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Doug: 

Welcome ladies and gentlemen to the January 2022 Mercer Advisors Client Webinar. We want to thank you for joining us today and taking the time to hear out thoughts on the capital markets. My name is Doug Fabian. I’m going to be the host today on part of the client communications team here at Mercer Advisors. Joining us today is Don Calcagni, our chief investment officer, and Drew Kanaly, one of our senior wealth managers.

Ladies and gentlemen, today’s format is slightly different than what we’ve done in the past. One of the things that we really want to do today is get into some deep discussions about what’s happening in the capital markets and answering your questions. If you’ll notice the tool bar on the right-hand side of your screen, there is a question tab. You can type in questions there. We’ll do our best to answer as many questions as we can.

We want you to remember this though, today is about general information. We’re not here to give any person investing advice. If you have questions about your portfolio and how Mercer Advisors is handling that portfolio, we want you to contact your wealth advisor.

With that broad opening, Don, let’s jump right into things and talk a little bit about what’s happening in the capital markets. A lot going on. Let’s look at 2021 and transitioning into 2022.

Don:

Yes, thank you Doug. Thank you everybody for giving us some of your precious time today. Like Doug said, today is going to be a little bit of a different format. To really set the stage for our conversation, I think it’s always important to set some context. When we look back over the past year, even the past two years, what we’ve seen is we’ve seen financial markets, especially stocks, do exceptionally well. Last year, we saw equity markets post very strong, very powerfully positive returns across the board.

What I would like to draw our listener’s attention to, if you’re looking at the PowerPoint slide on the screen is the far-right hand side of the screen, you’ll see this is the S&P 500 index. If you look at that upward trajectory. That steep flow. That is the rise that 100% rise in stock prices since March 23rd, 2020. That was the bottom. That was the depths of the abyss when the pandemic was really beginning to grip the economy and global financial markets. Since that time, the Federal Reserve has taken interest rates to zero. They’ve pumped trillions of dollars into the economy through bond purchases. The federal government has helped prop up the economy with really some unprecedented fiscal support. All of that ultimately fueled this upward rise in asset prices across the entire economy. Stocks, bonds, home prices, real estate of all forms and fashion. That’s what you’re looking at here.

Over the past two years, we’ve seen markets do phenomenally well. Doug, when we’re ready, we can pivot and talk about where are we now. That’s really the context in which we enter 2022. That fiscal support from the federal government, low interest rates, bond purchases from the federal reserve, all of that, frankly, is now coming to an end. That has serious implications for asset prices across the economy.

Doug:

Drew, let me get your observations on this market move that we’ve had since the depths of the pandemic. In your mind, what was the biggest surprise in terms of the capital markets over the last 12 months, last two years?

Drew: 

Well, it’s a two-edged sword. First the unprecedented bad policy over the last two years and now the complete reversal from the transitory inflation language to we’re going to tighten up. That’s the biggest single response here in the market. I understand there’s geopolitical risk. I hear you on all that. The Fed move. That’s what this is all about. This is what markets are looking at and you can look no further. I’m going to ask Don, give me the textbook definition of speculative assets, Don.

[Laughter]

Don:

It’s a great question. Speculative assets are those assets with very distant, or questionable, or even nonexistent cash flows. Cash flows ultimately determine the value of everything. That is the definition.

Drew:

It’s no surprise, with the liquidity being taken out of the system, that you have a sharp decline in main stocks, SPACs, cryptocurrencies. Don’t shoot the messenger here. I’m just here to tell you anything that doesn’t have a cash flow attached to it, a meaningful and visible cash flow, has gotten revalued. That’s what’s going on here. It’s all tied to what the Fed is going to do at today’s meeting. Everybody’s going to be listening to the Q&A at the Fed meet today. They’re going to try to discount these markets based upon the trajectory of Fed action going forward.

Doug:

Don, let’s shift our conversation over to 2022. Obviously, we’re only a few weeks into the new year. What is happening? Give us some context around the market indexes and how they’re moving so far this year.

Don:

Yeah, absolutely. I think the narrative for year-to-date 2022 actually begins in November of last year. That’s when the Fed first officially announced that they were going to begin tapering back their bond purchases. That’s when the Fed began to communicate that they were projecting anywhere from two to perhaps four interest rate hikes in 2022. To Drew’s point a second ago, if you think about what that really means in laymen’s terms. What it means is the Federal Reserve is going to be sucking liquidity out of the system. They want to mop a lot of that excess cash up that they’ve pumped into the system.

Year to date, the markets are now starting to seriously to digest that information. That’s what markets do. They are mechanisms for digesting massive quantities of new information. When we look at how markets have done, if we just look at the screen here that we’re sharing with you, we can see that there’s been a downward trend across a variety of different market types. I think what I would like to first draw everyone’s attention to is the purple line in the middle of the screen. That’s the Russell 1000 index. That’s the 1,000 largest companies in the US stock market. You can see that that’s pretty much the classic large cap benchmark. That is down about 9% thus far through yesterday’s close of business.

I want to highlight that not all companies are created equal. We’re going to spend some time talking about this. There’s a difference between those more speculative growth stocks that Drew was discussing a moment ago. That’s the orange line. That’s the Russell 1000 growth. Those are companies that are rapidly growing but perhaps don’t quite have the cashflows just yet. They’re just not earning as much in profits just yet. You’re buying the promise. You’re not buying the fact. Those companies are down about 13.6% year to date. Whereas the opposite, those classic value stocks that you often hear people talk about, think Warren Buffet type stocks, those companies are down about 3.91%. Those companies have actually done significantly better year to date because they’re cheaper. They have better cashflows. They’re not as overpriced relative to their earnings.

To stick with that theme for a moment, if you look at the green line, those are non-US companies. Non-US companies, and we’ll get into this in a few moments, are trading at a very deep discount relative to their US stock counterparts. Likewise, we see non-US companies have actually done much better year to date than their US counterparts.

No discussion of year-to-date returns will be complete without discussing this magenta-colored line. That is Bitcoin. Bitcoin year to date is down around 22%. Bitcoin is down close to 50% from its high back end early November. To Drew’s point, those highly speculative assets, putting aside the relative merits, at the end of the day, if they don’t have cash flows, those assets are going to come under stress given the fact that the Fed will be raising interest rates going forward.

Doug: 

Don, just give us a little context around growth stocks and rising interest rates. What that means for growth stocks. Why are growth stocks struggling in a higher interest rate environment?

Don: 

We’re going to have to get in the weeds just a little bit to answer that. If we think about how the value of every business, every asset, every piece of real estate on Earth is valued, it’s always function of its future cash flows. Future profitability. When you think about growth stocks, they don’t have the same profitability or the same cash flows as other companies. They’re selling the promise, not the fact. The promise of future more distant cash flows.

The way that we would value a business is we have to discount those cashflows back today to arrive at a stock price. A little bit of theory in there. We discount those cashflows back to today using some type of interest rates. All interest rates, all returns throughout the economy are ultimately a function of the interest rates that are set by the Federal Reserve. As they raise the interest rates, Drew said it a few moments ago, the market is trying to figure out how the discount back to today, those future very long distant in the future cashflows that companies are promising shareholders. Really, it just comes back to something as straightforward as that.

As the interest rates rise from lower risk investments, like bonds for example, as those rates rise, there’s a lot of investors who are going to say, “Why am I taking risk with these more speculative growth stocks when I can get a relatively respectable interest rate or an increasingly respectable interest rate by just buying fixed income?” That in itself will pull away capital from growth stock and therefore, push down the price of their stock.

Doug:

Great. One of the things that’s amazing about market movements is there’s always a story. There’s stories around big stocks. We all use Amazon. There was a big story around Amazon with the pandemic, people ordering from home, and that particular growth stock is actually down 25% since its recent highs. Another story stock that was in the news we all know is Netflix. Well, at one point in time, there was no competition to Netflix. Now, there is competition to Netflix. The story starts to unwind a little bit and the premiums start to come out of some of these stocks. We all have to be conscious of not getting caught up in the story and making big bets with our portfolios around story stocks.

Drew: 

Couldn’t agree more. Couldn’t agree more.

Doug:

Let’s talk about the Fed and what’s happening with the Fed. Give us some context around this discussion of interest rates and quantitative easing and taking away the punch bowl. There’s lots of things people have heard. Don, give us your point of view on what’s happening with the Fed right now. Of course, we have a meeting today, which could be significant.

Don: 

Sure. We’re certainly going to know a lot more by the end of today where the Fed is at mentally. Just to back up for a moment, the Federal Reserve Bank of the United States, it’s primary mandate, and there’s some debate around this these days, first and foremost is to combat inflation. Their mission is stable prices throughout the economy. To be fair to the Fed, when they took interest rates to zero back in March of 2020, and you can see that here on the slide. Just look along the bottom there 2020. You can see that they went right to the floor. I would argue they did the right thing. They had to prop up the economy. The economy was shutting down due to the pandemic. They did the right thing.

If we fast forward to last year, we knew that there were these inflationary pressures building up in the economy. We had supply chain disruptions, consumers were sitting on a lot of cash, a lot of pent-up demands, and then the economy began to reopen. We all started going out to eat again. We all wanted to travel again. I’ve been waiting for 18 months to get my kitchen remodeled. That started to put upward pressure on prices. The price of oil. The price of gasoline. A lot of those things started to rise quite significantly in prices. At the time, the Fed was saying this “transitory.” To say it more plainly, they were arguing this is temporary. This isn’t going to stick around. Once things right size, we get past the pandemic, all of this is going to stabilize. They may still be right in the longer term.

What we started to see is inflation really heated up last year beginning in April of last year. Throughout the majority of 2021, inflation was running pretty hot. We just had a very hot inflation number last month, 7%. This has really caused a lot of concern at the Fed that maybe the inflation we’re seeing isn’t as temporary as we were originally thinking. That has really pivoted the Fed to get more hawkish. You may hear the term hawkish when you’re reading the news or listening to the news on television. That just means that they’re becoming more aggressive with combating inflation. That means that they’re significantly more open to raising interest rates and dialing back the quantitative easing, the support that they’ve been pumping into markets to keep interest rates low.

That’s really the context of where we are today. Inflation has significantly heated up. As a result, the Fed is pivoting and sending a message that it is now time to take away the crutches, to take away all of that monetary support that they began to provide back in March of 2020.

Doug: 

Drew, when you’re talking to clients about quantitative easing and the bond buying that the Fed has been doing, obviously, we don’t have any interest rate hikes yet. Markets always try to anticipate things. What’s going to be impact on the bond market with the Fed backing away from this quantitative easing? How are you looking at that in your discussions with clients?

Drew: 

The first thing is you don’t have a roadmap for how this plays out because we’ve never been here before. Let me try to give everybody a feel for the three legs on the pegs action stool here. First one, as Don has pointed out, is the Fed funds rate. That one is dialed in. There’s an expectation the Fed fund rate is going up. We all know that. It at some point has to match roughly the rate of inflation, not 7%, but somewhere in between to try to blunt that.

There’s two other big tools that we’ve never seen used like this before. One is the monthly open market purchases have been so enormous over the last several years that we now have $8 trillion in securities, mortgages, and treasuries on the Fed’s balance sheet. Let that sink in for a second. Eight trillion dollars. They’ve already told you that they’re going to stop purchasing bonds through March. We know that 8 trillion number stops. It’s still $8 trillion. They hinted a while back when you really saw the market weightiness in the speculative current investments hit, they hinted that they would do something with that $8 trillion balance sheet. It was put into play. That’s billions of dollars. The balance sheet, about a third of it is very short term, two years or less. If they begin to let it naturally atrophy without doing anything, that’s billions of dollars per month getting taken out of the system. Liquidity being removed from the system.

I know this is in the weeds but it’s what this afternoon’s press conference will be focused on. They’ll be asking the chairman of the Fed these three questions. He’ll already have answered the middle one about curtailing purchases. They’ll be looking for the trajectory of interest rate rises and how aggressive they’re going to be about letting that balance sheet atrophy. Everybody will be focused on it. Real quickly, for stocks, if you want to watch, it’s the 10-year bond. The rate in the 10-year bond translates to the NASDAQ. I mean if it goes up, the NASDAQ goes down. It’s Don’s discounting mechanism happening in real time. That’s what you really want to focus on if you’re looking for market behavior where it’s going to land. In today’s meeting, those are the three legs to the stool that I watch, and I advise clients.

Don:   

Let me add one comment to what you said that I think is an important point here. I think one of the biggest risks to the economy and to markets coming into 2022, I would argue the very high probability of a Central Bank policy error. Now in English that means they mess up. They raise rates too quickly. Perhaps they don’t raise rates quick enough, and we see inflation continue to run at a piping hot rate. There is an argument and I think it’s a relatively good argument that many recessions, perhaps most, are ultimately started by the Federal Reserve Bank due to their policy errors. Meaning they raise too fast or too slow. They somehow get it wrong.

Not to blame these folks. The economy is infinitely complex. Trying to determine what the appropriate interest rate should be for the Fed Funds Rate is a very difficult exercise. I wouldn’t go out and start blaming people. At the end of the day, I think that is one of the most significant risks to the economy.

I think the biggest risk is quite obvious. That is what’s going to happen with COVID, the new omicron variant, and things like that. I think largely as that goes, so will the economy. The second biggest risk right behind that would be the very high likelihood of a Fed error with respect to interest rates.

Doug: 

Let’s go back and talk about the markets and stocks. Not all stocks are created equal. We want to look at this comparison between growth and value. We’ve already seen a significant delta between the performance of growth versus the performance of value. Give us some context, Don, around value stocks versus growth stocks as a starting point.

Don: 

Happy to back up there. What I’d like to do is draw everyone’s attention first and foremost to the lefthand side of the screen. This is a busy screen with a lot of information on it. I want to draw your attention just to the left-hand side for a moment. What this chart on the left-hand side is really telling us is how expensive are growth stocks relative to the value of stocks? If you see that green line in the middle, that perforated line, when the gray line is below that, it tells you that value stocks are really cheap relative to growth stocks. Think of your Berkshire Hathaway, Warren Buffet type companies relative to think of a Tesla, or an Amazon, or the FAANG stocks, Facebook, Apple, Amazon, Netflix, and Google. There’s a big difference in terms of how those companies are priced.

I’ll draw your attention to the box here in the bottom of the slide here. Forward PE is just one way to measure how expensive or cheap a stock is relative to earnings. That’s the price to earnings ratio. I want to draw your attention to where it says current. Growth stocks currently trade at about 27 times next year’s earnings. That’s pretty rich. You can see historically, they’ve traded it at around 20 times earnings. As a rule, if we just look at history, those types of stocks, think of those big mega cap technology companies and stuff like that, they’re trading at a pretty significant premium to where they were historically.

Now if we look right above that, we’ll see value stocks. Those are your classic dividend paying companies, so boring. Not growing as rapidly as the Amazons of the world. They’re trading currently at about 15.7 times earnings. A little bit of a premium to their long-term average of about 14 times earnings. When you think about an economy where we’re going to see a reduction in liquidity, when you think about an economy where interest rates are expected to rise, at least value stocks relative to their growth stock counterparts, at least historically, and in theory, and very much in practice from what we’ve seen, they offer some powerful diversification benefit relative to having a portfolio that would be significantly overweight growth stocks. That’s what it looks like when we look at the US stock markets.

Now if we pivot and we look at the right-hand side of the screen, what we’re looking at here is the relative price of non-US stocks relative to US stocks. If you can see this perforated purple line, it’s towards the top of the chart. I’m sorry. If you can see this black line here at the zero. Anytime the US stocks are below this line here, what it tells us is that non-US stocks are underpriced. Meaning they’re trading at a discount relative to US stocks. That’s actually what we observe if we look at the S&P 500 index currently trading at just under 20 times next year’s earnings. Non-US stocks for that same dollar worth of profits, are trading at only about 14 times earnings. A very slight premium to their long-term average. When we compare them to US stocks, they’re trading at probably about a 35, 30% discount relative to US stocks.

That shouldn’t come as a surprise to anybody. Non-US stocks have underperformed US stocks for a couple of decades. It doesn’t mean that they had negative returns. They had positive returns. It’s just that US stocks really just went through the roof as we took interest rates to zero. US stocks still close to respectable returns but certainly couldn’t keep up with the stratospheric growth that we saw in US stocks.

Now fast forward to where we are today, when we look at those US stocks, when we look at higher interest rates coming in the future, it tells us that those US stock valuations, especially for those growth e-companies, well they may not be sustainable going forward. We saw that on the previous slide. Thus far year to date, we’ve seen growth stocks underperform their value stock counterparts by almost 10% just in the first three weeks of the year. The takeaway from this slide is that a well-diversified portfolio should have an allocation to value stocks. A well-diversified portfolio should have a very health allocation to non-US stocks relative to US stocks.

Doug:     

Drew, you as a member of the investment committee, you’re talking to clients all the time about the way Mercer Advisors portfolios are positioned. In the recent past, international has been a drag. Now, we have great evidence that international can be a big positive for us. We’ve maintained our commitment to international stocks, and we think it’s going to benefit clients going forward.

Drew:   

It’s, relatively speaking, been a drag on the portfolio. It still had positive returns. Relatively speaking. What I explain to clients is rebalancing enforces a discipline that in simple terms is you’re selling your winners and you’re buying your dogs. There’s going to be a rotation at some point. The rebalancing last year would have captured a lot of the growth and rotated into value in international. That’s, relatively speaking, paying off here in the short term, but it’ll really pay off in the long term. The rebalancing is a discipline that you really got to enforce. You’ve got to resist the urge to let it run too much because you never know when that rotation begins.

Doug:  

Don, you as a chief investment officer of the firm, you’re looking at our portfolios all the time. Anything to add just in terms of how we’re allocated to international and what clients should be expecting in terms of their own portfolios?

Don:    

From an investment committee perspective, our allocation to global equities is currently around 32% non-US. It’s been pretty much in that range for the past decade or so. When we think about that, our portfolios already have a very healthy allocation to non-US stocks. That’s really helping us year to date. At least our non-US stock managers are only down about 2% even though non-US markets are down closer to four.

Similarly, almost all of our portfolios have a strategic allocation to the value. Again, that’s been in place for many decades for a lot of very good reasons. Year to date, the value indexes are down about 4%. Our value managers have done better and are down somewhere around 2.5 to 3%. I think there is an important point there that our investors should keep in mind. Not all value stock managers are necessarily created equal.

There’s a lot of different ways to measure value. One of those that I’m sharing with you here on the screen is the forward price to earnings ratio. That’s arguably not the best but that’s the one that we’re sharing here because I think that’s what most investors are familiar with. There are lots of other ways to measure value arguably much better from an academic perspective too when we actually look at the long-term data. I think the takeaway to answer your question, Doug, is our portfolios already have an allocation to non-US. Our portfolios already have an allocation to value.

When we look at all of the headwinds, the storm clouds that are on the horizon for 2022, the real takeaway for investors from that information, from that discussion is that we need to build globally diversified portfolios. The most important asset to include in any portfolio is humility. What that means in terms of actual portfolio construction is to be very careful not to get too excited about an investment thesis for one stock, one asset class, or one country but to instead build a globally diversified portfolio across and within multiple asset classes. Continuing to own an allocation to fixed income even though rates are rising. We can talk about that perhaps in a few moments. I think that’s the takeaway that our investors should keep in mind is that we are fundamentally building globally diversified portfolios to help ensure that ultimately that they are going to achieve the financial goals and objectives that they have mapped out with their advisor for their family.

Doug: 

One of the things I think that we want our audience to be prepared on is there’s a big unwind happening in speculative assets. Don, talk to us about just the speculation that’s in the market. Obviously, when people are seeing big swings, that’s not necessarily reflecting their own portfolios. I think that there is a human behavior story around Bitcoin because we’ve been talking about it for a couple of years. We’ve been certainly hearing from clients, new clients, “What should we be doing with Bitcoin?” We’re now seeing this speculative unwind not just in Bitcoin, but Drew mentioned the SPAC investments. A lot of IPOs this past year that have very little short-term earnings, cash flow. It’s a long-term bet and so the speculative unwind is going to be with us for a while.

Don:  

Absolutely. Drew touched on this when we first started our conversation. Putting aside the relative merits or lack thereof of the investment thesis for digital assets as a whole, or SPACs, or growth stock companies like Peloton. How many of us have purchased a Peloton over the past couple of years? I’m not saying that those assets don’t or shouldn’t have a place in a portfolio. I think that’s an intellectual debate. At the end of the day, it’s important to keep in mind that regardless of your views on digital assets or cryptocurrencies, is we need to understand that, first off, that is very much the Wild West. The digital asset space. There’s still a lack of regulation. There are some new regulations coming. These are speculative assets. New regulations could either outlaw or severely restrain the growth in digital assets. There are many countries around the planet at the moment that are looking to outlaw crypto. China, of course, being one of the first. Being one of the world’s largest economies that has a serious implication for the future growth of digital assets.

Again, I’m not commenting on the relative merits or lack thereof of those. It’s just important to keep in mind that these are highly speculative. With the exception of a very few marginal cases, something like Bitcoin, you really can’t earn an interest rate on it. When you look at something that does not have a cashflow in a world where you’re going to be earning more on cash on your risk-free assets, it is going to put downward pressure on the price of something like Bitcoin. Bitcoin is down, like I said earlier, about 50% from its all time high in November. I read a statistic just this morning on CNBC that only 32% of all Bitcoin holders are actually at a gain on their Bitcoin investment. If you think about what that means. Almost 70% of investors in Bitcoin have actually lost or are only breaking even on their Bitcoin investment despite the fact that we’ve seen a stratospheric increase in Bitcoin prices over the past decade.

It is a highly volatile asset so anyone who’s investing in a digital asset, I think we have to keep that in mind. These are highly volatile. The regulatory environment is really lacking at the moment. You don’t have the same investor protections in a crypto investment as you would in say, a stock, a bond, or a mutual fund. I don’t want our listeners to think that Don is just anti-Bitcoin. No, let’s have that discussion another day. We just need to have an adult-level conversation around the fact that these are highly speculative assets. When interest rates rise and we begin to pull liquidity out of the system that all of these speculative assets, everything from growth stocks, to SPACs, to special purpose asset companies, to digital assets, all of those assets are going to come under pressure as interest rates rise.

Doug: 

Don, we haven’t talked much about inflation. Let’s spend a few minutes talking about it. Let’s begin with some context from you on inflation and then we can talk about expectations going forward and what it means for markets.

Don:    

Sure. Like I was saying a little while ago, inflation for the better part, candidly, for the both part of two decades has really been coming down. In fact, deflation has been a bigger concern for the Fed than inflation in recent history. Just going all the way back to 1990. Even going back further. I know when we think inflation, we think of the ‘70s, right? We think of Paul Volcker, early 1980s, double digit interest rates. We’re not there yet. [Laughs] I don’t know that we’ll ever get there again. It’s important to understand that we’re not there at the moment.

To set some context, inflation has been coming down quite dramatically over the past two or three decades. Coming into the financial crisis, coming into the global pandemic in March 2020, the Fed felt very comfortable taking interest rates to zero, pumping $120 billion a month into the markets by way of the bond purchases that Drew was mentioning a few moments ago. As the economy began to reopen, like I said, all of that pent up demand. If we also consider the fact that on average–and these are averages–I understand there’s a big distribution around this. On average, US household wealth today is the highest that it has ever been since we have been tracking it. Now again, those are averages. I understand that that’s not true of everybody. On average, consumer wealth today has never been higher. On average, consumers’ savings, the cash that they’re sitting on, has never been higher. When consumers have lots of cash, when wages are going up, when unemployment is dropping, when consumers feel wealthy or wealthier than they did in the past, all of that translates into demand for goods and services. That’s what we started to see when the economy began to reopen last year.

We first saw in the price of used vehicles, interestingly enough. That quickly manifested itself in the price of new vehicles. We saw double digit rises in prices in new and used vehicles. Now, if you yourself weren’t in the market for a new or a used vehicle, the reality is the increase in prices for new and used vehicles, that does not impact you, right. We’ll get to that point here perhaps in a few moments. As the economy began to reopen, we saw very powerful GEP growth last year as the economy began to reopen.

You have a rise in demand. You still have limited supply due to the COVID lockdowns in many countries and supply chain disruption. Supply comes down, demand goes up, prices rise. Fast forward to today, that’s where we find ourselves. Still disrupted supply chains. You mentioned Amazon earlier. All of us went to Amazon. We couldn’t go to a local mall. We all go to Amazon. We go online and we buy our Christmas presents. All of that has really worked to push up inflation.

Doug:   

Drew, you’re talking to clients all the time. I think many people are feeling that inflation is a big threat to their long-term financial plans. How are you talking to clients about this? Obviously, we have this inflation spike. We can speculate on what inflation can be going forward. How are you talking through that with clients right now?

Drew:    

First thing is you don’t disavow them of their grocery store experience. I mean it’s real. You can see the price change, right?

Doug:  

Yes.

Drew:  

What is the price change? The price change mathematically speaking is a change from where you were to where you are now. Now, if it’s sustained, if it keeps going, then you have an inflationary cycle going on. If we keep watching the numbers month over month, remember you lose a month. You gain a month. This inflation number basically has to come down. Now 4 and 5% is still not a good number. The optics of inflation should be coming down just the way the math works unless we continue to see price increases. Oil made its move in October of last year. By the time we get to October, as long as we’re not at $100, we ought to see a year over year number that looks a little more palatable. It shouldn’t jump in prices. It’s not inflationary.

When we run people for retirement scenarios, you run the Monte Carlo Simulation and you show them 3% numbers. You show them 4% numbers. You give them a feel for the price sensitivity of their lifestyle against the portfolio’s capacity to handle it. They should know you go through these periods, especially older clients that look like me. You’ve been through inflation scenarios before, and you know you emerge from them.

The final thing to look for this year, and I encourage everybody to pay attention, it’s in too many people’s vested interests to solve this supply chain. Nobody makes money on a bad supply chain. There are forces out there to fix this supply chain. There’s something to look for if they solve it in this calendar year where suddenly we have all these supplies of goods. People have already paid up for stuff and you have an excess supply of goods. Maybe not semi-conductors. That’s a bigger ship to turn around. It could be in a lot of other products and services. It could be in oil. We’re going to see how this year plays out. That’s one thing I think we should all be looking for is maybe supplies on the supply side.

Doug:    

Don, anything you want to add to that? You have a new slide up here if you could talk us through a couple of these inflation in different categories.

Don: 

I mean I encourage clients to think about inflation really in three ways. Number one, Drew mentioned what I call base effects. You got to remember that a 7% inflation rate, that is a historical number. That’s what happened. That doesn’t mean that that is what’s happening right now. It doesn’t mean that that’s what will happen over the next 12 months or even over the next month. That’s a historical number. It’s a data point. It’s water under the bridge. That’s point number one. Keep those numbers in context.

Let me back up. Number two is that when you hear a 7% inflation rate, there are certain assumptions that goes into that. The Bureau of Labor Statistics, which puts out that number, they’re looking at the average US household in terms of the goods and services that they buy and in certain ways. There’s a lot of assumptions that go into that number. I’m not saying it’s wrong. I’m just saying there’s a lot of assumptions that go into it.

How is that relevant to clients? What you really need to look at, and Drew said this, is what is your personal mix of consumption of goods and services? What does your actual lifestyle look like in the balance across these different product categories that you see on the screen. If you were someone who’s entering retirement, I think naturally, one of your concerns should be what’s happening to the price of healthcare, medical care, prescription drugs? You’ll see that those are all towards the bottom of our chart here. We have not seen substantial inflation, for example, in prescription drugs. I mean, ironically, prescription drugs. That’s been a headline item for the better part of three decades. It’s actually at the bottom of the list. You really need to work with your advisor. Understand what is the actual impact of inflation on your actual consumption habits, the different goods and services that you and your family need. That’s point number two.

I think point number three that I would encourage clients to keep in mind, from a financial planning perspective, when you’re building a portfolio, when you’re building a financial plan, arguably inflation is the greatest threat to your long-term financial security. More so than anything else. It’s important to keep in mind that the whole objective it to outperform inflation over time. Not every time. I often have folks come to me and say, “The stock market is down 9% for the month of January. Inflation is up. Oh my gosh, my financial plan is in trouble.” No, that’s not true. Your portfolio is designed to outperform inflation over time, over a period of years. Not every day, every week, every month, or every quarter. I think that’s an important point to keep in mind. Your financial plan, your portfolio should be designed to outperform your personal inflation impact over time not every time.

Doug:

We have talked about some head winds. We’ve talked about rising interest rates. We’ve talked about inflation. We’ve talked about valuations. These are headwinds against what we’re doing with our portfolios. There’s also some tailwinds. If you’ve ever been out on a sailboat, there’s nothing better than sailing downwind than sailing upwind. Don, just give us some context around what is happening in the economy right now? What are some of the good things that are going on? These can be helpful to produce positive results for us in 2022.

Don:

That’s a great question Doug. I think it’s important for all investors to keep in mind that there are always headwinds and tailwinds. There are always buyers and there are always sellers. It’s just a question of price. It’s a great question. When we look in the economy, I actually think there are a lot of powerful tailwinds that are worth acknowledging.

Number one, we are expecting that this is the year where we should hopefully get COVID behind us. We have a lot of pent-up demand like I mentioned a few moments ago. Consumers, especially the US consumer, is still really the workhorse of the US economy and the global economy, I would argue. They are in a great position financially. Unemployment has come down. Wages are going up. They’re sitting on a lot of cash and household net worth is at an all time high. That’s good news.

When we look at profit projections, earnings estimates for S&P 500 companies, at the moment, analysts on average are estimating about a 9.4% growth in company earnings over 2022. That’s not as high as last year’s. Last year, it was 21% but that is still a very respectable growth rate for a growth in earnings. That’s another good thing. Now where is some of that growth coming from? I think one of the things that the pandemic has forced us to do is to do a much better job as an economy, as a business community, a much better job of embracing the use of technology, for example. Here we are. We have thousands of people on a video call across the country. We have clients in Europe. We have clients in Hawaii and everywhere in between. Here we are having a video conference.

We are seeing significant increases in labor productivity in part to increases in technological embracing, different work habits, allowing people to work remotely for those who have jobs and have careers where that is something that’s possible. I think all of that is actually positively impacting the economy.

I think one last tailwind, if I can go out on a little bit on a limb here, I do think that the Federal Reserve with respect to the increasing interest rates, I have a suspicion they’re going to move much slower than what they are communicating. Said differently, I think their bark may be a lot worse than their bite. I think there’s some politics behind the messaging. I find it hard to believe that the Fed is just going to radically start jacking up interest rates. In fact, even when you look at the Fed’s own projections, they’re talking about taking interest rates back to where they were in February of 2020 and they’re talking about doing that over the next two years. Meaning it’s going to take them two years to slowly raise interest rates to get back to where we were in February 2020. That is not a draconian increase in interest rates. At least not at the moment. There certainly could be new information that comes in in the future that we don’t currently have where maybe the Fed has to move more aggressively. That doesn’t feel like an aggressive move from an interest rate perspective. I think all of those are some pretty positive tailwinds and there’s probably a number of other ones that I failed to mention. Those are the ones that immediately come to mind for me.

Doug:

Drew, what about you? What are you talking to clients about? What are you positive about as we’re going into 2022? Your conversations with your clients.

Drew:

In an odd sense, I welcome a little higher interest rates into this environment to stabilize portfolios. I really do. In terms of risk management, there are very few tools we have besides cash, which earns nothing, to balance out the risk of people’s portfolios. What you’re trying to do in building a set of uncorrelated returns is to put the peaks into the valleys over time. With these low interest rates, it’s been very difficult to do that. As we get to whatever normal interest rates are, that’s really going to help smooth out portfolio returns going forward. I actually welcome that event.

I think what Don’s saying about the COVID thing that’s still headline. You hear a lot about it. It’s a lot of energy around that particular topic. I think it’s a tailwind for the economy in all of our spending as we get out and about more. That’s going to be really good for the economy. Maybe perhaps, like I said, we get a nice supply side surprise towards the back end of the year as people solve some of these supply chain problems.

Doug:

Something we haven’t mentioned…

Don:

Sorry, Doug. I just want to double click on something Drew said that I think is really important for our listeners to understand that higher interest rates will and should bring back some rationality to financial markets. Over the past decade arguably, we’ve seen very sloppy risk management by investors as a whole where investors have bid up all kinds of highly speculative assets without any real consideration to the price of those assets or the real merits of those assets. I think bringing back some rationality to how investments are valued in financial markets, that’s a big plus. I think that’ll be a nice tailwind for the economy going forward.

Doug:

I’ll mention one other item that is now off the table. It wasn’t that long ago, we were looking at the potential of higher tax rates, higher capital gains rates. That is really off the table this year. I’ll just add that in. That uncertainty of taxes in 2022 is calm. Certainly, long term we have tax issues. Tax revenue for the federal government is at an all time high, so is spending. I realize that. Just a couple of other things to add in.

Don, talk about what we’re doing as a firm for our clients in these times of uncertainty. We have new clients who are joining us for the very first time on this particular broadcast. First time they’ve heard you. If you wouldn’t mind just talking a little bit about the Mercer Advisors investment philosophy, how we’re managing risk, how we’re diversifying assets, I think it’d be helpful for everyone to hear that again.

Don:

Yeah, absolutely. Doug, there’s a lot of things that we’re always doing to prepare clients for market volatility. Everything from messaging. We’ve been talking about fair markets and market volatility for a number of years now. We’ve been expecting this rotation to come at some point. I think messaging is really ultimately where it begins so that our clients understand that, look, we’re not going to see 100% rise in stock prices every two years. It’s just not going to happen. It always begins with messaging.

From the business philosophy perspective, it’s important to keep in mind, we are fiduciaries. We have a legal obligation to make sure that we are globally diversifying client portfolios using the best thinking available anywhere when it comes to portfolio construction and portfolio management. That’s why we are building globally diversified portfolios. That’s why we own thousands of companies on average. That’s why we invest in a variety of different asset classes. Diversification is really about diversifying across many asset classes but then also diversifying within asset classes. Owning US and non-US stocks.

What it means is actually having the discipline, intestinal fortitude, the institutional commitment from our investment committee and from our organization to stick to an investment philosophy that embraces global diversification and not having an investment committee or an organization that’s just going to chase what’s hot or pitch to investors whatever is in the headlines. There’s a healthy degree of discipline that is required from your advisory firm from the investment committee when it comes to maintaining globally diversified portfolios.

We have an exceptionally large investment committee. It’s broad. It’s deep. We meet monthly. Most days, we’re in constant contact through Teams. Those things are all happening behind the scenes. To take it a few steps further, Doug, having a systematic framework in place to rebalance portfolios, to take the emotions out of the rebalancing exercise. To not engage in market timing. To have a very methodical approach, a disciplined approach to rebalancing client portfolios. Like what Drew said earlier, that means selling what’s done well and buying what has not done well. Continuing to have a very systematic rebalancing framework in place is extremely critical.

Not letting taxes ultimately drive what the portfolio looks like. Taxes are critically important. I’m not saying otherwise. Taxes should not dictate ultimately, what the portfolio looks like. By that logic, right now, you would be very lopsided in growth stocks and that would be inflicting a lot of harm on the portfolio.

The last thing that I would touch on that we do as an organization, which I would argue is one of the most critically important, is our advisors meet with our clients consistently throughout the year. We run stress tests on clients’ financial plans, on their portfolios. Doug mentioned a Monte Carlo Simulation earlier. In English, that is a stress test. We are stress testing client portfolios to see how they might respond in the event of a market sell off. We’re stress testing their financial plan. At the end of the day, that’s where it matters. The portfolio is designed to support the needs of clients’ financial plans, not the other way around.

Those are just some of the things that we’re doing. Proactive ongoing financial planning, constant stress testing, building globally diversified portfolios, having an institutionalized investment committee that’s committed to an investment philosophy predicated, grounded in modern portfolio theory, and building globally diversified portfolios. Those are just some of the things that I think that are critically important to preparing for market volatility.

Doug:

Don, if you wouldn’t mind showing that last slide, that disclaimer slide. I want to remind everybody that we operate in a highly regulated industry. We care about the rules. We want everybody to know, once again, that there’s no part of our presentation today was personal investing advice. I want to encourage you. If you have a question, something’s come up in your mind that you should have a conversation with your personal wealth advisor to discuss that more thoroughly. Don’t jump in and make decisions on your portfolios on something that you’ve just heard on a whim. Drew, let me go back to you. Any closing comments that you might have for our clients today?

Drew:

I think what we finally are seeing now is the test of the [Inaudible 00:59:42] of what was working now. We need to get back to fundamentals on how you invest. I don’t know how long this test will last but things tend to regress to the mean over time. I think that’s what we’re witnessing here. If you really get into it, if you really watched last year, people ran from one side of the ship to the other all year long. It was difficult if not impossible to time this market. It really was especially on a sector basis. That’s why you stick to the factors as Don has pointed out, of quality value and momentum. That’s where you’re going to capture the returns, not in chasing sector rotations.

Doug:

Excellent, Drew. Excellent, thank you. Ladies and gentlemen, we are going to be posting this presentation to our insights page at MercerAdvisors.com. If you only saw a portion of it, you’d like to view it again, it certainly will be posted out at MercerAdvisors.com. One last reminder to have a conversation with your wealth advisor. We really believe in having that close contact with out clients. We appreciate you joining us today. Certainly, we will be back in 90 days to talk about what’s happening in the economy, in the markets. We want you to know we really appreciate your business. Thank you for being a client of Mercer Advisors. Have a great day, ladies and gentlemen.

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