Legislative Update
We do not typically comment on local legislative initiatives, but two have materialized recently that are worth presenting.
Washington State Long-Term Capital Gains Tax
Senate Bill 5096 was passed on April 25th and was signed into law on May 4th. The bill imposes a 7% tax on long-term capital gains in excess of $250,000 per couple filing jointly and per individual. In other words, realized long-term capital gains exceeding this amount are to be taxed at 7% beginning in 2022. Our general understanding is that legal action has been initiated, in opposition to the new tax, arguing that the Constitution of the State of Washington specifically prohibits income tax and that this is a tax on income, as generally understood by most states and the federal government.
To help avoid confusion, let us identify which accounts are subject to the tax and distinguish between realized and unrealized capital gains. First, capital gains tax does not apply to retirement plan accounts, which grow in a tax-deferred manner and are taxed as income upon distribution (except for Roth IRA accounts, which generally distribute tax-free). This tax does apply to non-retirement plan accounts such as individual investment accounts, joint investment accounts and trust accounts. Long-term realized capital gain results from selling an investment which has been held for longer than one year for more than its purchase price. During the period of ownership, investments are worth either more or less than their purchase price; this fluctuates daily. This is called “unrealized” gain or loss. Unrealized gains or losses become realized when the investment is sold, not before. Therefore, this new tax will only apply if one or more long-term investments are sold, in aggregate, during a tax year for at least $250,000 more than the purchase price of those investments.
Our understanding is that this new tax does not apply to residential real estate. Still, please consult your tax professional for additional details. We recommend asking about the applicability of this tax to capital gains resulting from the sale of other assets, such as businesses, buildings, or other financial assets outside the purview of PIM, as applicable to you. Should your situation be such that PIM should be involved with your tax professional for some degree of strategic investment planning, please let us know.
Long-Term Care Tax and Benefits
Washington State passed a payroll tax on all W-2 compensation, including salary, bonuses, stock, etc., of 0.58%, effective January 1st, 2022. And by “all W-2 compensation”, we mean that there is no cap, or limit. All compensation is taxed. Translating the tax to dollars, workers will pay $580 in tax for every $100,000 of W-2 income. In exchange, once vested, total lifetime long term care benefits are $36,500 per person, indexed for inflation, paid at a maximum rate of $100.00 per day. If you already have a long-term care policy, you may be able to opt out of this tax by submitting an attestation to the State; the deadline for acquiring a personal policy is November 1st, 2021. Self-employed individuals and some others may be able to opt out. There are a great many more details that go beyond the scope of this general announcement. For more information, please see: http://www.wacaresfund.wa.gov/.
Market Commentary
The Jobs Market and Inflation
Much like the weather in the Puget Sound during spring, the economic data points released in May were wildly inconsistent. Labor market and inflation data both missed analysts’ forecasts by huge margins, but in opposite directions. Inflation data was consistent with a booming economy, while labor market data suggests an economy struggling to find its footing. The pandemic is easing, but the protracted effects remain very much present.
The labor market seems to be operating in a world of its own. Analysts expected 1.2 million new hires in April, but only 265 thousand were added. Weekly jobless claims have been declining rapidly in May but remain roughly twice as high as what is considered normal. At the same time, job openings are at a 21-year high and growing on a weekly basis. Due to enhanced Federal unemployment benefits and lingering COVID related issues (especially childcare) the labor market appears to be several months away from establishing a pathway to normalcy.
The inflation report in May generated a great deal of interest and consternation in the markets. The consumer price index (CPI) notched its highest reading since September of 2008, at 4.2%. Core CPI, which removes energy and food prices, hit a 25-year high at 3%. Here too we find the fingerprints of COVID related distortions. Driving most of the gain in inflation measures were higher used car, lodging and airfare prices. Even with 10% increases, the latter two remain 20% below their pre-COVID price level. The jump in used car prices is largely attributed to a lack of new car supply, thanks to computer chip shortages, and greater financing options in the used car market for those consumers with low credit scores.
We explained in our March newsletter why we believed that inflation would be transitory, spiking over the summer and normalizing into the fall. Although recent data has been surprisingly high, the nature of the data does not change that viewpoint. Inflation is a challenging thing to measure, one that gets sliced and diced depending on time frames and motives. The Federal Reserve is focused on core prices, which exclude volatile energy, food and home prices (rents are included). This always raises an eyebrow during client conversations, as we have never met a person who doesn’t at least heat their home and buy food. Yet this is the convention set by policy makers.
The inflation datapoints released in May were high enough that many investors hit the alarm button. When we look at the forest instead of the trees, the inflation picture looks much more muted. April of 2020, the reference point for the data, was smack in the middle of the worst part of the economic shutdown. At that point inflation was -0.8% compared to the prior year. From April 2019 to April 2021, both core and headline inflation were 2.2%. Through all the influences of the past 14 months, the health crisis, the lockdowns, the policy responses, the vaccines, the re-openings, the shortages, core inflation is roughly unchanged from its rate prior to the crisis.
Supply and Demand
Capital markets are concerned with where inflation is headed. Monthly inflation figures will likely accelerate as we move further into the recovery. Increasing inflation rates is an aspect of any economic transition out of a recession, based not on lasting inflationary pressures, but on short-term supply constraints. Firms always face a challenge deciding how many goods consumers will demand as a recession ends. If they overestimate demand, inventory will sit on store shelves gathering dust, potentially cause cashflow disruptions, and other inconveniences. If firms plan for too little demand, they miss potential sales. To put this into perspective, retail sales have changed by -3%, +10% and 0% in previous three months. In the ten years prior to COVID, there were zero periods when the figure changed by more than 2.2% or less than -2% in one month.
This process of calibrating supply to demand after a recession typically takes a year but is even more complicated today as much of the rest of the world is still dealing with the spread of COVID and slow vaccine distribution. Even early COVID success stories such as Taiwan and South Korea are currently dealing with lockdowns, disrupting the production of the world’s leading semiconductor producers. This has many second-order effects, limiting the availability of items ranging from new cars to refrigerators. These shortages and resulting inflation will ease over time, though it is reasonable to assume that the process will be volatile.
Wages
Wage growth is an area that does lead to sustained higher inflation. The jobs report from last month suggests that many prospective job candidates are waiting for some combination of higher wages, a clearer public health picture and additional childcare options. Several large employers have made headlines by announcing higher salaries to fill job vacancies. Unfortunately, the data does not support the argument that higher wages are widespread. Wage growth, according to the Atlanta Federal Reserve, is lower today than it was just prior the pandemic. With 23 states ending Federal enhanced unemployment insurance (1/3 of the working population in the US) over the next two months, and all states in September, it appears wage growth will remain muted as employees are forced back to work by the expiration of pandemic related social programs.
Commodities
Another argument for higher inflation that is beginning to unravel is commodity prices. Even the much-reported lumber shortage is easing as prices have fallen 20% since mid-May, as measured by futures contracts. Iron ore, the input for manufacturing steel, is also down 20% from recent highs. Agricultural commodities (corn, wheat and soy) are down 10% over the same time frame. Commodity prices remain elevated, but it appears they have lost momentum for the time being.
Federal Reserve
Inflationary concerns are overblown, based upon current data. But the strong economic growth we are experiencing will eventually cause the Federal Reserve to decrease or “taper” its Quantitative Easing (QE) program, which involves the monthly purchase of $120 billion of Treasuries and mortgage-backed securities. Quantitative Easing is effective in supporting the economy in times of significant stress. If the economy is strong enough to generate high rates of growth, which seems to be the case, then there is little need for the Fed to take extraordinary measures such as QE. This is a reasonable argument and has significant market implications.
When the Fed slows the QE program the most speculative assets in the market will feel the impact first. These are the type of assets that have benefited the most from the Fed’s easy money policies over the past 14 months. Several Federal Reserve officials have made public comments in recent weeks preparing the market for an end to QE. The exact timing is subject to much speculation; estimates range from this fall to next spring. Historically, ending QE programs has created a challenging period for capital markets. The Fed will move very slowly and “taper” the QE program on a set schedule to increase transparency and reduce market anxiety. In preparation, some investors have begun heading for the exits in vulnerable areas of the market. Examples of this type of speculative investment range from solar stocks (down 37% for their January peak) to unprofitable tech stocks (down 30% from their February peak) and most obviously Bitcoin (down 30% from its April peak, at time of writing).
We anticipate that domestic economic data in the coming months will be supportive of both sides of the inflation and QE debate, resulting in continued market volatility. The uneven nature of vaccination programs across the world implies eventual foreign equity market growth, though the timing is uncertain. Vaccine distribution must improve dramatically, hopefully resulting in a reversal of recent new case trends and eventually leading to the reopening of emerging market economies.
Summary
Inflation is real, normal coming out of a recession, and driven by supply constraints which we believe will be relatively short-lived. Investment markets have reacted too strongly in our view. Wage inflation is a legitimate cause of sustained general inflation, but the case for this is not strong at present. Commodity prices spiked but fell back and appear to be on the way to normalizing. Economic growth may lead to the Federal Reserve tapering its bond-buying program. Market reaction to this may be negative. All of this is transitory. Forecasting is particularly difficult due to the contrary nature of certain economic data points. For the moment, our position is to remain patient.