2021 Annual Letter – The Year Ahead (and Beyond)

Executive Summary

  • There is a cost to the monetary and fiscal stimulus that has propped up asset prices;
  • Market imbalances will result in government intervention through regulation and rising taxes;
  • Investment opportunities exist, but a more active approach is recommended.

2021 – The Year Ahead (and Beyond)

In the spring of 1907, the panic on Wall Street first appeared as market volatility increased. Economies of the world were more closely tied to one another than ever before and fear of a global financial contagion was realized. The resulting panic erased nearly 50% of the U.S. stock market’s value and led to intervention by key financial figures, new legislation, and eventually monetary management via a central bank.

The years following the Panic of 1907 included America reluctantly at war and a novel influenza pandemic. Even though the economy was strong, a technological revolution exacerbated the existing income divide even as it improved the lifestyles of many. The war, economy, large-scale unemployment, riots and a desire to make America less interventionist influenced the Presidential campaign with a call for a “return to normalcy.” As 1921 began, America looked forward to a new year.

George Santayana wrote, “Those who do not remember the past are condemned to repeat it.” The similarities of the Panic of 1907 to the Financial Crisis of 2008 are striking. Both were caused by the failure of a bank that led to the evaporation of liquidity and debt unwinding. It was the strong financial leadership by John Pierpont Morgan in 1907 and Hank Paulson in 2008 that arrested the economic fall. Both experiences led to more monetary tools for economic intervention.

The Flu of 1918 and COVID-19 are, of course, coincidences. Both are the result of continuous mutations that eventually produce something awful. These two pandemics occurred nearly 100 years apart (like the cheating scandals that tainted our national pastime – the Chicago Black Sox and the Astros’ Banging Trash Can). While it is a stretch to compare WWI with today’s Middle East and Afghanistan, the resulting desire by many for America to turn its gaze homeward and away from the world is a familiar sentiment.

Today we find ourselves amid a technological revolution. One hundred years ago, the automobile, electricity and the assembly line were changing and, for the most part, improving the lives of everyone. These technological leaps hurt some industries and forced many workers to change occupations, but the efficiency and lifestyle improvements they brought were incredible. Today, we find ourselves in a similar state of technological evolution. Cloud computing, social networking, video conferencing and AI are disrupting the way many people and businesses conduct themselves. And while they are improving efficiency and creating new opportunities, they are also adding to social anxiety. This anxiousness is showing up everywhere, from the boardroom to our family dinner tables.

Sitting at our desks we cannot help but wonder if these similarities continue. Does the next decade look like the roaring 1920’s? Does President Biden imitate President Harding, who stated:

“America’s present need is not heroics, but healing; not nostrums, but normalcy; not revolution, but restoration; not agitation, but adjustment; not surgery, but serenity; not the dramatic, but the dispassionate; not experiment, but equipoise; not submergence in internationality, but sustainment in triumphant nationality.”

More specifically though, does the economy of this decade develop the same time bomb as the economy of the 1920’s? What are the differences that hopefully result in something less depressing?

There are plenty of differences. The biggest is the standing of the United States on the world stage. Following WWI, our nation was just becoming a world power. Whereas today, the U.S. is a superpower, and our dollar has replaced gold as the world’s reserve currency.

A more nuanced difference is the possibility that today’s technological revolution permanently reduces the labor input required for economic activity. Whether it is the rapid adoption of videoconferencing as a substitute for business travel; contactless order and pay features replacing the need for checkout clerks; autonomous driving displacing taxi, truck and ride-sharing drivers; or Artificial Intelligence executing tasks from administrative to reading x-rays, the common thread is less future demand for human labor. This has severely affected the service sector. The big question now is where do these displaced employees land? It is easy to see how the saddleries of the 1900’s could evolve into the filling station of today and factory workers displaced by manufacturing improvements became the truck drivers delivering the mass-produced goods. Yet it is not as easy to see what will happen to the warehouse worker displaced by a robot, the kid at McDonald’s replaced by a mobile device, and the administrative assistant replaced by Siri.

These unemployed or underemployed exacerbate the social unrest that already exists. How much longer can technology companies improve profits by leveraging a low wage workforce? Think about it, Uber is worth $110 billion, and its main means of profit is making sure it doesn’t have employees but rather low-cost contract labor. How America and other world governments will respond to this is not known. However, the populist ideas catching fire across the world provides us with a hint. Governments will try to break up many of these new efficient companies or create policies and regulation that decrease efficiency (i.e. Uber drivers will be employees and subject to a new minimum wage).

Finally, the stimulus that governments have thrown at their economies has been primarily captured by the investor class, and the economic divide between the have and have-nots has continued to widen. What is the most probable government solution to this? Just look back to 1932, when the highest marginal income tax rate jumped from 25% to 63% (on its way to 94% in 1944). It is going to be hard to avoid the redistribution of income and wealth via the tax code.

Another difference and likely justification for increasing tax rates is the total U.S. debt-to-GDP ratio. In 1929, the U.S. Government’s debt to GDP stood at 16%. As of June 30, 2020, the U.S. debt-to-GDP ratio stood at 136%. Old debt is like an anchor when it comes to growth. You must spend money on interest and paying off the old debt before investing in the future. Thus, the US and most developed economies all have a heavy yoke to bear.

What is our prediction for the future? A relatively strong U.S. economy supported by its reserve currency should provide a better path than that of the 1920’s. However, combine increasing regulation and rising tax rates with the potential for inflation caused by a permanent expansion of the money supply, and valuations must come down. So, while we are looking forward to seeing our friends and families, we must unfortunately face the result of a decade of monetary and fiscal stimulus. There is no way around it. When a system becomes unbalanced, something must change to set things right again.

The forced rebalancing will cause a continued increase in the variability of asset prices. This increasing volatility will provide sharp investors with ample opportunity for excess returns. Thus, we believe that shifting a portion of passive market exposure (indexing) to more active, opportunistic investing (public or private) is justified. For those who have known us a long time, what we are saying is contrary to what we have said in the past. But the situation has changed, and a rising tide is about to start receding.

It is very difficult, if not impossible, to time the market. Thus, our belief of keeping risk capital invested remains unchanged; underinvestment is itself a risk. The key is to navigate the upcoming volatility with a more diverse portfolio of uncorrelated investments and stable assets that can withstand the upcoming political and inflationary risks. All of us at Autumn Lane will continue to look for these opportunities.

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