Mercer Advisors Capital Markets Update and Outlook: April 2021
Doug: Welcome, ladies and gentlemen. We’re going to get started in just a couple of minutes, just letting people get seated in their room. So, looking forward to today’s webinar.
Hello and welcome to our first quarter of 2021 Mercer Advisors client webinar. Our goal with these broadcasts is reporting on the progress of the stock market, discuss economic developments, and what you should do to improve your finances as we’re moving through 2021. Thank you for joining us today.
My name is Doug Fabian. I serve on the investment committee at Mercer Advisors and I’m part of the client communications team. For those of you viewing our webinar live today, I want to point out the toolbar on your webinar screen. There is a question function for submitting your ideas and questions you have. Please tell us what’s on your mind. What questions do you have today about the markets, the economy, and your personal finance issues?
Now, joining me today is our Chief Investment Officer, Don Calcagni, and fellow investment committee member, Drew Kanaly. Now, Drew is one of our senior wealth advisors out of the Houston area. Now, before we get into today’s content, and we wouldn’t be having a financial webinar without a disclaimer. And we want you to know that the purpose of today’s presentation is education and information.
No part of today’s broadcast or commentary should be considered personal investing advice or personal finance advice. We want to encourage you to have deep conversations with your advisors about your own situation. We hope the ideas that we discuss today will be a good catalyst for those conversations. We want you to know that as we put together today’s presentation, the data is as of March 31st, as of the end of the first quarter. And fortunately, the stock market has continued to trend higher into April. And so, the data that we’re going to share with you is not completely out of context.
So, with that discussion about the disclaimer Let’s take a look at our agenda. One of the things we’re going to do is talk about the economy and do a review of the numbers. We’re going to talk about the equity markets and how they’re performing. We’re going to discuss fixed income and what’s happening there. And then, finally, and I think really the favorite part of today’s presentation, is your questions and our answers. So, please bring those questions on. So, hello again, Don Calcagni. Great to be with you today, Don.
Donald: Thank you, Doug. It’s great to be here.
Doug: Don, I wanted to ask you. We’ve been doing these webinars for several years now. Every quarter, we get in front of clients and talk about strategy and update them on the economy. What’s your perspective on the purpose? And what should clients expect from these quarterly webinars?
Donald: Yeah, that’s a great question, Doug. I would say two or three things. First, the whole intent here is to provide our listeners a broad overview of what’s happening in the economy and global capital markets. So, that’s number one. Number two, which I think is probably one of the more valuable aspects of these engagements is to hear from clients, to get your questions submitted. Tell us what’s on your mind. So, that’d be the second. And then, the third would be to really give you some information to discuss at a deeper level with your personal advisor. So, those would be the three key takeaways that I hope our listeners would take away from these.
Doug: Great, Don. Drew, you are one of our senior wealth advisors down in Houston, Texas. You’re having deep conversations with clients every day. Share with us the topics that clients are asking about right now, and those things that we’re going to address today.
Drew: Yeah, I’d say the big one is still a little shocked from last year. Why didn’t the world financially come to an end? I think that one’s still kind of a mystery to them. And then, attached to that then is, “Okay. Well, there’s good news here. But these valuations in the stock market, Drew, what are your thoughts about valuation on stocks? And then, obviously, top of mind, taxation going forward. What does all this mean? We’re going to hear from the President tonight about his policies going forward. What does that mean at my house?”
Doug: Great. Good. And ladies and gentlemen, we’re going to try to hit all of those things today. And again, I want to encourage you ask those questions. This makes the presentation much more dynamic. And we’ll jump into those. So, Don, let me turn it over to you. And let’s jump into a review of the economy.
Donald: Absolutely. Thank you, Doug. Appreciate that. So, when we look at where the economy is at at the moment, I think any discussion of the economy has to begin with COVID. Are we there yet? Where are we at with the reopening? Where are we out with vaccinations? And so, I think the picture overall, it looks good. I’m not a physician. But I think when we look at the big picture, we see that new infections have come down dramatically from their high back right around the holidays. Fatalities are down. Vaccinations are up.
The right-hand side of this slide, just to kind of give you some color here, is showing us the number of Americans who have actually been estimated to be infected or have been infected with COVID combined with those who have received vaccinations. And the theory is if we can get into that 60 to 80 percent zone that we will have reached this level of herd immunity that, hopefully, that’s a point where we will have successfully beat COVID, hopefully, by that point.
I just read the other day that currently about 40% of Americans thus far have received at least one vaccination, so. And we’re starting to see a relaxing of things like mass mandates and things like that. So, I think that’s a catalyst for this coming reopening of the economy. I see it in my town. People want to go out to eat or going out to eat more. The nice weather is here. And so, I think we’re seeing that. And we’re seeing enormous pent-up demand in the economy so much so that when we look at the global economy, what we see is really strong GDP growth. GDP stands for gross domestic product. That’s how we measure the size of the economy.
So, not just here in the United States where we’re projecting real GDP growth of anywhere from 6 to 8 percent, depending on who you talk to. But even globally, places in China, the emerging markets, and places like Europe that are a little bit behind the United States when it comes to their success in rolling out vaccinations but, nevertheless, we do see really strong global economic growth coming. And that’s largely a result of the economy beginning to reopen. We’re seeing all of this pent-up demand. I told my wife for the next six months, I’m going to eat out every single night once all the restaurants reopen.
So, again, when you combine those forces, that pent-up demand, the stimulus checks, combined with government stimulus, right? The new administration has recently pushed through the American Rescue Plan Act. It’s about $2 trillion worth of spending. And like Drew said, we’re going to hear tonight from the president, proposing perhaps as much as another $2 trillion worth of spending. All of that combined is a powerful stimulus for very strong economic growth going forward. And I would argue it’s one of the key reasons to Doug’s point a few moments ago, why the stock market has continued to trend up into April.
Now, let’s not forget that we are still in a recession. So, if you look at the left-hand side of our slide here, you’ll see we have two lines. We have this gray line that collapses significantly last year. That’s the economy. That’s actual GDP. That blue dotted line that you see sloping from left to right, that’s theoretically the potential, the economic potential of the United States. And the gap between the two is what government in theory is trying to fill in with all of these stimulus packages.
And so, you’ll see that there’s maybe about a $1 to $1.5 trillion, what economists call an output gap. And that’s what government is trying to fill in. That’s why that $2 trillion stimulus package, the American Rescue Plans Act that was passed about a month and a half ago, probably isn’t going to create a ton of inflation by itself. Because in reality, it’s probably enough to just fill in that gap over the next, say, 12 to 18 months.
On the right-hand side of the screen, this is the breakout of economic activity, government spending. You see that big blue chunk, consumption, that is the American consumer, which is the workhorse of the global economy and certainly of the US economy. That pent-up demand is going to show up right there. So, for all of those who are dying to go out and eat again, it’s going to show up right there in that blue chunk there. What the Biden administration is trying to do is trying to beef up that green piece to try to help push up overall GDP.
Now, obviously, all of the government spending that we have seen since really the beginning of the onset of COVID has come in the form of additional borrowing. And so, when we look at this orange line on the screen here, that represents the total amount of federal debt that’s currently outstanding. And we’ll see that it started to pick up there right around 2016 where it now exceeded the size of the economy. And you’ll see under the Trump administration, it continued to rise. And then, certainly when COVID hit, it took off like a rocket. And at the moment, we are now about $28 trillion in debt. That’s about 130% of GDP, quite substantial by any objective measure.
And I’ll be the first to argue that when the economy is in trouble or the country is in crisis that, candidly, that’s not the right time to worry about your credit card balances, right? First, we have to win the war. We have to beat COVID. But I would remind us that there’s going to come a time when this bill comes due. And we have to be smart about how we think about taking on debt.
What I will highlight here, a couple numbers here at the top of the screen. When the federal debt is growing at a rate equal to or less than the growth of the economy, I would argue it’s not a concern. It is a real concern when the debt is growing faster than the economy. That would be analogous to a household debt growing by more than their income. Very dangerous, very precarious situation to be in.
Now, I would argue that when we see this national debt taking off like we have, this is why on these webinars and certainly in our writings and our communications with clients, this is why we’re expecting higher taxes in the future. And like Drew said, tonight, the President will be speaking to the American people and at least communicating his vision for what tax policy should perhaps look like going forward.
So, when I see a gap like this, my view is, “I don’t know that it’s coming now. I don’t even know if higher taxes are coming next year. But when I see this gap, I have a hard time accepting the argument that taxes are not going to rise sometime in, say, the next 5 to 10 years.” So, our message to clients is all of us should be working closely with our advisors to make sure that our financial planning, that our portfolios, that our retirement planning, that our estate planning has been fully updated to prepare for higher taxes in the future.
Now, you might think… And I get this question all the time. This is probably the number one question I receive from clients, from advisors, from prospects. “Don, how can we have so much debt? How can we have so much stimulus? How can the economy be doing so well yet inflation is still virtually missing in action?” Well, economists are debating that. They’ve been debating that for over a decade. I have my views, right? But the reality is inflation is still exceptionally low.
So, if we look at this slide here, let’s just take our time, go from left to right. First off, the shaded areas represent years when we were in a recession. Okay? And the blue line is the one that I’m going to ask you to focus on. That’s what we call headline CPI. That’s headline inflation. That’s the growth in prices across the economy for all goods and services. All right? So, that includes food, that includes energy, that includes everything. And we’ll see here… And this is the late 1970s, right? So, when we often hear inflation, I think a lot of us think of the boogeyman, right, from the late 1970s and early ’80s, right? And I think rightfully so, that was a very traumatic time for many people.
But the reality is we are a far cry from late 1970s inflation. In fact, at least as of the end of February, the inflation rate year over year, the past 12 months trailing inflation rate was only around 1.7. It’s crept up to around 2.6 as of the end of March. But the reality is the Federal Reserve has been begging to see inflation of about 2%. In fact, that’s the Federal Reserve’s official inflation target is 2%.
So, the reality is inflation still remains very low by historical standards and for a lot of reasons, globalization, technology, and a number of other concerns. It’s just really hard to see any inflation being permanent. I think we may experience some shorter-term inflation over the next couple of years. But longer term, it’s hard to see a case where we have really high persistent, perpetual inflation.
Drew: Don, right there for a moment. One of the biggest contributors to this chart… There’s a trend, correct? And one of the drivers of that trend is productivity. And that’s the technological advantage of productivity and where it’s showing up. Interestingly, right now in this quarter’s earnings reports are the profit margin. So, there’s profitability, then there’s the margin of the profitability.
That’s one of the things that’s really sustaining these valuations is, okay, we can say they were sandbagging their earnings estimates. But it’s really hard to sandbag those profit margins that are coming in very healthy. And so, this productivity trend is still in place. And it’s showing up even in the aftermath of last year’s disruptions.
Doug: Don, just a question we’ve already gotten from the audience here on the subject of inflation. In particular, the question revolves around wage inflation. And certainly, many employers are having a difficult time hiring. And so, again, many of these numbers we’re looking at right now are backwards. So, thinking in terms of forward, is that something for us to be concerned about and paying attention to, specifically wage inflation?
Donald: I think the answer to that is yes, but it also depends. We’ve often heard a lot of folks talk about the recovery being K-shaped. So, the economy over the past year has been really good for those who can work from home, who perhaps work in technology or finance or healthcare, right? So, I see less wage inflation for the higher income earners, perhaps ironically, because the reality is that part of the economy continued to function quite normally throughout the pandemic.
Where I do think you’ll see some wage inflation is at the lower-end of the wage spectrum. So, services, hospitality, places like that are finding that they’re having a hard time filling their job openings. So, I’m expecting that we’re going to see some wage pressures there. But at least among white collar, technology, finance, I’m just not seeing as much wage inflation there, at least not at the moment, but really remains to be seen.
And here’s the other thing, as the unemployment insurance programs ultimately expire, as government stimulus ultimately burns off, the reality is the incentive for more people to return to the workforce will be that much greater, and that should serve as a little bit of a lid on longer-term wage inflation.
Doug: Well, one of the things we’re going to be doing, too, and that’s the whole purpose of these quarterly webinars, is to be able to update people. So, it’s going to be very interesting in July when we get back together again and get updates on these numbers. Great, Don. Thank you. Ladies and gentlemen, just want to continue to encourage you to use that question function in the webinar toolbar there to send in your questions. Thank you, Don.
Donald: Before we leave inflation, I just wanted to highlight. We have to be a little bit careful with how inflation is calculated. So, this headline CPI number includes energy, for example. It includes oil, right? So, if we just go back to last year, oil actually bottomed that around $16.80 a barrel for WTI crude and that was in April, right? So oil fell to around $16.80. It was previously over $60 a barrel. It falls to around 16.80. And at the moment, it has since recovered to around $62 to $63 a barrel.
So, if you look at… If you just measure the growth in the price of a barrel of oil from $16.80 to $62, for example, that is a significant increase. It’s over 200%. Is that really inflation? I would argue it’s not. Now technically, when you calculate headline CPI, that counts as inflation when you’re including energy. I would call that reflation, returning to where it was pre-pandemic. So, be a little bit at least skeptical of some of the inflation data that you’re going to see over the next year or, say, 18 months because of those facts.
Now, like I said, I think shorter term, we are going to see some inflation. And the bond market is actually predicting that we will see some inflation in the year ahead. And I just want to spend a moment on this slide for a moment. So, this is the 10-year treasury rate. So, the US federal government finances its debt through the issuance of treasury bonds. This is the interest rate on the 10-year treasury bond. It began to rise back in August, right? In August, it was somewhere around 50 basis points. That’s one half of a percent.
And you can see that it began this slow steady climb such that by the end of March, it was around 174 basis points, 1.74%. That is a significant increase. That is a tripling of…more than tripling of the actual interest rate on the 10-year bond. So, very significant increase in interest rates. And again, why? Well, the bond market does not need the government’s permission to raise interest rates. I know there’s this thinking that somehow the government through the Federal Reserve Bank controls interest rates. And that is true when it comes to really short term interest rates.
But once you get beyond, I would argue one year, two years, the Fed has very little control. They can still influence interest rates. But at the end of the day, interest rates are set by financial markets. And in this case, the bond market is saying, “You know what? We think inflation is going higher in the future. And as a result, we require now more interest, higher interest on the debt that we purchase.” Not just from the government, by the way, all right? Interest rates have risen across virtually all fixed-income sectors. This is a base rate, a benchmark rate that is used to ultimately set interest rates for lots of other types of bonds and different types of debt throughout the economy.
So, Doug, I think in going to pivot. I just want to highlight equity market returns. And then, we can hand it over to Drew to talk about what’s happening at a little bit deeper level on the fixed income market. So, with respect to equities, like Doug said earlier, Q1 saw a pretty robust growth in equities across the globe, so much so that by the end of March, as of March 31st, the S&P 500 index was positive 6.2% by the end of March. Now, that comes on the heels of an 18.4% growth in the S&P during 2020, right? So, the market’s growth has continued quite strongly into into 2021. All right?
And by the way, when we look outside the United States, we continue to see strong equity market growth, right? Non-US stocks last year similarly had really strong returns. And again, this all goes back to the economy, right? As the economy begins to reopen, given all of the government stimulus, given the pent-up demand, it logically follows the companies. We can expect companies to do well. All right? And we’re seeing that. It’s been a strong earnings season. There’s been a few shenanigans that I might touch on in a few minutes. But it’s been a really strong earnings season. And to Drew’s point a few moments ago, profit margins remain quite healthy throughout most S&P 500 companies. Now, before I leave this slide…
Donald: Yeah. Go ahead.
Drew: I think everybody should kind of zero in on here is the breadth of returns. So, this time last year, we had five stocks, count them five, holding up the whole market. Now, we have a broad spectrum of stocks, international, small cap, mid cap. All cylinders are firing. A diversified portfolio is working. And I know that’s what everybody hears from their advisors. And it’s very frustrating when five stocks are driving the whole deal. But now, we finally see diversification at work. In the international markets, you’re actually paying a lower price to participate in these returns. So, this is real portfolio management visual of markets and breadth. And I always view breath as a very healthy sign. Always worry about valuation. But when I see nice breadth and participation across all markets, that’s a very, very good sign.
Donald: Indeed, it is. That’s a great point, Drew. And I’m going to double click on it just a little more is when we look at, for example, the performance of small cap stocks and value stocks over the past, say, five years, they’ve trailed the returns on large cap and growth and certainly technology companies. Certainly, those five companies that Drew mentioned. But we saw that rotate quite violently, quite quickly, beginning in early September last year. And so much so that over the past six months, value stocks have substantially outperformed their growth stock counterparts.
And as of March 31st, value and small company stocks were at the top of the leaderboard. They were hands down the best performers year to date. So. again, underscores the power and the importance of making sure that you maintain a globally diversified portfolio.
Before I leave this slide, the donut on the left-hand side of the chart is a breakdown of global stock market capitalization. So, what does that mean? It just means if we look at the entire global stock market, what percentage is each country in terms of making up the global stock market? So, you’ll see the United States is almost 60% of the global stock market, followed by emerging markets in Europe and places like that.
Doug: Don, one more point I’d like you to comment on, and that’s the dollar. The nuance of this table on the right is the fact that in the 2021 year to date return data, there was a local currency number and a US dollar number. So, give some context around what’s happening with the dollar there.
Donald: Yeah. We’ve actually seen the dollar increase in strength here a little bit year to date. So, coming into the year, I think most market watchers were expecting it to decline. The bond market threw us a curveball. When interest rates rise, the world wants your currency. So, what that means is the dollar has strengthened. So, for example, if you look at EAFE, right, that stands for Europe, Australasia, and Far East, you’ll see that for US-dollar-based investors, our returns were 3.6% versus investing in local currency, which was up 7.7.
The reason why there’s that underperformance is because the US dollar has strengthened relative to non-US currencies. And so, you would think, and this is often what many folks predict, as we see more quantitative easing, as we see more printing, as we see lower interest rates, in theory, your currency should weaken. Okay? But in reality, what happened is we actually saw interest rates rise. And so, the dollar thus far this year has strengthened.
Longer term, there aren’t many who predicted that that trend will continue. Longer term, we’re expecting a weaker dollar and that would actually help the non-US portions of our portfolios. So, Drew mentioned valuations. No discussion of equities right now would be complete without a heavy focus on valuations. And like Drew said, stocks are expensive at the moment. Now, they’re expensive for a couple reasons. And you have to be careful just buying into the argument that stocks are expensive. All right?
So, at the moment, the S&P… I should say as of the end of March, the S&P was trading at about 22 times next year’s earnings. Now, that’s pretty expensive. The long term average is right around 16, 16 and a half times earnings. Now, to Doug’s point a moment ago, non-US stocks are actually trading currently at somewhere around 15 to 16 times earnings. So, if you’re worried about valuations, you should definitely own more non-US stocks, right? Because they are trading at a very healthy discount relative to their US counterparts. And I would also add that non-US stocks also pay a much higher dividend than their US stock counterparts. So, if you’re an income investor, if you’re concerned about valuations, non-US stocks should definitely be an important part of your portfolio.
Now, back to valuations, all right? The long-term average, which is this dotted line in the middle, like I said around 16 to 16 and a half times earnings, right? 16.6 times earnings. All right? These other dotted lines are just showing you sort of the spread, right? It’s what we call the first standard deviation. Don’t worry about that. All right? But it’s important understand how this is calculated. That’s the earnings, right, and the price, right? So, how can we get this number to come back down? And I think this is where investors get concerned. We often think, “Well, gee, this means that the price is going to come down.” Well, not necessarily.
One of the reasons why the P/E ratio is so high is because earnings collapsed quite significantly last year, right? So, the E came down, right? As the earnings came down, the valuation goes up assuming no change in the price. But we also saw the price of the stock go up last year, right? That’s because interest rates fell. The Federal Reserve in March took interest rates basically to zero and that really pushed up the value of stocks. So, that’s point number one. And I’ll come back to earnings here in a moment.
Point number two is be careful. That 22 times earnings, that’s an average. That doesn’t mean that every stock in the market is trading at 22 times earnings, right? And in fact, when we actually look at companies like Tesla and Amazon and Netflix, we can see that these stocks are trading at nosebleed valuations, right? They’re quite high. All right? So, those stocks, obviously, pull up the average. Well, there’s also undervalued value stocks that trade at valuations less than 22 times earnings. And they’re pulling down the overall valuation of the market.
Now, when you look at your Mercer portfolio, you’re going to see that we have a tilt towards those less expensive value stocks, right? That’s why we build the portfolio the way we do. It’s to help diversify this risk that comes with having Teslas and Amazons and Netflix in your portfolio. All right? Now, you may be thinking, “Well, gee, Tesla is a great company.” And I have no objection to that comment necessarily, but Tesla does trade at a nosebleed valuation.
And Tesla just reported their earnings a couple of days ago. The market was estimating… They were expecting 79 cents a share in earnings from Tesla. They reported 93 cents a share. And the market, in turn, punished Tesla’s stock. And it sold off by about $30 a share. So, you may be thinking, “Well, gee, why? How? Why would the market punish Tesla when they overperformed on earnings?”
Well, it’s because about 22 cents of their earnings came from speculation in Bitcoin, right? It didn’t actually come from the production and sale of electric cars. So, after you do the math and you remove the Bitcoin component, what we see is Tesla actually underperformed what the market was expecting. And they only delivered about 71 cents in operating EPS, earnings per share. And so, the market punished Tesla. All right? That’s our view on that.
So, my point is this, these growth stocks are often priced for absolute perfection, right? And that’s why they trade at nosebleed valuations. But it’s also why it’s easier for them to stumble if they do not deliver on the market’s expectations. Now, with respect to what I said a moment ago, there’s two ways to deal with high valuations. The prices could come back down, and that would bring down the overall value of the market, or earnings could rise. And earnings rise as they are projected to do this year. What we’ll see is valuations will come down. This year, consensus estimates by analysts is for about 26% earnings per share growth.
And in fact, most companies right now are actually beating their earnings estimates. So, as the economy recovers, given the stimulus checks, given all of the federal government stimulus spending, that is a powerful tailwind for stocks. It’s a powerful tailwind for earnings. And as you can see here on the far right-hand side, we are projecting… We mean the entire Wall Street community are projecting a pretty steep increase in earnings over the next year, year and a half. And if that happens, by the end of 2022, the market will have come down to around 20 times earnings. So, still trading at a premium relative to its long term average, but it will come down all things equal, which rarely they are.
The economy is infinitely complex, right? But as earnings grow, that, in theory, assuming the price remains flat, will bring down the overall valuation of the market. So, just keep that in mind. Two ways to deal with high valuations. The price can come down. Nobody really wants that. Earnings could go up. That’s ultimately what we all want. And I think at the moment, we can optimistically say with a little bit of confidence that we think that’s going to happen over the next 12 to 24 months. And that’ll help bring down some of the pressure on these high valuations. Drew, why don’t you pick it up here with fixed income, and then we’ll open it up for some Q&A.
Drew: Finally, something interesting to talk about. I know everyone has been waiting for fixed income. And so, here we go. And everyone, this is the bedrock of the economy. This is where the action happens. Stocks are all the glamorous stuff. But when you really get down to it, it’s fixed income and the extension of credit. That’s the mother’s milk of economic growth. So, this is where it happens. So, in in y’alls portfolios out there, we invest in fixed income as a damper against the volatility in the stock market. That is not say that bonds don’t have their day in the sun to lose money. And so far this year, that is the case.
So, as we look at returns this year to date, that green column that’s highlighted, as you look across the fixed income spectrum, it’s almost entirely negative on a year to date basis. So, the chart we looked at before, the 10-year Treasury rising from sub 1% rates up to 1.75 at the end of the first quarter, it has ramifications on the total return in the portfolio. And so, as we look at it, the biggest thing you should take away from this is this is an issue of maturity or duration. This is not a credit problem. We’re not seeing defaults or anything like that that’s affecting the holdings in your portfolio. It is strictly a function of the math involved when interest rates rise.
So, what we do at Mercer to mitigate that risk that you certainly notice last year is we have a shorter average maturity, a shorter duration in the portfolio. And this dampens the effect. So, it’s pretty eye popping to look at the 10-year Treasury. They’re sort of in the middle of the screen. Negative 7% on a year to date basis. And it’s presently at about 1.6, so that’s come off that number. But there’s every expectation that these interest rates, relatively speaking, will become unanchored to Fed policy. And they’ll start seeking their own level or normalizing over time. And so, our strategy of high quality and shorter duration is going to mitigate this. This is honestly one of the few ways over time to offset the risk in the stock market. But it doesn’t mean there aren’t times when it doesn’t earn your money. And so, this is clearly probably one of those years.
What’s interesting to look at when you see sort of like… It’s hard to… Investment grade corporates is below that black line and then the US aggregate. When you look at the difference in those two returns, again, look to the duration or average maturity column to the right that really explains the difference in the return. So, we do not have a credit problem. We have a rising interest rate. And so, we’re positioned for it, okay? Me, personally, I’ve been a little bit wrong about this for a number of years. But it looks like it’s finally coming to pass. We’re in the right duration stance in the portfolio, certainly the right quality. And it will earn its own over the long haul against stocks, for sure.
Donald: Drew, I’ll add two points to that is, one, let’s not forget that the market, the bond market, is really just reclaiming some of last year’s unbelievable gains, right? Last year, the US aggregate was up over 7%. The year before that, I forget what it was but it was exceptionally high. I think it was around 9%. So, we’ve actually seen exceptionally strong returns in fixed income over the past 24 months. So, it logically follows that as rates rise, we give a little bit of that back. Point tw is the average Mercer portfolio at the moment has a duration of around 2.8 years. So, it’s, to Drew’s point, really short term and that’s because we’re protecting. We’re trying to hedge a bit against rising rates in the future. Drew.
Drew: Yeah. So, here’s what we talked about when we talked about the yield curve. And so, it’s a little hard to see. But if you look down the bottom, this sort of purple line is 2020, where we were in August of 2020. And where the Fed really lives is at that short in over there on the left-hand side. And when you think about going back to the stock market, what’s happened in value stocks, this steepening of the yield curve where we are presently helps financials, helps banks, right? They’re still not paying you any more for your deposits, but they’re able to lend at a much higher rate.
And so, when the rally and value began last year, it was anticipating the banks getting a bigger spread in their lending. And they still aren’t lending tons of money but it’s coming. And that’s part of the engine behind the economic growth. So, rising rates help the economy in that sense in that there will be more money available credit-wise to drive the engines of growth. And so, this is a pretty normal pattern. And so long as we don’t become, like they say in economics, unanchored against inflation expectations, which you’ll hear a lot about, you just are. Because the year over year, month over month numbers are so eye popping coming off bottoms.
I’ll actually kind of correct Don. The front month contract on oil traded at negative 40 bucks. So, we’re actually over $100 a barrel increase. Do the math on that one. But my point is, what you’re seeing are maybe transitory price increases in commodities off of lows. And you need to be patient to see if supply and demand doesn’t work itself out like it normally does. The greater fear for me always is wage price inflation, and that’s the one to really keep an eye on it, in my opinion.
Donald: Yeah, that’s a good point. What I would highlight is financials were the second worst performing sector last year. This year through the end of March, they are the second best performing sector, followed by energy. Energy was the worst performer last year. Energy is the best performer this year through March 31st.
Drew: So, Don, why don’t you tell about [Inaudible 00:45:25] coming attractions here?
Donald: Sure. So, looking beyond public markets for income… This is probably one of the top three questions I get from clients, from prospects is, “Gee, Don, how do we get the yield that we need, the income that we need for the family, for retirement, or a trust, or whatever it might be?” And so, we know that yields are low in equities. And like I said a little while ago, they’re higher when we get outside of the United States. Value stocks also pay higher dividends. But when you look at these dividends here, they certainly leave a lot to be desired. So, obviously, we can also invest in REITs. Here’s high yield bonds. Never thought, Drew, that I would be excited to see a 4.2% yield on a high yield even low investment grade bond, but yet here we are.
Looking further afield. Now, full disclosure here. There are no free lunches in capital markets. And anybody who tells you differently has something to sell, period. All right? So, please keep that in mind, right? There’s no way to effortlessly without risk get all of the income that we desire. What I would say is that there are opportunities for those investors who qualify, right? So, for about three or four years now, Mercer has had several opportunities for investors who qualify to invest in global infrastructure. So, global infrastructure, these are private investments. They’re not publicly traded, right? These are private partnerships where you can earn a higher yield.
Now, they’re not liquid, so I just want to be fully transparent. But when you’re investing in global infrastructure, you’re investing in things like railroads and deep water ports and airports and things like that. And these are very long-term assets, very long-term investments. And who knows, with the new administration’s infrastructure push, that could also be an additional opportunity for investors to earn some higher yield.
Moving further to the right here, you’ll see something called direct lending/PC. PC stands for private credit. So, there are many private companies that for whatever reason cannot access traditional lending channels, the banks that Drew was referencing a few moments ago. And you can see that those yields are close to 9% presently. Now, again, these are private funds. They’re private partnerships that are also taking on a bit of leverage. They’re not liquid, okay? But for those investors who meet the SEC’s qualification requirements, there are opportunities.
And so, if you’re looking for yield and you’re questioning, “Gee, how can I get extra yield on our portfolio?” Discuss with your advisors. “What does Mercer have available to help me get a higher yield on my overall portfolio?” So, there are opportunities out there. I skipped over preferred stocks. Those also are another opportunity to get a little bit of extra yield for those clients who require it.
Again, I just want to underscore that these assets here tend to behave a lot more like stocks over time. So, no one should ever seriously look at these types of investments and think well, “Gee, those are bonds.” No, they’re not bonds. They may have a lending component to them, but they tend to behave like stocks. Okay? But there are some great opportunities out there to get the yield that you may need. Drew, do you want to wrap this up?
Drew: Yeah. So, the three big takeaways. Inflation pressures are building, but we’re not in a major concern at the moment. It looks more like the current numbers are going to be transitory. We’ll be looking for wage prices going down the road. We’ve got to continue to de-risk, staying diversified, tilt towards value. I know [Inaudible 00:49:38] had a nice little run here again. But if you look over the past nine months plus, value is really having its day. It’s a cheaper buy. And always be wary of concentrated risk of the portfolio.
So, get with your advisor, have a plan. Revisit that plan. Think worst-case scenarios. Test the portfolios. We have a lot of great technology on the platform to test the portfolio’s capacity to handle everyone’s retirement needs. Look at that risk once again. And you change that risk through diversification. Stick with those and really, really try to avoid the church of what’s working now. Stick to that old time religion in your portfolio.
Doug: Well, Don, let’s get to some questions. Drew, let me jump in because I’ve been monitoring the question queue here. And two big subjects that we want to talk about that we need to drill into a little bit more. One of them is on inflation and the other is on taxes. So, let’s start with the inflation question and talk through, “Well, we know there’s some pent-up demand. It may be transitory.”
I think the historical view is, “Look, we do not have 1970-style inflation.” And there is this tendency for us to build into our heads emotionally when we’re hearing so much in the news headlines about inflation that people think it’s going to be a disaster. So, Don, put some context around, “Okay. How do we hedge inflation? What are the tools we can use for inflation? And how is that somewhat built into our portfolios right now?”
Donald: No, absolutely. In fact, I have a slide here in the appendix, if you bear with me for a moment. So, yeah. I mean, we often hear questions like, “Gee, shouldn’t I use commodities or gold or whatever it is?” And I’m going to emphatically say, “Absolutely not.” And there’s a couple of key points I want to make here, Doug. One, your job as an investor is not to beat inflation every time. All right? It’s to beat inflation over time, right? The inflation that we’re experiencing right now, I would argue it’s too late. There’s nothing you can do to combat that, right?
But let’s get back to the central question. How do we beat inflation over time? And so, if you look at this screen here, you’ll see we have four bar charts. All right? And I’ll draw your attention first to the two at the top. There’s a dotted line in the middle. But look at these two top ones. These are periods where we had high inflation. And the left-hand quadrant is high and rising inflation. And this one is high and falling inflation.
Well, we know we don’t have really high inflation at the moment, so that takes us to this bottom screen here. We have these two charts down here. Low inflation when it’s rising and low and falling inflation. And all we’re trying to show you here is, “Well, how do these different types of asset classes, these different types of investments, how did they perform given the inflationary environment?” And I think one of the things you should take away from this is a couple things. One, if you’re looking at gold, for example, gold actually performed quite poorly in three of the four scenarios. It did really well in only one of the four.
Similarly with commodities. Commodities did very poor in two of the four inflationary environments, right? And in fact, the only inflationary environment where gold or commodities did well, they were actually on par with stocks. It’s a sample size of only four times, right? That’s not nearly enough to be statistically significant. All right? Now, if you look at these four different inflationary environments, this is the most powerful, actionable takeaway when we look at actual real world data is that the green bars seem to have done well in all four inflationary environments. Well, what are those? They’re stocks. They’re stocks, right?
Look at high yield bonds. They also did well. Remember what I said a few moments ago. A lot of those higher-yielding type investments tend to behave a lot like stocks. High yield bonds behave a lot like stocks. So, my point is this, if you really want to build into your portfolio, the best hedge against inflation, it sure as heck isn’t gold and it sure as heck isn’t commodities, it’s stocks. It’s things like stocks.
I’m ignoring real estate for a moment here because real estate is now actually part of the broader stock market. It’s part of the S&P 500 index. So, you already own real estate by way of owning a diversified equity portfolio. So, Doug, the answer to the question is equities, a globally diversified portfolio of equities especially with an allocation to emerging markets is probably, at least historically when we look at all the data, hands down the absolute best hedge against inflation.
Doug: Don, we want to mention two things there, too. We have the issue of, you mentioned it, best performing sector so far this year is energy, that obviously is commodity-related. And then, another… And I have some questions in the queue here about what’s happening in materials, building materials, obviously steel, these kinds of things that drive the economy. And that is a top performing sector this year. And that is part of a globally diversified portfolio. So, we do have exposure to these commodity-like inflation hedges within the stock allocations that we currently have. So, I think our message is…
Doug: …we don’t want our clients to abandon stocks or think that we need to make a change in order to be able to stay ahead of inflation. They need to stay committed to equities. And also, remember that the global diversification of Mercer Advisor strategy is really kicking into high gear right now and that’s going to be important for us moving forward.
Donald: All great points. Absolutely.
Doug: Let’s switch the conversation over to taxes. Now, we all know that there’s a big speech tonight by the President. He’s going to be talking about a new economic plan and how he proposes that we’re going to pay for it. The tax picture is in flux. But let me set the stage. There’s four areas. And all of these areas may affect all of our clients. But there has been talk about raising taxes on corporations. There’s been talk about raising taxes on capital gains. There’s been talk about changing the estate rules, and that can generate additional tax revenue by lowering the exemption.
And then also, and I was actually surprised that I read several stories about this this morning, about the loss of the step up in cost basis. And that’s big. It’s big for families. It’s big for many people’s portfolios. Now, again, we have no legislation. We do not know what the final tax package is going to be. But we are getting clarity on what the President is proposing. And so, that’s where we’re at. So, Drew, let me go to you first and just ask, what do you think the mindset of our clients should be relative to taxes? And how are we going to be working with clients to overcome the changes in tax rules?
Drew: Yeah, the one I’m digging for, and I haven’t seen anything, if you all have let me know, is the 15% rate on qualified dividends. And I think that one’s a big one. Okay? In a lot of client portfolios, we not only have a value tilt but we’ll have a little dividend tilt in some of the portfolios. I recommend everyone talk to their advisor. We have a very, very solid dividend strategy, broadly diversified. It’s quantitative in nature, and it has a great yield. And it’s a little different beta, if you will, than the general market. So, it’s a good diversifier, I believe, over time.
That dividend preferred rate is a very big deal to our clients and to the value of stocks, in my opinion. And so, I’m looking to see where that one is. It doesn’t appear to be on anybody’s radar right now. But it’s one I’m really, really watching. The next thing for clients is they’ve tried these capital gain losses, the step up and basis in states before, it didn’t work. It was an unmitigated disaster. I think it’s posturing, but we’ll see. This is a new group in here. It’s been a long time since the 1970s when we had a really punitive estate tax code. But we’ll see.
It would certainly point you in a planning sense towards accelerating your gifting if you had a taxable estate or what you projected to be a taxable estate. How much for whom and when is always one of the more important personal decisions. Don’t let the tax dog tail wag the dog here. But you want to go through that in a very measured decision process with your advisor and make sure that’s compatible with your retirement at the same time. So, let’s let some of this stuff crystallize. But the big one I’m looking for is that qualified dividend tax rate. I think that’s a very important feature to the present valuation of stocks.
Doug: Don, we’re we’re getting close on time here. Just kind of general comments and takeaways you feel for clients today. Any additional comments you have on taxes, inflation, and some words of wisdom going forward.
Donald: There’s really no substitute for having a plan, revisiting that plan, working with your advisor. I mean, all the things that Drew just mentioned on the tax front. I mean, these are real issues, I mean, the tax proposals. I mean, look, we all know that the sausage gets made in Congress. And the reality is whatever the administration proposes is probably unlikely to come to fruition at least in its initial form. But that said, the directional accuracy, right? Tax rates are going higher. I just can’t see a world where tax rates remain at this level given the absolute size of the national debt. So, no substitute for working closely with your advisor. And really, connecting that to your plan and trying to make sure that you are as prepared as humanly possible.
If you are sitting on concentrated risks in your portfolio and by that, I mean, your portfolio perhaps has not been rebalanced or maybe you have too much wealth in one stock or one fund or one asset class, I would argue it is absolutely imperative that you revisit that with your advisor with extreme haste and get your portfolio right sized to prepare for more volatility to come in the future. If we see higher taxes, if it looks like those tax rates are to become law, we should expect market volatility. And so, the best time to prepare for that is now. And so, those would be my parting words of…my call to action for our listeners.
Doug: Great. Well, thank you, Don. Thank you, Drew. Ladies and gentlemen, just a couple of final comments from me. All of us at Mercer Advisors are going to be working very hard to stay ahead of changes in estate and tax law. We’re very focused on this. There’s a lot of discussion. No laws have changed yet. We’re not going to jump the gun. But we’re going to give you the advice and counsel strategies that you need to manage your wealth going forward.
So, we want to say thank you for joining us today and participating in another client webinar. We’re going to be doing these every quarter. Obviously, next quarter’s webinar will be in July. We’re looking forward to that conversation. And if your question didn’t get answered today, I really want to encourage you to have a conversation with your advisor. Send your advisor a note, and we’re going to do our best to get you the answers to your questions directly. So, ladies and gentlemen, that concludes our presentation today. Thanks so much for joining us. And thank you for being a client of Mercer Advisors.