InSight

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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Let Bitcoin Fail

Let Bitcoin Fail Before it becomes, too big to fail also. The Federal Reserve and Treasury need to establish a better policy regarding their role and behavior when Bitcoin fails. Continued ‘bailout’ for speculative players in the market has a critical and damning effect on the rest of us. Taxpayers have already lived through the negative economic and social impacts of watching banks and speculators who took on unjustified risks get reimbursed for their recklessness once this century. Watching banks stash and store cryptocurrencies under the same speculative bubble is foreboding. The U.S. simply cannot afford to bail out speculators who have driven the market of Bitcoin past $1T with no concern for uninsured assets. It is already bad enough that U.S. financial regulators have proven to be ill-equipped to enforce current AML and BSA policies in the wake of crypto adoptions. Financial institutions’ exposure to the crypto-asset industry is affecting their bank’s anti-money laundering compliance and oversight and several years’ worth of infractions are piling up at some of the nation’s biggest banks. Additionally, several of the ‘online’ banks that are continuing to offer crypto-trading as part of their expanded services are doing so without the proper due diligence and vetting of their counterparties. Market regulators aren’t watching closely to see how financial institutions’ exposure to the crypto-asset industry is affecting their banks’ anti-money laundering and compliance. As the broader public becomes more interested in crypto assets, some bank customers are seeking ways to fund crypto trading. In this environment, banks need to assess how these activities are isolated from their current operations and be prepared to mitigate illicit finance risks emanating from these new assets. Additionally, the Fed and FDIC allowing high-risk speculative assets to be connected to U.S. currency is as irresponsible as the housing crisis demonstrated; and these Federal authorities need to make more clear that they will let this speculation fail or rise under its own power and that using taxpayers institutions to protect this asset is not in our best interest and a lesson in moral hazard that should eventually be learned. Suspend FDIC insurance for all banks that continue to mask their crypto-speculation with support and protection of the Fed and the FDIC Now.  Contagion is Spreading As major U.S. Banks are getting swept up into the asset bubble they are taking our oversight and insurance institutions with them. In February the U.S. Office of the Comptroller of the Currency (OCC) issued a cease and desist order to New York-based Safra Bank. In the order, the OCC cited that “the bank gave accounts to money service businesses (MSBs) that facilitated crypto-asset trading” but that the bank did not “address the increased Bank Secrecy Act and Anti-Money Laundering (BSA/AML) risks associated with these accounts.” While the OCC has caught this bank, the ecosystem of back offering these ‘crypto trading accounts’ is outpacing the oversight of the banks and regulators. Simply put – the market is growing beyond our ability to control, and U.S. banks supported by the Federal Reserve are connected to this exposure.   In the Safra Bank case, the bank allegedly did not have sufficient transaction monitoring systems in place in the onboarding process to confirm these new “digital asset customers” were legitimate and this caused its volume of domestic and international wires and ACH transfers to spike.  Unfortunately, the OCC has yet to specify the crypto-asset-focused companies involved with Safra’s breach of the KYC ecosystem.  Though the San Francisco Open Exchange (SFOX), has allowed SFOX traders to maintain FDIC-insured cash accounts at the bank. This is general incompetence and complacency that is allowing the crypto asset bubble to contaminate the federally insured accounts at other banks. Liquidity is Drying Up The world’s largest cryptocurrency, bitcoin sits just below $60,000 today, as the total market cap of BTC is above $1.1 trillion. Despite the recent price jump, there is a major concern BTC holders and even non-speculators should be aware of. That is the liquidity of Bitcoin. JP Morgan’s strategist Nikolaos Panigirtzoglou writes “the market liquidity in Bitcoin is significantly lower than S&P 500 and gold.” Panigirtzoglou adds that “even a small change in Bitcoin flows can have a large impact on the price of BTC.” The liquidity issue is driving up the speculative costs of bitcoin but should be a major concern for those that purport the BTC is some kind of store of capital. Low liquidity will have a negative impact on the rash of new Bitcoin lending schemes that are proliferating in the market. Several new companies are offering interest on bitcoin deposits made possible by lending out those coins to speculative investors. As the underlying price of bitcoin rises out of control the borrowers become less and less likely to return the borrowed coin (almost an impossible default rate to handicap). These defaults, coupled with the lack of liquidity, will make it almost impossible for borrowers to cover. If this ‘bank run’ scenario were to play out in cash the Fed can step in to increase liquidity and control interest rates, and the FDIC can insure the lenders against defaults and make them whole. There is no such protection for Bitcoin lenders.   Low Reputation Counter Parties The crypto market has still yet to solve its illegal and illicit underbelly. While widespread adoption is making for more legitimate transactions, it is similarly eroding the capacity of regulators and compliance officers to confirm they are not transacting with corrupting counterparties. While making the ecosystem ‘bigger’ lowers the percentage of bad actors, it also increases their space to hide among legitimate actors. Criminals who keep their funds in cryptocurrency tend to launder funds through a small cluster of online services that exist outside of regulator authority. Essentially saying, banks and speculators are doing business with criminals (if done in dollars is criminal also) but because it’s done in crypto it is willfully existing outside the law. Services like high-risk (low-reputation) crypto-exchange portals, online gambling platforms, cryptocurrency mixing services, and financial services

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What is Tax Loss Harvesting?

Tax loss harvesting works by taking advantage of the tax code’s treatment of investment gains and losses. Here’s how it works: 1. Identify Investments with Losses: To start, investors review their investment portfolio to identify assets that have decreased in value since they were purchased. These are the investments that are candidates for tax loss harvesting. 2. Sell Loss-Making Investments: Once the loss-making investments are identified, investors sell them. This action triggers a capital loss, which can be used to offset capital gains generated from the sale of other investments. 3. Offset Capital Gains: The capital losses realized from the sale of these assets can be used to offset capital gains from other investments. If the total losses exceed the total gains, they can be used to offset other income, such as salary or interest income. 4. Maintain Portfolio Allocation: After selling the loss-making investments, investors may choose to reinvest the proceeds in similar assets to maintain their desired portfolio allocation and investment strategy. However, there are tax rules, such as the wash-sale rule, that restrict repurchasing the same or substantially identical assets within a specific time frame. 5. Carry Forward Unused Losses: If the total capital losses exceed capital gains and other income, the remaining losses can be carried forward to offset future capital gains and income in subsequent tax years. This can provide tax benefits in the future. By strategically realizing losses and offsetting gains, tax loss harvesting can help investors reduce their current tax liability while maintaining their overall investment strategy.

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1031 Exchange Alternative
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Peter Locke

An Alternative or Back-up for the 1031 Exchange

The Delaware Statutory Trust (DST) is a trust that is structured as a pass-through entity and can hold passive Real Estate. It can function as a 1031 Exchange Alternative. All of the debt is nonrecourse and the income, net of expenses, is distributed to the investor.  What are the advantages?   1031 Exchange compatibility Passive investment with no management responsibility Estate planning tool – pass DST on to your heirs, tax deferred Who benefits from them? Investors no longer wanting to manage real estate Retiring real estate investors Backup/ alternative option for 1031 exchanges Investors looking to diversify into properties typically unavailable to them A Delaware Statutory Trust is a legal entity used to arrange for the co-ownership of property. DST’s are a great vehicle when constructing real estate offerings as co-owners are entitled to profits earned from the property, like rent, without the management responsibilities. For many it can be a 1031 Exchange Alternative. So why do people use DST’s? Let’s say you have an investment property that you’ve held for a long time and because you’ve depreciated the property for a number of years your basis is very low and the property has grown considerably simultaneously. Well you’d have a large capital gain on your hands if you sell it. You could do a 1031 exchange (1031 Exchange)  but that means getting another investment property, following a number of rules, and doing it in a short amount of time. Although very doable, looking at a more passive strategy may benefit you.  If you want your capital to be invested from your home without losing a majority of it to capital gain taxes and are accustomed to cash flow from your rentals then deferring your gains and reinvesting your capital into like-kids real estate can be done through a 1031 exchange. You may also decide to hire a third party management company to take the day-to-day responsibilities away as well which although cuts into your income, saves you from the downside of being a landlord. If you’re the one being a landlord, want to expand your investment portfolio, and want cash flow then the DST is the best of both worlds alternative where you don’t have to choose between paying taxes now or being a landlord. With the DST, you get passive income, capital grows free of capital gains tax, you avoid being a landlord, and you get diversification. Let’s walk through how you’d do this. First, you’d make use of the 1031 exchange by swapping the proceeds from your real estate sale of your investment property for interest in a DST. By doing this, you become co-owners/investors in a diversified portfolio of properties and pass the management responsibilities on to the sponsor who acts as the trustee for the DST. This satisfies your IRS responsibility of finding a “like kind” property and enabling you to defer capital gains.  DSTs provide you limited liability protection, regular (at least quarterly but often monthly) cash flow income, high-quality assets, and 1031-compatibility. Since with any trust there is a trustee (takes legal title for purposes of management) and a beneficiary (takes equitable title). DSTs are pass through entities, so as a beneficiary, this structure entitles you to a fractional share of income, appreciation, and tax benefits from the properties.  This structure is key for 1031 eligibility as the acquiring property must be “like kind” to your sold real estate and even though you don’t hold legal title, for tax purposes, you’re treated as owning that property. Since the DST is a separate legal entity, beneficiaries have limited liability and therefore any debts incurred by the DST won’t put the investors personal assets in harm’s way. It also protects personal assets from the liabilities of other owners and the DST itself.  DSTs are the only statutory trusts to be explicitly recognized by the IRS as legal entities that can facilitate a 1031 exchange.  What are the risks of DST’s? Macroeconomic risks Economic downturn can mean lower returns and income Liquidity risks Most DST’s have an investment period of 7 to 15 years Although you get cash distributions your principal is off limits during this time Management risks A bad sponsor may pick overvalued properties when compared to peers  A low yield while the investor is still collecting fees for management and organizing the investment Do your due diligence to check the sponsors history, background, and how similar deals have done in the past to see if projected return rates were met and problems due to bad management didn’t occur High vacancy rates and unforeseen costs hurt cash flow Financing Risk DSTs are managed differently but if the trustee uses high loan to value offerings there is a higher risk of foreclosure Fully amortized loans need to be paid by the end of the loan agreement so that could affect your cash distributions Eligibility The DST needs to be structured to facilitate your 1031 Exchange Alternative In conclusion, DST’s when done properly, are a great way of getting away from being a landlord or paying a large sum of capital gains taxes while simultaneously giving you the passive income, limited liability, 1031 compatibility, and high quality asset diversification. However, just because it does all these things doesn’t make it a great investment. They require proper due diligence to review the sponsors reports, loan documents, appraisals, underwriting data, etc prior to investing.

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