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Mercer Advisors Capital Markets Update and Outlook: October 2019

Doug: Welcome, ladies and gentlemen, to this Mercer Advisors client webinar. Today, we’re going to be discussing the capital markets through the third quarter of 2019. Our goal with this quarterly broadcast is to inform you about the progress of the financial markets in real-time and to answer your questions. And we certainly appreciate you taking the time to join us today. My name is Doug Fabian, I will be facilitating today’s program. I’m the Science of Economic Freedom podcast host, and I’m part of the client communications team here at Mercer Advisors. I want everyone to take a look at the toolbar. This is where you can submit a question to us. It’ll send us a text message, and we’ll do our best during the Q&A portion of today’s broadcast to answer as many questions as possible. Now, our formal program today will last about 45 minutes, leaving about 15 minutes for Q&A. Joining me today is Don Calcagni, the Chief Investment Officer of Mercer Advisors, and Drew Kanaly. Drew is one of our client advisors and a member of our Investment Committee.

So, let’s take a look at today’s agenda and discuss what we’re going to be talking about here today. We’re first going to go over the economy and market updates and look at some real facts about what’s happening in the financial market so far in 2019. Next, we’re going to address the issues of the day. One of the things that we do in preparation for these webinars is we reach out to our advisors, and we ask them, “What kind of conversations are you having with clients right now?” And one of the things that’s been evident over the past quarter is that there is some concern about interest rates and the yield curve. Certainly, we’re paying attention to the deficits, and we’re going to be talking about that, this is the federal budget deficits. And then, lastly, we’re going to be addressing the trade discussions going on as well. But the big issue we’re going to be focused on is, is there a recession on the horizon.

And then, lastly, today, we’re going to look at the overseas portion of our portfolios, talk about what’s happening in the emerging markets, and answer the question, “Will emerging markets continue to drive growth into the future?” And we always like to end our webinars with what should clients be focused on right now, and we’ll talk a little bit about year-end considerations as well. So, let’s begin by taking a look down memory lane. And I would like to invite both Drew and Don into the discussion. These are some of the headlines that we were seeing in January this past year. Of course, we had that big correction in the fourth quarter of 2018. And as we began this year, there was just some concern whether or not the stock market and the economy was going to roll over into recession. So, Don, what do you remember about where we started out the year?

Don: Yeah, it’s always interesting how memories are so short in our profession. Earlier this year, even professional money managers, the ‘smart money’ on Wall Street, the Goldman Sachs’s of the world were predicting recession, market correction, poor market returns, the whole nine yards. And, Drew, I’m sure you’ve probably heard a few comments from clients, earlier this year, some concerns about what’s going on in the markets. I heard it from professional money managers, and I’m sure you heard it from clients as well.

Drew: Sure, and they were not unfounded. We were right here this time last year, the correction began, and the correct question asked of me, “Is there another leg down?” And so, what you were looking for is, “Okay, what’s the data that will tell me there’s another leg down to this situation?” And, in the end, what ended up playing out was the Fed was not going to keep tightening, and they were going to be accommodated. Earnings actually came through. Fundamentally, profitability… Now, the growth rate of profitability wasn’t there, but profitability was intact, so valuations were fine. So, my comments at the time — and I think it was even on these calls — “10-15%, yeah. Another leg down. It’s just not there.” And here we are, third quarter of this year, we still have some of the walls of worry in place, they haven’t gone away, but the prognostications of a complete meltdown, obviously, were unfounded, and stay in the course was the right decision because fundamentals were in place.

Don: Absolutely. It’s always amazing. And I often hear folks say, “Oh, this is the death of the bull market.” We had this longest bull market in history for the last 10 years. And, obviously, reports of the death of the bull market were probably unfounded, and certainly, a bit of an exaggeration.

Doug: One of the things I wanted to bring up on that, Don, is the fact that one of the things that’s important — and this is something that our advisors do — is it’s our goal to help our clients through these more difficult times and to coach clients so they don’t make a mistake. And if you would have pulled all of your money out of the market in the fourth quarter of 2018… And many people did, statistically. We saw the flow of money leave mutual funds in the fourth quarter of 2018. That was a mistake. And our job as advisors is to be having these conversations with people so they don’t make mistakes and blow up their financial plans.

Don: Absolutely. One of the most critical roles of a great advisor is to help clients separate emotion from fact. Now, when you look at the headlines, when you look at the talking heads on television, their job is to sensationalize the news and really try to get investors to make an emotional response. And so, our job here… And this is what I love about these client webinars, doing these with Drew and Doug, is to just help our clients separate fact from emotion. So, we’ll do a little bit of that here today. Obviously, earlier this year, we had all of that negative energy, pessimistic outlook. But the reality is, through the end of September… And I’ll draw your attention to the information here in the middle of the page, if you can see my arrow here. You’ll see that year-to-date US stocks through the end of September are up 20%. So, healthy returns by [Laughs] any objective measure. Certainly, far above average, right, Drew? When we think about average equity market returns, we don’t think 20% is average. [Laughs] It’s probably three times higher than average. And we saw great returns also outside of the United States. So, we saw a very rapid V-shaped recovery.

Drew: And the V-shaped comment is very important for a buyer to understand. The next correction we get — and you will get one — the question will be just like it was this time last year, “Is there another leg down, and will it be a V-shaped recovery, because they’re so difficult to time?” So, let’s just not time them. Let’s just leave that alone and understand that is part of market behavior. And it was probably a year or so ago when we were going through this and we were illustrating that market volatility was actually at an all-time low. It was unusual, very unusual behavior. Now, we’re in a market that looks like something you recognize as everybody attempts to discount the next piece of information that comes along sometimes to extremes. So, the V-shaped recoveries are probably a pattern until something isogenous happens to be expected in this market.

Doug: Well, and one final point on this, that 20% return we’ve seen in markets so far this year… We know that the historical average of market is around 10%. You never know when a 20% year is going to show up. And I think we can all agree that none of us were expecting this to be a 20% year. But if you miss out on a 20% year, you’re not going to achieve market returns over time. You’re going to be running to catch up, you’re going to be making the move in your portfolio to try to be able to get excess return that the market is not going to deliver to you. So, we just want to continue to remind our clients that we have to be there so we can participate in years like this.

Don: Absolutely, Doug. And what you just said actually also equally applies to the bond market or the fixed income markets. So, when we actually look at fixed income returns on bonds year-to-date, we’ve actually seen really, really healthy year-to-date returns across virtually all bond asset classes. So, the US Aggregate Bond market is up 8.5%. If you would have asked anybody on Wall Street 12 months ago if we were going to see an 8.5% return on the US Agg, no one would have told you 8.52%. Nobody. And you’re right. And so, if you miss out on that, then you’re constantly playing catch-up, and that’s often when investors make really poor investment decisions that could be very detrimental to their long-term plans for themselves and their family.

Doug, it’s always natural when markets have a great year… We’re up 20%. We put on the news, we hear all this negativity, “It’s trade war,” all kinds of stuff. There’s now a loss of net outflow of manufacturing jobs. “Is the market overpriced?” I hear this all the time, and I just don’t see the evidence, I just don’t see it. If you look at this page here, you see this perforated sort of green-bluish line here in the middle of the page. That is the 25-year average price forward price to earnings ratio. Not going to waste a lot of time explaining what all that is, but it is one of the most popular measures of valuation. And when you look at that, you’ll see here that at the end of September… Or September 30th. It’s a little misplaced. It should be right up here by the dot. But at the end of September, the S&P was trading at 16.8 times earnings. Pretty darn close to its long-term average. Now, that doesn’t mean that there aren’t some companies that obviously are trading at nosebleed levels. I know Drew and I have talked about that in the past. But, overall, when we look at the market, we’re solidly in line with our long-term averages.

Drew: Yeah. So, the takeaway here on this chart is the move has not been an expansion of price-earnings multiples, stocks have not gotten ‘more expensive’. It’s the earnings have actually come through and supported the valuations, which is really healthy. The other point I’d make here is it’s still a market of stocks. And so, there are different constituencies here that have different price-earnings ratios. And so, for folks that really follow this closely, you’d be thinking about value versus growth and what are their relative PE ratios in this average. Don didn’t want me to say this, but I’ll say it anyway. It’s capitalization-weighted, [Laughter] which means that the larger companies skew this statistic. So, I’m bringing home the point that it’s not going to be a valuation problem if we get into another correction. We’re not looking at big multiples. And handful of stocks, yeah. But across the board, no. If you’re diversified, it’s going to work.

Don: Excellent point. For sure. I think it’s a good point that if we do get into another market correction, it’s probably not going to be driven by valuations. This goes to really separating fact from emotion. Doug, I want to highlight that if you look at the headlines for the past quarter, two quarters, it’s all been recession, recession, recession. We have an inverted yield curve. I’ll explain to our audience what that is in a few moments. But the thinking is, “Oh, inverted yield curve automatically has to be followed by a recession.”

Well, let’s look at the facts. Well, the facts are the US economy still continues to grow at about 2.3% on an annualized basis. So, while the rate of growth has slowed down a little bit, we still have a growing economy, and that’s a good thing. And I don’t want to be pollyannish about this, but when we look at the hard data behind the economy, it’s actually okay. It doesn’t mean we don’t have headwinds — we definitely do — but probably the biggest engine of the US economy is the US consumer. It’s all of us when we go out for sushi, or we hit the mall… Well, I guess today we don’t go to malls, we go to, right? [Laughs] It’s when we go and we buy stuff. And I just want to highlight this upper right-hand chart. Household debt service as a percentage of their disposable income is at probably the lowest point since before 1980. Households are in great shape by any objective measure, household net worth is at an all-time high. And when you have unemployment at 50-year lows, when you have wage earnings growth, when you’re feeling wealthier, you do what? Americans spend money. So, that’s really fueling the economy at this point. So, I think the real question, Doug… And I’ll hand it over to you here for the transition. But I think the real question we want to tackle is inverted yield curves and recession.

Doug: Well, one of the things that we did, ladies and gentlemen, is we selected — from the feedback from advisors — topics that are on people’s minds. This is things that you’re seeing in the news on a regular basis, and we’re going to walk through… You might not even know what an inverted yield curve is, but it has been a hot topic of discussion in the financial press, and we’re going to talk about the historical data regarding that. Then, we’re going to talk about deficits because we do have federal budget deficits that are exceeding a trillion dollars now. And we also have trade issues out there. So, the question goes, “Are we headed for recession?” And let’s look at the information. Don.

Don: So, like Doug just said, the US Federal Government is ringing up nearly a trillion dollars a year. That’s with a T. That is a [Laughs] really big number. A trillion dollars a year in new debt. That’s on top of the 22 trillion in debt that we already have at the moment. So, we think this is a big issue here at Mercer Advisors, we’re paying attention to this. At the end of the day, this is a bigger issue that needs to be handled by our elected officials, but it’s definitely a concern. Anytime the government is borrowing a trillion dollars from the private economy to fund government spending, that is now a trillion dollars that is not available in the economy for businesses to borrow, for consumers to borrow, to buy new cars, to send their children to college, and things like that. So, this is a concern, and I think it’s something just as a government we’re going to have to address at some point in the future. But I do think this is part of the problem with respect to what’s happening in the economy.

Drew: Don, you called it drag on the growth rate.

Don: Yeah. Anytime the government continues to borrow this much capital from the economy, it’s going to drag on our broader economic growth. So, this is a concern, it’s definitely a big concern. Probably the number one issue that has dominated the headlines for the past quarter is this question of an inverted yield curve. So, I think we should spend a few moments, Doug, just to make sure our listeners understand what that really means.

Doug: And, Don, let me chime in here and just kind of set this up. Let’s begin with the gray line that we have on the screen here because what we would consider this to be a reflection of is a normal yield curve. So, walk us through that, Don.

Don: Correct. So, when you think about what a yield curve is, all it’s really showing us is what the interest rates are at any point in time for loans of different maturities. And a maturity just means when is the loan supposed to be paid off, how long is the loan going to last. So, if you look at this sort of perforated dotted gray line that Doug referenced, this is a normal yield curve, this is what it should look like. And this makes intuitive sense. What it means is that shorter-term loans should have a lower interest rate than longer-term loans. And for all of us who have home mortgages, maybe have a 15-year mortgage, obviously, the interest rate on that is less than what it would be for a 30-year mortgage. So, that’s how a healthy, functioning debt market is supposed to function. However, an inverted yield curve is when these shorter-term interest rates… If you can follow my arrow here on the screen, you’ll see where it says 1.75%. When you look at these shorter-term interest rates, you’ll see that they’re actually higher than some of the longer-term interest rates. And that’s a yield curve that is said to be inverted. So, it doesn’t mean that the whole line would slope down. What it means is there’s a point somewhere… And you’ll see that there’s that dip between the three-month treasury and, let’s say, the five-year. And that dip tells us that this is an inverted yield curve.

Drew: And, Don, typically, the yield curve behaves this way because the Federal Reserve looks out over the economy and the assumed rate of inflation in the future and wants to cool things down, they want to take the punch bowl away. And, historically, markets react to that, say, “Oh, the Fed’s going to change the interest rate, and that’s going to cool things off.” And so, that, typically, is the explanation and response to an inverted yield curve. But history doesn’t play it out straight that way, does it?

Don: Not all the time, certainly. But to Drew’s point, the Federal Reserve has the most influence over the short end of this yield curve, the three-month, the one-year. And so, to Drew’s point, anytime we see this, the Federal Reserve can act… Which they have, they’ve cut interest rates, they’ve done that twice now. So, the Fed does have some control over this shorter end of the yield curve. And to Drew’s point, when the Fed is raising interest rates, it’s because it’s trying to cool off the economy. Right now, the Fed’s not trying to cool off the economy. If anything, it’s trying to goose it a little bit and try to bring down those short-term interest rates. And so, the real question… And probably not the real question, but a common question is — and we hear this in the press all the time — “Inverted yield curve automatically means there’s a recession on the horizon.” I’m just going to say maybe, maybe not. And the reason I say that is we look at the evidence.

And I understand this is a chart that has a lot of moving parts here, but I want to draw our viewers’ attention to this 0% line here in the middle of the screen. Anytime that the squiggly line is underneath the 0%, that means that you have an inverted yield curve, okay? And the red dots and the green dots tell us whether or not that particular yield curve inversion was followed by a recession. And so, what’s the real takeaway from this slide? The takeaway is recessions don’t always follow inverted yield curves. Now, they have about 80% of the time, but it’s not 100. And sometimes, when you listen to these folks on television or in the far dark corners of the internet, they make it sound like it’s sort of this law of physics relationship, and in reality, it’s not. We have had instances where we’ve had inverted yield curves not followed by recessions. The other thing that I would highlight is that when an inverted yield curve is followed by a recession, it takes an awfully long time for that recession to show up. So, I’m just not convinced that there’s a cause and effect relationship.

Drew: Yeah, more of a broken watch kind of scenario where it just happens to have coincided. And, instead, statisticians will look at this and say, “What’s your sample size?” We’re talking about, what, 10 observations?

Don: Yeah, if you’re lucky.

Drew: And so, statistically, you’re really kind of pushing the envelope on how reliable this predictor is going forward.

Don: Absolutely.

Drew: But if you look at it, the average, when you stretch that over a longer period of time, how do the observations with more data samples actually play out?

Don: It remains to be seen. We need more data. [Laughs]

Drew: Yeah, but when you look at three and five years later after an inversion, what’s the data?

Don: Exactly. So, when we select our set of broken watches right twice a day, that doesn’t mean that the recession is automatically a function of the inverted yield curve. That’s my point. So, I would just encourage our clients to keep that in check when you hear all these talking heads trying to draw this cause and effect relationship. But I think the real question, as investors, that we want to know, Doug, is how do markets respond to an inverted yield curve? Because that’s what we care about, what’s the impact on our wealth, what’s the impact on our portfolio. And so, first, I just want to look at year-to-date, one, when did the curve inversion began. It began actually back in March. Went positive again, but then became inverted again in late May.

And so, the real question is, “Well, how has the market done since then?” Well, we’ve actually had pretty good market returns over the past six to nine months. We’ve had an inverted yield curve now for a fair part of the year, and yet, we’ve had positive investment returns, all right? But what if we look longer term? Let’s look at all of the inverted yield curves that we’ve had since the ‘60s. And what we see is that on average… I’m just going to draw our viewers’ attention here to the bottom of the slide. On average, the one-year return following an inverted yield curve is 7%. That’s not bad. That’s not a bad return. It’s positive. And then, over time, three years and five years, we’ll see that those returns are actually quite handsome on average. So, the moral of the story here is there might be some relationship between recession and an inverted curve, maybe. But we’re not seeing a relationship between poor future equity market returns and inverted yield curves. And, by the way, there’s a lot of academic work that actually supports what I just said when we look globally. To Drew’s point, when you have a broader sample size. We don’t see a relationship between inverted yield curves and negative equity market or stock market returns.

Drew: But you do end up with some whopper nominal moves in the market reacting to Fed behavior, and that’s part of the game, that we have to understand those 800-point moves. [Laughs] It’s all part of it. And when you really look at how it really shakes out, more the data points to staying invested than trying to…

Don: Yes, trying to time it.

Drew: …trying to time it.

Don: Exactly.

Doug: Ladies and gentlemen, I want to mention that we are getting some questions from the audience. I want to encourage you to submit a question if you have one. And we certainly will be answering some questions during that portion of the presentation. So, what we’re doing now is we want to talk about what’s going on in the world, and specifically, emerging markets, and answering the question, “Will emerging markets continue to drive global growth going forward?” Certainly, all of our portfolios have an allocation to emerging markets, and emerging markets are part of the global growth story, so they’re important not only to our emerging market allocation but to markets worldwide. So, Don, take us through the numbers.

Don: Yeah, and just to follow up with Doug just for a moment here. And Drew and I were discussing this before this morning’s podcast… Even US companies — think of Coca-Cola — do a significant amount of business in emerging markets. There are parts of Latin America where the word for soda is actually coca. [Laughs] It’s synonymous with Coca-Cola. So, it’s critically important to understand that US companies do a lot of business in emerging markets. So, even if you didn’t invest directly in emerging markets by owning stocks in those markets, your American stocks that you own in your portfolio, your US stocks, do have exposure to emerging markets. And so, I think this is a powerful question, an important question, is, “How will emerging markets perform in the future?”

And so, for context, if we look at the map that’s up on the screen, those countries that are darkest green are the emerging markets with the highest economic growth. So, there should be no surprise here. We see China, we see India, we see a lot of Southeast Asia. We also see parts of Africa coming online, which is really exciting to see. We see Ethiopia and a few other places on here that are really starting to crank from an economic perspective. And we look at Eastern Europe. Eastern Europe, definitely some pretty strong economic growth in Eastern Europe. So, these are the parts of the globe that are growing most rapidly from an economic perspective. And when we actually break out global growth and we look at emerging market economic growth… That’s what the GDP stands for, gross domestic product.

You’ll see this red line here at the top. And we’re just showing you here economic growth since 1980. And you’ll see, of course, there’s that big decline there during the global financial crisis. But if you’d look subsequent to that to the right, you’ll see that the red line is at the top. Most of the growth on planet Earth is in the emerging markets. Global growth is that sort of beige, mustard-colored line in the middle. And then, developed market or advanced economy growth is that blue line there that looks a little anemic. So, frankly, that’s the United States, that is Western Europe, that’s Japan, that’s places like that. So, as investors, we want to tap into that red line, we want to tap into those emerging markets. And the question that we’re answering today, Doug, is, “Can that continue? How will they do going forward?” And so, one of the most important things to look at when trying to determine economic growth is population structure. When we look at Germany, when we look at Japan, these countries actually have very rapidly aging demographics. In fact, Japan and Germany for a short while there actually had negative population growth.

When we look at the emerging markets and we look at the population growth in those markets, it is substantial, they have a young population. Here, we’re just showing you the population under 30 years of age. These are tomorrow’s workers, these are going to be the most productive human beings on planet Earth over the next 30 years as they get into the prime of their working years. And we see Africa, we see Asia, we see Latin America, Central America. These are places that have massive reserves of human capital that’s going to contribute to the growth of their economies. Obviously, United States, Japan, places like that, we’re an aging society. If it wasn’t for immigration to the United States, we would actually be aging even more rapidly, when you look at the boomers and everything else. Interestingly — just an interesting data point to share with our listeners — the average age of an American is 38 years old. The average age of a citizen of China, 38 years old. China has the same demographic challenges as the United States with respect to caring for an aging population. So, again, when we look at population structure, that is a very powerful input to future economic growth. So, this tells us that, yes, this should help fuel future emerging market growth going forward. Take it a step further.

I want to draw our viewers’ attention to the screen on the right. This is the projected growth of the middle class. Now, remember what we said a few moments ago? We were looking at the American consumer. The American middle-class consumer is the engine of the US economy. And that is true in places like India, Indonesia, China, Brazil, and Mexico. And so, one of the things that economists want to understand is what does the growth of that middle class look like in those markets. And you’ll see here, I’ll draw your attention to the grayish, teal-colored bar. Over the next 11 years, we are looking at a nearly 80% growth in India’s middle class. India today is probably the most populous country on planet Earth. They are running neck and neck with China, and I think by 2020 next year, India is projected to surpass China in terms of number of human beings. 80% growth in their middle class is phenomenal. We see this in Indonesia, 40% growth, China, 70% growth, 61% middle-class growth in places like Brazil, 80% growth in Mexico, our neighbor to the South. We are ideally positioned as a country to capitalize on the growth of Mexico’s middle class. So, we see great population structure for workers, we see projected massive growth in the middle class in these countries. By any objective measure, that’s what you need if you want to have powerful economic growth going forward.

So, Doug, to the question, “Will the emerging markets continue to grow?” Absolutely. Just look at the basic facts. They’re in a good, good place. Now, from an investment perspective… And, Doug, we don’t have this information here for our viewers, but we’ve shared it on previous podcasts. When we look at emerging market stocks, for example, they traded about half the price as their US developed market counterparts. So, emerging market stocks are a veritable bargain by any other measure. And so, to your point, yes, they are an allocation in most of our portfolios. And when I look at this data, this tells me that that should remain the case, that should remain the case.

Drew: Yeah. And when you’re looking at these growth rates, you can substitute or read consumption, right? So, you have productive people that now have the capability of consuming, consumption, and they don’t have to get to our consumption rates.

Don: That is true. [Laughter]

Drew: They could be a quarter, a third of our consumption rates, and the economic impact would be tremendous when you think about these bases of populations.

Don: And I’ll add one more data point in terms of economic productivity. Oftentimes, when I have this discussion, folks look at the map, and they’re like, “Well, yeah, but those are parts of the world where maybe educational systems aren’t as good, so it’s hard for them to be as productive.” And I would challenge that. We are beginning to see the educational systems in these countries maybe not entirely rival the United States just yet in terms of our higher education infrastructure, but I would argue — talk to any education professional — a lot of these countries have superior elementary and high school educational systems relative to the United States. And so, in terms of worker training and productivity, I’m very bullish on what we can expect to see out of the emerging markets over the next 10 years.

Doug: Well, ladies and gentlemen, one of the things that we want to do here now is kind of recap what we’ve talked about in the webinar and talk specifically about some next steps before we get to some Q&A. I want to remind everyone, if you have a question that you would like to ask us, please submit that question via the toolbar. I’ve got a lot of questions that are queuing up, but still have room for more, and we’re looking forward to this. So, Drew and Don, we’ve talked about the economy and the markets. The US economy continues to grow, but it is facing some serious headwinds. How do we, as investors, deal with, A, we’ve got good numbers going behind us, but what should be our thinking going forward?

Don: So, I think the two biggest headwinds — and, Drew, certainly want to get your thoughts on this — one is trade. We are now beginning to see a net reduction in manufacturing jobs in the United States that I think most economists are directly attributing to the trade war with China. So, I think the trade war with China is a real issue, it’s a serious headwind. You go to anywhere in the Midwest, talk to any farmer, they’re feeling it. That’s number one. The other headwind we touched on is deficit spending. My personal view is we have to get our deficit spending under control. So, those are probably the two biggest headwinds. And, Drew, anything you want to maybe add to that?

Drew: So, you can take off your list of headwinds Federal Reserve policy, that they’re going to be accommodative. They might continue to draw down on their quantitative easing, but interest rate policy is going to be favorable for the economy and stocks, that’s for a fact. The next thing that’s very favorable for the economy is energy. We’re awash in energy. If you’re a producer in energy, the only bright spot are the flares in West Texas. We’ve got so much natural gas and oil. The stat, I’ll throw at you all real quick… Currently, the United States is exporting 2.9 million barrels of oil a day. By 2022, we’ll be exporting 6 million barrels of oil. There is no upward pressure on the price of oil or natural gas, major sources of BTUs. That is not going to be a problem going forward. You’ve even had tankers, they’ll be attacked and seized in the Straits of Hormuz. The price did what?

Don: Virtually nothing.

Drew: 10 years ago, it would have been a disaster, and it would have affected the consumer, and it’s just not going to be that playing out over the next couple of years. Now, capitals dry it up, so new exploration is going to slow down for a while. But they have so much momentum in what they’ve already realized, that it’s going to last for a number of years.

Don: I think those are good points.

Doug: I want to come back to something here, gentlemen, and talk about the issue that, certainly, we could get headlines on the trade issues going forward. And, Drew, you said the Fed was really off the table a year ago, we were worried about rising interest rates. We’re certainly not worried about rising interest rates right now. But if the economy does start to slow down, what kind of tools does the Fed have at its disposal today to counteract an economic slowdown? And I thought we should talk about that.

Don: That’s a good question. And I think the way I think about that is the Fed today, when we just look at their arsenal of tools, is actually much better than it was prior to 2008. And that’s a strong statement. I’ve talked to some of my friends who are economists, and they won’t understand what I mean by that. What I mean by that is, prior to 2008, it was inconceivable that the US Federal Reserve would go into the market, print money, and buy bonds in the market. It was not something we… Other than US treasuries, right? But we’ve now done that, and we survived, and the economy crawled out of the global recession, the global financial crisis. And, now, that is a tested policy tool. Now, we can debate whether or not we want our Central Bank to do that, but that’s an academic debate or a policy debate. Bottom line is, that’s on the table. The Federal Reserve can also stop shrinking its balance sheet.

So, in previous webcasts, we talked about how the Fed bought all these bonds during the financial crisis and after the financial crisis as a way to pump cash into the economy. A lot of those bonds are now maturing, and the Fed can take those dollars, which they did for a period of time, and basically, just threw them in the shredder. Now, they don’t have to do that, they can just take those dollars and reinvest them in other bonds. So, there are a lot of things the Fed can do to push rates lower. And I would add, globally, we have $17 trillion, not in the United States but globally, $17 trillion worth of bonds that are trading at negative interest rates. So, there are other central banks, specifically in Europe, who have not been afraid to push interest rates negative. So, there’s a lot the Fed can do to keep the economy moving. And, again, we can debate whether or not we want them to do all these things, but I would argue, they’re in a pretty good place. And the fact is, they did raise interest rates beginning in, what, December 2015? That gave us a little bit of room to cut rates, and here we are. So, I think they’re in a better position. Certainly, it would be great if rates were a little higher and they had more room to cut, but point being is they definitely have weapons in their arsenal to fight any potential economic slowdown.

Doug: Don, let’s summarize this inverted yield curve and how they are not predictive of negative market returns. And something I want you also to address… Isn’t it also that the level that interest rates are at now, we have a much flatter yield curve than we have had historically? So, when we go back to previous market cycles, there was a much larger disparity between the long end, and the short end, and vice versa? Does that also help us in this current environment?

Don: Yeah. And so, first thing to recap is, my message to clients is, there’s maybe a tenuous relationship at best between an inverted yield curve and a recession, all right? The more important question is, as investors, what’s the impact of an inverted yield curve on our portfolio. And as we showed with some of the data, you should remain invested, you should continue to stay diversified, you should rebalance your portfolio, you should remain invested because equity market returns are still positive, subsequent to inverted yield curves. It is true that the curve today is flatter than it has been historically. What does that mean in terms of prospect for recession? I would say TBD, to be determined. In many ways, we’re in uncharted waters. And I would argue we’re always in uncharted waters to some degree. What does that mean for the economy? Like I said, to be determined. But we do need, I think, an upward sloping yield curve to have healthy economic growth.

Doug: Don, Drew, let’s jump down to talking about kind of next steps and what should clients be doing. And one of the things that we are very committed to is making sure that clients remain globally diversified. In all of our portfolios, we have allocations to developed markets and emerging markets. Why should we continue to do so?

Drew: So, going back to what I was talking about on relative prices of stocks, if you’re really astute of reading the papers, there’s getting to be more and more crowded trade, people are buying the same stocks over and over and over again. All kinds of interesting statistics out there about fund managers, and they’re three times the weight of the market in a given security. And you’ve seen this historically many times. You’ve energy stocks in the ‘70s, consumer non-durables in the ‘80s, tech stocks in the ‘90s. And so, we’re entering that kind of phase again. And so, good students of diversification look at this, recognize it for what it is, realize that value stocks still have a place in your portfolio as well as momentum stocks.

But Don’s mantra of rebalance, rebalance, rebalance is the correct one. You want to keep that balance between those two stocks. They’re going to work out their own pricing tensions over time with what the growth rates are in momentum versus the better value in valuation. In addition, something we haven’t touched upon, these stocks and bonds are paying interest. We’re getting rent on our assets all the time while we wait for a price move. And so, it’s not like we’re looking at a negative holding opportunity cost here, they’re actually paying us. And, if anything, if you look into stocks, they’re in better position to pay their dividends now than they’ve ever been. And so, it’s keeping that balance and resisting the urge to get into the crowded trade or give up on an emerging market because it just doesn’t seem that attractive. Don’s point about demography is destiny, it’s going to play out, it’s just going to play out. Those people want the same things we all do, and they’re going to seek it. They’re going to work for it, and they’re going to get there. And bonds too. Now that they’ve made their move, you still want to stay invested in bonds. It’s going to be your place when we do get a correction. And, remember, we talked about Vs. I always worry about the sustained market corrections that last years. And the only thing I’ve found that beats that is being diversified, that beats those sustained drawdowns. And back in the ‘90s, when tech stocks blew up, emerging markets and global stocks carried the day. Carried the day.

Don: Absolutely. The message investors should keep in mind is, the objective should always be to remain globally diversified. Being diversified is a type of defensive strategy. People always ask me, Doug, “Well, what can I do to be more defensive?” Well, be more diversified. [Laughs] That’s the best most proven approach to really preparing your portfolio for any of these headwinds that are out there in the economy. And that means owning emerging markets and bonds like Drew just said. The one thing, Doug, I’d want to finish on is, I know there are many clients sitting on significant unrealized capital gains. And, oftentimes, I hear from advisors, and clients, or prospective clients that one of the reasons they are not in a more diversified portfolio is because of this concern around harvesting the gain and paying the taxes. And I always encourage clients, especially now, to seriously reconsider that, discuss it with your advisor. We have had a very long market expansion, there are always headwinds on the horizon, and, Doug, I think one of the most important points that I would drive home to our listeners is capital gain rates today are at historic lows. They’re not going lower, they’re not going lower. And so, if you’re concerned about some of these headwinds that are out there in the economy, a way to deal with that is to diversify. And I would encourage us to at least explore with our advisors the prospect of paying those taxes, get better diversified so that you’re better positioned for the next market correction.

Doug: That’s great. Let’s jump into some questions. We’ve got about 12 minutes left on our broadcast here. And, Don and Drew, we’ve had a question asked several different ways. Clients want to know if we get some different scenario in an election year or if something comes along that is unexpected, when would we make changes to our equity allocation? And I think this goes back to our basic investment philosophy, and I think it’s important to reassert what that philosophy is constantly with clients.

Don: The right answer is, always stay globally diversified. Meet with your advisor. Your personal portfolio should never, ever be a function of what you think is going to happen politically in this country, it should never be a function of who you think is going to win the election or what you think that candidate’s policy prescriptions might be. Never, ever. So, let me say it one more time, Doug. Never should you change your portfolio because of your political beliefs. And I know that’s hard, I know that’s hard.

Doug: In the same context here, Don, let’s address asset allocation and how we arrived at that asset allocation for our clients because that is a big driver of what is happening in somebody’s portfolio.

Don: Absolutely. Every single client in this firm, their portfolio is a direct function of their personal financial plan that they have constructed with their advisor. That portfolio has taken into account their time horizons, what they’re trying to accomplish, how big or small their balance sheet is, even the structure of their balance sheet, how much of the wealth is taxable, how much is tax-deferred. That portfolio is a function of your personal income tax bracket and where you’re at from a tax perspective. It’s a function of your estate plan. So, to blow all of that up because of a belief system around election-year, politics, or something like that, I would argue would be a foolish move. But the portfolio is always a function of their personal financial plan.

Doug: Question from a listener, Don and Drew. With our aging population — and you talked about demographics, and we know this is happening in other countries as well — and the need that an aging population is going to have in terms of cash flow, how is that potentially going to impact the investment markets going forward?

Don: So, this has been an academic question for probably 30 years now. And so, there’s been a ton of research done on this. The interesting thing is we have 10,000 baby boomers retiring every day. We saw a significant reduction in the US workforce during and after the global financial crisis, yet US stocks took off like a missile for the past 10 years. So, despite retiring boomers, despite the global financial crisis, people leaving the workforce, asset prices continued to rise. Why is that? The reality is, it is a global market. Investors from other countries… I was just talking to somebody last night about real estate prices in Vancouver, Canada. Sky-high because of foreign money pouring into Vancouver. So, I don’t see any evidence that as Americans retire, that somehow that’s going to put downward pressure automatically on equity prices. We haven’t seen that. We have other buyers of US assets. The Europeans love to buy US bonds because they earn significantly more interest on US bonds than they do on European bonds. So, Drew, you want to add to that?

Drew: Yeah, add two things to that. It’s something you don’t really pay much attention to, and that’s scarcity. The actual number of publicly-traded securities available to you, it’s down. There are fewer number of shares outstanding today than 5 years ago, 10 years ago. So, it’s a scarcity issue of being able to identify and add quality companies to your portfolio. Interestingly, the same holds true in municipal markets. This would be counterintuitive to you because you’re thinking, “Oh, gosh, this state’s going broke, and this state’s borrowing money all the time.” The actual number of municipal bonds available in the marketplace is down, and going down. And you talk to the people that actively trade in these securities, they will tell you it is really remarkable, the fiscal responsibility that’s going on in local states and municipalities to curtail the issuance of municipal debt. So, those two things, they have an impact on pricing because of scarcity.

Don: Absolutely. Good point.

Doug: Don and Drew, a client is asking a question about corporations. Are corporations in a better position to make debt payments today, and how is this going to… Obviously, we see in the news that new debt is being issued all the time. So, just kind of comment on the capital markets, and also bring into account, Don, if you will, how we go about our investments in the corporate debt arena.

Don: Yeah. And I’m going to speak broadly because that’s a broad question. So, all corporations, obviously, are not created equal. So, we have to keep that in mind. So, speaking broadly for a moment, the interest coverage ratio, which is how we measure whether or not a corporation can reliably make its interest payments… Companies today are in a very good place from an interest coverage ratio perspective. And that’s because rates are low. There are lower today than they’ve been 10, 15, 20 years ago. So, when you look at debt payments relative to interest rates, they’re actually much, much lower today. So, we’ve had great earnings growth over the past 10 years, we’ve seen low-interest rates over the last 10 years, and what a lot of corporations have done is they’ve refinanced their debt to get better terms.

I hear the fearmongers always talking about, “Oh, the corporate debt issuance is at an all-time high.” It’s actually not when you look at it and you compare it to the size of the US economy, because that’s how you have to think about that. Too often, folks are looking at these things in absolute terms, and from an economic perspective, that’s completely the wrong way to think about it. So, is it true today that corporations issue more debt? Absolutely, but the economy is also significantly larger, and US equity markets are significantly larger. And not to bore our audience, but there is an optimal capital structure that all corporations are trying to achieve, and that typically requires that they issue some debt. So, is it alarming trend? No, I don’t think so. What you really want to pay attention to are things like default rates and things like that. That’s what you want to pay attention to. So, again, when I look at all the different storm clouds out on the horizon, that’s probably not one of them for me at this point. When we think about building fixed income portfolios, and the managers we work with, we’re really looking for market exposure. Ideally, we don’t want to get in this game, I’m just trying to pick and choose different kind… Just like with stocks, we prefer to take a more diversified approach to a given market or given asset class. The best way to hedge your risk with anything is to diversify as much as humanly possible. I’ve seen client portfolios where they own bonds issued by PG&E, the California utility that went bankrupt. Well, that’s why you don’t want to try to play games and just pick 10 stocks or 10 bonds. Ideally, you’d want to get as many as you can that’s more representative of the asset class.

Doug: Don, address in that same context on that same subject how we apply our factor investing strategy to bonds.

Don: Absolutely. So, when you think of bonds, there are really two factors that you should really be paying attention to. Number one is the maturity or the term, when do you get repaid your principal. Obviously, in normal-functioning credit markets, the longer the term, the higher the interest rate, like we were saying earlier when we were talking about yield curves. So, you want to pay attention to term but you also want to pay attention to the creditworthiness of the borrower, what’s their credit score, if you will. That’s where we look at A rating, or BBB, or AA, or whatever it is. Those are the two levers you pull on. So, when we think about bond portfolios, we’re thinking about them in terms of credit risk and in terms of their term, their duration or their maturity, how far out are we effectively lending client capital. Most of our bond portfolios today — not all, but most — are pretty short-term, meaning that their average maturity is less than five years, and most of our bonds are what we call investment-grade, so BBB+ and up. We generally try to avoid high yield or what we call junk bonds. There are some portfolios where clients need junk bonds because they need a higher yield, but with that, obviously, comes more risk.

Doug: Excellent.

Drew: Yeah, the biggest change I’ve seen over the last 30 years is the absence of AAA corporate bonds. It’s a unicorn. So, the actual credit risk structure of a bond portfolio, it needs to be managed like never before. We’ve been through a rating agency fiasco, you don’t have AAA anymore. So, all the more reason to really have those bonds looked over from both credit and duration.

Don: Absolutely, and all the more reason to make sure you’re extremely well-diversified across that particular segment of the bond market.

Doug: So, one of the things I want to do as we’re closing up today’s webinar is I want to remind our clients that we have resources for you out at our website. We have a fully redesigned One of the things I want to point out to you is the Insights page, we have a lot of content out there. This webinar will be posted out there in the next few hours. We’ll be getting the webinar up. And we have previous webinars out there, you have access to the podcast through the Insights page, we have articles out there. So, just want all of our clients to be aware that we’ve got a lot more content and educational material. This is great stuff. If you want to share some of the things that we’re doing with your kids, with your friends, want to continue to encourage you to go out to and realize that we’ll be posting this content and more content as we go forward.

Lastly, ladies and gentlemen, because this is a project near and dear to my heart, I’m continuing to produce podcasts on the science of economic freedom. In just the last few weeks, we’ve done a podcast specifically for economic freedom for women. Prior to that, we did a podcast on long-term care. But there are over 60 podcasts available out there. And, again, you can find the Science of Economic Freedom podcast by just searching through your podcast app. And you can become a subscriber, so anytime we do a new podcast, it will automatically load up on your mobile device, and then you can find the full and complete podcast library in the Insights tab out at So, Don and Drew, want to thank you, gentlemen, for joining us today and having a productive discussion about what’s going on in the markets. I want to remind all of our clients, we’ll be doing these quarterly going forward, and we appreciate everybody joining us today. Don, any closing comments?

Don: Just thank you, Doug, for moderating. Thank you to all of our listeners for joining us today. And we certainly look forward to your questions and having you join us on future podcasts.

Doug: Drew?

Drew: Thanks for having me, enjoyed it, and I’m sure this was some good valuable content for all our listeners.

Doug: Great. Thank you, ladies and gentlemen. That concludes our broadcast.

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