, in my opinion giving corporate CFO’s carte blanche to begin issuing new debt and extending all maturities on existing debt. Seeing these companies become so tenacious in the debt market normally would spook investors, but it’s hard to imagine a more supportive environment for borrowers than sub-2% borrowing costs for AAA companies and sub-4% for high yield borrowers. Debt was low for the recovery after 2009 and is now bargain-basement prices. These are rates that are likely to persist through 2021 and with Janet Yellen (Dovish) at the treasury, and no change in the attitude of the Fed I’m not seeing a change in sight. This will likely mean yields will be below inflation for some time as central banks try to juice the recovery at the expense of inflation. 

Earnings – Companies have broadly been able to understate their earnings projections through the pandemic. The science of slow-rolling their debts, and lowering the expectations of analysts has been fantastic. Companies across sectors have been able to step over the lowered bar without major disruption this year. Now while, for the most part, the pandemic has given them top cover to have earnings below their historic figures, the companies in the S&P 500 have done a fantastic job this year of collectively using this window to reset the expectations of investors without sounding alarms. Managing expectations lower, then beating them has been a theme in 2020, that in 2021 will look like a great trajectory for earnings as we emerge from COVID-19. This is going to be a fantastic and virtuous atmosphere of rising earnings. The usual suspects for this earning improvement cycle will show up, banks, technology, and consumer discretionary investors will like this reset in the cycle and the aforementioned upswing in earnings these groups are poised for.

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Kevin Taylor

Euro-Trap: The Trap of Low Valuations Amid Declining Fundamentals

In recent months, investors seeking diversification have been drawn to European equities, attracted by their seemingly inexpensive valuations, low price-to-earnings (P/E) and price-to-book (P/B) ratios compared to the overheated valuations of U.S. markets.  On the surface, these metrics offer a compelling narrative: European stocks are significantly cheaper than their U.S. counterparts, promising potential for higher returns as markets normalize. Yet, these valuations are not necessarily indicative of opportunity but rather a reflection of deeper, systemic issues plaguing the region’s economy. Europe’s industrial heart, once a powerhouse of global manufacturing and innovation, now struggles under the weight of low GDP growth, rising unemployment, and declining corporate earnings. Economic expansion in the eurozone has slowed to a crawl, with Vanguard’s projections for 2025 GDP growth at a mere 0.5%, underscoring the region’s persistent inability to rebound from the energy crisis and other structural inefficiencies. Rising unemployment—forecasted to hit 6.9%—exacerbates these woes, signaling broader challenges in labor market adaptability and productivity. These economic struggles are compounded by structural risks, including the looming specter of tariffs that threaten to undermine Europe’s export-driven economy. Trade tensions with the United States have escalated, and any new tariff measures on key sectors like automotive manufacturing could deliver a significant blow to economic activity in major industrial hubs such as Germany and France. Additionally, declining earnings across sectors signal that the region’s companies are struggling to navigate an environment marked by persistent inflationary pressures, weakening external demand, and high levels of debt. For many firms, the low valuations investors find appealing are symptomatic of these fundamental weaknesses rather than hidden potential. Taken together, these factors suggest that European equities may be a trap for unwary investors, lured by attractive metrics but unaware of the precarious foundation underpinning the region’s markets. Understanding these dynamics is essential for making informed investment decisions in a landscape fraught with risks. The Economic Landscape: Subdued Growth and Rising Unemployment The euro area’s economic outlook is fraught with difficulties. Vanguard’s recent economic report projects GDP growth of a mere 0.5% year-over-year for 2025, far below the region’s long-term trend. This sluggish growth stems from persistent weaknesses in the manufacturing sector, ongoing repercussions from the energy crisis, and weakening external demand. Germany, often considered the industrial engine of Europe, exemplifies these struggles. Industrial production has been declining steadily, as supply chain disruptions and softening global demand weigh heavily on output. Meanwhile, the broader region’s unemployment rate is forecasted to rise to 6.9% by year-end 2025, driven by slowing economic activity and structural inefficiencies. This figure reflects not just cyclical challenges but also deeper issues, such as a failure to implement productivity-enhancing reforms and adapt to technological advancements. Inflation Erodes Earnings and Competitiveness While headline inflation in the euro area has declined from its October 2022 peak of 10.6%, core inflation remains sticky. Both headline and core inflation are projected to fall below 2% only by the end of 2025. However, inflationary pressures have already eroded corporate earnings across the region, particularly in energy-intensive industries and consumer sectors. Companies have struggled to pass on rising costs to consumers, leading to margin compression and weakening bottom-line performance. Adding to the economic malaise is the looming threat of a dovish monetary policy pivot by the European Central Bank (ECB). While the ECB is expected to reduce its policy rate to 1.75% by the end of 2025, this move could signal a lack of confidence in the region’s recovery prospects, further unsettling markets. Valuation Metrics: A Double-Edged Sword European equities are undeniably cheaper than their U.S. counterparts, with the Stoxx Europe 600 Index trading at a 47% discount on a P/E basis and a 61% discount on a P/B basis. However, these metrics may not indicate value but rather reflect the market’s justified concerns about the region’s future earnings potential. Historical data shows that low valuations often coincide with declining revenues and profits. For instance, European companies with net debt exceeding 50% of market capitalization have consistently underperformed, and many sectors—including telecommunications and traditional manufacturing—are burdened by structural inefficiencies and high leverage. Currency Risk: The Hidden Drag on Returns For American investors, currency risk adds another layer of complexity to investing in European equities. The euro has been weakening against the U.S. dollar due to divergent economic growth trajectories and monetary policy stances between the two regions. While the Federal Reserve has maintained a relatively hawkish stance, the European Central Bank’s dovish pivot has placed downward pressure on the euro. This currency depreciation means that even if European equities deliver modest gains in local currency terms, those returns can be significantly eroded when converted back to dollars. For instance, a 5% gain in euro-denominated equities could be entirely offset by a 5% decline in the euro-to-dollar exchange rate, leaving U.S.-based investors with flat or negative returns. Moreover, a weaker euro increases the cost of importing goods and services, exacerbating inflationary pressures within the eurozone and further weighing on corporate margins. This creates a feedback loop that dampens both the economic outlook and investment returns, particularly for foreign investors who must navigate these currency fluctuations. The Impact of Tariffs and Trade Tensions Compounding Europe’s woes is the specter of new tariffs, which threaten to disproportionately impact the region. Trade tensions between the U.S. and Europe have escalated, with potential tariffs on European automotive exports and other industrial goods looming large. These measures could further dampen Europe’s export-driven economy, exacerbating the challenges faced by key sectors. The automotive industry, which accounts for a significant portion of Europe’s GDP and employment, is particularly vulnerable. With major automakers reliant on exports to the U.S. and other global markets, tariffs could trigger job losses and deepen the economic slowdown in manufacturing hubs like Germany and France. The Spillover Effect of U.S. Market Corrections Investors hoping to escape the turbulence of U.S. markets by pivoting to Europe may find little refuge. Historically, major drawdowns in U.S. equities have dragged European markets down with them. American investors, who now own an estimated 30% of European

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What to know about investments in office space

Investing in office buildings can be a lucrative opportunity for investors, but it also comes with its share of drawbacks and risks. Let’s take a closer look at some of the benefits and drawbacks of investing in office buildings. Benefits: Steady income stream: Office buildings can provide a steady income stream through rent payments from tenants. These payments can be a reliable source of income for investors. The creditworthiness of the tenants can be easier to determine and there is more resource for making sure they pay owed rent. Potential for appreciation: As the value of the property increases over time, investors can realize gains through appreciation. Office buildings have always been a part of the landscape, recently Covid-19 has thrown a wrench in the demand for office buildings, but the long-term expectation is that more, maybe different looking, office space will always have an interested buyer. Tax benefits: Investors can deduct expenses such as property taxes, mortgage interest, and depreciation from their taxable income. Control: Investors have a greater degree of control over their investments, including selecting tenants, setting rental rates, and making improvements to the property. Drawbacks: Market fluctuations: The demand for office space can fluctuate with economic conditions, which can affect the rental rates and occupancy levels of the property. Tenant turnover: Tenant turnover can lead to vacancies and decreased rental income. Capital expenditures: Office buildings require maintenance and occasional renovations, which can be costly and impact cash flow. Location: The location of the office building can significantly impact its value and potential for rental income. The most exciting benefit of investing in office buildings is the potential for a steady income stream and appreciation over time. However, the cap rate, or the ratio of net operating income to property value, should be carefully evaluated to ensure a good return on investment. Generally, a higher cap rate indicates a better return on investment, but this can vary depending on the location and condition of the property. There is a moderate level of risk involved in investing in office buildings. Economic conditions can impact the demand for office space and tenant turnover can lead to vacancies. However, careful due diligence and evaluation of market conditions can help mitigate these risks. An investment in office buildings can offer a reliable income stream and potential for appreciation, but it also comes with risks and drawbacks. Careful evaluation of the property and market conditions can help investors make informed decisions and maximize their returns.

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Peter Locke

How do the rich pay less in taxes than you?

A large number, if not the majority of our clients at InSight come to us looking for ways to mitigate their tax liability. While a CPA will find backward-looking ways to lower your tax liability, our clients are working to build a tax ecosystem that mitigates current and future instances of tax risk. Although their salary and bonuses are high, their take-home pay is a mere fraction of that. Now, I am no Allen Weisselberg, but I have found many ways after a decade in the industry to help clients pay far less in taxes than they do today. This article will provide several solutions that you’ll need to investigate further and talk with your tax professional more if you’re trying to implement them. Cash Balance Plans Are you a business owner or high-income earner at a small business? Implementing a cash balance plan in conjunction with a 401(k) profit-sharing plan can help high-income earners defer more than $400,000. Now many may say deferring just means I have to pay it later which is correct, however, later also means you get tax-deferred growth and that same person will also most likely be in a much lower tax bracket once they’re retired and not taking a salary. Life Insurance Come on, really? Absolutely! Do you ever wonder how the rich stay rich? They own permanent life insurance that enables them to borrow against their own money while simultaneously getting tax-free income. Additionally, providing a death benefit for your heirs means helping pay estate taxes with a lump sum death benefit for those lucky enough to have a very high net worth and want their legacy to live on for generations. Additionally, some banks enable you to use life insurance as collateral for loans which is a win-win especially if you have a non-direct dividend policy. Mega Backdoor Roth IRA Ever wondered how to get more money into your Roth 401(k)? Wouldn’t it be nice to add up to $64,500 into your Roth 401(k) each year? The answer is a resounding YES. At InSight, we help business owners change their 401(k) plans to enable after-tax contributions and in-plan rollovers so that you can store away an incredible amount of money today and get TAX-FREE money back in retirement. This strategy combined with a Cash Balance Plan is the one-two punch you’re looking for. Opportunity Zone Funds Use your capital gain proceeds from a recent sale and invest it into opportunity zone funds, real estate or businesses. The benefit now is the ability to defer your current tax liability until 2026 while also receiving tax-free growth on your investment after holding it for 10 years. This is a program that allows them to mitigate the past liability and avoid some of the taxes they will owe as the new asset grows in value. Private Placement Life Insurance An incredible way to fund a life insurance product that gives you tax-free growth and access to the cash value. The reason the rich like using this form of tax-free growth is it gives them the freedom and flexibility to fund other real estate ventures, grow their brokerage, or find other investments. This is only available for ultra-high net worth individuals. Debt It’s no surprise that those that have an appetite for risk and the ability to take it, accrue large amounts of debt instead of selling appreciated assets to grow their net worth. Most people want to pay off their debt as quickly as possible and this usually makes sense for those with high-interest erosive debt. However, if you accumulate accretive debt at extremely low-interest rates then your probability of success in terms of appreciation in net worth is high. For example, if you can borrow money against a business, bank, home, friend, etc at 2%-6% and reinvest that into something that averages 8%-12% then you have a positive delta in your return and you didn’t have to sell anything (i.e pay taxes on gains) to grow your net worth. These are just a few of the popular strategies we’ve implemented for clients in the past but they’re not appropriate for everyone. Make sure you speak with your CFP® and tax professional before implementing any of these strategies as they’re complex and if done incorrectly can be extremely detrimental.

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