Q1 Market Outlook Webinar: Capital Markets Update and Outlook

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Science and friends of Mercer Advisors to our quarterly markets update.

My name is Jessica Caruso. I’m the senior managing director of Mercer Advis West division. And joining me today as always is Mercer Advisors chief investment officer, Don Calcadney.

The two of us are looking forward to spending the next hour with you and getting into some good discussions about what’s happening in the capital markets.

As we go, please feel free to type in questions. We really value our client’s perspective. We wanna hear from you as questions come up.

I do need to remind you that today’s discussion is meant to be general educational material.

You should not consider any information provided today as personal financial advice. If you have questions about how anything we discuss here today applies to you and your personal situation, Please contact your local wealth management team and your adviser would be happy to review your specific plan with you and make sure you’re on track.

With that, let’s dive in.

So here at Mercer Advisors, it has been our vision for almost forty years to put our clients’ interest first. And in that spirit of a client first mentality, we always like to structure these quarterly conversations as discussions around topics that you our clients said you want to address. So we did ask for questions in advance as a part of the registration for this event I mentioned, you can continue to add questions into the question box in your Zoom webinar window. And in preparation for today’s webinar, Don and I went through each and every question that came up with the registration.

And summarize them to some major themes that are gonna guide our discussion today. Those themes are displayed here in a word cloud created directly from your questions from questions from our clients.

So Don, I wanna start with just with so much going on the markets and economies today.

I’m wondering if you can, sort of review the key themes that you’re seeing out there. Some of the words we’re seeing on the side, and talk a bit about how those themes may impact our portfolios.

You know, absolutely. And thank you everybody for investing, some of your time with us today. And, like just said, our our our mission here is to do our level best to answer all the questions that that came in. So thank you for submitting those, and just to echo what Jeff said, please feel free to submit your, questions that you may have that come up throughout today’s conversation.

Into the into the Q and A or or the chat log for Zoom. Like Jess said, we did go through every question that was submitted as part of a registration.

And we drop those into the word cloud that you see on the screen. And, and just to your to your to your to your question, yeah, I mean, there there are some major themes now actually driving how investors and specifically our clients are thinking about markets. And perhaps no surprise, I think recession was by far the most popular question, that we were seeing, in in the in in in what people had submitted you know, lots of questions around crypto. The SEC recently approved a new spot Bitcoin ETF.

I’m sure we’re gonna talk about that at some point. And But certainly things like interest rates, the election, things like that. Naturally, I know, continue to weigh heavily on investors’ minds. So we’re gonna do I’m gonna do my best to try to connect all of these dots for everybody to the best of my ability, and we will go from there.

Thank you. So before we dive into some of these topics in a little more detail and how they might impact our portfolios moving forward here at the beginning of twenty twenty four. Let’s pause and just take a moment to look back on the markets in twenty twenty three.

Don, can you give us a sense for how markets performed last year?

Sure. Absolutely, Jess. And so just to draw our attention to the slide, let me just walk you through a little bit what you see here. What we’re just summarizing are the returns on major asset classes, US stocks, non US stocks, bonds, so on, and so forth, We’re looking at last year, but then we’re also looking at over a slightly longer period of time.

And look, last year was the polar opposite of twenty twenty two. I think in order to understand what happened in twenty twenty three, we have to go back and look at twenty twenty two. Twenty twenty two, both stocks and bonds were down. And that was really one of the first times in a very long time where that had actually happened.

And coming into twenty twenty three, I think one of the ironies is that Wall Street strategists, economists were all forecasting recession, that it was not going to be a good year for stocks and bonds. And lo and behold, We we’ve all been humbled. Right? The economy did well last year.

We’ll touch on that. I’m sure. But from an investment perspective, we saw very nine base returns in US equities. You can see US stocks up twenty six percent.

Non US stocks up eighteen percent. Even emerging markets, have been unloved for the better part of a decade, positive nearly ten percent, and then bonds, bonds that that foundation in our portfolio that I know a lot of folks were disturbed to see bonds go down and value in twenty twenty two. Bonds posted, you know, respectable returns, not blockbuster returns, but respectable returns last year. Just despite the fact, that the Federal Reserve still raised interest rates a little bit last year.

Right? So they they were still raising rates, and they’ve been very, hoches in their in their language. By hawkish, I mean that they have been very clear that they’re not afraid to continue raising interest rates. And yet despite that, we saw stocks go up in value quite handsomely.

We saw, US bonds deliver positive returns. Now over longer periods, which I think is always important. Right? We are long term investors.

We see that stocks have done very well over the past five years, and Jess, it has been a very momentous past five years. Right? That takes us back to eighteen, two thousand eighteen, twenty nineteen, twenty twenty. Right?

COVID and the onset of the pandemic and so on and so forth. And yet despite everything that has happened over the past five years, we have still seen positive returns in major asset classes. Now before I leave this screen, I just wanna highlight one major asset class that I know folks continue to ask me about. And that was Don, what happened with commodities last year?

You know, when when inflation is super high. Everybody I hear this all the time. Every conference I go to, we need to put more into commodities.

Well, commodities were down eight percent last year as a basket.

Some some commodities, cattle, coffee, gold, were positive. Right? Gold was up about seven percent last year. Not great, but, hey.

I mean, it was positive. But commodities as a basket were negative last year, Jess, despite the fact that we’ve had some of the highest inflation in forty years. And so I highlight that just to emphasize a point, and that is, you know, a lot of these short shorter term strategies or asset classes that people think of as being inflation hedges, I would caution. When we look at the data, I think the data is far from conclusive that things like commodities are quality, high quality inflation hedges.

Thank you, Don. So commodities you talked about as something that was down last year. I do think it’s easy as investors for us to see the chart that you have up right here and kind of focus on that. Twenty six percent return number. A conversation I think many of our advisors are having with clients is that the drivers of that twenty six percent return last year were fairly narrow and concentrated.

So for those of us on the line with more versified portfolios who weren’t concentrated in a small handful of technology names and may not be seeing that full twenty plus percent return in our equity portfolio those. Talk to us a little bit more about kind of where that return came from and whether we’re recommending any shifts in light of that that pretty narrow leadership.

Yeah. That’s a great the great question. This has been one of the enigmas of twenty twenty three that’s gonna that’s now in the history book forever, and it’s something that Financial economists, like like myself, are gonna constantly go back and look at and try to understand what happened. Well, it’s not really rocket science.

What happened? If we actually look at the S and P five hundred, let me walk you through what your what’s on your screen here. What we’ve done here is we’ve taken all five hundred stocks that make up the S and P five hundred index. And what we did is we built a chart here.

In fact, I I say, we, I really mean that our friends at the New York Times built this. This is from, January nine, nineteenth. And what they did is these boxes correlate to the size of the company in the index.

Right? So that’s based on what we call market capitalization. That’s basically the equity value of the company. And one of the things you’ll observe when you look at the S and P five hundred index today these days, I should say, is that it’s highly concentrated in only seven stocks.

These stocks have been, referred to as the magnificent seven. They were definitely magnificent last year, but I don’t think they were so magnificent back in twenty twenty too. So I I love the naming conventions that we come up with as as humans and journalists and and media pundits, in twenty twenty too, this these same stocks, right, which delivered spectacular returns in twenty twenty three, We’re down about fifty percent in in twenty twenty two. And just to give you a little bit of context, the worst year ever For the S and P five hundred index, all five hundred stocks was two thousand and eight when it was down thirty seven percent.

So to to put it a little differently. These same seven stocks in twenty twenty two lost more in value than the entire diversified S and P five hundred index did during the global financial crisis in two thousand and eight. Now these are great companies. I’m not here to say that they’re not.

These companies delivered spectacular returns. That’s this orange line that you see over here on the right. They delivered amazing returns last year compared to the index.

Right? Wonderful returns. The rest of the index, the other four hundred and ninety three stocks, which are the blue ones down here, lagged the index because the index is essentially a weighted average. The bigger you are in the index, the more the returns on your stock count towards determining the return of the index.

And so just what we saw last year was this highly concentrated very small basket of stocks deliver explosive returns for the index. Now one of the questions I saw that were submitted was, hey, why don’t we own those, or why don’t we own more of those? Let me just be very clear. We own every single one of these stocks in our portfolio.

Right? I know that because I I can tell you to the penny how much we have with these companies on any given day. We do own these. It’s just that we don’t own just these.

Right? We are diversified investors because we know that these big draw downs, I can’t tell you when they’re gonna happen. I can’t predict when they’re gonna happen, but we do know that a big drawdown like we witnessed in twenty twenty two for our clients a fifty percent decline would really be something that would just be unfathomable.

Right? And and likely something that clients would not recover from. We are fiduciaries. We have a legal mandate to make sure we are diversified buying portfolio.

So, yes, let me be clear. We definitely own the Magnificent seven. I love the Magnificent seven. Especially Amazon definitely has made my holiday shopping so much more enjoyable than it used to be in the old days.

So these are great companies, but we do caution against just owning these companies or being overweight these companies.

Okay.

And, Don, whenever we do have those spectacular returns in the so called magnificent seven without an equally big increase in earnings, we obviously get a change to valuations.

So what you’ve just pulled up here is that investors are essentially saying They are so excited about these seven stocks and growth companies in general, that they’re willing to pay a higher and higher premium for the same dollar of earning I see a question here from Clay asking what your forecast is for value versus growth and more generally wondering if you think those valuations are justified, or if that that those spectacular returns put investors at and maybe it’s sort of a subtle combination between those two.

Those are great questions. Just before I leave this slide to help maybe address that, one thing I would just say is that the leadership in the market at any one time changes dramatically from year to year.

You’ll see ExxonMobilon here. ExxonMobil was the best performer in twenty twenty two. In fact, if we go back to be when when COVID began, The energy sector is up three hundred percent since since the beginning of COVID. Since that time, technology is up two hundred percent.

So I just wanted to highlight that leadership changes, and that’s because earnings change, Jess, to your to your question. Earnings are are are really fundamental to how investors should think about the value of a company. Right? And I think a good analogy would be think of the neighborhood, perhaps where you live.

Right? Chances are you when your when your neighbor puts their house on the market, we all rush to Zillow to see what’s it worth. What did the what did the magical Zillow algorithm say the houses were what is the what is the house listed for? And if you look across your neighborhood, I think we all know who has the nicest home in the neighborhood, and that home is probably by far the most expensive, but there’s other homes in your neighborhood that I would argue are probably equally or maybe almost as nice, but maybe traded a pretty big discount.

So I want us to start thinking about our investments, thinking about stocks, like you do the homes in your neighborhood, right, in terms of the value, right, is the home worth the price that you’re gonna pay. It may be a wonderful home, but it may also be true that it is overpriced.

So when we think about stocks, we think about earnings. And so to Jess’s question, if we just look at the market for a moment, right, I’ve I’ve a bunch of data here. So just give me a moment to kinda walk you through it. The weight of the top ten stocks in the S and P, it might be a little hard to read, but they make up thirty three percent by value.

Of the entire S and P five hundred index. But on an earnings basis, they only contribute twenty percent of the earnings. So think about that. They’re getting thirty percent of the pie, but they only did twenty percent of the work.

Right? Now maybe it could be that we’re thinking, well, wait a minute, they’re gonna do a bunch of work in the future and get those earnings up. Maybe, but earnings have to rise fifty percent to justify their slice of the pie. That’s a pretty big jump.

I’m not saying it can’t happen. Not saying it won’t happen. I’m just saying, wow. That that takes a lot of almost religious like faith to think that those companies are gonna crank out that kind of earnings growth.

Right? And again, these are wonderful companies. I like them. Now when we look at the valuation of these top ten stocks, it’s important to pair, well, how do they compare relative to the broad market?

Well, they’re trading at about thirty times forward earnings. That means that we’ve already accounted for these these perhaps two rosy future growth projections.

Right? We’ve already baked into the price.

This belief that they’re gonna do amazingly well in the future in terms of earnings growth. Remember, as a stock investor, the only thing that matters is earnings.

Right? That that’s what matters, because out of earnings that can pay you dividends, Right? They can reinvest those earnings in continuing to grow your wealth. Now those companies are priced at about a hundred and fifty two percent in valuation relative to the S and P.

Now I’m not here to claim that they’re overvalued. I’m just sharing with you data. When we look at the data, they are trading at a massive premium relative to the broad market. And so that’s why you need to ask yourself that home on the corner that has the best landscaping, is it worth fifty two percent more than the house right next to it.

The answer to that may be, maybe. Maybe yes. Alright? But that’s an important question. When we look at all of the other stocks in the market, they’re trading at a discount to the market.

So when we go back to here, All of these blue boxes relative to the ones in the orange boxes are trading at a discount. So What should you do? I think there’s a question there, Jeff, value stocks versus growth.

We like the other four hundred and ninety three stocks. We think there’s diversification benefits in owning the other four hundred ninety three stocks. So we would caution against going overweight these seven or perhaps just ten ten companies.

Great. So that was a great summary of the market in twenty twenty three. Let’s switch gears and take a look at the economy and specifically the economic environment we’re now in going into twenty twenty for. So Don, I see you have some key themes up here, talk us through what you’re seeing in the economy and how these themes may impact our investor portfolios.

Absolutely, Jess. I mean, economists are a funny bunch. Right? They are not known for being the most optimistic group of human beings.

Right? It’s It’s called the dismal science for a reason. Coming into twenty twenty three, I think over eighty percent of economists had predict predicted a, I think it was about a seventy percent probability of a recession last year. It has not happened.

It has not happened. And, interestingly, even coming into twenty twenty four, when I look at all of the different outlooks, I still see this pessimistic view where a lot of economists are still forecasting about a thirty, perhaps forty percent probability for a recession. Now just to give you a, a data point, another data point, the probability of session in any given randomly selected year is about fifteen percent. So when someone says or claims, that there’s a thirty percent odds of a recession this year.

That’s actually twice what you would expect in any given year.

Most economists, all the ones that we fought that that we follow here at Mercer are all saying somewhere between twenty five to thirty five percent probability of a recession.

And it could happen. And I’ll maybe I’ll touch on that with some of these key themes. So I think, and we’ll touch on this perhaps again in a few moments, Jess, but Think the biggest theme is first inflation has come down dramatically.

It’s nowhere near where the Fed wants it to be. It’s still too high, but it has come down dramatically. That’s a good thing. I think that’s a tailwind for stocks.

That’s a tailwind for bonds. That’s a good thing. Interest rates are still They’re still high. It the Fed’s December meeting, Jess, they they were very clear with their messaging.

They said we’re sitting tight. We’re not raising rates. And they actually hinted suggested and actually put into their forecast a three, three different interest rate cuts later this year. That was a big pivot.

I did a whole podcast called the Fed’s pivot. That was a big pivot. And I think that caught the market a little bit off guard, and that’s why we saw a big tailwind for stocks at the end of last year. The Federal Reserve’s balance sheet.

What is this? Just to go back in history, if we go back to COVID, if we go back to the global financial crisis, the last fifteen years, the Fed had printed a bunch of digital money to inject into the economy.

Right, to to protect consumers, to protect jobs against COVID, the pandemic, the the whole nine yards. And despite, you know, put putting aside our views on that was it good? Was it bad?

From an economic perspective, it buoy it protected the economy. Right? Now what’s happening when the Fed does that, they bought bonds. They own bonds, and those bonds are now maturing. And as those bonds mature, they’re actually deleting those digital dollars. So this is actually also putting upward pressure on interest rates. So these two things taken together are why the interest rates that you’re seeing today are as high as they are.

The market did very well last year. I already mentioned that, the market recently hit an all time high, just, think about a week ago. So, so, you know, equities are continuing to to recover quite nicely.

Manufacturing date is a bit of an anomaly. Looks like Anything under a fifty would suggest that you’re in a recession. So it’s kind of interesting that we’re at forty seven point four. But again, by any objective measure, Jess, we are not in a recession. The economy grew at about a five percent annualized real rate after inflation in the fourth quarter This is some of the fastest economic growth that we’ve had in years. So the economy, again, by any objective measure, not in a recession currently, Still exhibits pretty powerful momentum. We have low unemployment.

Consumer spending remains strong.

Again, I’m not saying that these things won’t moderate. I expect that they’re gonna moderate throughout twenty twenty four. I think consumer spending could come down a little bit. We are expecting unemployment to tick up slightly.

But again, I I don’t see a recession really in the cards at the moment given the momentum of the US economy.

Okay. So we actually got questions on almost all of these things. No one asked about manufacturing, but otherwise people asked about each one of these different topics. As you mentioned, the number one participant question actually for several years in a row now has been recession. You just touched on that a little bit right now. I wonder if you’d talk to us a little bit about some more data around this. And before I turn it over to you to do that, and talk about the possibility of a recession this year, I just wanna point out that investors and our clients and folks putting questions in for this call have been nervous about this for a long time.

And part of our job as your advisors here at Mercer is to coach our clients to stay disciplined and to invest in a way that’s really aligned with your financial plan rather than with every fear mongering headline out there.

The reality is sometimes those headlines are true and recession does come But sometimes like we saw last year, it doesn’t. And so there were many retail investors going into twenty twenty three that were scared and went to cash and said, hey, if I can get five percent yield at a money market and a recession is obviously looming, then why would I ever invest in stocks? And then that recession didn’t come. We had a great year in the market like you talked about. And those investors missed out.

So with that context that the reality is whether or not a recession is coming shouldn’t actually really affect how we invest.

Don, I do want you to comment a bit more just because so many people asked about this on GDP growth and the possibility of a recession and just how to think about that.

You know, I I I absolutely, Jess. And and before I walk our our our audience through this particular slide, you know, one of the things I would like to echo that Jess just said is, and I know this is hard for us to believe.

Right?

There is no relationship between recession and financial market returns.

And you’re you’re probably thinking, well, what did he just say? How can that be true? Right? The reality is that the market always leads the prospect of a recession.

Right? Markets, if if a recession was coming, the market would price that in and has historically priced that in very quick sleep. Alright? So if you actually go back and I would challenge anybody, go back.

Look at the data if you don’t believe me. Right? There’s no relationship between recessions and stock market performance. Right?

What you’ll find is that the stock market typically goes down in anticipation of a recession. And I believe we saw that in twenty twenty two. Right? I actually thought that by twenty twenty three, that we would probably be in a recession.

I admit I was in that camp. But I’ll also admit that the economy is infinitely complex and trying to draw predictions especially any confident predictions around what you think is gonna happen based on that data, I would argue that’s hubris. And I’ve been studying, you know, economics for thirty years.

When you look at economic history, there’s just no relationship between stock market performance and recessions. And so to Jess’s point, You know, certainly, look, recessions are gonna happen. This is why you work with your advisor. It’s why you build diversified portfolios. That’s why you have an emergency reserve, you know, and so on and so forth. So, so I just wanted to double click reemphasize what I think is a critically important point.

So GDP growth consists of several different buckets of activity, and that’s what we’re sharing with you here on the screen. These different colors represent different types of economic activity that economists add up, and then we strip out inflation, and then what we call real GDP growth, right, after we take out the growth in prices. And along the bottom here, this is the timeline. So we’re looking at this by quarter. Going all the way back to the first quarter of twenty twenty one. Now if you look at these different colors, there’s two there’s two buckets that I would like to highlight. Number one is the blue bucket.

That’s consumer spending. That that’s me and you. That’s the American consumer that you often hear so much about. For those of you who read the Wall Street Journal or the New York Times, you’ll you’ll hear them often talking about consumer spending, driving economic growth. In any given year, about seventy percent of economic growth is all of us going out for sushi. It’s all of us buying new Teslas and so on and and so forth.

The US consumer remains the world’s primary economic driver.

Now we had a lot of cash as consumers that we’ve built that we built up during COVID. There was all of this pent up demand during COVID that by the first quarter of twenty twenty one, when the economy began to reopen, we all rushed out. Like, we were tired of buying stuff from Amazon. I actually wanted to go walk through an empty mall again, right, which is typically not something that I enjoy to do doing, but it was just nice.

It was nostalgic to go to a mall. Again and to go out to eat, right, even if it was just for pizza or something, it’s just nice to get out. So you see that here, and In twenty twenty two, we saw a contraction in economic activity. Right?

But not enough that was really meaningful. You can see that GDP growth here over the past year was really, really strong. And so the other component that I’ll highlight is government spending. I know we are in an election year.

I know we’re gonna talk about the election here in a few moments, Jess. But government spending contributes to GDP growth today.

Now the other side of that coin is they’re they have to borrow a lot of that, which means they’re actually taking GDP, of government spending from the future and pulling it into the present. Okay? So that means future government spending is gonna be harder because now they have to pay interest on our debt. But when we look at where we are today, I mentioned that we had almost five percent real GDP growth in the fourth quarter of last year, very powerful economic growth. We have these other areas, which I probably won’t spend too much time on here, but probably the change in private inventories is another big one. That’s the blue here. When you look across the economy, again, when you look at the data jest, there is no objective evidence that we are in a recession or candidly that one is coming, at least not in the immediate near future.

Great. So in light of that, I want to, move on and talk about interest rates but before interest rates, obviously the Fed was moving in response to inflation. So I’m wondering if you can touch briefly on inflation.

Before you do that, I wanted to share a fun fact that I heard recently on a conference call with our friends at BlackRock.

That apparently in the last inflation print. One of the highest inflation categories in the food sector is restaurants and fast food, and one of the lowest is lettuce. So If you need an excuse to keep those new year’s resolutions and stay home and make salad, the economy seems to be on your side.

But all getting aside inflation fears seem to kinda be in the rearview mirror. Is that an accurate assessment or what are you seeing in the data on?

I cannot believe if that inflation is in the rearview mirror. I am hearing that a lot, Jess, on a lot of my conference calls, and I do not believe that, and I’ll explain why. What I will say is it is objectively true that inflation has come down dramatically.

Now here’s one of the things that I think our listeners have to understand, and this is this is hard.

Prices are still rising.

Right? So prices were were growing. Inflation was at nine percent in June of twenty twenty two.

And most recently, come down to a year over year rate of about three point nine percent.

That means prices are still rising. Right? So this is what we call disinflation.

Disinflation is when the growth in prices comes down, but prices are still going up. It’s just that they’re not going up at the same rate that they were previously.

Deflation is when prices go down. So we are seeing some deflation.

We’re seeing it in airfare if you can believe it. I have not seen that. Right? But, you know, we’re also seeing it in medical services if you can believe it. Don’t think I’ve seen that either, but it’s in the data.

So it is true inflation has come down.

I think that’s because of the Fed. I think it’s also because supply chains have begun to normalize post COVID. That’s a good thing.

But inflation at three point nine percent. That was the December print is still about twice as high. As the Federal Reserve’s official average inflation target. So I don’t believe that inflation is here in the rearview mirror, and I don’t think the Fed believes that either. I think the Fed is gonna continue to watch it very closely.

But I don’t doubt for a moment if we see an uptick inflation, I would not expect the Fed to flinch. They may raise rates another quarter point. Now, again, at the moment, no one is forecasting that. But again, it’s the things that you don’t expect that can often that that certainly would surprise us. But I don’t think inflation’s in a rearview mirror. It’s still far too high and the Fed still has some work to do.

Okay.

If that’s the case, let’s move on and talk about interest rates.

It’s sort of tied into some of these questions around, recession, around inflation, We got a lot of questions on interest rates. And so I’m wondering is the Fed gonna cut rates if so, how quickly and what would the implications for equity markets be?

So the Fed, like I said, in their December meeting, had forecast three interest rate cuts in twenty twenty four later this year. So the fed themselves are already expecting that it’s not if they need to cut interest rates. It’s when they will need to cut interest rates. And so I think this is a situation where, you know, two or more things can be true at the same time.

It can be true that inflation is still too high can also be true that the Fed is forecasting that they will need to cut rates at some point. So what the Fed then subsequently would be thinking is that if we leave rates just where they’re at for a little while longer, that should then start to continue to rain in inflation we should start to see the economy slowing down a little bit, and then we could take our foot off the break. You know, we could we could cut interest rates and support the economy. And you see that here in this particular chart.

This is just showing us, going all the way back to ninety three, a history of the fed funds rate. This is the interest rate that the Fed controls, right, specifically the Fed’s, federal open market committee. That’s what that FOMC word means. And you can see that they’re the purple.

They are projecting that over the long run, they’re gonna bring rates down to probably somewhere around two point five percent.

Now does this happen in, say, twenty thirty or does it happen sooner? That’s what we’re all trying to figure out. This is the when. Now the blue market or I’m sorry.

This, this right here, the green, is what financial markets think the Fed is going to do. Right? In financial markets, we’re always trying to guess through futures and options trying to figure out what do we think the Federal Reserve’s gonna do and when are they gonna do it? And by how much are they gonna cut or raise interest rates, The bottom line is this, both the Fed and the market agree, which is kinda rare.

They agree that their that rates are gonna come down over the next couple of years. Now how quickly the magnitude I think that’s all still open to debate, but I think directionally, it is true that the Fed will have to bring down interest rates. Right? So I think interest rates will come down.

I think it’s gonna take a little bit of time to get there, Jess. So for those folks who are perhaps, you know, trying to buy that first home and they’re worried about their mortgage interest rate. You know, I I don’t mean to be, pessimistic, but I think you’re not gonna see any serious rate cut until late this year, maybe even not until, next year.

So, I wouldn’t wait too long and you know, I I won’t hold your breath expecting its rates to come down anytime soon.

Okay. And what the Fed does is gonna be data dependent as they say on what’s going on in the economy and what’s going on with inflation. We have a question here around what their inflation target is and what it should be.

There’s some questioning on whether the two percent target is appropriate where that came from, kind of what we think the Fed is aiming for.

So, huge academic debate. Right? This is something that economists and academia get, really upset over, and this is a highly controversial topic among macroeconomists.

The target is an average rate of two percent.

Where did that come from? There there’s a lot first off, there’s a lot of theory that says, look, the Fed wants inflation to be slightly positive. Deflation is really ugly. Could be very dangerous.

So the I think the Fed’s biggest enemy, if you would actually get them over a glass of wine, they would admit it is it’s deflation. Deflation is the number one enemy.

This the the second enemy would be inflation. The third enemy would be unemployment.

Or or or a lack of full employment.

The two percent, there’s something called the Taylor rule. Taylor’s an economist. I think he’s at Stanford currently. He put together a whole framework around this two percent target. He wanted to have a formula. We don’t have to get into the weeds on that, but there’s a lot of academic work behind somewhere around the two percent.

I don’t know that it’s right. I’ve told you before, the economy is infinitely complex. Whether it’s two percent, whether it should be three percent, I think is less material, then we know we it can’t be at nine. Nine is a real problem. Whether it’s two or three, I would argue I wouldn’t lose too much sleep over two versus three.

Okay.

Let’s spend a little bit more time on interest rates. You talked about the fed eventually reducing rates.

What does that mean for fixed income? Are we thinking about fixed income differently in mind of that? We got a lot of questions about bonds and this is just a really different interest rate environment than anything we’ve seen in the last ten years. So I’m wondering if we are thinking about fixed income differently.

So we certainly are on the Mercer Advisors investment committee, and we we began thinking differently on interest rates and bonds, in June of last year. Right? And actually, if we go all the way back to January of twenty twenty two, that’s when the Federal Reserve for several months by then had been telling the whole world that, look, come march, we’re raising interest rates. Inflation’s too high, we’re gonna raise interest rates.

Our investment committee said, well, if that’s gonna happen, then we should shorten duration in bond portfolios. So what does that mean?

Well, duration me is a is a is a is a really refers to, I’ll say the maturity of the bonds in your portfolio. When do they mature? When do back your capital. Remember, when you buy a bond, you made a loan. Right? And there’s an interest rate you get paid, but then there’s also a date when you are repaid, your principal.

And so when rates are rising, you wanna get repaid as soon as humanly possible. That way, you can reinvest your dollars as interest rates go up. That way, you benefit from higher interest rates. The problem is if you own a ten year bond that pays one percent and interest rates go up to five.

Nobody wants to buy your ten year bond anymore. They’re gonna go buy the new ones that are paying five percent. Right? Now the reverse is true this year, Jess.

Coming into this year, interest rates were high. We knew they were high. The Fed continue I’m sorry. This year, I meant twenty twenty three, the Fed was already telegraphing that they were gonna slow down on their rate hikes.

Right? They were already beginning to telegraph there may come a point where they have to cut interest rates. This is an environment where you wanna own longer term bonds. So it’s actually the opposite of twenty twenty two.

Right? When bond when interest rates were rising, you wanted you wanted to be in those money markets. You wanted those short term CDs that I saw in all the questions that people were submitting.

The opposite is now true. You wanna own those five year bonds, those seven year bonds. I’d be careful not to get too crazy. You don’t have to run out by ten and thirty year US treasury bonds.

This is an environment where you wanna add some of that duration back to your portfolio because as rates go down, the value of your bonds will go up. Right? That’s how bonds work. Rates go down.

The price of your bonds go up and vice versa. So the fed, I just showed you here on this slide, the fed and the market both directionally are saying, look, rates are gonna come down. There’s nothing here suggesting they’re gonna go up. The market and the Fed are saying they’re gonna come down.

In this environment, you want to extend duration. Our investment committee voted to do that in June of of twenty twenty three. So we wanted to reextend it we actually implemented those trades in our portfolios throughout July and early August. So this is an environment, yes, where for our client are sitting in those money markets.

And I know that five percent’s really attractive, but those are very short duration investments. If you look at, like, a Schwab money market fund, that has a duration of maybe only thirty days. So as rates come down, the interest rates on those money markets are gonna come down very, very quickly. So you wanna this is an environment where you wanna extend the duration in your bond portfolios.

Thank you, Don. And I would argue that really how much cash you hold is a financial planning question.

For money that you’ll need in the next six to twelve months, you really shouldn’t be in anything other than cash and money market are very short term instruments.

For those more intermediate term goals, a lot of our clients like to match their cash flow needs with the maturity of their short term fixed income. So they have that peace of mind that the money will be there when they need it. And then for anything with really a five to ten year time horizon, you really should be meeting with your advisor to understand your retirement goals, your legacy goals, what’s your risk tolerance, what are your liquidity needs, How does that match with what the investment committee is thinking relative to duration?

And make sure that that money is really growing for you and not just sitting in cash especially with yields coming down.

Before we leave interest rates, I am seeing some questions about real estate from both participants prior to as part of registration.

And then also here live in the chat. So there’s some questions on sort of as it relates to interest rates, we know that interest rates can very much impact the outlook for real estate.

So, Don, I’m wondering if there are any trends you’re seeing that client should be aware of. The questions that we got prior as part of registration were a lot about residential real estate. Then I’m seeing a question here in the chat about basically does Mercer invest in real estate? How are we thinking about real estate as part of a portfolio?

Yeah. No. That’s a that’s a that’s a great question. Let’s tackle residential real estate first, and then I’ll just make a a quick comment perhaps about commercial.

Real estate. You know, residential real estate, I think the real challenge that we see in that market at the moment, I mean, home prices are still unbelievably high nationally. Which is not something we would have expected. Right?

We saw mortgage interest rates go from about two and a half, three percent to over eight percent. And so you would think logically, well, wait a minute, then home prices need to come down. Well, all things being equal, that would indeed be true. Right?

We’ve that, those of us who’ve owned homes for the past thirty or forty years, we’ve seen that objectively throughout our life experience. However, not all things are equal. And here’s part of the challenge beginning in two thousand eight, two thousand nine, coming out of the global financial crisis, homebuilders really stepped back on their new starts. They stepped back on building new housing.

And so it’s estimated at the moment that we have a housing shortage in this country of anywhere between one point five to as high as four million units, and there’s a lot of variance depending on your models and all the assumptions, but all the models agree there’s a significant shortage of housing in the United States. And for that reason, I think the simple dynamic between supply and demand continues to push and keep home prices high despite the fact that the affordability for new families, especially, has been really challenged with the with these higher interest rates. So there’s currently I know a number of homebuilders, building a lot of multifamily housing, trying to really bring that demand bring that supply back on the market, but building new homes is a long term project.

You have to get permitting. Often there has to be zoning law changes. You need financing. You need lumber. And then remember, we have an economy that’s already at full employment.

You know, there there are not a lot of unemployed carpenters out there that builders can just go higher and say, great. Let’s build a thousand new homes. So remember, builders have to, you know, they compete in the same markets that all of us do for labor. So I think it’s gonna take some time.

In fact, Mark Zandy is the chief economist at Moody’s, they did a a podcast the other day. They estimated it would take fifteen years for home builders at current levels to to to fill this gap that exists in the US residential home market. So, at least based on that data, based on that analysis, doesn’t look like home prices will be coming down anytime soon. And I think that’s probably irrespective of what happens with with interest rates.

Think commercial real estate is the complete opposite. Right? I just heard this morning that there’s a building on, I think, fifty fifth, Av in New York. I forget what the cross street was, but it was a building owned by Blackstone, big high rise that was just Mark down seventy percent, a seventy percent reduction in value because they lost their biggest tenant.

I think there’s more of that to come. Right? I think the commercial real estate, COVID has fundamentally changed how American business gets done. There’s a significant number of service oriented professions that can easily work from home.

And I would argue are probably actually more productive despite all of the sort of the ideological beliefs around this, actually more productive working from home. And so it’s kind of interesting. We actually are seeing increases in worker productivity.

But at the same time, there’s less of a need for lots and lots of commercial real estate. So I think those prices, because there has not been a lot transactions in the commercial real estate market, those prices have been sticky, but we’re starting now to see some markdowns And I think that’ll fundamentally alter the landscape for commercial real estate investing. We need those prices to come down in my view for commercial real estate to really look attractive again. Now that’s a broad comment.

Commercial Real Estate is a very broad asset classes. There are certainly sub components of commercial real estate that I think could be very attractive. I’m just I’m giving you a very broad high level comment at the at the moment. The quest last question, Jess, do we invest in real estate?

Absolutely. If you own the S and P five hundred you own real estate. Real estate is one of the sectors in the S and P five hundred index. So you don’t have to add a separate refund or ETF to the portfolio to have real estate exposure, you already have it by way of the S and P five hundred index.

But we also invest in private real estate. We have a number of private real estate funds, opportunities, own fund vehicles and things like that that absolutely invest in private real estate.

Okay. One more question on that before we move on. You talked about some of those big markdowns.

How might that affect the broader equity markets?

Yeah. I mean, I actually think so if we think of commercial real estate for a moment and think of large employers that on their on their income statement, they have a rental expense. Right? And think about what that really means as as we see these big markdowns in commercial real estate, and we are seeing it anecdotally.

We’re already seeing commercial rents come down quite nicely. That’s gonna translate into savings for companies. Right? Now companies have growing expenses elsewhere could be wages, could be other things, could be components of their supply chain.

But it’s actually I think generally a good thing for businesses to have lower rent expense. And like I said a moment ago, one of the things we have we’re we’re seeing in the economic data, which is a bit of a not not what anybody expected, We’re seeing worker productivity in the United States is actually going up.

Right? It’s going up. And so there was a there was a suspicion that, wait, if people are working from home, Does that mean that their productivity, their output per hour, does that start to decline? We’re actually seeing the opposite in the data.

And again, that’s a very broad economic comment. It’s not certainly true for everybody or for every company. But I think broadly, we see that in the data. So I think working from home, lower rent expense, higher employee productivity.

Look, those things are good for companies, and I think that shouldn’t logically translate into good things for company stock prices.

Great.

Okay. Next, I want to move on to a couple of, political related questions.

First, how should we be thinking about all this federal debt? We have a question here in the chat. What should the US do about its growing federal debt and I would maybe add to that as investors. How should we be thinking about debt as part of our outlook and how we are investing our retirement assets.

So there’s definitely a lot in there. These are the these are the fun questions, right, once we start to touch on touch on politics.

So let’s begin with what you’re looking at on your slide here is how we and I say we because we are our government we we we hire these people. We send them to Washington. How do we spend our money?

Well, That’s what this left hand column represents. Right? We collect. We meaning the federal government collects about six trillion dollars from all sources that includes taxes and borrowings, and this is how we spend it.

And the truth is we spend the majority of our dollars on three programs.

Defense, spending, social security, and Medicare.

And you can see, you know, you can see the interest expense That that’s been growing. That is alarming. That is a concern. I’m gonna I’ll come back to that in a moment.

But if you look at the other if you look at the interest and you look at non defense discretion canaries spending, that’s, you know, it’s not insignificant, but trying to get to a balanced budget, I would argue is impossible.

Without addressing defense spending, social security, or Medicare.

Now if we look at the right hand side, This shows us the taxes that we collect, right, taxes from all of our paychecks. Right? But then this white block represents borrowing. That’s the corporate credit card that they have to tap, right, or the government credit card in order to buy all of the things on the left here that we care about And you can see that that’s one point seven trillion dollars with a t.

I’m not a politician. I’m also not a policy expert. I’m not gonna, make any judgment calls on what we should be cutting from our spending, but I will say that economically, this kind of deficit spending is is is unsustainable. It’s unsustainable. Right?

I and I’m not predicting some doomsday apocalyptic scenario, but this is a problem. It’s certainly a political problem. We’ve seen in Congress where Congress has been paralyzed over this question around increasing the, the federal debt. Right? So the deficit just to be clear on some terminology. That’s the new debt that we, our government, accrues in any one year.

The debt is the accumulation of all prior deficits in all prior years. And so this down here is the debt.

And the debt is currently at about ninety seven point six percent of GDP.

That’s really high. And it’s projected to grow by early twenty thirty three to a hundred and twenty one percent of gross domestic product. This is very significant. Naturally, the more debt we have, the harder it is for us as a as a government as a society to respond the geopolitical crises, wars, environmental challenges, and things like that. So, again, I stand by my point, Jess. I think this is unsustainable.

The people that we hire to send to Washington every every couple of years, and certainly this is an election year. You’re just my personal view. We should be challenging them to talk intelligently about these issues? Like, how are we gonna solve these without the sound bites?

Like, let’s get into the weeds. Like, let’s be real. You know, my view is, you know, what, many of us have children. I don’t feel good about passing on this kind of debt to my kids and to my grand kids.

And so I feel like, hey, let’s tackle this. Let’s let’s have an adult conversation.

And try to tackle this. This is a big problem.

Your question just I think your last question was around debt. How should we think about debt with respect to our portfolios?

Well, remember debt is the other side of debt are bonds. Barnes are debt. You’re buying someone’s debt. If you own US treasury bonds, you own part of this debt on the bottom right hand quadrant of your screen.

I actually think that’s a good thing. Right? You’re getting fixed income. They’re paying you an interest.

I mean, part of this seven hundred billion in interest over here is going into our accounts at Schwab at Fidelity and so on and so forth. Right? So I think that there’s value to this. I would also argue.

And this this is, not everybody agrees with me on this. I totally respect that. But it is impossible for the federal government to actually go bankrupt, and that’s because their debt is denominated in US dollars. And the US government has a monopoly on the printing of those dollars.

Right? Now I’m not saying this would be good policy. I’m not recommending that we fire up the printing press and pay off our debt with funny money. But my point is that usually countries deal with their debt through a combination of raise cuts in spending, hikes, and taxes, enter what we call monetization of the debt, fancy way of saying, hey, let’s inflate some of it away.

Many countries have done this throughout, throughout, world history. Again, I’m not recommending that. My point is this, if you own a US treasury bond, The likelihood of the US government not being able to pay you your interest or your principal back on that bond is virtually zero. Right?

And I do believe that.

Okay. I wanna get to the question we’ve all been waiting for. The upcoming election.

Don, we have been getting this question for a little while and we have try to avoid it until an actual election year. And here we are. So should people be thinking differently about investing in an election year We have some questions in the in the chat about how would a possibility of x person coming into office affect the markets in twenty twenty five Are you worried about the market based on who end up in office?

This is where I tend to alienate all of the listeners on our call because I don’t tell anybody what they wanna hear. So what I would say is no. There’s absolutely no reason. There is no evidence that you should be investing differently. One because it’s an election year, or two, based on who wins office.

Right? Markets, the economy, they both have done very well over time. Regardless of which party controls the White House Congress or some combination thereof.

And I’ll come back to your the the the last part of your question in a moment, but what I’m sharing with you on the screen here is two things. Going from left to right, right, from nineteen forty seven to twenty twenty two. We’re looking at GDP. So this is the economy.

Right? We often hear, well, one party is better for the economy than another. Well, Let’s actually just look at some real world data. Okay.

And here’s what we see. The economy has grown about two point eight percent in real inflation adjusted terms when a Republican controlled the White House, or I should say it when Republicans controlled government So that means both chambers of Congress, and that means the White House. Okay?

The economy has grown four percent when Democrats controlled all of Congress plus the White House. So a little bit higher. I would argue there’s a lot of variance in the data, so I’m not not to get too nerded out on sticks, but I would argue these numbers don’t really mean anything. You can’t draw a powerful conclusion that Democrats are better than Republicans.

And and I I know all my ocratic friends are saying, no. No. No. No. That can’t be true.

You just showed me. No. There’s a lot of noise in the data. It bounces around quite a lot.

Alright? But it is objectively true that the average GDP growth, real GDP growth was four percent when Democrats controlled all of government and two point eight percent when Republicans controlled all of government. Okay. And then when government was divided, it was about two point seven percent.

And this is what happens most of the time. That’s what you see over here in the right hand column. Most of the time, it’s kinda rare that one party controls all branches of government. So Down here is the return in the S and P five hundred index under Republicans, Democrats, and divided government.

And we see that Market return, stock market returns have been highest when Republicans controlled government. Again, that’s both chambers of Congress, the White House, up, twelve point nine percent. Alright?

And then markets had been up about nine point three percent when Democrats controlled government and then divided government was eight point three percent. So, again, Jess, there’s a lot of variants, a lot of bouncing around volatility utility in the data, that I would be really careful not to get too excited.

But what I love about this slide is my public and friends have something to get excited about. They’re also not gonna talk to me for a few days because of of the what’s up top here. And then the same thing for my Democrat friends. They, you know, they can get excited and say, see, we’re better for the economy. And my Republican friends are gonna say, yes, but we are better for the stock market. So, again, I would never, never recommend anybody make a change in their portfolio based on who they think is gonna win the White House in the fall. Your question the last part of your question that I’ll touch on, I know we’re coming up against time, is am I concerned about anything heading into the election?

I am concerned about the level of political discourse in our country. I feel like it has definitely degraded in the past, you know, five to ten years. I am worried about the prospect for some social unrest. Right?

So I’m just gonna be really candid with our listeners that I think that is something we do to pay attention to. I don’t think that changes how you invest. I just I say that as a citizen, as a father, as a husband, that I I I would I wish that we could come together and have more intelligent debates about some of these real challenging policy issues. So, To me, that’s more of a disappointment.

It’s not an investment thesis.

Okay. So, Don, we are almost at time, but we have One more question that came up a lot, and there’s a person asking it live as well. There’s been a lot of interest in the new Bitcoin ETFs. And you have been very clear on your stance on cryptocurrency and mercer stance. But in sixty seconds, can you remind us what that stance is and does that change now that Bitcoin is more accessible via ETFs?

Yeah. My stance does not change. I do wanna emphasize I have an open mind. If somebody can convince me how to properly value a cryptocurrency, whether that be Bitcoin or any of the other twenty thousand plus cryptocurrencies that exist, I would I would like to hear it.

You know, when when Bitcoin trades trades at forty thousand, nobody can convince me whether that’s the right price, whether it’s overvalued or undervalued, at that price. And that’s because Bitcoin, like gold and many of these other assets, they don’t generate any cash flows. Bitcoin will never pay you a dividend. Right?

So it is not a cash flow generating asset. So, you know, my objection or my concern around crypto assets is it’s not clear that you actually own anything.

You don’t have investor protections. Just look at the FTX debacle.

Right? And you really don’t have any ability to press ownership claims in a court of law because it’s not entirely clear that you even own anything. And so I think as a fiduciary, Jess, when we’re thinking about investing client capital, their life savings, we are looking at investments where they have a clear title of ownership where we can clearly value what they’re worth and not have to worry about, you know, a collapse, for example, in some unregulated exchange in the Bahamas.

Thank you.

Thank you, Don, and thank you everyone for joining today. Replay of this conversation will be posted on our website at merceradvisors dot com in the insights section.

If for any reason any of your questions were not answered on today’s call, please reach out to your adviser team. I did see quite a few questions about social security as part of registration about taxes, Roth convergence, five twenty nines. Those are all perfect questions for your adviser. We are here.

We’re ready to help. And I know I speak for our entire advisory team here at Mercer when I say that we really consider it a great privilege to be trusted with your hard earned wealth. We don’t take that responsibility lightly. So we appreciate you being clients of the firm, and we will see you back here next quarter.

Have a great rest of your day.

Thank you, everybody.