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Earlier this year we identified the three E’s during our January quarterly markets update webinar: exogenous shocks, earnings, and the election. The exogenous shock on March 9, Saudi Arabia getting into a price war with the Russians, has taken center stage of the three Es with earnings soon to come. What does this mean for the market, our economy, and your portfolio?
Announcer: The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell, or hold any specific security. Consult your investment advisor and read any investment perspectives carefully before making any changes to your investment portfolio.
This program is sponsored by Mercer Advisors. Mercer Global Advisors Inc is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors Inc is the parent company of Mercer Global Advisors Inc and is not involved with investment services.
Doug: Hello, this is Doug Fabian. I’m the podcast host and part of the client communications team at Mercer Advisors. This is a special Mercer Advisors client podcast recorded on Tuesday, March 10th, 2020. I’m joined today by Chief Investment Officer Don Calcagni and investment committee member Drew Kanaly for a current conversation about the recent drop in global equity prices.
We wanted to get this timely conversation out to clients to share our thoughts and ease your concerns about how the market is reacting to the global health concerns around the coronavirus as well as the new wrinkle, oil prices. We encourage you to speak with your Mercer Advisor client advisor if you’d like to address specific issues around your portfolio.
Drew and Don, thanks for making time for this podcast and making it a priority for clients.
Drew: Happy to be here.
Don: Thank you, Doug.
Doug: Don, let’s start with you. You were interviewed this morning by the Wall Street Journal about recent market volatility. What are your words of wisdom for clients as they look at the markets today and may be concerned about the recent sell-off in stocks?
Don: Well, I think the first words of wisdom, Doug, would be:
The market is a mechanism for digesting new information into asset prices. This isn’t the first time we’ve seen a market sell-off. It certainly won’t be the last, so the market is functioning perfectly normally.
There’s nothing here that I would argue is alarming in terms of market functionality. Even though certainly, the losses that we’ve experienced for the last couple weeks don’t feel good, it’s important to keep in mind that the markets are doing what they’re supposed to do and keep that in mind, use it as an opportunity from a planning perspective, and of course always remain calm.
Doug: Drew, you’ve spent your career studying what’s going on in the energy markets. Many of your clients are involved in the energy industry. What is happening with oil right now? It seems unexpected, and what can we expect going forward?
Drew: Well, I think the first observation is the one we made is our original client webinar to start the year where we identified three Es that we thought would define the market this year. That was:
The election is now not in the headlines. Earnings soon will be, but the exogenous shock no one could have predicted is what happened over the weekend with Saudi Arabia getting into a price war with the Russians and really, behind the scenes, probably shale producers here in North America.
The interesting little tidbit there is that the shale internal rates of return had already been revealed as the economics just weren’t there. The technology is there; this is not a shortage of energy by any stretch of the imagination, but maybe a shortage of economical production.
So that was already in motion in the oil patch, cash…well, let’s just say capital to provide for additional production had already been withdrawn from the energy patch, but the big change is this exogenous shock on price.
When you have a price move of 30-odd percent in a matter of hours, really does dramatically change the complex of the energy industry and those that provide capital to it.
This was a big shock. It’s going to accelerate things, it’s going to cause dislocations, and remember, energy is a component of the S&P 500. It has been a driver of GDP these many years as we have doubled our production in North America, and so here we are with a 40-odd percent reduction in energy stock prices. It’s unfortunate, but it’s where we are.
The good news on the backside is, this is a boon to the consumer across the board, from natural gas prices to the price of crude all the way to your gas pump. So on the backside of this, when we’re looking out months about what the hit to GDP is presently that we’re experiencing but not yet measuring, we’re going to see a nice effect to the consumer’s pocketbook.
Don: Doug, I just want to add a couple of things to that. When we look at really the impetus for this price war, it was really the OPEC meeting from Friday, and negotiations broke down. The purpose for OPEC’s meeting was to set production targets beginning in April once the current production targets expired.
I just want to give our clients some numbers. As of this morning, Brent Crude is trading at $37 a barrel at the moment. I’m looking at my screen right now. It’s $37 a barrel. The Saudis need oil to be at around $83 to $85 a barrel for them to balance their national budget. The Saudis, obviously, use the sale of oil to fund a lot of their social programs for their citizens. Russia needs oil to be at around $50 a barrel for them to pay for their social spending.
But let’s take it a step further. Even though that’s what those two countries need the price of oil to be at, the Russians can produce oil at $30 a barrel, so they’re okay if the price goes down below 50, but they need it to stay north of 30.
The Saudis can produce oil at about $3 a barrel, so the reality is, even though they need $85 or so a barrel to balance their budget, it really only costs the Saudis about $3 a barrel to bring a barrel to market, so it’s a bit of a game of chicken between these two large oil suppliers, and it’ll be interesting to see how that unfolds.
Drew and I were talking yesterday. In order for a US producer here in Texas to break even, it costs them about $50 a barrel. So we are the more expensive provider in terms of our cost structure when it comes to bringing oil to market, and so the reality is, with oil at $37 a barrel, there’s a lot of producers here in the great state of Texas that, unfortunately, just aren’t going to be profitable.
Doug: Don, that brings up what happened from a price movement yesterday. We saw a 2000-point move in the Dow Jones Industrial Average. This was tied more to oil, and we haven’t even mentioned the coronavirus yet, so we might as well get that on the table.
I think a lot of people, just doing the drive-by of what happened on the news last night, are really not connecting the oil move and the move in the market, so if you can kind of give a little bit more color around that.
Don: There’s a couple of signals that the price of oil sends to the market.
I think when you take those two pieces of information and combine them, that’s what we saw reflected yesterday in the market, and that’s why we saw a pretty steep sell-off.
Doug: Drew, additional comments? And, Drew, you’ve been observing the energy market. Obviously, a 30% move in a single day in a commodity like oil is… I’m not going to say unprecedented, but it happened.
This is not something that is normal. Is this a move…are we moving to $20 oil? Is there the potential that yesterday was a market low in oil? Just give me some of your comments around that.
Drew: Well, we’ve had a price bounce today. Certainly, $20 isn’t out of the question. 2016, we were at 20 bucks, so it’s not out of the question. Is that what’s really going to happen? We’ll see, I think. Saudis announced today they were increasing production even more to try to put the squeeze on.
So where the commodity bottoms out, anybody’s guess, but the changes to the industry, they’re going to be a little bit different this time around given the change in the actual profile of global production over the last couple of bottoms. There’s just so much more production this time. It’s going to be a real retrench for the industry.
One more anecdotal thing, they’ve experienced, out in west Texas, a couple of quarters where they’ve actually given away natural gas, actually gave it away, gave it to electric utilities. It was cheaper to give it away free than to have someone pay to have it shipped through the pipeline.
It kind of gives you an idea of the abundance of the commodity here nationally, and how ironic is it that a collapse in the price of a commodity that benefits all of us is somehow a panic.
Oil shocks used to be the other way on the price of energy, so it’s very, very interesting times. I think it does connect to the whole coronavirus concern. I’m going to call it a concern. What is the doctrine of the ultimate outcome in economic weakness? Putting aside the human toll that the virus may cause, what is the economic, you know, either delay or disruption?
That’s what the market weighing machine is trying to weigh, so it’s looking at a weakening commodity price on one hand, and it’s looking to…total activity is dropping because of an abundance of concern about the virus, so the market is trying to weigh this.
If it is recessionary, for how long? If it is recessionary, is it just going to move activity into another quarter away from these first two? So the volatility is actually kind of logical.
Don: Doug, I’ll add to that, like Drew said, the market is a weighing machine, and the market is currently putting more weight towards this message that the price of oil is sending around the economy.
The market, if I’m reading the market properly, which is [Laughs] always a difficult exercise, it’s more concerned about future economic growth than it is the money we’re going to save at the pump.
A few days ago, the Fed cut interest rates 50 basis points and the market shrugged it off, so that tells me the market is much more concerned about economic growth going forward, the prospects of a recession going forward than it is saving a few dollars or a few pennies at the pump.
Doug: Well, that brings us to the next subject, which is the US economy, and what are the latest projections. Obviously, the coronavirus has thrown a wrench into things, but Don and Drew, give us a short- and long-term look on what we should be paying attention to regarding economic activity.
Don: I think, short-term, a recession is definitely in the cards. In fact, we might be there already, not to get our listeners alarmed, but it’s important for our listeners to understand that recessions are only identified in hindsight.
It takes time, the National Bureau of Economic Research is the entity that officially determines whether or not we’re in a recession, and they typically identify that three to six months after the fact.
We’re not going to know if we’re in a recession until we’re probably already on our way out of it. So, just to calm our listeners down, it’s definitely a look in the rear-view mirror, but I think in the short run we see a recession. I think it’ll be really mild, to be candid. I think the tailwinds are still pretty strong, you have basically full employment in the United States.
Longer-term, I think we’re fine. I think we grow our way out of this. By longer-term, I mean probably about a year out. I think we see two quarters, which is the definition of a recession, is two successive quarters of negative GDP growth.
But, again, short-term, I think we see earnings growth this year probably flatline, and we’re seeing some economists are making that projection coming out of Goldman-Sachs and a few other Wall Street banks. But, again, short-term, we see a recession. Longer-term, I think we get back to probably long-term steady-state growth of probably close to 2%.
Drew: If you look at the February numbers, they were so strong across the board. Even Ernies [Phonetic 00:15:03] were showing surprises. It just looked so solid, so what we’re really looking at here, presently what we’re really looking at are two exogenous shocks that we’re still measuring what their full potential is in the face of what was a pretty solid economy.
I guess that’s a vote for, if this does turn into a recession, it would be mild by most standards, and this market reaction may be a little heavy-handed at this point in time. We’re going to get so much data coming out of the path of the virus coming up and the path of what the damage is to this economic activity pretty shortly. It’s going to start coming in pretty shortly, so it’s good to heed what Don said at the top of this podcast. Stay calm.
Doug: Well, let’s switch to the global economy, especially China, I think the country that has been most adversely affected. Give us your read on what’s going on with the global economy right now, Don.
Don: Well, the reality is, China’s probably already in a recession. In fact, I think that’s quite a definitive statement at this point. In fact, there were a fair number of economists that I respect who were arguing that China was in a recession even before the virus was first identified and began to spread, largely due to the trade war with the United States.
So the fact is it’s going to take China some time to grow out of this. I think the global economy, I think it’s in trouble. I mean, Italy has pretty much shut down the entire country at this point. That’s going to put a significant hit on the EU’s economy. Definitely the global economy is…it’s got its work cut out for it in the year ahead.
The US economy is probably the relative bright spot. I would also argue that the emerging markets are probably going to benefit quite handsomely going forward. You have a really strong US dollar right now, and once this economic recovery really gets going ahead, I think you can see southeast Asia doing very well.
I even think you can see some of the sub-Saharan African economies coming on pretty strong.
Mexico is probably going to be the biggest economic winner coming out of the coronavirus and everything else over the next 10 years. Our listeners probably aren’t aware of this, but the United States, Canada, and Mexico signed a new trade agreement, and that should benefit Mexico quite handsomely.
So, when you think about the virus, when you think about the trade war between the United States and China, Mexico is primed to do very, very well over the next 10 years. While times are tough right now, mostly because of China, mostly because of what’s happening in Italy, I think the long-term prospects are quite bullish.
One more thought on that is, think of shifts in production. If you’re the Chinese government, you are laser-focused on not losing your customers to shifts in production because of what was exposed here for what they supply around the world, just ask Apple.
So, Mexico, the emerging markets, they’re all going to be holding their hands up wanting to be the suppliers of choice. There will be shifts in production just as a strategic move, so it’s a real boon to other economies around the world.
Doug: Let’s get into the numbers a little bit. Don, talk to us just about some of the major indices, Dow, S&P, NASDAQ. Obviously, these numbers are through Monday at the market low, but just want to give clients some perspective on the moves that we’ve seen so far.
Don: Yeah, what I’ll do is, I’ll really begin and stick with the S&P since that’s probably the better measure. I’d like our listeners to keep in mind that the Dow Jones is only 30 stocks, and so, while we all tend to talk about the Dow Jones, the 2,000-point drop yesterday in the Dow Jones Industrials, keep in mind that’s only 30 companies. That’s not a very good barometer of the entire market.
So I’m going to give you some numbers for the S&P 500 Index, which is actually 505 stocks and is a much broader measure of the US market. The S&P 500 Index is down about 19% from its high several weeks ago. It’s negative about 15% for the year, so I think that’s an important point for all of us to keep in mind.
The Bloomberg Barclays US Aggregate, which is a bond index, was actually positive about 5.7% for the year. Doug, I just want to stick with those two indexes for a moment. So stocks are negative, let’s call it 15% for the year. We have bonds that are positive about 5.7% for the year, and Doug, as we’re always telling our clients, stick with a diversified portfolio.
I’m going to ignore international markets here for one moment just to keep the math really simple. If you had half of your money in bonds and half of your money in stocks, you’re down a heck of a lot less than the S&P 500 index, and so, Doug, when we actually look at a Mercer 60/40 portfolio, the 60 represents stocks, a basket of global stocks, and the 40 represents short-term high-quality bonds, that portfolio’s only negative about 9% for the year.
Again, I don’t mean to offend our listeners or to minimize how that feels. Being negative never feels good. But the reality is, volatile markets are a fact of life, and they won’t go away, they’ve been with us since the dawn of history, and they’re going to be with us until the end of the world.
The point being is, that’s why it is so critically important to maintain a diversified portfolio. Being negative 9 is a heck of a lot better than being negative 15.
Before I finish up this round of questioning here for a moment, Doug, I just want to highlight, the non-US markets are negative a little bit more than US markets. So I just want us to keep that in mind. They’ve been hit harder than we have. They’re probably down an additional 3-5% depending on which market specifically we’re talking about.
But what’s interesting, Doug is that was the year-to-date. Over the past week or two, believe it or not, non-US markets have actually performed slightly better than US markets.
Doug: So let’s talk about our strategies for managing risk and what we’re doing proactively. Certainly, the investment team is monitoring things on a daily basis, we’re always on top of things, but, Don, give us your overview on how Mercer Advisors handles risk in an environment like this.
Don: The most important thing you can do to manage risk, Doug, is to remain diversified. If you want to be defensive, you have to be diversified. They both begin with the letter D for a reason, right? So you have to keep that in mind.
You got to stick to the plan. Before you invest any capital, you have to have a plan.
Doug, this is why our advisors meet with our clients on a quarterly basis, to update the plan, to review the plan, to make sure that the client is on track to achieving economic freedom. Those are the absolute most important things we can do to manage risk because all of those things help manage our behavior.
The biggest threat to our economic freedom, the biggest risk in our portfolio, frankly, is the human dimension. It’s us. It’s our emotions. And so we have to have frameworks, we have to have tools, we have to have relationships with our advisors to help us keep that in check.
The biggest, the best investors in the world, they know this, and they try to keep the human element very much out of the investment equation, because they know, ultimately, that is the biggest risk in the portfolio. Drew, anything you want to add?
Drew: I think, for us, we’re going to be reviewing the possibility of looking at an additional rebalance this year for the portfolios. We have a periodic, but maybe we’ll step in here and do some rebalancing.
As Don pointed out, the markets aren’t performing uniformly to the downside. That creates opportunity. You rebalance and stick to your plan. So that may be an additional move this year.
Doug: Gentlemen, we’ve had some talk over the last 24 hours about the federal government doing some economic stimulus. What are some of the tools that are available? Obviously, in an election year, the markets being down, that’s kind of unusual, but we’ve had these shocks to the system. So, Don,
Don: Well, I mean, Doug, we’ve already seen the Fed cut interest rates 50 basis points. The market is pricing an additional 50 basis point cut at the Fed’s March meeting.
It’s interesting, I hear a lot of folks say, “Well, rates can’t go below zero.” Well, indeed they can. [Laughs] You can look to Switzerland, you can look to the EU, the German Bund. Rates can go negative. In fact, I would argue the US probably had negative interest rates for a while there probably seven or eight years ago.
The Federal Reserve can also print money, which is what we did to fight the financial crisis previously. When they print money, what they’re doing, Doug, is they’re actually buying assets, and that effectively pumps cash into the economy.
I know a lot of our listeners probably recoil when they hear that, but I would argue that’s a more complex discussion, and we should be careful not to get wisdom on monetary policy from the dark corners of the Internet or radio talk show hosts. [Laughs] So we should try to keep that in context.
You know, the payroll tax was floated this morning. I’m not really bullish on that, and the reason why, Doug, is because, ultimately, they have to walk that back. They need those dollars to shore up Social Security and Medicare. They can certainly cut it, George Bush did there sometime around 2002, I think it was, 2003, we cut payroll taxes. But I’m not a big fan of that.
The market basically shrugged off a 50 basis point cut last week, and my concern is, I just don’t see how the market can get really excited about a payroll tax cut. If the market does, great, but I’m just not bullish on that particular technique.
I think what the market needs, I think the White House, I think the government could show better leadership with respect to combating coronavirus, a bit more transparency with information, sticking to the science. I think those things would help. Just give consumers, give the American people some confidence.
So the government could display better leadership, certainly a payroll tax, it won’t hurt in the short term, but I think we’re going to be looking to the Fed ultimately to put a floor under us at prices.
Doug: Well, and since this is a global phenomenon that’s happening with the coronavirus, it would probably be a coordinated economic stimulus with other governments around the world because the US is not the only economy that has had a major shift here. Obviously, think Europe and China as well. We can’t predict, but we’ll watch what’s going on there.
Drew: Well, Doug, there’s a number of things. I’ll list a few off the top of my head.
You have to pay tax on that conversion amount in the tax year in which you execute the conversion, but then you at least have assets now in a tax-exempt environment so that when the market does recover, all of those gains will now be income tax-free as well as capital gains tax-free. So, Roth conversion, a very powerful planning opportunity.
Doug: Well, we certainly have seen the interest rates come down significantly, especially on the 10-year, and that many mortgage rates are out there. I think looking at a refi would be another area if clients could take advantage of lowering their cost of borrowing.
Drew: Absolutely, and for those who are on the fence thinking about buying a home or maybe for many of our clients who are looking at buying a second home or a retirement home or something along those lines, now is an opportune time to take out a mortgage.
Doug: Gentlemen, closing thoughts. Drew, let me go to you first.
Don: I think what we’ve covered here is, the big things are remaining calm, stick with your plan. All that is vital to the success coming out of this. Remember, this is not our first market correction. There’s been any number of them. Lord knows I have the scars to prove it, but they’ve healed, and I’ve come out of this thing.
Like my mentor. Dr. Arthur Laffer, told me, “Don’t make any decisions when you’re drunk or panicked.” So I think I’m going to heed Dr. Laffer here.
Drew: That’s great advice, Drew. You know, Doug, absolutely. I would encourage our listeners to remain calm. This isn’t the first time we had a market correction. The last time we had one was 2008. Market was down 20% in the fourth quarter of…2018, I mean, not 2008, 2018.
Before that, it was 2016.
Before that, it was 2015.
Before that, it was 2012, before that it was 2011.
Before that, it was 2009, and before that, it was 2008, and so on and so forth.
Since 1928, we’ve had a correction or a bear market, on average, about once every 18-24 months, so I just want our listeners to understand that market corrections are normal.
They don’t feel good, but they are normal, and every correction has a beginning, a middle, and to Drew’s point, they have an end. So,
I know that’s hard, especially right now when it feels like the markets are just beating you up, but we have to remain diversified.
You know, Doug, I want to highlight, it wasn’t all that long ago, maybe a year and a half ago, where I had clients asking me, “Don, why should I own bonds at all? The market is doing so well, interest rates are going up, and bond prices go down, you’ve always told me when interest rates go up.”
And I told them that they should own bonds because I knew, we knew, that this day would eventually come, we just didn’t know when. Right now, I don’t think there’s anybody who wishes they had less bonds. So, number two, I would say, remain diversified.
3. Stick to the plan.
Revisit the plan if you need to. If you have to, call your advisor, meet with your advisor, talk to somebody. That’s what we’re here for. We take the privilege of being your trusted advisor very seriously, and we certainly encourage you to reach out to us if you need to speak with someone to revisit your plan and make sure you’re on track.
Doug: Great. Gentlemen, thank you very much for providing our clients with this up-to-date discussion on what’s going on in the financial markets, and we’ll meet again soon.
Drew: Thank you, Doug.
Don: Thank you, Doug.
I want to remind you, please send me an email. Give me your comments, your questions, your show ideas. My email address [email protected] and thank you for joining us today.
Announcer: The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell, or hold any specific security. Consult your investment advisor and read any investment prospectus carefully before making any changes to your investment portfolio.
This program is sponsored by Mercer Advisors. Mercer Global Advisors, Inc. is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors, Inc. is the parent company of Mercer Global Advisors, Inc., and is not involved with investment services.