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Doug: Hello, ladies and gentlemen, and welcome to our quarterly client webinar for Mercer Advisors. Today, we’re going to be updating you on the latest developments in the economy and the financial markets. It is our goal with these broadcasts to help you understand what’s happening in the capital markets, what’s going on in the economy, and what you should do to continue to improve your own personal finances. So, thank you very much for taking the time to join us today. My name is Doug Fabian. I serve on the investment committee, and I’m part of the client communications team here at Mercer Advisors. Those of you who are watching this broadcast live, there is a Ask a Question function in the toolbar, and one of the things that we want to do today is answer as many questions as possible from our clients, so please feel free to submit questions using that function in that toolbar.

One of the things that I want to mention right at the top of the broadcast is that markets are at an all time high. Interest rates, interesting enough, have been actually trending lower of late, and then of course, we’ve got this big uptick in inflation. One of the things that we want to do today is help make sense of it all. Joining me today are two of our top advisors. Tracey Turko, senior wealth advisor from the Midwest. Tracey has been with Mercer Advisors for 21 years, and she’s going to be adding her expertise and talking about conversations that she’s been having with clients of late. And of course, most of you know Don Calcagni. Don is our chief investment officer, and he is going to be taking us through a lot of data. One of the things that we want to do today is we want to change the format up just a little bit, and we want to get into your questions sooner. So, if you have a question right now that you wanted to ask on this broadcast, please go ahead and submit it. As we start to talk about different subject matters, I’m going to be monitoring the question queue and going to be asking questions of Don and Tracey, as we’re going through today’s broadcast. We want to make this as interactive as possible.

Before we jump into our subject matter, there is the business of disclaimers that we want to talk about. One of the things that we want to say right up front is no part of this broadcast should be considered personal investing advice. We take our relationships with clients very seriously, and if something comes up today that you have a question about or you think applies to your situation, we want to encourage you to have a conversation with your wealth advisor. So, please pick up the phone and give us a call, and schedule an appointment, and have a talk about your personal situation. Furthermore, every effort, and since we are fiduciaries, every effort has been made to provide you with the most accurate information possible. And that’s just a part of what we do, is the normal course of business and this is some of the highlights, this disclaimer that we have on the screen.

So, with that, let’s jump into today’s agenda. We’re going to, of course, review some economic statistics, talk about how the capital markets have been doing, and I think the big takeaway from today is going to be the inflation discussion, the inflation question, and how does that apply to our investment strategy? How does it apply to your long-term financial goals? So, let me jump in and ask Tracey. Tracey, you’re having conversations with clients each and every day. You contributed to this agenda. What do you want clients to take away from today’s webinar?

Tracey: That’s a great question, Doug. Thank you. So, I think it’s really important to understand that the markets are going to do and perform what they’re going to do. We don’t have a crystal ball. But it’s really important for clients to understand their journey to economic freedom, making sure they have a financial plan in place, making sure they have the right investment allocation in place, so that when things get volatile or don’t turn out quite the way we expect in the market, we know that their plan is on track and it works.

Doug:Awesome. Well, Don, here we are, once again. You’ve put together a lot of good data for us. What do you want clients to take away from this discussion we’re going to have today?

Donald: Yeah, it’s a great question. First and foremost, I think it’s important for clients to understand that markets, at any given point in time, are really balancing mechanisms between tailwinds and headwinds. Markets are always trying to price in good news and bad news. And so, I’ll often have clients come to me, Doug, and say, “Gee, how is it that the market isn’t moving higher with all of this great news that’s been in the headlines?” Well, that stuff is often already priced in, so markets are very quick to price in information. So, we do have some new information, obviously, that came out over the past quarter, that I think is going to really inform our conversation today, specifically information around inflation. So, it’s all about markets ultimately balancing new information with the old, and incorporating that information into asset prices.

Doug: Okay, Don. Well, let’s jump into some of this data. It’s quite interesting.

Donald: Right. Well, I think it’s interesting. When we consider the state of the world at the moment, there certainly is obviously no escaping COVID. I think it’s important that we look at COVID as not something that will just miraculously disappear some day. It’s probably like the flu virus in that it’s going to be with us persistently in the years ahead. And so, what we’ve seen recently is we’ve seen a pretty dramatic uptick in new COVID cases, and this isn’t just happening in the United States. This is happening globally due to the new Delta variant, and I think that’s giving the economy a little bit of pause. This is some of that new information, Doug, that I think markets are trying to figure out how to price in. So, just to explain this slide here, on the left-hand side of the slide, we’re showing you the blue line, which are confirmed COVID cases. That’s the seven-day moving average. That comes from Johns Hopkins University. And then, we see fatalities, which is that dark gray, black line, and we can see, thankfully, fatalities are still largely being flat at the moment, but it’s important to keep in mind that fatalities lag confirmed cases. So, hopefully, we don’t see an uptick in fatalities, but it does seem likely given historical trends here with COVID .

On the right-hand side of the screen, and I think this is what the economy is looking for, it’s what all of us as citizens are looking for, is at what point can we beat this thing enough to where we can reopen our economy with a high degree of evidence. And so, that gray zone is what J.P. Morgan has estimated to be this zone for herd immunity. It’s a bit of an amorphous concept, as I understand it from experts. I’m not a doctor. I’m not a physician, so I don’t really have a view on that. But we continue to expand vaccinations, but we’re also seeing some resistance in certain parts of the country, and so there’s certainly debate around that. So, this is something the market will continue to look to in the next 6 to 24 months, as an indicator as to whether or not the economy is going to improve or perhaps deteriorate. So, this is something that I’m watching very closely.

So, with respect to the economy, how is the economy doing? If we back up for a moment and look at what I call micro-level transactions, what I’m sharing with our audience here is what we call high-frequency economic activity. What is that? Well, high-frequency economic activity are those micro transactions that occur zillions of times every day. Think of when you whip out your credit card to buy something on Amazon, or perhaps last night, you went out to a diner for a meal, or maybe you stayed at a hotel this past weekend on a summer vacation. So, these are what we call micro-economic transactions. And what we’re showing you here on the screen, you see all these different colored lines at the top there in the middle, you can see the different types of transactions that we’re tracking here. And we’re looking at these micro transactions, because if they’re trending up, it tells us that the economy at a macro level should ultimately be improving.

If you go back to March of 2020, you can see that was the collapse, that was the decline. So, if you’re looking at these percentages up here, where it says, “Minimum,” and you go down to US Seated Diners, negative 100%, well, back in March, the economy shut down. Every restaurant was closed. So, for that period of time, there were no US Seated Diners. And so, what we’re showing in the column to the right is, how do we compare to where we are today to where we were pre-COVID, with respect to these transactions? And Doug, Tracey, what you can see here when you look at the data, is you see this upward slope, and you really see where it started the slope upward in a pretty significant way, sometime around February or March is when we saw pretty significant uptick. So, this data tells us the economy is improving, perhaps not where we want it to be just yet. Like I said, COVID is still a significant overhang. But directionally speaking, it looks like the economy continues to move in the right direction.

Doug: A couple of things here, Don, just looking at it. Look at this anecdotally from all of our lives. First of all, one of the things as I drive around my city, I see Help Wanted signs everywhere. Isn’t that a positive? Isn’t that great? Isn’t that the fact that businesses want to hire? There’s a lot of opportunity for people out there. And then you go to your favorite restaurants. Restaurants are full again. There’s good activity. And so, just personally, I’ve done a couple of business trips of late, been at the airport, lots of good economic activity. A little bit too much traffic for me when I was in Los Angeles, but that’s just part of being in LA. But there’s a lot of good things happening in the economy, and that’s what we want clients to understand, as we start to talk about the stock market and what’s happening, that there’s a lot of positive economic activity.

Donald: Yeah, for sure. For sure. And when we step back, and we aggregate all those micro transactions up to the global economy, what we see is that global GDP growth is exceptionally strong at the moment. So, this blue perforated line that you see in the middle of the screen, that is the long-term average GDP growth, what we call real GDP growth, which means inflation-adjusted. So, when you see that term in economics, it means that we’re looking at these things after inflation. So, we can see that the average GDP growth over the past 15 years has averaged about 2.9% after inflation. And these gray bars, these prior to 2020, show us the actual economic growth in those years. Now, the 6.7% that you see on the far right, the 4.6%, those are forecasts for this year and for next year. And what you can see is that the forecast at the moment, and there’s a lot of data to back this up, is that the global economy is doing exceptionally well. So, we have above average growth, a lot of reasons for that, and a lot of it is fiscal stimulus, low-interest rates, monetary policy, pent-up demand. Everybody now wants to go out to eat and travel. So, by any objective measure, when we look at the economy as a whole, the economy is exceptionally strong, not just here in the United States, but globally as well. And actually, when we look at individual countries, what we see is that the United States, India, China, Spain, Turkey, these countries are really the leaders when it comes to global GDP growth. So, there was a time when the United States was a bit of a laggard globally in terms of growth. That is not the case at the moment. We are among one of the most fastest economies growing at the current moment.

Doug: Tracey, what kind of conversations are you having with clients? Mercer portfolios, of course, are diversified globally. Talk to us just about how you’re framing up what’s going on in the international markets?

Tracey: Yeah, that’s a great question, Doug. So, we always recommend an allocation to non-US equities in our portfolios. And the research has shown that the inclusion of non-US equities can provide better diversification, little higher return, and a few other benefits. There are a lot of clients who are just uneasy about including US equities into their portfolio. So, it really boils down to a conversation of my duty as the advisor to walk them through the decision. And it’s also one thing to note here, too, that non-US equities have delivered strong returns for our investors over the past year. So, it’s important to have a good diversified portfolio that includes non-US equities in it.

Doug: Absolutely.

Donald: And, Doug, I would add to that, non-US equities, they have lower valuations than US equities. So, oftentimes we have investors who are concerned, and I think rightly so, that US equities are getting a little frothy in terms of valuations. Well, the reality is non-US equities trade at a discount of anywhere from, say, 25 to even 40% relative to their US counterparts, so I think that’s an important point. And for those investors who are seeking income, the dividend yield on non-US equities is at least twice that of what it is on US equities. So, something to consider when you’re struggling with this decision, do I include or do I exclude, for example, non-US equities from a portfolio?

Doug: Don, before we leave this slide, if you could comment, we had a question from a client specifically about China. First, I wanted to have you just comment on really our portfolios’ exposure to China and emerging markets. And secondarily, the client is asking the question, “Boy, China is really starting to clamp down on technology, education, data. There’s some things going on there.” But I think the influence of it on our portfolios is an important takeaway, but if you would address that as well, Don.

Donald: Yeah, absolutely. It’s a great question. It’s something that our investment team is constantly monitoring. I am concerned about China’s crackdown in Hong Kong, China’s crackdown on just this week, cracking down significantly on technology companies and educational companies. China has also effectively banned Bitcoin from their financial system. It’s certainly a lot going on in China that warrants a lot of attention. In terms of our China exposure in our portfolios, it’s exceptionally small. If you just look at our 100% equity portfolio, that’s where you would see China exposure. When you look at the emerging markets allocation, China is an emerging market, so it’s part of that sleeve of the portfolio. Our exposure to China is typically around 1%. And that’s for a portfolio that’s all 100% stocks, and interest very, very few clients are 100% stocks. Most clients have a 30 to 40 to 50 percent allocation to bonds and only a 50 or 60 percent allocation to equities.

For the typical client portfolio, the exposure to Chinese companies tends to be maybe one half of one percentage point, or maybe 0.6, something quite minor in the grand scheme of things. You want to be careful here. You still want to have exposure to China. China is hands down the best performing emerging market thus far year to date. I would argue that’s been largely true for the past 15 to 20 years. From a diversification perspective, from an unexpected returns perspective, it’s still a market that I would argue you want to have exposure to, but with that, of course, comes the attendant risks that are inherent in investing in a market where you have such a heavy-handed regime that is cracking down. With that comes, of course, the volatility.

Doug: Great. Thank you. And ladies and gentlemen, just want to continue to encourage you to use the question function in your toolbar. I can see my questions live here. I want to answer as many questions as we can today. But please, bring those questions forward. So, let’s turn our discussion to what’s happening with inflation, Don.

Donald: So, this is where the new information, Doug, and Tracey, that came out in Q2. It was in April where we saw inflation data really start to run really, really hot. If you’re looking at this particular slide, we’re showing you what we call headline inflation, that’s the blue line. That’s inflation, the change in the price of goods and services for all goods and services in the economy. Core CPI carves out highly volatile sectors like food and energy. I, as a financial planner, when I put on my hat, I like to look at headline CPI. I don’t like to sugarcoat it. I just want to see all the data. So, the blue line there, that’s really what I consider to be the inflation rate. If you go to the bottom right-hand side of the slide, you’ll see where it has spiked up quite dramatically. You see, it looks like a rocket just went off into outer space. And you can see that dotted line across the middle of the screen. That’s the average inflation rate. That’s the 50-year average. We are now above the 50-year average.

If you look at the little graph there, where it says June 2021, right below that, you’ll see that inflation is running at about 5.3% over the past 12 months. We’ll get into this perhaps in a little while here. But the takeaway here is that inflation is running hot. I would argue, combined with COVID, these are the most material debates right now that are driving markets, and markets are trying to get some insight into what really is going to happen with inflation going forward. Remember inflation data once it’s reported, that’s a history story. It’s showing you what already happened. The real question is, what does it look like going forward. When we back up and we consider the fact that inflation now was running really hot, at around 5%, 5.4%, typically, you would expect interest rates to rise. This is classic textbook finance. If inflation goes up, interest rates should follow. And say, this gray line that you see on the chart here, that is the real after inflation interest rate on 10-year US Treasury bonds. And we’re showing you that all the way back to the ‘50s. But what’s material is the bottom right-hand side of the screen.

So, there’s the nominal yield, which is what you get paid. The nominal yield minus inflation is the gray line and because inflation has gone up significantly, you’ll see that gray line looks like it just fell off a cliff. And so, at least for the time being, it’s a bit ironic, it’s not what we would have expected. Interest rates actually came down over the past couple of months. Their treasuries, the 10-year treasury bond, it hit 1.74% at the end of March. April comes along, we get all of this really hot inflation data. And lo and behold, what happens, interest rates actually came down. The complete opposite of what we would have expected, and certainly the complete opposite of what we’ve really witnessed historically. And so, it’s a bit of an anomaly. The question remains, is this short term? Is this long term? Will markets ultimately price in this higher inflation? And that’s the debate that markets are having right now. The real question, Doug, is whether or not the inflation that we’re experiencing: is it temporary, is it just due to COVID, or is it something more permanent? And that’s what markets are currently trying to figure out.

Doug: Tracey, you’re having conversations. You’re building financial plans for clients all the time. How are you factoring inflation into your financial plans, and how was the environment changed in terms of conversations with clients right now?

Tracey: So, clients are concerned about inflation. When we’re putting together a financial plan, we actually have two different inflation rates that we apply. We apply an inflation rate for lifestyle expenses, which is set by the Investment Committee, and it’s updated annually. So currently, it’s at 2.1%. The other thing that we inflate a little higher is medical expenses, we know the medical expenses are going to significantly go up. So we’re inflating those at around 5 to 6 percent. We want to make sure they may not go up 2.1% every year or 5. There’s going to be fluctuations, but we want to make sure that we’re accounting for it. And furthermore, when we’re creating the asset allocation for our client, not only does that investment portfolio have to keep up with inflation, it has to outpace inflation to help keep the plan running and functioning.

Doug: Sure, great. In summary, we’re going to talk more about inflation. Ladies and gentlemen, this is something that we’re very focused on as an organization. We’re looking at it through the lens of your personal financial plans, but also looking at it from the perspective of the investment portfolios that we are constantly monitoring for clients. So, Don, please take us forward here.

Donald: So, given what’s happening in the markets, given the economy, given that inflation is running hot, let’s pivot a little bit, and let’s actually review how have markets done year to date? And when we consider the fact that markets have done so exceptionally well, over the past, say, 12 months, it naturally raises lots of questions around evaluations. I get this question almost daily from our advisors and from our clients. And what I want to draw your attention to is the upper right-hand side of the screen, you’ll see where it says July 21st, 2021, 21.54x. That’s the price to earnings ratio. I’m not going to get into a big lecture on how that’s calculated, other than to say it’s basically a company’s earnings that we expect them to earn over the next 12 months divided by price. And so, the higher that number, the more expensive the company or the market is. And so, right now, as you can see, the market’s at 21.5 times next year’s earnings, and you actually have to go back to the late 1990s, during the Internet bubble, to find a time when the market was trading at a valuation that was this high, and another are very material differences between today and the late 1990s that I won’t get into. So, sometimes that comparison is flawed. So, you want to be careful not to equate too much what’s happening today with what’s happening in the late ‘90s. But you can just see that you’re graphically on the slide.

Now there are lots of other measures of valuation. You’ll see in this box here, we have CAPE and dividend yield and price-to-book. These are just other ways to measure the market as a whole. Virtually all of them at the moment, with the exception of one, are actually indicating that the market is trading at a very, very high valuation. And if you look at these dotted lines in the middle of the slide, the one that says 25-year average of 16.7, well, that’s the 25-year average price to earnings ratio. So, markets are trading at close to all time highs. Valuations are high. There are two ways to deal with high valuations. One of those, the good way to deal with that, is through earnings growth. And Tracey, and Doug, this week actually happens to be a huge earnings week. It’s the biggest earnings week of the quarter, and we are seeing exceptionally strong earnings growth across most sectors in the US economy, most sectors in the S&P 500 Index.

And so, I would draw our listeners’ focus to the right-hand side of the slide, where you see those three blue bars. Those are analysts’ earnings estimates, and you can see that they go straight up and these would be all time high levels of earnings for S&P 500 companies. We’re actually forecasting 60% plus earnings growth for 2021. That is, by any measure, substantial. Now part of that is due to the fact that earnings declined this time last year, so we’re coming off of a low base, but nevertheless, earnings continue to grow quite handsomely. As earnings go up, the valuation of the market comes down, all things being equal. The bad way to deal with high-market valuations is for prices to come down, like we saw last week, when we saw a pretty significant sell off in the Dow market has subsequently recovered. But that’s the bad way to deal with market valuation. That’s the way that nobody wants to see ultimately happen.

So, how have equity markets done? What I’ll draw your attention to is this green box on the right-hand side of your slide, and these are year-to-date returns through July 22nd, so about a week ago, and you can see that the S&P, the US equity market, was up about 17% for the year. Now that comes on the heels of a staggering 18.4% increase last year, despite COVID. Despite COVID, despite the recession, despite all the challenges that came with the pandemic, we’ve seen very, very substantial growth in US equity values over that time. When we look outside of the United States, we also see similarly strong growth, 8.1% pretty much in the rest of the world, EAFE, which stands for Europe, Australasia, and the Far East, up about 9%. Europe outside of the United Kingdom, 12.7%. Emerging markets are coming up in the rear here at 4.1%. I think that is largely due to the fact that emerging markets are really behind the curve, unfortunately, when it comes to vaccination rollout. And so, that’s going to start to weigh on their markets, at least in the short run until they can get more expanded vaccinations.

Doug: Tracey, let me ask a question here from clients. And Don, I know you will chime in as well. I’ve had several questions from clients with valuations that are near record highs of the market, how should we be thinking about this? I had a client ask a question about stop-loss orders, how is Mercer Advisors adjusting portfolios with these high-valuation levels? So, Tracey, let me ask you, because you deal with this every day with clients who are concerned about the level of the markets, how do we respond, what does Mercer Advisors do? Talk a little bit about rebalancing these kinds of things.

Tracey: Yeah, absolutely. So, what I’m hearing, I’m hearing a couple different things, having a couple different kinds of conversations. So, on a conversation of when a client is three years away from retirement, we’re having conversations about taking risk off the table, “Hey, your portfolios are at a very high mark, why don’t we carve that out and just get into a little better asset allocation, one that’s more aligned with where you’re heading for in the next three to five years and just take those gains?” The other conversations that I’m having revolved around concentrated positions. There’s a lot of people out there with Tesla, Amazon, Google, just a low basis. So, how do you diversify out of those? So, on one hand, we’re having conversations about, “Let’s set up a capital gains budget every year, let’s carve out these gains.” The one thing to keep in mind, too, is there’s some legislation in DC right now that could raise the capital gains tax. So, we want to make sure that we’re keeping that in the front when we’re diversifying these portfolios.

Doug: Don, would you comment on our rebalancing strategy for clients? Because with just my experience with how we do this, it’s quite remarkable, both the results and how it works from risk management is also taking more risk. So, please, tell us how that works.

Donald: Absolutely. I mean, rebalancing in our portfolios works at two levels. So, there’s the portfolio level, the account level, where, for example, equities have done exceptionally well, and now the portfolio is lopsided, and to Tracey’s point, “Hey, let’s try to rebalance to get that back to a risk appropriate level for the client, so they can sleep at night and not run the risk of blowing up their financial planning.” So, that’s what I call tier one rebalancing. So, that’s at the accounts level. There’s tier two rebalancing, which clients don’t see typically, but it’s actually very real and very impactful. And that’s the rebalancing within the funds, within the ETFs, or if using a separate account manager. You’ll actually see the balance themselves for the equities if you’re using an SMA. So, there’s the rebalancing inside the sleeves of the portfolio.

So, for example, if you have a value strategy as part of the portfolio, which you should, but certainly if you do, you always have companies that you bought at a low price and suddenly they’ve risen in price. Well, they really no longer fit your definition of value stocks, for example. So, you need to sell those and then go buy other value stocks or new value stocks that are in the market. A new value stock would be a company that had a really high valuation, perhaps it got hit really hard and it fell in price. Now, it’s perhaps a good value. So, that’s tier two rebalancing that occurs inside the sleeves, inside the funds, inside the portfolio that clients don’t see, but it’s actually very powerful, very impactful. And that rebalancing is typically done, not always, but typically done monthly, by the managers in our portfolios. So, it’s actually quite active.

Doug: And actually, we have a third level, Don, with what Tracey was just talking about, for clients who have come to us with positions in their portfolio. This is where an individual advisor is working with that client. There is some capital gains risk forward. There’s not going to be capital gains changes this year, could be next year. We don’t know. We’re not predicting. But this is the part of the advisor working with the client to their specific needs and being proactive at, you’re doing two things, you’re taking advantage of the low capital gains rate, and then you’re also reducing risk in the portfolio and getting more diversified. So, actually, a third level that we’re doing things.

Donald: Excellent…

Doug: Don, did you complete this one?

Donald: Yes. Yes, let’s move on and talk about the bonds market. The bonds market is where all the action is these days. And so, the bonds market year to date, I’ll draw your attention to that greenish box in the middle of the slide. And those are year-to-date returns through July 22nd. And you can see here, there’s a lot of different types of bond asset classes. That’s what you see over there on the far left-hand side of this graph. But you can see here that the bond market took back some of its explosive gains that it had over the past couple of years. So, as rates came down last year, bonds went up substantially. Now that turned a little bit here at the beginning of this year, in January, interest rates started to go back up, and bond prices started to come back down. I know many of our listeners have heard me say this before, but it bears repeating. “Bond yields and bond prices move in different directions.” So, if the yield goes up, if interest rates in the market rise, the price of the existing bonds in the market, mathematically, they have to come down. And they do. And we see that here with the 30-year US Treasury bonds. It’s down about 5.5%.

Now, just to calm our listeners, we do not own 30-year US Treasury bonds. All of the bonds in our portfolios are very short-term bonds. We’re typically around two and a half to five years. Now we have a few portfolios for those clients who are really trying to stretch to get higher yield. Sometimes we’ll go up to seven or eight or nine years. But that’s exceptionally rare. Most of our strategies, around two-and-a-half to three-and-a-half years, that’s what we call them maturity. With bonds, the longer the maturity, the riskier they are, also the higher the interest rates. So, that’s why some folks, they give into that seductive allure of those higher long-term rates, but with that comes higher risk. So, the shorter-term bonds you can see are virtually flat at around -0.3. The five-year bonds are down about .9%. I’ll draw your attention to about halfway down versus US aggregate. That’s the entire US bond market, the investment grade US bond market, -64 basis points. So, we’ve given back some of those gains, that same index, that same basket of bonds was positive over 7% last year. So, we’re giving back a little bit of it so far this year.

But this is where the debate is, and the debate is essentially this and I said this before, but I’m going to say it again. The question is, the inflation that we’re seeing, is it permanent or is it temporary? That’s what the bond market is trying to figure out. Once the bond market figures that out, then the equity market, the stock market will ultimately know what to do. And right now we’re all looking to the US Fed. We’re looking to the economic data, to try to read those tea leaves to get an understanding of whether or not we think the inflation that we’re seeing is permanent or not. So, Tracey, I think when we think about risk, and here we are, we’re talking about inflation. I think this is probably a good place for us to pivot a little bit and explain to our listeners how our advisors, how you talk to clients, and how we think about risk. And so, perhaps, this is a good place for you to step in.

Tracey: Yeah, absolutely. So, if we think about risk, we think of it in three circles. So, a client’s tolerance for risk. So, that’s the ability to stomach market fluctuations and not panic. So, what’s your tolerance or appetite for risk, the need for risk? That’s why we start with a financial plan first. We need to know how much risk we need to take in the portfolio to make sure that their financial plan works. And then their capacity for risk, what does their capacity look like from a long-term plan situation. So, there’s a couple different areas, and that black area in there is that sweet spot of all of them. And I want to show you an interesting slide. So, eMoney is our financial planning software. So, there’s this great little tool inside of eMoney. So, this particular situation, this portfolio is an all-equity portfolio. So, you can see the rate of return and the standard deviation is about 14.8%. As a proposed portfolio, we added 20% bonds to the portfolio.

Now I get a lot of feedback about bonds. I don’t know why bonds got such a bad reputation. But in this case, if you look at this one example, by adding 20% bonds, we can lower the return just a little bit, a slight lower of return, but we lower that standard deviation by about 4%. And that’s significant. If you see the little box on the left-hand side of the screen, that’s the efficient frontier. So that orange dot is the current portfolio, and that red dot is the proposed portfolio. You can see that we’re moving closer to that line, which is important. And then furthermore, if you can flip to the next slide, the outcome of this right is, in this situation, we were also able to increase the client’s longevity in their financial plan from 74% to 87%. That’s a big deal. I mean, that’s a huge deal. We’ve moved, if you think about it from the yellow zone, which is sort of okay to a strong green zone, which is what we call the gold zone, from a financial plan standpoint.

Donald: So, this is one way to think about inflation. The reason why I wanted to pivot at this point in the conversation to these slides, is that, yes, inflation is running hot. Yes, inflation, it could be persistent, it could be more permanent. The point is that it’s important to look at risk holistically, because I see a lot of clients and say, “When inflation is running hot, I’m going to get out of the stock market, or I’m going to get out of bonds. And I’m going to go invest in…” Lord knows what. And the point is, to back up here and stay focused on a diversified portfolio and try to understand what does it mean to make slight adjustments to your portfolio? What are the implications for that on your financial plan, given those three dimensions of risk. It’s important to keep in mind that all of us have a certain risk, need. There’s a certain amount of risk we have to take, if we’re going to achieve certain goals. And irrespective of what’s happening with inflation or markets, there’s still a certain required rate of return that portfolios need to earn. But in order to do that, we don’t have to take some crazy level of risk. And I think that’s one of the powerful takeaways here.

Doug: Don, and Tracey, I want to add something else here. I’m constantly talking to a lot of potential new clients to Mercer Advisors. And in that discussion, certainly, I have a tendency to want to look at how you invested today and many new clients that have joined the firm or have been sitting on very, very large cash positions. I’ve even had a couple of questions in the queue here today: does raising cash make sense with our current investment strategy? But the most important point that we want everyone to understand relative to cash is that inflation is eating at that cash. And right now it’s eating at that cash at a level of 5%. And so, imagine, if you had $100,000 CD at the beginning of the year, we’d have a 5% inflation rate. Well, that CD is now down because it’s hardly paying anything. It’s down year to date, at least 2%. And so, if you were going to sit in the cash position for a year, that’s a -5% rate of return. Now, would anyone want to move from a positive investment experience to a negative investment experience? I think most people would say, “No, I don’t want to do that.” But there’s this tendency to think that cash is risk free. And it is not risk free, especially in a high inflation environment, as we are in right now. We don’t know how long this is going to last. Cash is not risk free. And so, it is very important for people to understand that, because certainly banks, they would love for you to just sit on your cash and they can take advantage of using that money, but you’re actually going to experience a negative rate of return.

Tracey: You know, Doug, one of the ways that I address that with clients, I’ve had a couple clients call and say, “Maybe we should think about going to cash.” And so, I walk them through that scenario, and what I typically end up doing is, if that client is like a 70/30, or a 60/40, what I say to them is, “You can’t go to cash. You can’t sit in cash for a number of reasons, right? Let’s get you invested in a conservative portfolio. For the time being, you’re not sitting in cash, you’re going to earn a little more. You’re going to earn more than you would in cash,” to make sure that they’re getting some place in their investment allocation in return.

Doug: Great.

Donald: Just to add an anecdote to that. Tracey, that’s an excellent point. And just to add an anecdote to that. I mean, I work with global asset managers, I talk to asset managers every day, and it is alarming how many asset managers, in 2011, substantially increased their allocation to cash in response to the downgrade of US government debts. And my point is this, just because inflation is running hot, or there was a debt ceiling fight and debt was downgraded, that doesn’t mean that the returns on your portfolio over the next 3, 5, or 10 years are going to be impacted directly by that information. And in fact, what we saw subsequent to the US debt downgrade is markets rallied substantially over the past 10 years. In fact, we had double-digit returns in equities over the past 10 years. And so, for those asset managers, and for those clients who raised cash in response to something that was admittedly new information, it was scary, it was negative information, those are returns, those clients will never earn back because of that decision to move all or part of their portfolio to cash.

So, pivoting here towards the end of our discussion, I think we’ve been talking about inflation for so long already this morning. But I think it bears continuing the conversation, given how critically important inflation is to successful wealth building. So, what I wanted to do is just add a little bit of context. And so, inflation for the past, actually, 20 years has been really coming down, ever since actually, the early 1980s, inflation has just kept coming down decade by decade by decade. And over the past 10 years, inflation has only averaged about 1.75% annually. And so, what we’re showing you here is actually monthly inflation. And you can see the back when COVID hit in March and April, that we actually saw some deflation prices collapsed, prices went down. In fact, just to refresh everyone’s memory, in April of last year, oil contracts were trading at a negative $37 a barrel. So, I know that probably wraps our brain in a knot, and we’re thinking how can that be? But it did. It did. Oil was trading at a negative $37 a barrel. So, we saw that deflation there for that three-month period, it then ticked up a little bit with all the stimulus and all the stimulus checks and low interest rates, and then it came back down again here. And we saw a little bit of deflation in November, right around the time of the US presidential election. But since that time, it has been off to the races. And so, you can see here for June inflation averaged for the month, prices were up almost 1% just for the month.

The challenge is you hear these 5% inflation rates. And I just want to give you some context. We’re measuring that over the prior 12 months. And so, anytime you’re doing a simple math exercise, and you measure back to say April of last year with this -0.67 obviously, the inflation rates are going to look a little inflated. Pun intended, it’s going to look a little inflated. It becomes more meaningful once those data points burn off, and now we’re measuring from, say, June of 2020. Now we’re starting from a higher base rate. So, the bottom line is inflation is going up, and the debate remains whether or not it will stay or if it will be temporary. And when you consider that inflation really began to spike in April, I think one of the most popular questions I receive is, “Really, Don, what’s the best way to hedge inflation as a gold, as a Bitcoin, as commodities?” And certainly, Bitcoin has been dominating the headlines for the past couple of years.

So, I thought it would be interesting to go back and say, “Well, where was Bitcoin right before all of the new inflation data came out?” And then ask ourselves, how did Bitcoin respond. And what we see here is, Bitcoin actually collapsed about 40%, since all of this really hot inflation data has been released. So, I’m in the camp where I don’t think Bitcoin is a reliable hedge against inflation. I don’t think it meets the definition of a currency. Even though its returns have been spectacular for the past couple of years, it has been nothing, if not exceptionally volatile, so volatile that I don’t know that you can rely on it to hedge much of anything. And so, that orange line that you see in the middle of the screen, that is the consumer price index over the past quarter. So, just over the past 90 days, we’ve seen prices rise about two and a half percent, while Bitcoin ultimately came down in value, about 38% during that time.

Doug: Don, while we’re on this, let’s just broaden the discussion around digital currencies, if you will, and I want to go to Tracey in a second. But Don, first to you, there’s a lot of talk about the Federal Reserve getting involved in digital currencies. Now digital currencies is much broader conversation than just Bitcoin. China has been talking about digital currencies, and actually, the discussion in China, as you mentioned earlier, is banning Bitcoin. So, can you give us just a broad overview, Don, of this concept of digital currencies? And one, of course, type is Bitcoin that I want to talk a little bit further about with Tracey, but go ahead, Don, give us an overview.

Donald: Yeah, I mean, digital currencies or digital assets that use blockchain technology. There’s a digital ledger that would record transactions between two parties they’re transacting in the digital currency. I think that’s where folks tend to get a bit confused as there’s been some really amazing technological developments in terms of having secure digital transactions. Blockchain technology is exceptionally interesting. And I think that’s why the central banks like the Central Bank of China, Central Bank of the United States, the Federal Reserve Bank, there’s interest in harnessing that technology for use for our own sovereign currencies. So, I don’t think there’s anything wrong with the technology. I think it’s interesting. I think it’s exciting to make it more secure.

However, I think there’s some confusion. I think folks commingle blockchain technology with Bitcoin, when in reality, those are two different things, or Dogecoin or Ether, whatever it is. Those are very different things. And my personal view is that sovereign authority, sovereign monetary authorities are never going to outsource monetary policy to something like Bitcoin. It’s arguably the most powerful weapon that any nation has in its arsenal, and that is the sovereignty over its own currency. So, I’m not surprised that China is cracking down on Bitcoin. China has to maintain sovereignty over their currencies so they can prop up its value. So, it’s not surprising that the Chinese have been cracking down. I think one last point that I would just make here is that we had digital currencies effectively for several decades. It’s not new. How many of us have been using credit cards and wire transactions and ACHs and everything else for a couple of decades now. So, the whole concept of using digital money effectively to pay for things to transact is certainly not new.

Doug: Tracey, directly to you on this subject of Bitcoin. You’re having conversations. I’ve got questions in the queue here about Bitcoin. Is Mercer looking at that? Talk just a little bit more about the conversations you’re having and the feedback you’re getting from clients and giving to clients.

Tracey: I get this conversation a lot, at least once a week about Bitcoin. And what I say to them is, “Look, Bitcoin is speculative.” I mean, you can see this graph right here how speculative it is. We manage your serious money. If you feel that you want to get in and a little bit of Bitcoin that’s fine. 10,000, 20,000. But we’re not going to put your economic freedom assets into Bitcoin. It’s speculative. This is no. I go back to a conversation that I had with someone several years ago, similar but about gold. I need to have gold bullion. You can not walk into Meijer or Kroger or whatever grocery store is, and buy a gallon of milk with a gold bar, or a Bitcoin. The cashier is just going to look at you and go, “What am I supposed to do with this?” If you want to invest in Bitcoin, a small amount where if you lose it, it doesn’t matter. It doesn’t upset your economic freedom. Your serious money needs to be invested with a process that needs to be invested in a diversified allocation.

Doug: Great. So, Don and Tracey, just watching our time. We’ve got about five minutes left, let’s continue with our presentation, because we’ve got some conclusions we want to bring to our clients today.

Donald: Absolutely. So, Doug, I think the three takeaways that I would have for our audience would be, first and foremost, inflation pressures are building. For me, they are becoming an increasing concern. This is a debate that I follow daily, looking at the data, trying to assess whether or not this is more permanent, or if this is something that may be more fleeting. Investors should just know that this is really what’s going to, at least in our view, drive markets going forward is ultimately how this debate, this tug of war is ultimately settled. Number two, given that uncertainty, it is important to de-risk portfolios, stay diversified. If you wanted a small piece of Bitcoin in a portfolio, I don’t see a problem with it, as long as it’s exceptionally small. That way it does not derail your entire financial plan.

You should pay attention to valuations. Valuations are frothy. Portfolios should be rebalanced. They should be tilted towards lower valuation type stocks. Those are value stocks. Owning non-US stocks, by definition, will start to bring down the valuation of your portfolio. So, we should be very careful of concentrated risks in our portfolio. Right now, markets are really priced for perfection. I make no bones when I say this, that it’s much harder for markets to go higher from here than it is for them to go lower. That’s not a recipe for market timing. In fact, I could say that almost about any market at any point in time. And part of that’s just my inherent conservatism. But pay attention to those risks. Make sure you’re working with your advisor. Do that stress testing that Tracey walked us through. That stress testing is important. At the end of the day, investing is a means to an end. It’s not a spectator sport. It’s meant to help you achieve something for your family. And so, that would be my advice to all of our investors.

Final point is, always have a plan. Those without a plan are ultimately just planning to fail. Now understand your individual, your psychological tolerance for risk, understand how much risk you have to take in order to achieve your financial goals, and then understand what’s your capacity. What’s your balance sheet look like? What do your sources of income look like? Those are ways of trying to understand what’s your capacity for risk taking. And I think when you have that insight, you’ll be well positioned to make the best decisions possible for you and your family.

Doug: Tracey, final thoughts from your perspective to our clients?

Tracey: I’m with Don on number three, I cannot stress enough to have a financial plan. One of the ways I explain a financial plan when I’m talking about the process is if you’re going to hop in the car and drive to Santa Barbara, you’re going to put the address in your GPS. You know you’re going to get off at certain locations and certain access, but you’re going to get back on the road. That’s what the plan does. We know that you want to get from A to B. We want to make sure that we’re planning for all of the flat tires and the pitfalls that can happen between A and B, so that we know we get you safely to where you need to go.

Doug: Great. Ladies and gentlemen, I know we did not have an opportunity to get to everyone’s question today. So, one of the things I want to do is each of you have a dedicated wealth advisor, and I would encourage you to email your wealth advisor with your question, if you didn’t get an answer today, to have that conversation. If you feel as though you’re concerned about the market, let’s get back and have a conversation with your advisor about managing risk. We certainly want you to understand the big takeaway from today’s presentation is that our allocation to equity, many times people get nervous about the allocation to equities, it is the allocation to equities that is keeping our portfolios ahead of inflation right now. So, there is no better inflation hedge in your portfolios than equities. And that’s what’s been working for us. So, we want to continue to use equities. When you go back and look through history when we’ve had high inflation, equities continued to be a great place to invest. So, don’t be afraid of equities. But certainly we want you to be comfortable, and if you’re uncomfortable, that’s the time to have a conversation with your advisor.

So, Don, and Tracey, thank you for joining all of our clients today. And we are going to continue to do this quarterly. Ladies and gentlemen, you’re going to get a survey. We’d love to get your feedback. So, thank you for joining us today on this Mercer Advisor Quarterly Capital Markets Call.

 

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