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Fall 2021 Investment Strategy Update

Fall 2021 Investment Strategy Update

November 02, 2021
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The equity markets were performing well during the 3rd quarter of 2021 until a dramatic stock market correction in September in which the S&P 500 declined about 4.8% and Nasdaq closed down over 5.3% for the month. While rising interest rates weighed on risk assets, a bipartisan deal in Washington to extend the debt ceiling and mostly upbeat economic data saw stocks stabilize at the start of October. Fundamental factors driving the equity markets higher in July and August were the corporate earnings outlook improving, the Federal Reserve meeting market expectations and not reducing stimulus until very late in 2021, and the economic recovery showed impressive resilience in the face of yet another COVID wave.The equity markets were performing well during the 3rd quarter of 2021 until a dramatic stock market correction in September in which the S&P 500 declined about 4.8% and Nasdaq closed down over 5.3% for the month. While rising interest rates weighed on risk assets, a bipartisan deal in Washington to extend the debt ceiling and mostly upbeat economic data saw stocks stabilize at the start of October. Fundamental factors driving the equity markets higher in July and August were the corporate earnings outlook improving, the Federal Reserve meeting market expectations and not reducing stimulus until very late in 2021, and the economic recovery showed impressive resilience in the face of yet another COVID wave.
However, despite those positives, the markets and the economy more broadly faces several sources of uncertainty as we begin the final quarter of the year with the impending budget battles in Washington in December and, until resolved, that uncertainty will remain a headwind on stocks. With the Democrat reconciliation bill now on a slow walk (it’s likely the Democrats will still have to roll the debt ceiling and spending/tax bill into one, but now it likely will not come until December at the debt ceiling deadline), and with that focus of the markets will turn towards earnings and yields, and what happens there will determine whether the S&P 500 re-tests the lows at 4,300 or moves back towards the highs above 4,500. The violent and short term swings in markets that I have alluded to in past updates, came to fruition in September of 2021.
Federal Reserve policy
The Fed has made it clear that it will begin to reduce (or taper) its quantitative easing program in November or December. However, the Fed has not revealed the details of its plan, and the details of their tapering plan (specifically how quickly it will reduce QE) could cause volatility in the markets if it differs from market expectations. Quantitative Easing or QE is when the Fed creates money out of thin air and buys mostly government backed and mortgage backed bonds in the markets with the intent to keep interest rates low. This Ponzi Scheme has worked so far for the equity markets which have floated higher on a sea of fiat paper currencies.
However, one of the consequences we are witnessing is that inflation remains elevated and at multi-decade highs, and that combined with continued supply chain disruptions due to the ongoing pandemic is starting to impact corporate margins and profitability. Consequently, if many companies warn about future profitability due to these factors at the upcoming third quarter earnings season announcements, it will negatively impact equity markets going forward. On the other hand, positives for the markets are that the Fed will likely remain historically accommodative long after tapering has begun and interest rate increases will likely be pushed into late 2022.
In addition, COVID related cases death rates are declining with improving therapeutics and the world is learning to “live with” COVID so that it does not cause major societal disruptions and corporate profitability remains strong on an absolute basis with the potential for improving economic growth. Over the near term, more stock market volatility will likely be with us as elevated earnings expectations clash with a plough horse economy struggling with the persistent impacts of the COVID-19 virus and ongoing supply chain delays and disruptions. Moreover, these events are taking place in the context of long-term, innovation-driven disruptions to many businesses that have accelerated with the pandemic.
Blockchain technology and Cryptocurrencies
Cryptocurrencies have gripped the attention of many market participants, especially with crypto in the spotlight from a rip-roaring bull market. Bitcoin’s explosive move from five cents in 2010 to a high of over $65,500 earlier this year has a magnetic impact on investment behavior. At about $57,000 per coin as of the writing of this newsletter, the token's appreciation stands as the most incredible investment story of our lifetime. Also, the runway for cryptocurrencies appears to be opening up further with U.S. Federal Reserve Chairman Jerome Powell stating that he does not intend to ban cryptocurrencies while stablecoins will require greater regulatory oversight (regulations equate to acceptance). In addition, the U.S. Securities and Exchange Commission (SEC) Chair Gary Gensler noted support for a narrow class of bitcoin ETFs that would invest in futures contracts instead of buying the cryptocurrency directly and there is newfound optimism around the launch and approval of an Exchange Traded Fund or ETF in the U.S.A.
Bank of America joined a growing list of financial institutions that will cover digital assets with the publication of a report entitled Digital Assets Primer: Only the First Inning, led by Alkesh Shah, head of global cryptocurrency and digital asset strategy. Digital assets represent an over $2 trillion market value with more than 200 million users and growing, and have the potential to transform almost every industry by improving efficiency and reducing friction and costs across transactions with hundreds of companies forming within this new ecosystem, creating a new asset class. Bitcoin is important, but the digital asset ecosystem running on new Blockchain technology is truly revolutionary! Canada's decision to approve multi-cryptocurrency ETFs or Exchange Traded Funds that holds Bitcoin and Ethereum may have added more impetus to the advance pushing the SEC's final verdict on several bitcoin ETF applications and a first response on futures-based ETFs to the 4th quarter of 2021. The consensus in the crypto market is that U.S. launched ETFs would become the most important source of demand from yield-hungry institutional and traditional market investors.
European investment manager, Nickel Digital Asset Management, published a survey saying that 62% of global institutional investors with zero exposure to crypto now are expecting to get into crypto within the year. Bitcoin is widely considered as an inflation hedge like gold as a programmed code called mining reward halving reduces the pace of bitcoin's supply expansion by 50% every four years. Analysts told CoinDesk recently that more and more investors are buying Bitcoin as an inflation hedge amid the inflation scare as cryptocurrency has moved in tandem with the U.S. inflation expectations in the past while gold has disappointed as an inflation hedge of late.
The coming Metaverse
On Facebook’s earning call, CEO Mark Zuckerberg and others mentioned the metaverse 20 different times. Roblox mentioned the metaverse 16 times on its call and Unity Technologies did so 8 times. Why are leading social media and video game companies so enamored with this term, Metaverse? It is because many expect the metaverse to emerge as the next evolution of the internet, presenting trillions of dollars of opportunities, as well as risks to today’s leading platforms and internet giants. The metaverse, a virtual space generated by the convergence of virtual worlds, augmented reality and internet services, is coming. No longer will just a physical store or online websites be the focal point of sales as there will be opportunities for the real and digital worlds to interlink, creating a new experiential dimension for businesses and consumers. By revolutionizing the way humans interact, the metaverse will redefine what businesses are and how they should operate. Some companies (like Gucci and Burberry) are watching and learning and those that do not evolve will be left behind. Accordingly, we are monitoring Blockchain and the Metaverse for new investment opportunities through professionally managed mutual funds and exchange traded funds along with the Grayscale Trusts for cryptocurrencies as noted in prior updates. 
China’s Technology, Education, Real-Estate & Cryptocurrency Crackdowns
China’s actions towards cryptocurrencies ties into broader steps the Chinese government has been taking to regulate other parts of its economy: strengthening its control over the tech, education, and real estate sectors. Given China's search for greater control across markets is likely not a systemic moment for crypto, and more akin to China's crackdowns on other sectors making up investors' portfolios. Due to these broader actions taken by regulators, investors have been turning sour on risk appetite for China, as seen by price movement in major indices like the Hang Seng and Shanghai Composite, which both peaked for the year back in early February. To curb slowdown risks, the PBOC or People’s Bank of China has increased liquidity injections into their financial system through reverse repo agreements.
Historically, greater liquidity in Chinese markets has benefitted both Bitcoin and the larger crypto market. The Chinese government strictly regulates its currency market in an effort to avoid capital flight. This has left citizens and investors more exposed to devaluation and property right infringement risks. Crypto has served as a useful tool for those looking to protect themselves from harmful political and monetary policy conditions as well as government overreach. Along this line, part of the cryptocurrency ban may be related to the Chinese government's ongoing rollout of their own Central Bank Digital Currency (CBDC), which many believe would increase their control over their citizens. However, there are many privacy, freedom, and human rights questions that emerge from CBDCs and I think China is shooting itself in the foot with their communist controls. Decentralized Finance (DeFi) may emerge as one beneficiary of the transition by serving as an alternative for Chinese crypto investors with crypto players being forced out of China.
China is suffering from the collapse of Evergrande, a gigantic real estate development company that took on too much debt that it cannot pay back, and the repercussions are now rippling throughout the global financial system and the concerns are how far those ripples will travel. Will they grow into the kind of seismic tidal waves we saw during the 2008 financial crisis or recede?  China’s highly questionable reported overall debt to GDP is about 270% and that growing debt may also facilitate the purchase of cryptocurrencies as a means of moving wealth out of China. Crypto offers an attractive free alternative economic system for many people who are concerned about these issues.
Historically, gold and cash have served as both a less controlled medium of exchange and store of value, but as money becomes increasingly digital, governments have tried to curb the use of digital assets as an alternative to fiat currencies and precious metals. India may be the best example of how Bitcoin and crypto benefit when governments seek to tightly control their citizens' free use of money. For example, in 2016, the Indian government "demonetized" large bank notes to cut down on the cash economy. This event was a key factor impacting the 2016-17 crypto bull market rally that saw Bitcoin go from under $1,000 to nearly $20,000. China's decision to eliminate the use of cryptocurrencies in the country, as well as recent actions to regulate Chinese fintech shadow banks like Ant Financial may signal that policymakers are strengthening their push to eliminate alternative forms of money before launching a CBDC. If this spurs a similar situation as what occurred in India in 2016, the result could create a massive boost in crypto demand from the world's second largest economy.
Gold, the real money of the ages
Gold rallied towards multi-month highs in the wake of the August jobs report, but failed to materially breakout amid concerns about a loss of economic momentum ahead of the Fed’s plans to taper QE. Also, the hawkish repositioning across asset classes, underscored by the dollar rally and rise in interest rates further weighed on gold over the course of the third quarter. The bullish case for gold is characterized by a very fragile balance between a steady but relatively slow economic recovery (data that is too hot causes hawkish money flows) and still accommodative Central Bank policy. Accordingly, anything that contradicts either will weigh on gold near term. However, gold is the real “money of the ages” and accordingly maintains its place as a hedge against a collapse in the global fiat currency system or a potential “black swan” event such as China invading Taiwan. Another scenario that is bullish for gold is a stagflationary one, where inflation continues to firm but growth loses momentum (particularly labor market growth) as that would see real interest rates continue to fall amid an acceleration in inflation (with more dovish-leaning Fed capping interest rates).
Cannabis, an explosive coming opportunity
The U.S. House passed the NDAA that includes landmark legislation to make it easier for banks to serve cannabis businesses, but it appears a long shot that the U.S. Senate will follow suit and approve some form of the SAFE Banking Act. However, the runway for Cannabis affords some of the best opportunities to increase wealth once the banking laws for cannabis and federal legalization potentially follows in 2022 with many Cannabis companies at compelling valuations. Once these hurdles are behind the sector, we expect an inflow of institutional capital that were previously unable to invest in public cannabis stocks because of federal restrictions (pension plans, banks, and mutual funds) and as Jackie Gleason used to say “and away we go”!
In Summary
The outlook going forward for U.S. equities will become better if: 1) The rise in yields is gradual, reflecting a strong economic reflation, 2) Washington gets to the $1.5 trillion reconciliation bill/debt ceiling extension sooner than later, and in doing so provides incremental stimulus for the economy to help offset coming tax increases, 3) The Fed stays on message about a gradual taper and the spike in inflation is transitory, and 4) The supply chain eases or U.S. corporations downplay the impact of supply chain disruptions in the coming earnings season. If all that occurred, we should not be shocked to see the S&P 500 make another run at the highs because the reality is that 1) The Fed is still very accommodative, 2) More fiscal stimulus is likely coming, 3) The pharma industry is continuing to attack COVID (the MRK pill announcement is a positive) and 4) The economic plough horse recovery remains in place with the economic horse breaking into stride, but we are monitoring rising oil and gas prices as headwinds, essentially a tax on the consumer reducing discretionary income and also leading to higher inflation or worse, stagflation.
As always, we will remain “tactical” in our approach to managing money focusing on sector allocations and great security selections as markets and new technologies continue to evolve. We continue to send our valued clients timely updates, videos and newsletters via email, so please call our office if we do not have your current email address and also advise us of family, friends and co-workers who you feel will benefit by also receiving our timely and informative email updates.
As noted earlier, we are facing elevated uncertainty as we enter the final three months of the year, and as such we should not be surprised if markets are more volatile than they have been so far in 2021 (which has been a non-volatile year aside from September). It is important to remember that volatility is historically normal, and volatile markets do not mean negative returns. Yes, risks remain to the markets and the economy, as they always do, but it is important to remember that a well-executed and diversified, long-term-focused financial plan can overcome bouts of even intense volatility, like we have witnessed over the last 21 months.
At Castle Financial, we understand the risks facing both the markets and the economy, and we are committed to helping you effectively navigate this challenging investment environment. Successful investing is a marathon, not a sprint, and even temporary bouts of volatility like we experienced during the height of the pandemic are unlikely to alter a diversified approach set up to meet your long-term investment goals. Therefore, it is critical for you to stay somewhat invested, remain patient, and stick to the plan, as we have worked with you to establish a unique, personal allocation target based on your financial position, risk tolerance, and investment timeline.
Castle has strategically partnered with some of the leading global money management firms in the world with tens of trillions of dollars under investment management and this quarter we have chosen to send you the enclosed the BlackRock 2021 Global Outlook Q4 update which covers the world markets in great scope and detail. Your third quarter 2021 account summary and performance report is enclosed. Our current disclosure statement is set forth on the Firm Brochure Supplement of Form ADV and our Customer Relationship Summary (CRS) are available for your review upon request. As always, thank you for your business and the trust and confidence you have placed in me as your financial advisor. Please visit us at for a wealth of information and a plethora of great content on a myriad of financial topics and connect with us on social media. Please do not hesitate to contact us with any questions, comments, or to schedule a portfolio review if you have not already done so in the last 6 months.
We wish everyone good health and great times for the upcoming holidays! God knows we all need a break. . . . .
Yours truly,
Al Procaccino II, MBA, CFF®, CFP™, CFS®
President & CEO