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January 2019 Capital Markets Outlook

Watch a recording of Mercer Advisors’ Capital Markets Outlook for January 2019, hosted by financial advisors Doug Fabian (host of the Science of Economic Freedom podcast), Donald Calcagni (Chief Investment Officer), and Drew Kanaly (Chairman Emeritus of Kanaly Trust and client advisor). Take a look back at how global financial markets performed in 2018 and a look forward to expectations for portfolio management in 2019.

Video Transcript

Doug Fabian: 

Hello Ladies and Gentlemen. Welcome to the quarterly Mercer Advisors Client Conference Call on the Investment Markets and the Economy. We appreciate you taking time to join this event. The purpose of this call is to provide you with an update on the global financial markets with a look back on 2018, and a look forward to 2019.

My name is Doug Fabian. I will be facilitating today’s event. I am the Science of Economic Freedom Podcast host, and part of the Client Communications Team here at Mercer Advisors. Joining me today is Don Calcagni, our Chief Investment Officer and leader of our 14-member Investment Committee, and Drew Kanaly, Relationship Manager, Chairman Emeritus of Kanaly Trust, and Drew is also a member of our Investment Team.

Here are some tips for improving your experience on today’s call. There is a toolbar on your screen for those listening live. You can move the location of the toolbar or even close it entirely if you desire. Some of the slides we will be sharing with you will have important information on the right side of the screen, so moving the toolbar to the left may be helpful.

One of the most popular features of this call is our Q&A session. If you would like to submit a question, please submit that question via the function in the toolbar. It will send a text message to us, and we will do our best to facilitate as many questions as possible during the question and answer portion of today’s presentation.

We do want to be respectful of your time. Our formal presentation will last approximately 40 minutes, leaving 20 minutes for questions and answers. We will be sending a survey after the call, and would appreciate your comments and feedback so we can continue to improve these presentations in the future.

Now let’s get to the main event – Don Calcagni, the Chief Investment Officer of Mercer Advisors. Take it away, Don.


Don Calcagni:  

Hello everybody. Thank you for your time today. Thank you, Doug, for the introduction. I’d like to share with everybody on the call that throughout the month of January I’ve spent a significant amount of time on the road. We hosted a series of Town Hall events up and down the West Coast, where we invited a number of our clients to come in. It was really just an open forum, an open Q&A, so we learned a lot on that speaking tour, and I’ll do my best to share with you today some of what I think are the more popular questions that came out of those events. So Doug, you and I have had a lot of discussions around a lot of those questions, and certainly, let’s be sure to raise those here today.


Doug Fabian:         Absolutely.

Don Calcagni: 

So just to set context for today’s discussion – we’re really just going to touch at a very high level on a number of different topics. We’re going to talk about last year’s volatility; we’ll talk a little bit about what we’re seeing in January coming on the heels of what was a very difficult December for financial markets. We’re going to touch a little bit on the economy, what’s happening in the economy. Is the economy growing, is it not growing, what’s going on there? We’re going to talk a little bit about earnings, the market. I may touch on Brexit – certainly many of our clients on our speaking tour recently were asking a number of questions about Brexit – what does it mean for the economy, so on and so forth.

Then we’ll wrap it up by talking a little bit about the U.S. Federal Government’s debts and deficits discussions, as well as what does next year look like for interest rates, and really what should we do in our portfolios in response potentially to additional rate hikes in the future.

By and large, the most popular question that I received over the month of January when we were on the road, Doug, was this: Don, tell us a little bit about market volatility last year. Was it unusual? Was it record-setting?

Certainly the media had a field day talking about the market declines that we saw beginning in mid-October, that really accelerated throughout the month of December.

So when I get that question I always like to step back and just take a look at the data, and when we do that there’s a couple of things that immediately pop out.

Number one, last year’s volatility was not unusual. What we experienced in the fourth quarter of last year was actually pretty normal when we look at market history. The slide that you see in front of you is showing you the intra-year volatility. It’s showing you the top-to-bottom decline in the S&P 500 Index in each of these calendar years that you see along the bottom of your screen, and the red dot represents that top-to-bottom decline. When you look at those red dots, at least since 1980, the average intra-year decline has been about 14%. Last year was a little bit above average at around 20%, but I think when we look at the data we see that there were many data points throughout history that were actually higher or equivalent to what we saw in the fourth quarter of last year. So, by no means unusual – maybe a little bit above average, but certainly not unusual.

Last fall, I think this was probably in mid-December, there was a news story that broke. It was on CNBC, it was on the website that they had where there was a talking head arguing that the volatility we saw in the fourth quarter was record-setting. I’m here to tell you that that was false. That is not true.

When we look at the VIX, which is an index that financial types like Drew and I, and Doug and I use to follow, to track market volatility, what we see is that market volatility last year, while it may have been a little above average, by no means was record-setting by any objective measure. What occurred in markets last year was not record-setting. It was actually quite, quite normal.

I think it’s important to understand what was driving volatility last year. In my view, what we saw over the last several years in the market was really to some degree the return of the internet bubble. We saw four, maybe five stocks actually drive the bulk of last year’s returns – actually, the last several years’ returns in the market – but there were four or five companies that drove most of the steep losses last quarter in the market. They are the ever-popular FANG stocks (Facebook, Amazon, Netflix and Google). Those stocks collectively lost almost 30% of their market value in the fourth quarter of last year. When we compare that to the rest of the market, the S&P 500 Index actually lost only about 13% in the fourth quarter. Definitely a significant difference between declines and those ever-popular FANG stocks, and really, the rest of the broad market.

A lot of the volatility that we saw last year was really coming from these four, maybe five stocks – if we wanted to include Apple in those as well. When we look at the market over longer time horizons I often get the question: Don, with the rise of the internet and computerized trading, it seems, it feels like the market is becoming more volatile than it was in the past.

Like I said a few moments ago, me and my team, we like to step back and say well, let’s look at the data.

When we look at the average daily price change in the market, since 1926 the average daily change has actually been about 0.73%. We’ve seen volatility in the market actually come down, certainly since ’09 during the financial crisis, but we’ve seen market volatility come down since the birth of the internet in the mid to late 1990’s, when it really came of age. And if we look a little bit more closely at recent history we see that volatility, if anything, was abnormally below average. What we really witnessed last year was a return to the average from very abnormal lows back in 2017. So last year would be what we would describe as a regression to the mean, a return to the average.

I think, Doug, that’s why it felt so unusual to many investors last year. It’s because we were sort of lulled into this false sense of abnormally low volatility, and assuming that was the new normal.

So Doug, I just wanted to kick it off by touching on that volatility, and certainly want to invite some comments from you, Doug. If you guys are hearing similar questions from clients, let’s touch on that.


Drew Kanaly:    

Don, this is Drew Kanaly. I think it’s been my observation in talking to clients in this volatility that they were paying attention to nominal moves in the market. You know, when it moves 600 points it gets your attention, but if you look at the base that it’s on as a percentage of the market, these moves aren’t 1987-esque. They are much smaller, and so I think that’s kind of the one thing I’ve been talking to clients about It’s yeah, I hear you on the nominal point move, but the percentage is sort of the key to volatility, as you’re pointing out here on this slide.


Don Calcagni:    

I think that’s a great point. When you actually look back at the largest point moves in history, we see that the top 20 – when we look at the largest top 20 point moves in say Dow history – we see there’s about six or seven of those top 20 places held by market days in 2018. However, when we actually look at the market in terms of percentage movements, I don’t think any of them are in the top 20. And so Drew, I think you raise an excellent point.

Obviously as the Dow or the S&P grow in point terms, the percentage moves is what we really need to focus on. These large triple-digit losses or gains in the Dow can be very misleading, and that’s why we have to step back and look at the percentages. So, good point – very good point.

Let’s move on and take a look at market returns over the last two years. What I’d like to draw your attention to if I may is really this data over here on the right-hand side of the screen. If we just go back in time to 2017, one of the things we saw in 2017 were very abnormally high market returns, certainly far above average. We saw 22% return on the S&P almost; non-U.S. markets were up close to 30%; the emerging markets up close almost to 40%.

Certainly what we saw last year was that markets gave some of that back. S&P was off about 4-½%. Non-U.S. markets were hit harder than U.S. markets and we see that here in the data, of course. When we look at the market year-to-date, however, one of the things we see is that this January (January 2019), is actually, Doug, starting to look like one of the best months in market history. So while December may have been one of the worst months in market history, what we’re seeing is that has been quickly followed by one of the best months in market history.

In fact, January at this point in time has already delivered pretty much a full year’s worth of average equity market returns to investors. So one of the things I was telling clients on our speaking tour was, look, with respect to market volatility there’s three things you need to do.

Number one, you need to stay invested. If you sold at the bottom on Christmas Eve and didn’t get back in, you’ve missed out on a pretty handsome recovery in markets. Number two, stay diversified. Don’t try to look for the next FANG stock or anything like that. Stay globally diversified. The third thing – which, Doug, maybe we’ll touch on in the Q&A session – is remain scientifically invested. Stay diversified across all of those different factors that you hear your advisor talk about, things like value, momentum and quality, because in the long run they do pay off. And certainly, year-to-date we have seen those pay off quite handsomely in a diversified fashion, so we would certainly encourage our investors to continue to do that.

What about the bond market? What’s really driving market volatility? And Drew, certainly feel free to jump in here to add some context. I know you and I were just having some discussion around this.

What’s been driving market volatility in my view has been really two things. Number one is rising interest rates. As interest rates rise that puts downward pressure on all assets on planet earth. That’s a mathematical fact. We’re seeing home prices come down in many markets. We saw stock prices come down as the Fed continued to raise interest rates in the fourth quarter of last year.

One of the things that you should notice is that when it comes to investing in bonds, shorter-term bonds are typically better than longer-term bonds in a rising interest rate environment, and we see that here, too. The two-year and the five-year U.S. Treasury Bond last year still posted positive returns despite rising interest rates. However, that was not true when we looked at longer-term bonds. When we look at the 30-year U.S. Treasury, that was down almost three percent. When it comes to investing in bonds and market environments like this, shorter is better than longer. Drew, did you want to add anything to that?


Drew Kanaly: 

Yes. The rise in the short-term rates have re-established a new asset class called Cash, which for the past several years has not been on anyone’s radar. But now Cash is a viable alternative for asset allocators, so you get a little more competition in markets as funds get allocated to Cash. What’s really driving these interest rate moves is the Fed’s predicament on the interest rate policy they’ve been pursuing, as well as the money supply policy they’ve been pursuing, lo’ these 10 years.

What kind of broke the dam on concern over interest rates at year-end was in the Fed minutes, the last set of Fed minutes. The Fed governors were discussing the lag in the effect of their interest rates moves, which can be three to six months. In that discussion, they talked about maybe not being so systematic in their interest rate increases in 2019, but rather more data-dependent, and that particular commentary really relieved equity concerns about interest rates proving to be a drag on the economy, if not throwing us into a recession. So that’s kind of where we are.

And just to refresh everybody, remember the Fed has two levers. There’s the actual Fed funds rate, and then there’s the actual money supply that they can affect. And for stock traders on a daily basis, it’s as much that money in circulation number that they focus on because that’s the liquidity, right? That’s just the total sum of dollars that they can, in effect, move into the economy. They were at one time talking about retiring some $600 billion a year by virtue of letting maturities roll off, and that really got short-term traders’ attention. It shouldn’t get your attention, but it got short-term traders’ attention, and that got reflected in stocks.

It would appear that they’re going to make two increases in 2019 but remain data-dependent, which I think stocks should have dialed up and priced in at this point.


Doug Fabian:   

Don, would you please comment on the uniqueness of the Mercer Advisors approach to bond allocation for many clients? Somebody on the call could have a 20, 30, 40 percent allocation to fixed income, and how we go about investing for our clients in that asset class.


Don Calcagni:  

Absolutely. I’ll certainly be happy to touch on that. Like I said a few moments ago, when it comes to investing in bonds and the way we think about risk at Mercer Advisors, when it comes to investing in bonds, shorter-term bonds are better than your longer-term bonds. So if you were to look inside your Mercer Advisors portfolio – and I’d certainly encourage you to do that – sit down with your advisor, do a deep dive, do an x-ray if you have interest in this particular subject. Look at the average duration. That’s a wonky financial metric that nerds like us use, but that’s the number that you really want to fixate on. And when it comes to duration, shorter is better than longer, especially when rates are rising.

This little graphic over here on the right helps to visually show that. What we’re just showing you here is the impact of a 1% increase in interest rates. If that were to happen, mathematically what’s the impact on different types of bonds? If you look at shorter-term bonds you’ll see that they don’t get hit nearly as hard as longer-term bonds when interest rates rise. So when you look inside the Mercer Portfolio, we’re shorter-term.

The other thing you want to look at is the credit risk of the borrower. Many of you on the line have maybe heard of junk bonds. Well, that’s just a nice way (or maybe not so nice way) of referring to companies that have compromised credit scores. Think of that person who’s trying to borrow money that has a very, very low credit score relative to somebody with a very, very high credit score.

At Mercer Advisors we focus on the companies with the higher credit scores. We invest in investment grade bonds, those are Triple A plus or higher. I think our average credit rating at the moment is AAA, so we try to focus on those types of companies.

When it comes to investing broadly, part of the exercise that we’re confronted with as a professional wealth manager is figuring out where’s the best place for our clients to take risks where the return is highest. OK? So when it comes to assuming that risk, we prefer to allocate that to equities, because they have the higher – I would say the highest long-term expected return for every little unit of risk that you are taking in your portfolio. That’s why in most instances you’re not going to find us investing in things like junk bonds or Greek bonds. You know, we’re all picking on Greece these days because of their credit challenges. You’re just not going to see that in a Mercer Advisors Portfolio.

One last comment that I’ll make on bonds. I often get the question – I certainly received it several weeks ago – you know, Don, given that we’re in a rising interest rate environment, why should we invest in bonds at all? Shouldn’t we just sit in cash or just put it all into equities?

I’ll just use the fourth quarter of last year as a prime example. You want to own bonds when equity markets are going through a correction. Oftentimes, equity markets go through a correction in rising interest rates environments. Bonds are that cushion. They are that shock absorber in your portfolio that helps smooth out your returns over time. So that’s why you want to own bonds.

Bonds did very well during the financial crisis, especially the short-term investment grade bonds. Bonds did well in 1987 when the Dow fell twenty-some percent in a single day, so bonds are a critical, critical part of a diversified portfolio even in rising interest rate environments.

Drew, do you want to walk us through what’s happening in the oil markets? Help us understand what’s going on there, and how should our clients think about oil relative to a diversified portfolio?


Drew Kanaly: 

When you look at the price of oil, no matter where you are (Houston, Texas withstanding), you should be thinking about what does it say about demand and global demand, and the robustness of world economies expressed in the demand for oil.

What we all know is the phenomena here in the lower 48 – the U.S. is now a net exporter of oil, so we have a tremendous supply of oil hitting the global marketplace. We begin to see the sensitivity to that increased supply expressed in the demand side, and therefore balanced out in price. It was interesting in the fourth quarter swoon that you had significant drop in the price of oil over that period of time, and that really got everybody’s attention. Call it a canary-in-the-coal-mine warning about a global slowdown.

While there’s no doubt we have slower growth globally, the fact that oil has caught a bid here – I was just looking at the tape – about $55, the markets look at that and they say OK, now we’re out of the zone where we’re going to $30. So the markets are going to view a price of oil, and they certainly don’t want to see $100, but anything north of $50 I think for global equity markets is an expression of a healthy demand, and you know, economies not necessarily rolling over.

This is quite a phenomena in total BTUs. Anecdotally, there’s a utility out in West Texas, Odessa Power & Light, they were actually paid over some months, paid to take natural gas. They made a profit in their feed stock. So that’s the type of supply situation we find ourselves in, so look for that price of oil to be kind of a barometer you can measure total demand and global strength.


Don Calcagni:       

What I would add to that is price is ultimately set by what Drew was just saying, and that’s by the balancing of demand with supply. I think that’s what this chart up here is trying to show us, that when the inventories increase it tells us that there’s excess supply in the marketplace. And naturally, if there’s a whole bunch of something, more than people are willing to buy, that’s going to put downward pressure on price.

I think one of the things that’s also interesting to see is that as the number of active rigs is increased, and adding to that, the U.S. I would argue is relatively energy independent at this point, whereas for most of our listeners, for the bulk of our investing careers, that was not the case. The U.S. was very dependent on the Middle East and certainly South America, Venezuela – a very interesting part of the world these days for energy.

At this point, I think as oil prices rise it doesn’t take too much from what I’ve heard for natural gas organizations to really just open up the pumps, and put more supply on the market. My sense is there’s a little bit of a lid on the price of oil because of the rig count, and because of the fact that the United States is at a point now where we are relatively energy independent.

To Drew’s comments – when we talk about oil going down, there’s some argument that’s because of a slowing economy, and I think that’s true in China. I think the trade war with China has certainly put a lot of pressure on their economy – certainly more pressure on the Chinese economy than the United States economy. But it is important to understand that the U.S. economy continues to grow. Since about 2016 we’ve seen economic growth really accelerate in the United States. So we’re at a point now where we still have a growing economy, but we’re starting to see some slowing in the rate of growth. That doesn’t mean recession, that doesn’t mean financial crisis. That means a slowing down in our speed. OK? That doesn’t mean we’re going backwards, it just means we’re slowing down.

And we’re seeing that in profits, and when we look at – and this has actually been a relatively good earnings season this week. We’re projecting a little bit of a decline in corporate profits before things start to pick up again towards the end of 2019. It’s been argued – and I agree with this argument – that this bump here is what led to a lot of the volatility that we saw last quarter. This morning Boeing and Apple – last night Apple actually reported their earnings. Companies are doing well. It doesn’t mean they’re doing great, they’re not blowing the doors off, but they are doing well. Boeing actually did blow the doors off – Boeing actually did very well. But we are predicting the economy is going to slow down a little bit. We’re having lots of debates among economists around hey, what’s the likelihood of a recession? and so on and so forth. Why the economy is slowing I think is because of interest rates. I also think it’s because of the trade war with China. I think that has put a lot of pressure on manufacturing and certainly put some pressure on the U.S. economy.

So even though the economy may be slowing, even though corporate earnings may be leveling off a little bit here, it’s important to keep in mind that markets by any objective measure are not overvalued. I hear this all the time. I’m listening to these talking heads on CNBC, and it’s just a really hard argument to make quantitatively. When we look at earnings we are just not seeing where stocks are suddenly grotesquely overvalued.

If you look at this particular graph, we’re showing you the long-term average price to earnings ratio for the S&P. That’s this dotted line in the middle of the screen. And obviously the market swings around that line over time, but that middle of the screen there, about 16 times earnings, is the long-term average. At least as of the end of December we were at around 14.4 times earnings. Again, I think when I look at the market overall on average, it’s a hard argument to make that stocks are somehow overvalued. That doesn’t mean that there aren’t some segments of the market or specific companies that are trading at nosebleed valuations, and I still believe that is true. You look at the FANG stocks. Last year at one point Netflix was trading at like 100 times earnings, which was pretty, pretty extreme by any objective measure.


Dew Kanaly: 

Don, sticking with that slide for a second, the comment I would make about this is when you get higher PE ratios, that sets the stage for greater amplitude in the stock price swings because you’re pushing off an expectation from a higher point going forward. So as we get the PE compression that we’re getting now, down to 14 or so, the potential amplitude is lessened is what I’m suggesting; and that when I would visit with folks about, you know, are we going to lose 30% in this stock market from these PE ratios, it was hard for me to see how we had a 30% or 40% correction, based upon where the earnings ratio was. When you look back to 2000 and you see those multiples, back then you can make that scenario, but from this price and the historical average, it’s very difficult to come up with that significant a volatility in price. That would be the takeaway I have when I look at this slide. It tells me it’s going to be very difficult to see a big market correction from here.


Don Calcagni:      

I would agree. I would definitely, definitely agree. I think likewise when we look outside the United States, I’m often asked Don, why should we own non-U.S. stocks? They have not done well over the last 10 years, at least relative to U.S. stocks.

And I would say while that may be true, non-U.S. stocks trade at a veritable bargain relative to U.S. stocks. So non-U.S. should and continue – at least at Mercer Advisors – to remain a critical part of a globally diversified portfolio. By the way, anecdotally we’re seeing this already this year. The S&P is positive about five and a half percent year-to-date, our multi-factor equity strategies are positive around six and a half, almost seven percent year-to-date. But outside of the United States we’re seeing even better returns – somewhere between seven and nine percent depending on the different market that we’re looking at. So non-U.S. equities thus far – again, the year is young, but non-U.S. equities are outperforming U.S. equities so far year-to-date in 2019.

What I’d like to do now is just wrap it up is by touching on the debt and deficits. Drew and I have been having a lot of discussions around this. One of the things that’s putting upward pressure on interest rates is the fact that there is pretty significant borrowing occurring at the federal level. This is not the forum to get into political discussions, so I just want to take a look at the math for a moment here.

Obviously we have deficits when the government collects less revenue than it spends. We had a tax cut in late 2017, meaning less revenue is now coming in to the federal checkbook. However, we have not cut spending. We still continue to spend on a number of programs, and again, this isn’t the forum to evaluate the merit of any program but just to highlight the simple arithmetic. We are now accruing deficits of about a trillion dollars per year – that’s with a T. That is a very, very large number, and this is new borrowing. We currently have about $21 trillion in total aggregate federal debt outstanding, and we are adding to that at about $1 trillion per year.

If we look over here on the right-hand side, what we see is that the Congressional Budget Office – which is supposed to be a non-partisan office that gives us lots of great data on federal spending – is projecting that these deficits will pretty much continue into the foreseeable future. There is really no evidence that we’re seeing that these are going to compress at all, at least over the next five to six to seven years. Part of that is because the current tax law that was passed isn’t scheduled to sunset until 2026, so the bottom chart down here I think is a bit more concerning. This is my personal view and Drew, I certainly want you to chime in here because I know that not everybody in our business agrees with me on this – but as our debt increases as a percentage of our economy, my view is that’s going to put stress on the economy. It’s going to make it harder for our economy to grow going forward. To be fair, there is a lively debate on that topic. There’s a number of academics who argue look at Japan. Japan’s debt is 250 times, 280 times the size of its economy, yet Japan continues to do relatively well. Drew, I don’t know if there is anything you wanted to add to that.


Drew Kanaly:        

Yes. The question is who will fund the debt. There’s one set of academics that basically say that central banks around the world have been funding these deficits through large central bank purchases, literally printing money. The question I was touching on earlier is, as they retire those holdings through maturities, who will step up and buy those securities going forward?

This portends a higher interest rate environment should there not be central bank intervention to artificially hold interest rates down. And given the central banks’ stated goal to normalize their holdings of treasury securities, then that is going to be tested, and that is the very reason why you see the shorter maturities/durations in the Mercer Portfolios. We’re anticipating higher interest rates. How much that crowds out the competition for capital and thus, economic growth – it’s a headwind, it’s something to pay attention to. For retirees, it’s good news. You’re going to see probably higher interest rates over the duration of your retirement. So there’s two sides to this.

The one thing I wanted to point out, though, is this isn’t the entire debt picture. We have household debt and non-financial corporate debt, and what do those percentages look like as a percentage of GDP, and is there something we can bench that against?

When you look back at sort of the high-water mark of corporate debt and household debt, it was right there in 2008–2009. It was some 130–140% of GDP, and we know how that turned out. We had, quite frankly, too much debt at the household and corporate level. Fast forward to today… the good news is the growth from household debt has been very low since 2011, just 1.6% per annum against GDP growth that has been higher, so this is sustainable. This is not a panic time on the consumer’s balance sheet or corporate balance sheet. We’re in pretty good shape there. But these numbers that Don’s showing here on government debt is something to pay attention to.


Don Calcagni:   

Thank you, Drew. And I think that would be my message – there’s nothing here to panic about. But I think as citizens in our democracy, I think we have to begin having candid discussions with ourselves and our elected leaders around how do we want to spend our dollars, and what is the appropriate level of taxation? So I think that would be my message to our clients and certainly to our country.

I think the last comment I’ll make is on interest rates here, before we open it up to Q&A, Doug. Last year, there was a blub for about 10 seconds in the middle of December – we saw an “inverted” yield curve. And for those of you who pay attention to the financial media, oftentimes that is a harbinger, maybe a canary in the coal mine with regards to a future recession. What I would just add is, I think that’s a bit hogwash, and I think that’s actually the wrong metric.

I think what all of us on this phone really care about is what do equity returns look like when the yield curve becomes “inverted”? And let me just define what that means for a moment here. An inverted yield curve means that shorter-term interest rates are higher than longer-term interest rates. You can see that was not the case at the end of September. It did invert, I think, about five basis points here in the middle of the curve, like I said, literally for about a day in the middle of December, and it has since right-sized. So that’s what an inverted yield curve is – when the future interest rates are lower than current interest rates. I think what’s really important is what does it mean for equity market returns.

There is actually no evidence that an inverted yield curve leads to negative future equity market returns. I think this is a bit of just noise that’s out there, and I would certainly encourage our listeners and our clients across the company to keep this in context. This is usually fear mongering by folks that want to talk their book and certainly have an agenda. Again, I’m not saying it’s unimportant, but I don’t think it’s something to fixate on or become alarmed over.


Drew Kanaly:    

Don – so, inverted yield curves. For everyone, they predicted all nine of the last U.S. recessions since 1955. But when you include all countries’ returns at a 12-month interval or 36-month intervals, when you include international stock investing, returns on stocks were higher 86% of the time 12 months later, and 71% of the time 36 months later. This includes foreign and domestic stocks, and it really brings home Don’s earlier comments about staying diversified, because I realize over the last couple of years emerging markets and developed markets have been a struggle in the portfolio. But here’s a reason they’re there, and that stat just really brings it home, especially when you start focusing on inverted yield curves. The key for us is what does it mean to stocks, not what does it mean to recession.


Don Calcagni:        Doug, do you want to open it up for Q&A?


Doug Fabian:

I do. Ladies and gentlemen, we’re going to enter our Q&A session. I have some great questions that have been submitted and I’ll get to those in just a moment. Don, I wanted you to comment on a couple of questions that we had submitted by clients over the past couple of days. We had a question submitted about our factor strategy and when do we reallocate, did we do any reallocation in reaction to the markets in the fourth quarter? And, of course, this brings into a discussion about rebalancing. Can you just give how we go about managing portfolios for clients? Some of the behind-the-scenes stuff that they may not be aware of?


Don Calcagni:       

Absolutely, happy to. Rebalancing occurs at two levels at Mercer Advisors. We rebalance client portfolios typically on a quarterly basis, and so if you think about what that means in Q4, for example, stocks were down, and what happened there is we were selling bonds and buying stocks. That’s really big-picture. Within stocks, if you look at that a bit more closely, your high momentum stocks, your high fliers, those FANG stocks, they did really well in 2018, actually for the last several years. So for the last several years both at Mercer Advisors, but also at the manager level – so think of DFA, PMC, or Blackrock, these are managers we work with – they, and we, were actually selling a lot of those high momentum stocks and buying value stocks which had underperformed. I know that oftentimes clients look at us like, why are you selling the stuff that’s doing good and buying the stuff that’s doing bad? Well, that’s called selling high and buying low. We do that very systematically across our portfolios, and if we just look year-to-date, those decisions actually paid off. Granted, hindsight is always 20/20 and it’s great when the data supports your narrative, but it’s true – year-to-date stocks are outperforming bonds. So selling bonds to buy stocks last quarter when we did our rebalancing? Well, that was a good thing.

Separately, year-to-date, value stocks are up 7­ or 8% relative to momentum stocks, the high fliers last year, which are only up about 3% to 3-½%. So that’s why we rebalance. It brings that whole risk and return balance back to your portfolio. Re-balancing is one of those activities, I think, that is under-appreciated. It’s often ostracized, but it actually creates a significant amount of long-term value for clients.

So Doug, I think that answers our clients’ questions on that front. Doug, any other questions that we have coming in?


Doug Fabian:        

Don, would you comment on the U.S./China trade talks and also the global trade talks that are also underway and give a little color on that?


Don Calcagni:       

I’ll be happy to. So obviously, trade wars are bad for business. The way to think about tariffs – tariffs are a tax. No matter how you look at tariffs that’s what they are, they’re a tax, and when you tax something you get less of it. I think that’s what the Chinese are saying, it’s what the Americans are saying – that this trade war is not really benefitting anybody. To be fair, it is hurting China I think more than it is the United States. Part of that is because the U.S. economy is so large, and the U.S. economy is actually relatively insular. As a percentage our economy is only maybe 9–10% foreign trade, whereas when you look at other countries, especially in places like Europe, almost one-third or a half of their GDP is a function of global trade. So I think the administration was right to begin challenging China. China has not been, at least in my view, an honorable actor in the trade arena. They have engaged in disingenuous activity. That’s not really a political statement, that’s an objective statement, and I think that’s pretty clear to most global actors. I think it’s good to bring China to the table to have a discussion. I’m pretty bullish that we’re going to cut a deal with China. I think there’s too much at stake for both parties to not cut a deal.

One of the things that concerns me over the last two to three years is this retrenchment that we’re seeing globally from engaging the world. I think global trade is a good thing. I think it is a prerequisite to healthy economic growth for all countries. So I get concerned when the United States pulls out of trade negotiations with Southeast Asian nations, and so on and so forth. My hope, my expectation is that cooler heads are going to prevail, and that’s going to have a positive impact on markets going forward.


Drew Kanaly:       

Don, the thing I’d add to that is the trade negotiations – you know, you can see soybeans, right? You can appreciate the loss and the trade of soybeans, and some of the obvious things. What they’re really negotiating over are the intellectual property rights that are being lost that you can’t see, that don’t show up economically, because how do you measure something that’s basically stolen or pirated, right? So the potential impact to U.S. companies and the value of their intellectual property is huge. It’s a huge win if you’re able to come to some reckoning even if it’s, I don’t know, if there’s such a thing as halfway on something like this. It’s a very, very big deal. So the sort of short-term pain you see in economies as a result of this is nothing compared to the potential upside to technology and intellectual property rights going forward.


Don Calcagni:        That’s a good point.


Doug Fabian:   

Don, would you please comment. One of our clients is asking about inflation. We didn’t get into inflation today but obviously this is an important part of our strategies going forward. Can give a little look back and any color on inflation concerns going forward?


Don Calcagni:       

Inflation – it depends on how you measure inflation, right? So when we look at different baskets of goods and services, not all Americans are confronted with the same inflation rate. I think that’s an important disclosure when you’re starting to have discussions around inflation. Look at senior citizens, who by definition tend to purchase a significant amount of health care services, for example. Obviously, inflation within the health care sector has been quite astronomical. We see this with drug prices and just the overall cost of medical care. However, when we look at inflation across the economy in the aggregate, and when you see a massive decline in the price of oil, inflation – which again is an average of price changes across the basket of goods and services. When you see that kind of decline in the price of oil it’s hard to see lots of inflation on the horizon. That’s because oil makes up a significant part of the pricing for all kinds of goods and services across the economy, because we have a very energy-intensive economy.

So I do think inflationary pressures are there. We have full employment and we are seeing some wage growth, and Americans spend money, right? Our saving rate as a percentage of our income is relatively low, so as wages rise and we have jobs, we’re going to spend it. So there’s definitely inflationary pressures there.

The Fed, by the way, does have a 2% inflation target. They want some inflation, and I think we’re right around that 2.2% mark, so I think we’re right on target with where the Fed needs us to be.

So does inflation concern me? At this point, not at all. As time goes on it will be interesting to see what happens with inflation, but I think just looking out over the next several years, inflation is not a significant concern when we look at the global landscape.


Doug Fabian:        

Don, let’s talk about the U.S. Dollar. This is one of the reasons why international markets underperformed U.S. markets in 2018. Color and commentary from you and Drew on U.S. Dollar 2019, and factors that could influence a rise or fall.


Don Calcagni:   

We can debate why the dollar has risen in value. My view is that the dollar rises in value generally when you have a strong economy, which we do. Our economy is doing well, and it rises in value when interest rates are rising. Global investors want to hold more dollars because if they hold more dollars, they can earn higher interest rates. They can buy U.S. fixed income securities with those dollars. So that’s going to put upward pressure on the dollar when you have a growing economy and you have rising interest rates. What I would argue, though, is that there’s a couple of things that happen when the dollar goes up in value and we export less. That means our goods and services are now more expensive for the Chinese to buy from the United States. I’m sure that’s on the table there between the negotiators trying to figure out, hey, how do we adjust for changes in the prices of the dollar relative to the Yuan?

But when I look at the dollar, oftentimes when I get the questions on the dollar, folks are asking me what about the dollar losing its global reserve currency status? First off, that’s completely untrue. There are more central banks today holding dollars than 20 years ago. Twenty years ago about 50% of global reserves were dollars. Today it’s about 72%. So the dollar is still very much king on planet earth, so central banks would kill to hold more dollars.

The dollar is strong. I don’t think it will be strong forever. Interest rates won’t stay strong forever and the economy won’t keep growing forever. Eventually the dollar will probably come back down at some point, but predicting that is always a bit of a challenge.


Doug Fabian:       

Don, talk a little bit about a question from a client here about value, and value obviously last year underperformed, at value premium and non-U.S. stocks. Just give a little color around those two areas that have been a bit of a drag on our portfolios in the past 12 months.


Don Calcagni:      

I think value has underperformed for quite a long period of time. So just to think about what value is for a moment, those are assets that have low prices relative to their hard assets or their earnings, right? So I think it’s important to understand why value has underperformed over the last several years. I think it’s important to keep in mind that the stock market to some degree is a popularity contest. We saw this with the FANG stocks, right? You had four, maybe five stocks that were trading at over 100 times earnings. We saw this in the late ’90s where we were all going to get rich investing in Netscape or EBay or EPets or something, or something like that. When you start to see that disconnect between your value stocks like your utilities or your Exxon Mobile, or your Johnson & Johnson or McDonald’s, it’s probably not because those stocks are doing poorly necessarily, but it’s because these high-flying growth stocks or technology stocks are winning the popularity contest and getting pushed up to nosebleed levels. Those are the high-momentum stocks, right? And I think you see the same thing happening globally. The U.S. stock market does not operate in a vacuum. We have global markets where this same phenomenon is going on.

Does that mean that we should join the herd and load up on four or five stocks? Absolutely not – you want to remain diversified. You want to own those lower-priced stocks because they are a cushion in your portfolio. They add a diversification benefit to your portfolio – that’s why we believe in them. You know, Johnson & Johnson, great company. McDonald’s, great company; I don’t eat their food, but great company.

So value stocks are a critical part of the portfolio. Remember, those aren’t the popular stocks most of the time, and my message to our clients is that’s OK. It’s OK not to try to win the popularity contest in the stock market. And we see this – so far year-to-date, value stocks have outperformed those high-flying momentum stocks by about four to five percent already in the month of January. Whether that continues, who knows; certainly predicting the future is impossible. But that’s why we own those value stocks.


Doug Fabian:        

Don, a couple of more questions in the time we have left that were submitted and also came from our client events. Can you comment on computerized trading and the impact on markets in your view?


Don Calcagni:    

There is this notion that somehow computers have taken over the market, which in many ways they have. I mean, the market today is much more automated than it was 20, 30, 40 years ago, certainly. But I think the question behind that is, have computers led to an increase in market volatility? And I think when you actually look at the data the answer to that is no. In fact, the conclusion looks to be the complete opposite.

If you look at the dot-com era that really came to age in the mid to late ’90s, since that point in time, average daily volatility in the market has come down. It has not gone up. Despite the fact that we have these spikes, we had 2008, and I think many clients look at that and say wow, that tells me, Don, that you’re wrong.

I would say, wait a minute, what about 1987 where it spiked and we lost 22% in one day? That was pre the days of the internet and computerized trading. So I think when you look at the data, that argument that somehow computers have led to a more volatile market, that argument just does not hold water – at least when we look at the data.


Doug Fabian:        

Don, last question. What keeps you up at night regarding the financial markets? And Drew, we would like to have your comments on that as well.


Don Calcagni:       

Regarding the financial markets, what keeps me up at night – and it’s really more of a broader commentary, and I said this on our speaking tour throughout the month of January – is what I consider to be this erosion in the quality of our discourse. I feel like today when we debate markets, or the economy or politics, it just seems like that suddenly we don’t value the science anymore. Whether we’re talking about things like climate change or the economy or the dollar, it seems like everybody shows up at these debates with a preconceived notion. They’ve already made up their mind. They have their ideological beliefs, and that makes it really hard for us to have meaningful discussions as a society, and think how should we regulate our markets, what should the appropriate tax level be? It’s just very hard to have an intelligent discussion these days.

I see it on Bloomberg News, I see it on CNBC, I see it when I go to conferences, so it’s not isolated to sort of the chatrooms on Facebook. I see it throughout our society, so that does keep me up at night.

I am a scientist. I deeply value scientific thinking, and I get concerned when suddenly as a society for some reason we don’t respect that or value that. So that does keep me up at night.


Doug Fabian:         Drew, any comments?


Drew Kanaly:  

Yes. I would echo what Don is saying. It seems we get detached from the fundamentals and we focus on things like I can’t quite grasp. His slides about valuation in the market and earnings growth, that’s where the truth lies. The rest of it is kind of speculation on the margin, and the data coming in, you know, generally is pointing to more favorable conditions, rather than disastrous that we’re seeing.

What’s come to pass was actually some slides we were showing in this call this time last year, kind of foreshadowing that there was a problem in the growth and momentum category based upon valuations when you run a regression. Fast forward – that’s really kind of come true, and you’ve had a compression in those valuations.

The next thing that concerns me or keeps me up at night is that price of oil. I really view it as a barometer of total economic health. We just don’t have perfect substitution for those BTUs yet. Until we get to that point that’s the number, when I get up in the morning and look at the futures, I always like to see that number in green territory. And it seems to follow – the markets seem to respect that number as well. So, that’s kind of what I watch.


Doug Fabian:  

Great; thank you. Well, ladies and gentlemen, I want to close today’s webinar with a few comments for everyone. If you have not visited, our company website, I would encourage you to do so. There are many resources there besides your access to your accounts. But I wanted to mention that we have, of course, the Science of Economic Freedom Podcast at the website. We now have over 60 podcasts. We have special reports, we have articles. This is where you want to go to share content with family, with friends, and to just expand your personal knowledge about all things financial.

We, of course, as an organization are now publishing a quarterly newsletter called Wealth Point, and at our website we have what we call the Insights Tab. This is where we have a lot of our educational information.

So we would really encourage you to go out to and explore. Listen to some of the podcasts, read the articles. We are also posting the webinars out there. I also want to mention if you had a question today that did not get answered, I would encourage you to reach out to your advisor, have a conversation with your advisor about your personal portfolio, your asset allocation, your individual holdings. We wanted to give you the macro view today on the global financial markets, but it is your advisor relationship who knows you best here at Mercer Advisors, and they would be the best person to talk about your individual situation.

We do want to thank everyone for attending today’s quarterly Mercer Advisors Webinar. We will be sending a recording of this event to all clients soon. We do want to mention to all of you who were on the call live, we will be sending a feedback survey. We would appreciate you filling that out and giving us any feedback that we could use to make these presentations more valuable in the future.

Thank you very much, ladies and gentlemen. This is Doug Fabian, and we thank you for being a client of Mercer Advisors.




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While the webinar presenters answered specific questions from audience members, the answers should not be construed as personalized investment advice tailored to that individual’s specific financial circumstances. Answers were provided upon the information provided and were intended to be educational in nature.

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