Doug Fabian:    Hello, ladies and gentlemen, and welcome to this Mercer Advisors Client Webinar. We’re recording this event on April 29th, 2020. Today, we will be discussing the capital markets during the first quarter of 2020 and the effects of the COVID-19 global pandemic crisis on the economy and these markets. These are unprecedented times for all of us. Every family, individual, and business in America has been affected. Today, we’re going to spend the majority of our time answering your questions.

 

My name is Doug Fabian and I am the host of the Science of Economic Freedom Podcast plus a member of the Investment Committee and part of the Client Communications Team here at Mercer Advisors. I wanted to point out the functions on the toolbar during this live broadcast. This is where you can submit a question. It will send us a text message and we’re going to do our best today to facilitate and answer as many questions as possible during the Q&A portion. I want to suggest if you have a question to submit those questions now. Now, our formal program today is going to last about 20 minutes leaving 40 minutes or more, and we will even go over the one hour allotted today, to accommodate all of the questions. We have a record number of attendees on today’s broadcast and we’re certainly looking forward to having some good interaction with you.

 

Now, joining me today is our Chief Investment Officer, Don Calcagni, and Drew Kanaly, Client Advisor and long-term Investment Committee member. Now, we’re all practicing social distancing. I am in California, Don is in Pennsylvania, Drew is in Texas, so we’re scattered all around the country as we’re bringing you this broadcast today. I know we’re not going to spend time reading this slide but what this slide basically says is we’ve made every effort to be as accurate and timely with the information that we’re presenting today. And we also want you to know that no part of today’s presentation or content should be considered personal investing advice.

 

So, here’s our agenda today, ladies and gentlemen. We’re going to be starting off on discussing the economy and getting out of this global pandemic lockdown that we’ve been in. We’re going to talk about the markets, not only for the first quarter but how things have gone year to date. We’re going to discuss the oil markets because it’s a big indicator of economic activity. And then lastly, we’re going to be talking to you with your questions. Let’s jump in and let me turn things over to Don Calcagni to talk about what we’re calling the flattening of the curve. Don?

 

Don Calcagni:    Thank you, Doug. First off, I just want to say it’s great to be here. Thank you, everybody, for giving us some of your time to listen in to our commentary today. Just to set some context, I think the first thing that we have to acknowledge is that the data from Johns Hopkins University suggests that we are beginning to flatten the curve. It looks like we’ve been doing that for close to a month now. Obviously, this is imperfect information. This is a rapidly evolving situation. As testing becomes more widespread throughout the United States, we’re going to get better and better information certainly with respect to the spread of the infection and so on and so forth.

 

But that said, the data does suggest that even though the United States has more confirmed cases than other countries, we have begun to flatten that curve. I think that’s really the first indicator of where we’re at and ultimately what we need to see to begin to win this war against the virus. I think it’s somewhat heartening to see this. We do have to keep the data in context though that, like I said a moment ago, we do have imperfect information. But thus far, it looks like we are beginning to flatten the curve.

 

Because we’re beginning to see this flattening of the curve, Doug, it looks like we’re starting to see more and more states slowly begin to open their economies. Obviously, not all states are in a rush to do so. The impact of the virus varies significantly from one locality to another. New York is very different from Texas which is very different from, say, Montana. We are seeing a handful of states taking some very small steps, I would argue, towards beginning to reopen their economy. I do think it’s important for our listeners to understand also that within states, cities and counties can ultimately move at a smaller pace than their state government.

 

For example, Denver, the City of Denver has not reopened whereas the State of Colorado has reopened or is slowly beginning to reopen. This is the first step towards ultimately slowly beginning to reopen the economy. I would encourage our clients to keep in mind that this is probably not going to be a linear process. It’s probably going to be one or two steps forward, one or two steps back, for a period of time. And so I would not look at this is if this is the end of all of this and we are now ultimately going to get back to normal. I think normal is still a long ways out personally, but I do think this is a good sign to slowly begin to reopen the economy when it strategically makes sense to do so.

 

Doug Fabian:    Well, Don, this is a great time for us to kind of move towards talking about the financial markets. I wanted to let everyone know that the data that you’re looking on the screen, especially in the box that Don is going to be walking us through, that information is through April 24th of 2020. Don?

 

Don Calcagni:    Yes, thank you, Doug. Great reminder. Like Doug said a moment ago, we’re trying to make every effort to bring to you the most recent market data possible. The market is always moving, obviously. But when we look at this data through April 24th, again like Doug said, look at that green box there. You’ll see the S&P is now, at least as of Monday, negative 11.7% year to date. When we look at outside of the United States, we see that outside of the United States, that those markets have not recovered as much as the US financial markets. And so you’ll see outside the US, we’re still seeing returns somewhere in that negative 20% range, whether it be the emerging markets or Europe or other developed markets.

 

What I will highlight on this slide, Doug, before we go any further, is something we may talk about during the Q&A session and that is if you look at the returns just to the left of the returns that are in that little green box, you’ll see that those returns are a little bit higher than the returns that are in the green box. And that’s because of what we call the currency effect. You’ll see that the returns are higher to the left of the box, they’re actually a little worse when you’re in the box. That’s because the value of the US dollar has strengthened relative to their local currencies. Anytime the US dollar strengthens relative to non-US currencies, that hurts US investors who own non-US assets. So because of the crisis, there’s been a significant demand for US dollars, and obviously, that has had a negative impact on US investors outside the US.

 

Doug Fabian:    I want to bring Drew into the conversation. Drew, set some context. Obviously, you have experience in previous bear markets. We went February 19th, stock market at an all-time high, just some four weeks later we had entered a bear market. Kind of put some context from your point of view on kind of how rapid this decline was and what have been your overall comments as you’re having conversations with clients.

 

Drew Kanaly:    I think the thing that I’ve been trying to emphasize to everybody is we all focus on the stock markets as we should, but remember that equity, the value of the company over and above its other capital structure, debt, still rests upon a bed of debt. And the thing that I was watching particularly closely as this thing began to unravel was what was happening in the debt markets. Because that’s really where the foundation, if you will, the economy is, the initial extending of credit. If you really paid attention to what government activity was centered around was not only the Federal Reserve providing liquidity in the debt markets but also the stimulus packages were targeted at small businesses and creating liquidity and debt underpinnings to the economy.

 

If you really think about where we troughed out here, it was those two things kind of stopped the market just cascading like it did ’08-’09. This is a little bit different than that experience. Now, it still remains to be seen what happens going forward. But that was the thing that I was talking to people about and so you were watching credit spreads, you were watching disparity. I know we have a slide on it. That was really the experience that I took from it, that I think we’ve kind of reached our lows for this particular episode, and credit was the key to it.

 

Doug Fabian:    Don, some context. We had a 33% decline high to low. What’s happened since? Of course, we have the summary numbers, but just put some context in the rally that we’ve had. All of us on the team still feel we’re in a bear market. We don’t have clear sailing ahead. Talk to us about what’s transpired just over the past few weeks.

 

Don Calcagni:    Yeah, go back to March. March is really where we saw most of the action, to Drew’s point. Credit markets were struggling in mid-March. The bond market was really having a difficult time pricing in and executing trades. It was really on March 23rd when the equity markets hit rock bottom and from the March 23rd low, we’ve seen about a 30% pop off of that low. So we didn’t fully recover the full 34% that we lost from the top, but we did bounce about 30% off of the bottom. So in order to fully recover the previous highs, we still need to claw back that 11.7% that our listeners see on the screen there, so we still have a little ways to go. But from that March 23rd low — and it certainly has not been a linear straight upward recovery, it’s been choppy obviously — but we’ve seen close to a 30% pop off of that low.

 

And even today, I’m looking at the Dow right now, it was up a little after 500 points last time I checked. So we’ve seen a healthy pop but a lot of that’s because, to Drew’s point, the Fed came into the market, put a floor under bonds, began buying investment-grade debt, opened up a number of lending facilities to ensure the free flow of credit throughout what I call the cardiovascular system of the economy to make sure that there was no blockage. That really helped to put a floor under equity prices.

 

Doug Fabian:    With that discussion of equities, let’s turn our attention to the bond market and go through some numbers here. Don?

 

Don Calcagni:    So again, just to direct our listeners, focus on that green box here in the middle. Those are year-to-date returns as of April 24th. On the left, you’ll see the different types of bonds, the different bond asset classes. If we’re looking at the two-year US Treasury Bond, that bond is up 2.85%. I never thought — I can see the smile on Drew’s face — I don’t know that we would have ever thought in our lifetimes that we would see year-to-date returns this high on US Treasuries. I’m looking at the 30-year US Treasury Bond. Positive over 31%.

 

Now, how could that be? Well, the Fed took interest rates basically to zero. Bond prices and interest rates move in different opposite directions so if interest rates go down, bond prices are going to go up. We see that reflected here with US Treasuries. When we go below that thick black line in the middle of the page here, you’ll see corporate bonds are also positive. Not as much, and that’s partly because corporate bonds… And then if you go a little bit further down, you’ll see convertibles, high yield. Those types of bonds are bonds typically issued by companies that have a fair amount of debt. And what happens when a company issues bonds and they have a fair amount of debt, their bonds actually start to behave a little bit like stocks. That’s why you see high yield is down a little over 9-1/2% through Monday. So we have seen sections of the bond market take a bit of a hit because they’re issued by companies that are somehow in a less than desirable financial condition. Their credit score, to use a consumer analogy, would be relatively low.

 

Before I move on, the US Aggregate Bond Market, which is an index that looks at the total US bond market, is positive basically 5% through Monday. Doug, I think this really does underscore the power, the need for diversification in our portfolios. Last year, I remember I had so many clients coming to me saying, “Don, why should I own bonds? It’s a rising interest rate environment. Everybody on TV or everybody in the far corners of the Internet’s telling me I shouldn’t really own bonds.” This is why we own bonds. It’s for when, not if, but when those bear markets occur, they provide a cushioning effect to the returns in our portfolio.

 

Doug Fabian:    Great. Let’s continue on. If I was to describe this slide, I would call this — and again, many of our clients are in a balanced portfolio — but this slide is really telling in terms of kind of volatility of one’s portfolio and what one’s owned. Explain it to us, Don.

 

Don Calcagni:    You’re right. There’s two big takeaways in my view from this slide. What we’re showing you here is the return on a bond, the US Aggregate Bond Index, which is that green line at the top. We’re showing you that dark gray/black line in the middle, that’s a 60/40 split between stocks and bonds. And then the dark blue line at the bottom, that’s the S&P 500 Index.

 

The first takeaway is that a diversified portfolio obviously lost less than an all-equity portfolio. We’re assuming you began with $100,000 and obviously, once the coronavirus crisis really took full effect, we saw that that put downward pressure on all three of these lines in the month of March. The first takeaway is a 60/40 portfolio actually weathered the storm relatively well, at least as of yesterday — that’s when I built this chart — as of yesterday, a 60/40 portfolio was down only about 7-1/2% from the market high on February 19th. That’s the first takeaway, that diversification does work to cushion the blow when these sorts of things happen in the world.

 

The second takeaway is if we zoom out and look at returns over longer periods of time, what we see is that they’re not so bad. So quarter to date, obviously we’ve had a great quarter, stocks are up 11.5% quarter to date. Our 60/40 portfolio’s up over 7-1/2. So not too shabby. If we scroll down and we look at year to date, we see that the returns are about negative 10 again, this was through yesterday’s close. Then we’re showing you the returns from the market peak. Now, this is a behavioral issue. As humans, we always like to understand our returns from the peak. But that’s a bit of data mining, we should really look at returns over a longer period of time. If we look at returns just over the past 12 months, we see that stocks are basically flat over the last 12 months. If we just go to the right, we’ll see that our 60/40 portfolio is actually positive almost 5-1/2% over the past 12 months. Bonds, the Bond Index is up 10-1/2%. So if we just zoom out, look at a longer period of time, Doug, it’s actually not too bad.

 

Doug Fabian:    Drew, you’re having conversations with clients each and every day. Going back to this particular slide and putting a client’s conversation in context with their portfolio, talk to us about how you have been explaining obviously the change from a bull market to a bear market and the conversations that you’re having with clients.

 

Drew Kanaly:    Yeah. I think the wildest part of this whole thing is the move in fixed income, especially if your duration is extended out long. We’ve been a little bit shorter obviously, so you’re not quite getting the 30-Year Treasury experience in your portfolio. Also I think clients were quite taken aback during the downturn that they didn’t get a better cushion in their fixed income in municipal bonds and that was a phenomena of liquidity. Not credit, liquidity for people just having to sell what they could sell, margin calls, all across the board.

 

You have to remember, municipal bonds are owned by a lot of different constituencies, more so than just individuals. Banks, insurance companies, everybody in that group owns some type of municipal bond so they were having to sell what they could sell. That caused quite a disruption in the municipal market and so we’re still probably year to date, technically speaking, negative on a big portion of people’s portfolio for fixed income. I’m not concerned about it in the least. Yeah, there are going to be some credit downgrades nationally. That’s going to lag but it’s probably priced in the securities presently. I don’t see any major defaults or anything like that. There’s been a lot of headline news about states going bankrupt and whatnot. We’re way, way far away from that issue being front and center. Like we were talking about, we’re all dealing with a lot of imperfect information right now and so the experience is going to be a little different for the municipal bond portfolio.

 

Doug Fabian:    Don, I have a question in the queue that I had gotten and I’m going to bring it in right now. I’m going to mention, ladies and gentlemen who are listening to us live here, please continue to send your questions in. We’re going to be getting into our full question and answer session in just a couple of minutes. But Don, handle this question. A client is asking individual bonds versus bond funds, compare and contrast. Is a bond fund safer because it’s more diversified? Give us some context and some comments and talk a little bit about our credit quality standard that we have for our bond portfolios.

 

Don Calcagni:    There’s a number of questions sort of baked into that. The central question is what vehicle is best for investing in bonds as an asset class. You could buy bonds individually in your portfolio, you could buy a bond ETF, or you could buy a bond mutual fund. My view is that all of those vehicles serve different purposes. It depends on what you’re solving for and I think this is a conversation that you should always have with your advisor. There’s a number of clients who like to customize their bond portfolios for whatever reason, maybe to dovetail with college tuition bills or retirement income needs or whatever the issue might be. In that situation, you could own individual bonds.

 

There’s other clients who appreciate the intraday liquidity that an ETF, in theory, provides and I underscore “in theory” because March reminded all of us that providing real-time intraday liquidity through these trading vehicles that have become quite popular in the last two decades is actually a really hard thing to do when there’s not a lot of liquidity, to Drew’s point. What really hammered the muni bond market and the broader bond market back in March wasn’t credit as much as it was just liquidity. Everybody was selling. When everybody’s running for the exits, we have a bit of a challenge.

 

My personal vehicle, just to share my personal bias with our listeners is I prefer mutual funds. The reason I like mutual funds is they’re generally significantly more diversified than ETFs or when a client builds out a bond portfolio in his or her account. What I also like about mutual funds is that they don’t offer investors intraday liquidity. So they don’t have to worry about this bid/ask spread between what the bonds are worth in the ETF and what the ETF is trading at in the open market. Back in March, we saw bid/ask spreads between 5% and as high as 20%. Not bid/ask spreads, I’m sorry. The price of the ETF relative to their net assets. That spread was almost as high as 20% for some of the muni bond ETFs in the market and so that meant the ETFs were selling at a discount relative to the assets that they actually owned. We don’t have that problem with mutual funds.

 

For those reasons, I prefer mutual funds over ETFs and individual bonds, but it just depends ultimately on what we’re trying to solve for from the financial planning perspective. At Mercer Advisors, we use all three of those approaches to investing in bonds. I think, Doug, that’s the first question in there. The second question was around credit. Generally speaking, we prefer to focus on investment-grade bonds. We do have below investment-grade bond offerings for select clients who need that kind of income. But we’re typically looking for stuff that’s BBB and up, things that are well-diversified, we’re looking for managers who aren’t trying to make some sort of outsized bet on a particular sector. Trying to make sure that those portfolios are exceptionally well-diversified so that what happened in March does not permanently derail a client’s portfolio. Diversification worked in March and I would argue it worked in the bond market as well and for those reasons we prefer highly diversified investment-grade bonds in client portfolios.

 

Doug Fabian:    Great, thank you. Let’s move to the oil market before we start to go towards our Q&A session, gentlemen. Don, let me go to you first and just talk a little bit about volatility but I know Drew is really one of our experts here on oil.

 

Don Calcagni:    For sure. If we just look at the price of oil, it’s interesting. In March, we got really hit with a double whammy. We had this coronavirus outbreak and then we had the Saudis and the Russians get into a pushing match over the price of oil and they had a major disagreement on what OPEC and Russia ultimately should be doing in terms of production cuts to prop up the price of oil. So we had this price war between two of the world’s largest producers — and Drew’s going to give us some color on really who was their real target in that shoving match — so you had this price war break out over oil but then you also had a very powerful demand shock. China was shutting down, the United States was shutting down, so just the raw forces of supply and demand really helped to push down quite dramatically the price of oil.

 

Certainly, this is going to have an outsized local impact on states like Texas or the Dakotas, but at the end of the day, this is a powerful deflationary force that’s going to put a bit of a powerful lid, in my view, on inflationary pressures. I know, Doug, some of the questions we’re getting from listeners are around inflation, the Fed, printing money, or expanding their balance sheets so we can talk about that during Q&A. When I look at the price of oil, this is more of a raw supply and demand story that’s been greatly exacerbated by the price war between the Russians and the Saudis. Drew, I’ll hand it over to you since you have infinitely more expertise in this area than I do.

 

Drew Kanaly:    Yeah, when you look at this chart, there’s a couple of elements missing. One is the Brent price, the European experience of the price of oil. Presently, it’s still trading over $20 per barrel even on the front month contract. So you ask yourself, “Wait a minute. Oil’s fungible, why is the Brent price materially higher than what we’re showing here, which is the West Texas Intermediate?” The answer is bathtub, bathtub’s the answer. What’s happening literally is the oil, since there is no demand as Don pointed out, the drain’s plugged and there’s no oil being taken out of the marketplace. People driving cars, getting on airplanes, getting in their boat. Whatever you want to say about it, it is literally not being used. So the bathtub is filling up and they’re running out of storage.

 

There’s even discussion about Nigerian producers can’t even find ships to put their crude on to store it temporarily. Everyone’s having to cut back. What you’re seeing here in these front month contracts is the paper buyers versus the actual people that take delivery. When you get to the end of these contracts, you get into a situation where there’s no place to put it and it traded negatively. The next thing that’s not on this chart is the actual wellhead experience. What the actual producers of the oil are getting when they sell it before it gets to the storage facility where it’s traded in these prices that you see here.

 

Just to give you an example, in April, producers at the wellhead were experiencing maybe $15 a barrel as compared to maybe something 20-plus in the cash price on the front month and back end contracts. Presently, for May, they’re looking at $4 to $6, depending on the grade of crude. Not all crude’s created equal. Anyway. What’s going to happen, what is going to happen is the actual supply of oil in North America in our bathtub, it’s going to go down and it’s going to go down dramatically. This wellhead experience has been going on for quite some time, well before the big price war targeted shale producers in North America. Flat out, it was targeted North American shale producers. Everybody knows it. But they have been laying down rigs for over a year, they’re going to start shutting wells in presently, and depending on who you talk to, the decline curve 24 months out could be as much as 70% for some production. But we’re 6 to 12 months into that decline curve already so you’re going to see the supply really begin to fall off very quickly.

 

In the meantime, if you’re an oil-producing region, you are begging them pull the plug on the bathtub, get the demand going, and this also ties to the economy. One more point real quickly. When you looked at the credit market disruption, almost to the day, the day they announced the price war on crude, credit markets went berserk and it was all tied to all the downgrades, all the bankruptcies that are going to happen in the energy complex, and that’s part of the big credit disruption. Really, if you really look at the whole broader market, and so this is one area, it’s bouncing back nicely now but it’s still got struggles ahead.

 

Doug Fabian:    Great. Thank you, Drew. Ladies and gentlemen, we’re at the point of our presentation that we want to open things up for questions. I’ve got some good questions in the queue and I’m going to jump in and start asking some of these questions. I’m just going to mention to Don and Drew, because we’d like to get as many questions as possible, just kind of be mindful on your answers. We don’t want to go too deep on any one question because I’d like to try to get as much variety of questions as possible in here. Let’s begin with this. Is it different this time? How can we plan for the future and how can Mercer Advisors give advice when what we’re going though is so unprecedented? Don?

 

Don Calcagni:    It’s a great question. What I would remind our listeners of, Doug, is that all bear markets have different causes, different catalysts, but at the end of the day, they all rhyme. Markets decline, we have credit challenges — to Drew’s comments — we see impacts on commodities prices like oil. Whether it’s a financial crisis like we had 12 years ago or whether it was the dot-com bubble, or Russia defaulting on the ruble, or Mexico defaulting on the peso, or the 1987 crash. At the end of the day, the causes are all different but bear markets rhyme and what a firm like ours is really adept at doing is counseling clients through these macro-level disruptions. We’ve been doing it since 1985, it’s not new to us, it’s not the first time we’ve seen a difficult market. We’re humans, we’re actually somewhat predictable. We’re predictably irrational, that’s actually the title of a book I would encourage all of us to read.

 

As humans, we tend to have the same sort of emotional response to these macro events and market declines. The same financial planning techniques that we use or the same for balancing textiles, harvesting, all those different things that advisors do for clients. Doug, that’s how I look at these things. I don’t look at this as materially different. It is unprecedented given the cause and really how quickly the market sold off. That is definitely unprecedented. But like I said, these bear markets, they rhyme, they’re not identical but they do rhyme.

 

Doug Fabian:    Drew, let me ask you to comment. Why aren’t stocks down more?

 

Drew Kanaly:    Well, they are. If you really dig into the market and you take out the FANG stocks, value stocks are still off close to 20% year to date. That would include banking and energy and other value companies. So stocks are off significantly. Small cap stocks are off. International stocks are off. They’re all fairly reflective of when you see unemployment numbers move like we have, it makes sense that you’re going to get this type of correction.

 

The difference this time around so far is ’08-’09 was a cataclysmic credit disruption. Orders of magnitude much greater than this time around. So we don’t seem to have — so far — the type of credit concern that we did last time and there’s reason to believe that some of this unemployment is transitory and once we reopen up, a lot of these folks will go back to work. Those are kind of the two takeaways. Whenever the market seems to get information about a new treatment or a new cure for the virus, stocks respond immediately because they’re looking out 18 months and so they’re looking out for these things being implemented perhaps this time next year.

 

Doug Fabian:    Don, we’re in a bear market, we understand that. We also understand that it’ going to be a bumpy ride. We all know when that seatbelt light comes on when you’re on a plane that the pilot’s telling you they see bumpy air in front of them and I think that that’s the situation we’re in right now. Certainly, we’re all positive that eventually the market is going to recover. How would you think in terms of the time cycle? Again, this is a listener question, client question. What’s the time cycle going forward and how would you answer that question in the context of how we go about managing money and helping clients through this?

 

Don Calcagni:    Yeah, it’s really difficult to predict when this quote ends. I have my views and I’ll share that here momentarily. The reality is I don’t see us getting past this particular crisis until we have better widespread testing, I think that’s one of the requirements we need to see. Ultimately, we need to see a vaccine. Once we can develop a vaccine, I think consumers’ll be more relaxed, they’ll be more confident that the worst of this is ultimately behind us. I’m not a scientist but most of the scientists that we hear on television are saying 12 to 18 months before we could have a viable vaccine. So 12 to 18 months feels right for me.

 

But remember, that’s when you have a vaccine. The market is forward-looking so the market is quickly looking past this crisis, I would argue already. The economy will lag the market. I do think we start to see a recovery towards the end of this year, maybe into the early next year, that’s my personal view. I think it’s going to take some time. There will be a new normal coming out of this in terms of more people working from home and things like that. I do think we start to get past the recession pretty quickly.

 

We’ve seen powerful action from the Fed, the US Congress with the CARES package, the question a moment ago, “Why aren’t stocks down more?” Well, we just fired a $6 trillion bazooka at this thing so I think that’s helped to put a floor under stock prices. My personal view is the economy starts to recover in 12 months or so, later this year and into 2021. I think the market ultimately is forward-looking and it’ll probably begin to price adjust long before then and I would argue it’s already begun to price adjust and look past a lot of the crisis. That’s my personal view.

 

Doug Fabian:    Great. And I’ve seen this question stated a number of different ways, but obviously the US government has passed a battery of legislation, totally about $6 trillion, including the CARES Act, including what the Fed has done. What’s the economic implications of so much debt and money printing going forward?

Don Calcagni:    It’s interesting, I get this question all the time. There’s this belief, and it’s a well-founded belief, it’s well-grounded in economic theory, Drew and I have this conversation quite often. The thinking is, look, if you pump this kind of cash into the economy either through borrowing or through the Fed expanding their balance sheet — which is just a euphemism for printing money — that in theory, we should see a significant uptick in inflation. Well, the reality is the Fed expanded their balance sheet by $4-1/2 trillion to combat the global financial crisis, and frankly, in the past 10 years since that crisis, we’ve been more worried about deflation than we have inflation. In fact, we have been begging, I should say we the Fed, has been begging to see a little bit more inflation.

 

The reason I bring that up, Doug, is we need to be careful trying to draw very simple cause-and-effect relationships when it comes to a $23 trillion highly complex economy. I admit, I was in the school that thought, “Gee. We’re going to see a lot of inflation because of the Fed expanding their balance sheet back in the aftermath of the crisis.” I still have those concerns, by the way, those concerns have not gone away. I share those concerns that, hey, we’re now expanding the balance sheet even more and the government is borrowing even more, that that should have a negative impact on inflation. It should push inflation up.

 

But like I said, we have this big drop in oil, that’s a deflationary pressure, so I’m not convinced we’re going to see massive inflation as a result of the new CARES package or the Fed expanding their balance sheet. So that’s a short-term comment. By short term, I’m thinking maybe the next 5 to 10 years. So short term, I don’t see a ton of inflation at the moment on the horizon based on the Fed expanding on the balance sheet. Longer term though, the reality is this is going to drag on growth. Our government has borrowed a significant amount of capital from the future. So that 23 trillion in debt that the US government has, that was future economic activity that was pulled into the present to pay for the things that we wanted to pay for as a nation.

 

So longer term, I think that’s going to drag on growth, personally. I think we’ve seen that in the last decade. Economic growth in the last decade has been very anemic. It’s been low twos, low 2% in real terms, and I think many economists would agree with me that that could conceivably be due to the debt drag that we have as a government.

 

Doug Fabian:    Drew, did you want to add to that? I know we have that discussion all the time.

 

Drew Kanaly:    Yeah. Because of the allocation of capital to less productive resources. Yeah, it may have stemmed the tide of an economic disaster but the flip side of it is is it’s a drag on the economy because it’s less productive allocation of resource. So that’s why your outward net growth numbers probably won’t be as high because of that effect.

 

Doug Fabian:    Another area, gentlemen, that there’s a lot of energy around is the US dollar. The US dollar remains the reserve currency in the world. We’ve enjoyed that status for a long time. Now again, I’m going to bring right up here, there are a lot of countries, even including Germany, who are going to the debt markets, who are doing this borrowing and the like. Let’s comment a little bit on the dollar. Strong dollar, its effect on our portfolios. Weak dollar and its effect on our portfolios. We’re going to have volatility of course in the currency markets but of late, the dollar remains strong. Don, let me go to you first on just comments relative to the US dollar and its future value.

 

Don Calcagni:    Yeah, Doug. It’s like we were saying a little while ago when we’re looking at equity returns globally. We’re in a strong dollar cycle. Anytime there’s a crisis, the demand for dollars goes up significantly. The dollar is still the world’s preferred global reserve currency. The other thing that’s pushing up the value of the dollars, our interest rates are still nominally positive. When you look at globally, there’s about 17 trillion in negative yielding debt, a lot of that tends to be European debt issued by countries like Germany and Switzerland and places like that. So because our interest rates are nominally positive, investors globally want to own dollars, so that they can invest those dollars in US denominated bonds. So when you have that stronger dollar, it does hurt the returns that we earn on our non-US investments.

 

The question is long term, do you really think that cycle can persist indefinitely and I don’t think that persists indefinitely, personally. We will, in my view, see a return, a regression to the mean, where you’re ultimately going to see the value of the dollar decline as time goes on. I can’t predict when but these things move in cycles and that’s why investors are best served to be globally diversified. That’s my current view on the dollar.

 

Doug Fabian:    Drew, anything you want to add on dollar valuation?

Drew Kanaly:    Well…

 

[Crosstalk 00:42:11]

 

Doug Fabian:    Having a little audio challenge there with you.

 

Drew Kanaly:    It’s really, it’s a good thing. When you think about the pillars of a good economy… Am I there?

 

Doug Fabian:    Yes, you are.

 

Drew Kanaly:    Doug, can you hear me now? Okay, good. When you think about the pillars of a good economy, a strong dollar’s one of them, an accommodative Fed is one of them, and good general tax policy is another one of them. So you don’t want to wish for a weak dollar in that sense. It’s a good thing. And what we’ve just learned about where we source things from around the world, you’re paying for them in stronger currency which is to your advantage going forward. I think the answer to what happens to the dollar isn’t so much that the dollar goes down, it’s that other currencies go up because their economies begin to recover and it’s a relative thing like you saw after the dot-com bubble. You better thank your lucky stars you owned international stocks and enjoyed some of the currency differential as well as their economic growth that came out of it. That’s the scenario you’d be looking for.

 

Doug Fabian:    Don, I want to go back to the discussion we had around the 60/40 portfolio. We had a question that came in where a client is asking is that 60/40 portfolio our portfolio, meaning the way that we allocate equities, small value-tilted portfolios. Could you comment on the example that you used and also talk a little bit about just our structure of how we’re putting portfolios together?

Don Calcagni:    Yeah. The examples we used do not perfectly mirror what we do in practice, and part of that’s for just the sake of simplicity so investors can compare when they’re reading something in the newspaper or in the news media. The example we used was a very simple 60/40, 60% US large cap stocks represented by the S&P, 40% represented by US bonds, the Barclays US Aggregate Bond Index. We take it a few steps further and then we diversify within the 60 specifically. When we allocate, we’re taking slight over weights, what we call tilts, towards value stocks, high momentum stocks, what we call quality stocks, and then we also add small cap stocks to that mix. We then add non-US stocks to the mix. So our 60 is significantly more diversified than, say, the 60 in the example that I just shared as part of this particular webcast. So we are more diversified than what you see in the literature, what you’ll see in the media when they’re looking at a 60/40. Just know that we are more diversified than what you’re seeing in those very simple examples.

 

Doug Fabian:    Thank you, Don. This is a very specific question we have from a client who’s asking us to kind of comment. He’s in retirement and the like. I believe that I’d like to get both of your comments on that and we’re going to start with you, Drew. Here’s the question. The market has been going up based on the fact that it’s looking past the COVID-19 crisis. At the same time — this is a comment from the client — the long-term effects of this on the economy look pretty bad to me. Should we be thinking about time span? Should retirees be thinking about moving some money out of stocks? So Drew, let me have you handle this question first.

 

Drew Kanaly:    [Laughter] Okay. The issue, I don’t know how old this particular client is.

 

Doug Fabian:    I understand.

 

Drew Kanaly:    Remember always when you’re doing financial planning, you’re planning for the three exigencies of life — living too long, dying too soon, impairment in between. This one strikes at two of them. Living too long and impairment in between, having the financial resources to live out a comfortable retirement. Well, you want to make sure that portfolio has that component for living too long or impairment in between so that’s going to include stocks. It just is. A fixed income is not going to provide for retirement, especially at these rates. We’re not going to see fixed income returns like this for quite a while, especially if you’re trying to live on the coupon, because some of these returns came off of darn near negative coupons, for goodness sake. You’re going to have to remain diversified. What you want to do as you go through retirement is make sure you match that liquidity outside the portfolio for times like these.

 

Clients are finding out they don’t have to do the required minimum distributions from their IRAs because of the CARES package. Now we’re looking to what other sources of liquidity so we can delay that tax effect. Well, a foundation of a good financial plan was having some liquidity outside the portfolio or the unplanned expense or moments just like this. A good plan would have had features in place and you stick to the plan. You stick to the plan. I know what we do, I know Heather Capps is really good at this, who works with me, she runs Black Swan events within the Monte Carlo simulation. We actually force it because everybody’s retirement experience is different.

 

Like I say, all my clients that retired in 1982 never looked back. My clients that retired in 1999, it’s been quite an interesting retirement deal. We’ve made it but it’s been pretty sporty at times. You look at what that Monte Carlo tells you about the expected returns, adjust your lifestyle to fit that scenario, and stick with it.

 

Doug Fabian:    Great. Don, anything you want to add there?

 

Don Calcagni:    Yeah, Drew’s points I think are excellent from a financial planning perspective, he’s spot on. What I would add is there’s this belief system… Let me back up. Humans have what we call a recency bias. We really tend to weight heavily very short-term information. And so we need to be careful not interpreting the current environment as if it’s here to last for the next two decades. If you’re retiring today at age 65, your time horizon is 20-plus years, to Drew’s point. So you need to keep that in mind.

 

If we were to rewind the tape and go back to the global financial crisis back in 2009, in March of ’09, nobody in their right mind would have made the argument that the US economy was going to fully recover and the stock market was going to more than triple in the decade ahead and yet it did. In the aftermath of the dot-com bubble bursting, nobody would have thought the stock market would have given you positive returns, yet it did. You can just go back to all these economic crises, all the way back to late 1970s, we thought stocks were dead, we had double-digit inflation, Reagan comes into office and the world naturally changed. Like Drew’s point, if you retired in 1982, life was pretty good. So I’d be careful just not putting too much weight on current events.

 

Doug Fabian:    Question’s about — and again I’m just going to the question queue, we’ve got over 100 questions in here I’m looking at — again, people are asking should we be more active, market-timing component of our portfolio, we’re going to be in a sideways market for a long time, shouldn’t we be making some sort of adjustment for that. Again, there’s assumptions that are being made on the part of clients asking the question. Let me go to you, Don, to talk about our strategy, buy and hold, rebalancing, how we implement, why we implement, and why we’re not getting active in terms of economic events and equity allocation changes.

 

Don Calcagni:    Yeah, there’s a couple things I would say. First off, we’re not in a sideways market obviously. It’s been up, it’s been down, so we’re not in a sideways market. What I would say is I think there’s a misnomer that our strategy is just “buy and hold.” I would argue nothing could really be further from the truth. Now, we are tax efficient. We’re not going to be swapping out of ETFs and mutual funds constantly. But when you look under the hoods, the managers that we hire of, say, a mutual fund or an ETF, their turnover is anywhere from 20 to as high as I’ve seen some of our turnover get close to 100%. So if you actually look inside our portfolios, I would say they’re exceptionally active. The question is how are they active. Are they shifting in and out of sectors, or are they trying to make changes based on perceived economic forecasts? No, that’s not what they’re doing.

 

We’re looking at fundamentals. I know our listeners have heard us talk over the years about factor-based investing. Well factor-based investing is really investing based on fundamentals. If you look under the hood right now and you look at our factor-based portfolios, you look at our quality strategies. Johnson & Johnson is our flagship quality stock right now, it has a return on equity of 25%. So quality stocks in our portfolio, we’re measuring those based on return on equity and operating profitability. So we are making shifts inside those portfolios. We see it all the time. I talk to our managers every single day. In terms of the actual holdings in the portfolios inside the funds, inside the ETFs, there is substantial turnover. There’s a lot of repositioning, which is what we pay them for. We want them to actively make changes but doing so in a very systematic, scientific way rather than relying on, say, Wall Street forecasts which are notoriously inaccurate.

 

So we’re active inside the portfolios but then we’re also active at the account level, to your point, Doug. We do rebalance portfolios, we do harvest tax losses in portfolios. And that’s all in an attempt to make sure that the activity in the portfolio is tax efficient and is actually adding value to the client. There’s a lot of firms who will trade aggressively in client portfolios but they don’t add any value. If anything, they just give the client a really big tax bill at the end of the year. So I would argue we are quite active, it just depends on how you think about active.

 

Doug Fabian:    I want to make a comment and get both of you to chime in on it. One of the observations that I’ve made being hunkered down here in California, watching the local news cycle, the national news cycle, kind of also watching kind of commercials that you see on TV. One of the things that I continue to just be amazed at is the amount of innovation that happens. We see companies innovating all the time. This is one of the great effects of capitalism is the fact that we’re able to make changes and make moves and certainly there’s some companies that are at 52-week highs right now who are in the right place at the right time.

 

Both of you, Don and Drew, if you would comment just on capitalism and innovation. Because we have a tendency as human beings to — and again using the news media, if it bleeds it leads — we have a tendency to be more focused on bad news and we have a tendency to kind of push aside the innovation that happens all the time. But especially in times of crisis, there’s innovation going on in the economy. And we, as investors, that’s what we’re participating in. Drew, let me go to you first.

 

Drew Kanaly:    Yeah, that’s the hardest thing to discount is human ingenuity is infinite. When you’re presented with a set of circumstances, you tend to think — I don’t know why we do this but we do — we tend to think very linear. We take a data point and the information that you get on TV. How many of the models for the coronavirus outbreak turned out to be true? They were useful but they weren’t necessarily true. That’s a function of how they construct the models and the thinking that goes into it but there’s a certain amount of linear bias in how we predict the future, because we can’t discount what we don’t know, which is innovation.

 

You can’t discount that, it’s almost impossible. But markets kind of have a way of doing that. We’re seeing it today. They’re discounting some innovations they think they’re seeing in the drug market. They’re discounting some innovations they think is going to happen in credit and they’re extrapolating that in the present value of the stream of earnings in the market today. That’s just today. But that’s what’s going on. That’s the most difficult thing to discount is innovation and get away from the linear thinking.

 

Doug Fabian:    Don, what are your thoughts on that?

Don Calcagni:    I completely, completely agree with what Drew said. All models are fundamentally wrong. The question is are they useful. Do they tell you something actionable about the future? Obviously, we do a lot of modeling here at Mercer, but just to give a broader high-level comment on capitalism. The power of human innovation is unrivaled. There’s a reason why our species has come to dominate the planet. It’s that three pounds of brain matter that we have between our ears. I am constantly impressed when I talk to companies, when I talk to managers. We do a fair amount in the private equity space and just seeing the innovation that is out there, the invention, the creativity.

 

Here we are today and half of Americans are successfully working from home. Granted, the other half are not, but my point is if this were to have happened just 20 years ago, half of us would not be working from home. And here we are, we’re videoconferencing across the country. For those of us that have gray hair, this was inconceivable 30 years ago. I believe deeply in the power of capitalism and specifically American capitalism. I guess I’m bullish on capitalism. I think capitalism over time has always found a way to solve problems. I have no reason to think that this time would be any different. We mentioned earlier how many labs globally are working on finding a vaccine to the coronavirus? Most if not all of them. Huge profit incentive obviously for the firm that develops a successful vaccine.

 

Doug Fabian:    Great. Gentlemen, as I have looked over the questions, I feel like we’ve done a good job of answering most of the questions in different categories for clients. One of the things I wanted to mention and get both of you to talk about it as well, is Mercer Advisors, we are open for business. Our offices are closed but every one of our client advisors gets up every day and thinks about the economic freedom of their clients and what’s the next step. How can I be helping my clients take the next step? There’s many things that can be done, that you can do as clients, that we can do as advisors.

 

Right now, just for example, tax planning for 2020. There is relief in terms of required minimum distributions which is a big part of our client base who takes RMDs. And so there’s adjustments and forecasts and things that can be done to help your future economic freedom right here and right now. And you have to remember that all of us here as advisors for you, our clients, we don’t know exactly how the coronavirus is impacting your family. Certainly, we hope you’re all healthy and you’re all safe. But if there has been a disruption in your cash flow, if you have had a drop in cash flow and an increase in expenses, if you are nervous about your finances, we want to hear from you. Certainly, our advisors are reaching out to clients, but if you have a situation that we need to know about, and one of the things that we’ve been focused on lately, is helping our small business clients get their arms around everything that’s going on in the CARES Act, to make sure that they’re getting some of the benefits that are coming from the CARES Act to support their businesses on a short-term basis.

 

Don, let me go to you. From an investment perspective and your team, the Investment Committee, Investment Operations, the things that we’re doing for clients right now, anything else you want to add in terms of how we’re working for clients, what we’re going to continue to do in the weeks and months and years ahead?

 

Don Calcagni:    Yeah. We still continue to meet regularly. Every day, I’m speaking to one or more Investment Committee members. We talk to managers all the time. Our management responsibilities, they don’t pause because we have the coronavirus crisis. In fact, in many ways, we find that we’re actually more productive working from home. So from a management perspective, things continue to proceed. We’re always reevaluating the managers, the strategies, the portfolio designs. We’re doing a lot of great work on the technology front to bring some really cool innovative features to advisors, to clients with respect to their portfolios. I would say in many ways it’s business as usual, but in many ways, it’s not business as usual.

 

When these things happen, Doug, we always step back and ask ourselves, “Hey, what could we have done differently? What should we have done differently? What does the science tell us and what are the lessons to be learned from this? How can we improve upon what we’re doing from a portfolio management perspective?” But you also need to make sure that you’re not just reacting to the current situation. That’s the great thing about these situations from a business perspective. I do want to be empathetic. There are many Americans who are suffering, our frontline workers are putting in crazy hours. Those folks are definitely our angels at this point in time. But for many businesses, this is an opportunity to step back and revisit how we do business. And so we continue to do that as an investment team here at Mercer and we’ll continue to do so.

 

Doug Fabian:    Drew, comments you’re having with clients and what your teams are doing for clients, please.

 

Drew Kanaly:    Here’s the one. If you’re a client of Mercer, and you’ve got a concentrated position or positions, you have just been given a do-over. You get a chance now to diversify your portfolio at bargain prices, eliminate the concentration risk, and get your retirement or your accumulation on a better balanced track. This is a monumental time to do that right now. I’m pounding the table if you’re out there and you know you’ve got these concentrations and some of them are the ones you just love. Boy, I’ve got all this Apple and it’s done so great for me. This is your opportunity. This is it. Bite the bullet and get diversified. Even if it’s a stock that’s down significantly — I’m thinking of my energy clients — bite the bullet, now’s the time. You’re given bargain prices on a diversified portfolio, it’s very actionable to do so. Before this year’s over, no telling what tax loss harvesting we can do to mitigate any gains. It’s just a great year to do it, a great opportunity to do so.

 

Doug Fabian:    Thank you, Drew. Ladies and gentlemen, I want to emphasize a couple more things before we close it out. This relationship that we have with you is a partnership. We’re not doing this in a vacuum. We’re doing this along with you and so we need information from you and we’re going to bring you ideas and solutions to make sure you stay on the path to economic freedom.

 

We talked a lot about investment management today, I talked a little bit about tax planning, but another big area that has been really emphasized with this healthcare crisis that we’ve gone through because we’ve had many Americans lose their lives. I know just from experience that there are many families who did not have their estate plans in order. They weren’t planning on a global pandemic, nobody was planning on dying. But it’s so important that you have your I’s dotted, your T’s crossed, your medical directives updated and those kind of things. That is part of our service offering here at Mercer Advisors. The place to connect on that is with your client advisor.

 

So we just want to emphasize again how important it is, if this is something that you’ve put off, this is something that you haven’t gotten to yet, this is really important stuff that you need to be part of this momentum in getting it done. So I just want to encourage you. Your next step would be to reach out to your client advisor. And then I want to mention ladies and gentlemen, our website, merceradvisors.com, from our home page, we have a lot of resources. You will probably notice that we’ve been sending out a weekly email to clients. We have produced videos, webinars, podcasts, articles. When we’ve gotten this different legislation that has come out, we have been at the forefront of bringing the salient information to individuals, to retirees, to small businesses.

 

But we are really working tirelessly for you. We’re going to continue to do so. But if you have not visited our website lately, if you have not looked at some of the articles, listened to some of the podcasts, listened to some of the webinars, we want to encourage you to do so. And remember that the best connection that you have to Mercer Advisors is right through your client service team and your client advisor. And that advisor, that individual, has the ability to be able to access all kinds of other resources within the company. The Estate Team, the Tax Team, the Investment Team, they have all of these resources for you. But they’re the conduit, they’re the hub, so we want to encourage to reach out to your advisor if you have information you want to share. Things that we talked about today, you’d like to discuss with them, we want to encourage you to do so.

 

Drew, let me go to you, any closing comments before we say goodbye to our audience today?

Drew Kanaly:    I don’t remember the question but those were my answers.

 

Doug Fabian:    Thank you, Drew. Don?

 

Don Calcagni:    I just want to thank everybody for their time and let them know we’re all thinking of them. We hope that you and your families are safe, that you’re healthy, and I would encourage all of us to keep our frontline responders in mind. Those folks, I have some of them in my family, they’re working tirelessly to combat this healthcare crisis so keep them in your thoughts and in your prayers. Thank you.

 

Doug Fabian:    Ladies and gentlemen, that concludes our presentation today. Thank you very much for being a client of Mercer Advisors and thank you for joining us on our webinar today. Have a good evening.

 

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