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WashingtonWise Investor: Episode 42

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Global Investing During Economic Expansion

U.S. foreign policy initiatives will take center stage at the upcoming G7 summit, but Congress will be busy at home working through a long list of policy decisions, including the president’s 2022 budget proposal.

Until recently, the administration’s approach to foreign policy has been low key, but now President Biden is headed out on his first international trip—attending the G7 summit and a NATO meeting. Jeff Kleintop, Schwab’s chief global investment strategist, joins host Mike Townsend to discuss the president’s efforts to build multilateral support for a global minimum tax and combat climate change. They also share insights on the global economic expansion, progress with China on intellectual property, and rising tensions over Taiwan, as well as the global semiconductor shortage and how it is impacting U.S. production.

Mike also shares his thoughts on the improving outlook for a bipartisan infrastructure plan; the new bipartisan retirement savings bill in the Senate; the SEC’s focus on cryptocurrency, SPACs, and the use of social media to spark retail investing; and an overview of the bumpy road ahead for Biden’s 2022 budget proposal.

WashingtonWise Investor is an original podcast from Charles Schwab.

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MIKE TOWNSEND: As the calendar flips to June, we are entering what is shaping up to be a jam-packed month of enormously consequential policy decisions.

When lawmakers come back to Washington after this week’s recess for the Memorial Day holiday, they’ll be facing a long list of tense issues, including the president’s massive spending proposals, the beginning of the 2022 budget process, a bill to push back on the competitive threat from China, and a voting rights bill, just to name a few. It’s shaping up to be a long summer in Washington.

But this month will also see an important first for President Joe Biden―his first major foreign trip. He’ll travel later this month to Europe for a meeting of the G7 leaders and a NATO meeting. He’ll also have a highly anticipated sit-down with Russian President Vladimir Putin.

Those meetings are expected to touch on a wide array of issues that are important to global investors, from climate change to global taxes to how countries can work together to curb China’s push to increase its power.  

Welcome to WashingtonWise Investor, an original podcast from Charles Schwab. I’m your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation’s capital and help investors figure out what’s really worth paying attention to.

Coming up in just a few minutes, I welcome Jeff Kleintop, Schwab’s chief global investment strategist, back to the podcast. Jeff and I will discuss what we’ve learned so far about President Biden’s foreign policy priorities and style, what to expect from the president’s first overseas trip, and how global investors should be thinking about it all.

But first, a quick look at a few of the key domestic issues making news right now.

What I’m watching most closely are the ongoing negotiations over a possible bipartisan infrastructure bill. Several weeks ago, President Biden set a deadline of Memorial Day weekend for a compromise to be worked out. That date has come and gone. But the negotiations continued into this week, with the administration reportedly setting a new “soft” deadline of June 9 to see substantial progress.

Last week, the White House reduced their original plan from $2.3 trillion to $1.7 trillion, while Republicans are countering with an offer of nearly $1 trillion. That’s still a big gap, but it does represent significant movement by both parties. And President Biden reportedly told Republicans that he would be open to a package of about $1 trillion in spending on traditional infrastructure, like roads and bridges, as well as broadband expansion to rural areas.

But Democrats on Capitol Hill are getting antsy and some are calling on the White House to abandon negotiations and push forward on a Democrat-only bill that includes more of the party’s priorities. They could do so using the budget reconciliation process, the special set of rules that would prohibit a filibuster and allow Democrats to pass the bill in the Senate with a simple majority. That’s the same process Democrats used in March to approve the economic stimulus bill. But that path forward would likely doom any chances of significant bipartisanship on any major issue between now and the 2022 midterm elections.

Even though Congress is not in session this week, it’s going to be a critically important week for the negotiations.

In other news, there’s been another development in an issue we’ve been following for the last few episodes―retirement savings. Late last month, Democratic Senator Ben Cardin of Maryland and Republican Senator Rob Portman of Ohio introduced their bill, the Retirement Security and Savings Act. This is a companion bill to the Securing a Strong Retirement Act, the bipartisan House bill that received unanimous support from the Ways & Means Committee earlier in May.

The Senate bill is similar to the House bill―with some analysts suggesting that about 70 to 80% of the bill overlaps with the House version. Both bills, for example, would slowly increase the age at which individuals must begin taking required minimum distributions from their retirement accounts from 72 to 75 over the next decade. And the handful of differences are considered relatively minor things that could probably be worked out fairly easily. For example, the Senate bill would increase the catch-up contribution for Individual Retirement Accounts to $10,000 for all individuals over the age of 60; the House version would do so only for individuals age 62 to 64.

The introduction of the Senate bill and the broad bipartisan support it appears to have only adds to the momentum for retirement savings legislation. While this isn’t the highest priority item on the Congressional to-do list right now, both chambers seem intent on focusing on the issue later this year.

Finally, SEC Chair Gary Gensler made his second appearance on Capitol Hill in less than a month, testifying before a House subcommittee about the agency’s budget. In his comments, Gensler noted that while the capital markets continue to grow in both size and complexity, the SEC has struggled to keep up, as its staff level is 4% smaller than it was in 2016. To that end, the president’s budget proposal asks Congress for a 5% increase in the SEC’s budget.

As expected, Gensler made a number of comments and responded to several questions about a variety of topics important to individual investors, including cryptocurrency, the rise of special purpose acquisition companies (or SPACs), and the increase in the use of social media to spark a boom in retail trading. He said the SEC is looking seriously at putting forward new rules in all three areas later this year―and in all three cases he argued that protections for ordinary investors seem to be inadequate and in need of strengthening. As I’ve said before, the SEC’s regulatory process is slow and deliberate, so we are still likely months away from seeing new rules proposed in these areas. But Gensler’s recent testimony makes it clear that these three issues have risen to the top of the priority list.

On today’s Deeper Dive, I’m delighted to welcome back a familiar guest, Jeffrey Kleintop, to take a spin around the globe with me and discuss some of the key issues impacting international investors right now. Jeff is Charles Schwab’s chief global investment strategist. Thanks for joining me, Jeff.

JEFF: Hi, Mike. Thanks for having me back.

MIKE: Jeff, I want to begin by getting your take on the foreign policy efforts of the new administration. It appears that President Biden and his team have taken a rather careful approach to foreign policy―avoiding headlines, working more behind-the-scenes, laying groundwork, and renewing relationships, such as rejoining the Paris Agreement on climate change. Do you get the sense that these efforts are getting a positive reception from our partners?

JEFF: It’s hard to measure, but I think actions speak loudest when it comes to measuring how the relationship has changed. As has been often noted, the chief thing that distinguishes President Biden’s foreign policy strategy from the previous administration’s is the aim for a multilateral approach when it comes to achieving his goals, especially in the form of creating coalitions to confront China on specific issues. An early success of this approach, I think we can see, in the Biden administration’s working with European allies to coordinate sanctions by the U.S. and the EU, the U.K., and Canada on China over alleged human-rights abuses in Xinjiang. These were imposed on four Chinese officials consisting of asset freezes and travel bans. And they’re pretty small, but for the first time since the Tiananmen Square protests in 1989, western governments took coordinated action to punish alleged human rights abuses in China.

MIKE: The president’s first major foreign trip will be to Europe later this month, where he will attend the G7 summit and a NATO meeting. The White House says the focus of these talks will be on “public health, economic recovery, and climate change,” and that they will “demonstrate solidarity and shared values among major democracies.” How much weight do you give the decision to make this the president’s first big trip in terms of where the transatlantic relationship stands?

JEFF: Well, the G7 meeting is always kind of a photo op. The hard work is done in the background by officials in anticipation of the event so that a pact is in place for a public agreement at the G7. Now, in this case, a big issue is a global minimum corporate tax rate. And it appears as if the behind-the-scenes work has advanced after the Biden administration made some concessions, including lowering the rate it was seeking. If a deal can be agreed informally by finance ministers in advance, then the G7 leaders could formally and publicly agree to it at the G7 meeting, and it can then act as the template for a deal among the 139 nations in formal negotiations.

So while the meeting may touch on climate and other issues, a tax agreement may lead to the largest shake-up in international corporate taxation in a century, severely curtailing the ability of companies to shift profits to low tax jurisdictions and ensuring the U.S. FANG stocks pay more tax in the countries where they made sales. So it’s a signature event for Biden to attend.

MIKE: Let’s explore that global tax system a little bit more. This is one of the Biden administration’s most prominent initiatives. The president made it part of his American Jobs Act proposal and Treasury Secretary Janet Yellen has been very involved with moving it forward.

In recent weeks, as you said, there have been signs of support from Europe for the tax. So could you lay out for us how would a global minimum tax work, and do you think it’s achievable?

JEFF: Sure, in theory it’s pretty simple. If a country with a global minimum rate of 15% is home to a company that earned some of its profits overseas that were taxed at, say, 5%, the home country would be entitled to apply an additional 10% tax to bring it to the minimum tax rate. Currently, a U.S. parent company doesn’t owe additional U.S. corporate tax on repatriated profits from its foreign subsidiary.

Over the past decades, a number of countries, of which probably Ireland is probably the best known, have enacted tax policies specifically aimed at attracting multinational business investment by lowering corporate tax rates. Responding to the incentives, many multinational corporations have moved their ownership of intellectual property to countries offering them low- or even no-tax treatment of the income those assets produce.

Moving the U.S. to a minimum tax system would be a major change and put U.S. companies at a disadvantage without similar moves by other countries, and that’s why the Biden administration is attempting to persuade other countries to reverse decades of lowering corporate taxes to attract businesses and instead get them to raise them.

It seems, based on what I’m hearing, that the tax rate is unlikely to be as high as the 21% the Biden administration initially wanted—maybe it’s 12.5% or 15% at most. And there’s no assurance countries like Ireland would even be on board with that. But there is some momentum for this now that the U.S. is on board—since about half the companies that this would apply to are U.S. companies simply by nature of the types of income that would be impacted.

MIKE: So what impact would these changes in taxation have on the markets? 

JEFF: The focus on applying this is to make the world’s biggest and most profitable hundred or so corporations, based on their size and profits, pay more where they operate, and it could raise their effective tax rate. Now, as I mentioned, most of the companies exposed to the proposal are American―about 48% of the 107 companies―followed by France with about 8%. So this is a net negative for U.S. equities were it to happen. But the timing of that is anything but clear.

Now the FANG names top the list, given their profit-generating IP, but other tech and pharmaceutical companies would also be most impacted. Those are two big U.S. growth stock sectors—and could help further the shift in market leadership to international and value stocks that we’ve seen so far this year.

MIKE: U.S. Treasury Deputy Secretary Wally Adeyemo recently said a broad international commitment to 15% or more global minimum tax could help garner support in Congress for an increase in the U.S. corporate tax rate by narrowing the gap between U.S. and overseas rates. We’ll see about that, as the debate in Congress over tax increases, both corporate and individual, is going to be intense over the next few months.

Well, Jeff, let’s go back to that upcoming G7 meeting. Beyond the tax discussion, what other elements of that trip will you be watching that investors should pay attention to as well?

JEFF: From an investment perspective, I think the climate change emphasis will be important. Not just on incentives for a transition to green infrastructure, but also on costs for traditional energy businesses—like we just saw in the Netherlands for Shell.

The massive green infrastructure spending plans from the U.S. Biden administration and the ambitious new “Green Deal” by Europe’s leaders are bold and include wide-ranging goals. Alternative energy and other green stocks could benefit from climate and green energy legislation and spending, including electric vehicles, renewable power generation, eco-friendly infrastructure, and home energy efficiency.

Now, in a hint of what could come, the lead-up to last year’s U.S. elections saw alternative energy stocks outperform traditional energy stocks by a very wide margin, about a 100%. Europe’s new Green Deal and candidate Biden’s emphasis on climate initiatives, combined with his lead in the polls, gave these stocks a boost. But that performance gap has narrowed sharply this year as oil prices moved up from $45 to about $70 a barrel, supporting traditional energy stocks. And some high-flying green growth stocks pulled back as interest rates jumped. And what unfolded, appears to me, to have been a classic case of “buy the rumor, sell the news.”

Now that green stocks appear to have given up last year’s post-election gains, and the recovery and stimulus driven gains in oil prices and interest rates appear to be moderating somewhat, it could mean it may be time for green stocks to begin to inflate again as progress is made on the Biden infrastructure plan and Europe gets closer to deploying its green funding initiatives. And so the G7 may put a spotlight on these initiatives and might even include some new bold proposals that could get the stocks moving.

MIKE: Jeff, when it comes to the markets, it seems they have been giving the new administration a bit of a grace period to get settled in. Possibly taking time to adjust to this change in style. But that can’t last forever. Do you see signs that the markets will soon be looking for more clarity on the U.S. approach to various foreign policy issues?

JEFF: I think the focus for the markets has been on the strongest global economic recovery in nearly 50 years. Global GDP growth is anticipated to be 6% or more this year by think tanks like the IMF. We haven’t seen that since 1973. In fact, you could say the recovery is over—and we’ve started a new economic expansion. Global economic output is at a new all-time high in the second quarter. And this may be the best year for earnings in decades. Those stocks that are most economically sensitive, like energy or financials, have performed the best—regardless of any policy impacts at the margin.

Now, as the momentum slows later in the second half of the year, the overall markets, along with the specific stocks and sectors and regions impacted, might become more sensitive to these policy initiatives.

MIKE: Well, let’s shift gears and look at some of the countries that are making headlines.

And I’d like to start with India where many American companies have outsourced jobs. They’ve built plants and call centers there. But the magnitude of the COVID-19 outbreak and the number of deaths there in recent weeks has been devastating. What impact has it had on the Indian economy, and how much risk does this pose to the markets?

JEFF: Fortunately, new confirmed cases have been cut in half since they peaked in early May, but they’re still very high. Despite the effective restrictions to contain the outbreak, businesses and households are, well, they’re learning to adapt. The April services index, the PMI, for example, was resilient and remained at 54 in April—a solid growth reading a world away from the devastating 5 it dropped to in April last year. Now on the manufacturing side, the electricity consumption, coal and steel production, and the stable April manufacturing PMI have also been resilient.

Thanks in part to this durability of output, India’s stock market has matched the performance of the S&P 500® so far this year.

I’d say the biggest risk posed by India may be that they have adapted without being vaccinated. And that means India may see an evolution of more variants of the virus that could get out and affect the rest of the world.

MIKE: Another key relationship, Jeff, that investors are watching is the U.S.-China relationship, which has really deteriorated over the past year, but perhaps stabilized a bit in the past few months. What do you see as the key issues that need to be on the table in that relationship?

JEFF: Well, theft of intellectual property is a concern for many American companies, but there has been meaningful progress over the last decade.

As Chinese companies have moved up the value chain, the need for stronger legal protection of their own IP has driven change, and this has also benefited foreign firms.

And over recent years, the Chinese government has made significant improvements in its framework for protecting IP. All major IP laws have been amended, and the results have been positive for American companies. In software, for example, Microsoft has won all 63 of the copyright infringement cases it brought in Chinese courts, and Autodesk won all ten of its cases. China established special IP courts in a few cities, and in Beijing, foreign plaintiffs won all the cases they filed in the first year of the court’s operation. Across all of the IP courts, as of 2019, foreign firms had higher win rates and average damages than Chinese firms. In civil cases between Chinese and foreign firms, the foreign party won 68% of the time.

Now in the 20 years between 1999 and 2019, royalty payments by Chinese companies to American firms rose by 24 times, far faster than the pace of Chinese economic growth. So this issue might be lessening in importance.

MIKE: Well, two issues that are linked have been in the headlines recently. One is the global shortage of semiconductors. The other is rising tensions in the South China Sea, as China continues to push the limits with regard to Taiwan. On top of that, the lack of vaccine availability―only about 1% of Taiwanese people have been vaccinated at this point―is exacerbating the semiconductor shortage―something that has the potential to spread across countless industries and sub-industries.

So how does this chip shortage in Taiwan impact companies and investors in the U.S.?

JEFF: The ongoing disruption to global auto production has highlighted the extent to which semiconductors have become an essential input in products that aren’t traditionally considered electronics and also how dependent the world is on Taiwan to produce them.

Taiwan is by far the world’s biggest producer of the processor chips that are increasingly found in new products. It has twice the market share of the next biggest producer. And its dominance at the high end is almost total: Over 90% of the world’s most advanced semiconductors are made by TSMC in Taiwan.

Automakers have struggled to source chips recently because chipmakers are responding to surging demand for electronics products and because of shipping delays. But the concentration of production heightens the risk of a shock to supply. Taiwan is prone to earthquakes, which have knocked out power to chipmakers in the past. And it’s currently suffering a drought―semiconductor production requires huge volumes of water. And, of course, the COVID outbreak. But the biggest threat may come from an increasingly belligerent China and its pledge to re-unify with Taiwan, if necessary, by force. The impact of lasting disruption to semiconductor supply would spread beyond producers of goods containing semiconductors to really encompass much of the modern economy.

The concentration of chip production in Taiwan will therefore, probably, remain a risk to the global economy for the foreseeable future. More positively, this shared dependence may be a reason the U.S. and China avoid any confrontation over Taiwan’s future.

The good news may be that the near-term shortage appears to be easing, rather than worsening.  Chip exports by Taiwan and imports by the U.S. have surged in the last month or two, and port congestion in the U.S. has been lessening. And this means that the chips may be finally getting to manufacturers that need them a little more quickly, and in greater numbers, than in the first quarter.

MIKE: Well, of course, here in Washington, there seems to be more awareness that we are far too dependent on foreign semiconductors. The Senate is expected to vote next week on legislation that would include a big boost in spending for the U.S. semiconductor industry.

JEFF: Right. We’ll need to see if greater awareness of dependence on Taiwan triggers a shift in the global distribution of semiconductor production. You know, President Biden did order a review of the U.S. semiconductor supply chain with a view to enhancing “national security.” And increased self-sufficiency in semiconductors and other high-end inputs is a central theme of China’s new Five-Year Plan.

But China’s failure to reduce its dependence on imported chips for many years now, and despite years of effort and significant resources, just underscores how hard it will be to replace production in Taiwan. Semiconductor production is immensely capital intensive, and it requires expertise and tools that aren’t easily acquired. These things are measured not in years, but in decades.

MIKE: Well, Jeff, let’s wrap this up with Japan. We are 52 days away from the start of the Olympics in Tokyo, and it’s not even clear that they’re actually going to happen. Japan is under enormous pressure from inside the country to cancel the games, and now the U.S. just put in place a do-not-travel advisory. Japan has invested so much in these games; it seems like the country is in an impossible position. What are the ramifications of a cancellation on Japan’s economy?

JEFF: Well, the Olympics can have a much bigger impact on a smaller economy. Japan is still the third largest in the world, behind the U.S. and China. So I don’t expect a sizeable impact, relative to the recovery taking place there now. The impact would probably be most acute on the hospitality sector—yet pretty low expectations have been in place for some time when it comes to hotels and restaurants, given the lingering pandemic.

The cancellation of the games has come down to a staring match, really, to see who blinks first. Japan and the International Olympic Committee both have the power to cancel the games. If Japan were to cancel them, the country would face hefty compensation costs for refunding the broadcasting rights—so, based on the numbers, Japan would rather see the IOC blink first and make the call.

MIKE: I think a lot of sports fans around the world want to see the games go on, both for the spectacle and just for the symbolism of a return towards something approaching normal.

Well, Jeff, obviously a lot going on around the world. Thanks so much for shining a light on some of these important issues for investors.

JEFF: My pleasure, Mike.

MIKE: That’s Jeff Kleintop, Schwab’s chief global investment strategist. He’s a great follow on Twitter―you can find him @jeffreykleintop.

On my Why It Matters section this week, President Biden released his 2022 budget plan on the Friday before Memorial Day weekend. That’s much later than usual. Typically, the budget is unveiled in February, though delays until March are not uncommon in the first year of a new administration. Three things to know about the White House budget proposal:

First, the budget document is what’s known in Washington as “non-binding,” which basically means that Congress is under no obligation to consider it―it’s more of a road map of the president’s priorities. But given that Democrats have narrow majorities in both houses, it’s likely that much of what the president has proposed will form at least the foundation for the Congressional budget resolution that Democrats will push forward in the coming weeks.

Second, it’s that budget resolution which is the important thing here. The president sending his proposed budget to Congress kicks off the development of the budget resolution―the framework document that outlines general spending levels. That document has two important functions. First, it’s the framework into which the Fiscal Year 2022 appropriations will be inserted. Think of it this way―the budget resolution is the big-picture spending levels for the year ahead, and the appropriations are the specific details that allocate that spending across every federal agency and every federal program.

But even more important, Congress has to approve a budget resolution in order to give Democrats the opportunity to use the budget reconciliation process that I mentioned before―that’s the special process that will allow the Democrats to pass the president’s spending plans without giving Republicans the opportunity to filibuster. If lawmakers don’t approve the budget resolution, well, that would close the door to using that special process and also create a new set of complications for the 2022 government funding process.

Finally, the third thing to know about the president’s budget is that it spells out the details of the president’s proposed tax increases. One item that caught the attention of investors was that the budget calls for a change in the taxation of capital gains and dividends to be effective “as of the date of the announcement,” which most people are interpreting as April of this year, when the president unveiled the American Families Plan. That plan calls for capital gains to be taxed as ordinary income for filers earning more than $1 million per year. Why this matters is that the budget seems to indicate that that tax would be retroactive to April of this year, even though it could be months before any bill is actually passed into law.

And this is where point number one comes back into play―just because the president put something in his budget does not mean that Congress has to follow that plan. As I’ve said many times before, we think there is very little chance that any of the tax increases proposed by the president will be retroactive. We think it much more likely that Congress, if it ends up passing tax increases later this year, will make them forward-looking―likely with an effective date of the beginning of 2022.

So why does all this matter? Well, here’s the bottom line―the president’s budget proposal is, at one level, pretty much meaningless. But in another way, it’s a critically important step in starting the process toward what could be an opportunity for Democrats to pass key elements of their agenda, if they can muster 50 votes in the Senate for those ideas. We’ll be watching this in the months ahead―and so will the markets.

Well, that’s all for this week’s episode of WashingtonWise Investor. I’ll be back in two weeks, so please take a moment now to follow the show in your listening app so you don’t miss an episode. And if you like what you’ve heard, leave us a rating or a review—that really helps new listeners discover the show.

For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.

I’m Mike Townsend, and this has been WashingtonWise Investor. Wherever you are, stay safe, stay healthy, and keep investing wisely.

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