Capital Markets Update and Outlook: July 2023

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Hello, and welcome, clients and friends of Mercer Advisors. To our quarterly markets update. My name is Jessica Caruso. I’m the managing director of Mercer Advisors team in Northern California.

And joining me today is Mercer Advisors chief investment officer, Don Calcadny. The two of us are really looking forward to spending the hour with you and getting into some good discussions about what’s happening in the capital markets.

As we go through, please feel free to type in any questions as we go. We really value our client’s perspective and we want to hear from you as questions come up. I do need to remind you that today’s discussion was meant to be general educational material. So you should not consider any information provided today as personal financial advice. However, if you do have those questions about how anything we discuss here today applies to you and your personal situation, please contact your local wealth management team. Your advisor would be more than happy to review your specific plan with you to make sure you’re on track and really take a look at your portfolio as well and whether you’re positioned well for our current environment.

With that, let’s dive in.

So here at Mercer Advisors, it’s been our vision for over thirty five years to really put our client’s interest first.

And in the spirit of that client first mentality, we always like to structure these quarterly conversations as discussions around the topic that you, our clients say you want to address. So we asked for questions in advance of this webinar as part of the registration And in preparation for today’s webinar, Don and I went through each and every question to come up with some major themes that are gonna guide our discussion today. Those themes are displayed here in a word cloud that was created directly from your questions. So, Don, we’ll just start with know, with so much going on in the markets and economy these days, can you talk about a few of these key themes, key themes you’re seeing out there, many of which are listed here and talk a bit about how these teams are impacting our portfolios.

Absolutely, Justin. And, again, thank you to all of our all of our clients for part of your summer with us here for the next sixty minutes. So we really appreciate that. So, to, to Jess’s point, yeah, I mean, this word cloud, certainly a lot of things jump off the page here at us.

And, Jess, I think we’ll just begin with recession. It’s the biggest one on the page here. It’s top of mind for many clients, and it’s it’s it’s top of mind for me as chief investment officer, and I know it’s top of mind for many of our advisors. And so, you know, this question around whether we are in a recession is one part of the question.

The other part of the question is, you know, are we perhaps heading into a recession? And that’s that’s a fundamentally different question. So Let’s start with the first half of that. And the best way to answer to that is to is to just look at some real world data.

And so that’s what we’ve done here. And the way to read this slide is over here on the on the left, these are the different categories that economists look at to gauge whether or not we are in a recession.

And whether or not we’re in a recession is there’s an official determination that’s made by a group of academics that are part of the National Bureau of Economic Research. And they’re looking at many of these metrics. They’re also looking at others. To determine whether or not there is a broad based decline, that’s the official definition, a broad based decline in economic activity.

And if we just look here at GDP growth, what we see is that GDP growth is still coming in. It’s positive. It’s coming at around two percent.

And this is a this is a spectrum here. It’s just showing you historically what has been the range of GDP growth. And this little gray bar shows you where GDP growth is most of the time. About two thirds of the time, GDP growth is somewhere in that range. So the short answer to the first question, are we in a recession or not, is we’ll know GDP is positive To be in a recession, GDP would have to be negative. And all of the metrics tell us GDP growth is positive.

Now sorry about that. If we look at some of these other data points, I think they can give us some indication of whether or not we’re heading into recession, which I think is the more interesting question. And just the other day, there was a survey of, of economists that Bloomberg put out that, most economists expect a fifty percent probability or less that we will be in a recession over the next twelve to eighteen months. So the economics profession as a whole right now thinks that the odds of a recession in the future are less than fifty percent.

And and by the way, anytime you’re forecasting the future, it’s always a a game of probabilities. Right? This isn’t physics, Nothing is guaranteed. These are all, estimates.

Right? But if we look at something like unemployment, unemployment still by any objective measure, is near historic lows. It’s really hard to dip into a recession when you have such a strong labor market. And indeed, this is one of the things that has the Federal Reserve concerned And in fact, they’re meeting today on, whether or not to raise interest rates.

And the Fed is concerned that the labor market is still a little tight. The Fed is concerned that inflation is still running a little high. And so, you know, if we do go into a recession, I think it’s really a function of what the Fed does. I think there is a real risk that the Fed raises interest rates too high and inadvertently pushes the economy into a recession.

I put the odds of a recession over the next twelve months at about fifty percent. And I think it’s really the Fed’s decision. I think the US economy has powerful momentum. It’s had powerful momentum for a number of years.

And, you know, so I think it’s really the Fed’s call. If they continue to raise rates, I do think we run the risk of pushing the US economy into but I think those odds are still at about fifty percent at the moment. Okay. Thank you, Don. The Fed is where I wanna go next, but before we leave the recession topic, I wanna share that in getting ready for our webinar today, I looked back at the webinar we did back in April of twenty twenty two. And can you guess what the most popular question was at that time?

Also recession. So I Probably recession.

That investors have been talking about this for a long time. We’ve kind of been on the edge of our seats waiting for whether we’re gonna accomplish that soft landing we were promised or if some kind of major economic downturn is just around the corner. And before we leave this topic, I just wanna remind people that your ability to get to and through retirement doesn’t rely on your or Mercer’s ability to accurately predict when the next recession is gonna come. We know downturns happen. We know one will come eventually beyond saying roughly fifty percent chance in the next year. But if your financial plan and portfolio are positioned appropriate, you’re appropriately you’re gonna be able to weather that. Now I say that with deep empathy for those of us on the line today who are worried about that recession coming.

I meet with new clients every week, and I’ve heard countless stories of folks who were over exposed to tech companies in two thousand eleven or lost everything in their real estate portfolio in two thousand eight. And so for those people and for many of you on the line, the idea of going through that again might be really terrifying.

And that’s all the more reason to make sure that you have stress tested your financial plan that your portfolio is diversified that you own lots and lots of different companies of different sizes and styles across different industries and countries, so that whether or not you can predict that recession doesn’t really matter that your portfolio is positioned appropriately for it.

So, Don, with that, I wanna go next to where I think you were headed, which is to talk about the fed, where the market thinks what a Fed is gonna do with rates today and where you think the Fed might take rates the rest of the year?

Yeah. Great. So just going back to the the comment I was making previously, you know, I think whether or not the economy dips into recession. I think it’s the Fed’s decision at this point, The Federal Reserve is meeting today, like I said. The Fed is really, you know, their mandate is to maximize employment, but their mandate is also to maintain what we call price stability. So they wanna keep inflation somewhere around two percent on average over time.

And to be fair, I mean, inflation has come down quite dramatically over the past, twelve to eighteen months. But at the same time inflation is still running a little hot. And I’ll I’ll walk you through some inflation data here in a moment.

But the Fed today is actually forecasted to raise interest rates and additional order percentage point. So what this chart shows us is the history of what we call the fed funds rate, which is the interest rate that the Federal Reserve controls, and that influences interest rates throughout the economy.

And you can see that they wrote they they increased interest rates quite dramatically beginning in March of twenty twenty two. I mean, you looks like it just took off, like, a rocket here. And we’re currently at about five point one three percent. That’s a it’s an average.

That’s where we’re at currently. The market is forecasting that the Fed’s gonna raise rates again today, and that we’re gonna peak out at around five point three two. The the blue line here is the Fed’s own estimates of what they think the future path of interest rates looks like. The the the raspberry line that you see here, that’s the markets, the bond markets forecast of where they think interest rates are going to be.

You’ll see that there’s a little bit of a disconnect between those two perforated, those dotted lines, That’s normal. The markets and the Fed, we always disagree on where interest rates should be.

But if you look at it, they’re both directionally moving in the same And this is part of the irony in my view of the current situation, is the Fed is looking to achieve some degree of precision that personally don’t think exists in in in the economy.

The reality is both the Fed and the markets forecast that they’re gonna have to begin cutting interest rates sometime in early twenty twenty four. Right? There’s an acknowledgement that the economy, the natural interest rate that the economy requires in order to grow at a healthy rate, then it will need to come down. Right?

And and so there was a question I know that I saw that somebody had submitted around the future path of interest rates. This is really our best guess on the future path of interest rates. All the economists at the fed, the entire bond market, which is millions of participants, all forecasting that this is where we think interest rates are gonna be over the next six, twelve, eighteen, twenty four months. Alright?

And we can see that by twenty twenty five, even the Federal Reserve themselves are forecasting that they’re gonna have to cut interest rates by about two percent from where they are today.

So this quarter point hike that the Fed might, embark on today, you know, at at the end of the day, I’m not sure how material it is, and I’m not sure what exactly the thinks they’re gonna accomplish with that, but, thankfully, I don’t run the Fed, and they they certainly didn’t ask my opinion. So, so this is where the Fed is at. At the moment, But, yes, there’s something else going on behind the scenes that I think all of us as citizens and investors should be aware of to combat the global financial crisis.

The Federal Reserve printed a bunch of digital dollars and injected those dollars into financial markets.

And that started, you’ll see back in o eight zero nine, back when we had the failure of Layman Brothers and Merrill Lynch and all these other, you know, AIG and Bear Stearns.

And they pumped a lot of cash into the market. And when they did that, they bought bonds. They bought mortgage backed securities. That’s what that’s what this MBS stands for.

They bought treasury bonds issued by the US treasury. And then they did that again to combat COVID. Right? They printed trillions of dollars to keep the economy afloat during these two very major economic crises.

So much so that the Fed printed nearly nine trillion dollars.

To keep the US economy afloat during those two major crises.

Now the fed to their credit, at least in my view, that’s a bit of a subjective judgment call on my part, They’ve said, look, you know, the economy is healthy enough. It’s time for us to start mopping up some of this extra liquidity that we pumped into the market, and they started doing that in June of last year, June of twenty two. And the way that they’re doing that is remember they bought bonds and bonds eventually mature. And when a bond matures, you get repaid your your principal, your original investment.

What the Fed is doing is literally taking those dollars that are being that’s being repaid to the Fed and going into their digital spreadsheet and simply deleting them. They’re throwing them into the digital shredder. So behind the scenes, The Fed is also removing cash from the economy very slowly, and they are shrinking their balance sheet. Now we can debate, is this a good thing, a bad thing, it’s a bit of an academic debate?

I think it’s a good thing just because it helps the Fed reload for perhaps any other future economic challenge that we may have in the future. I’m not saying that there’s one. It is imminent, but the reality is the modern world, you know, the crises come around, every so often. And so I think it’s I think it’s a good sign that our central bank is preparing itself and doing the prudent thing, and starting to clean up some of that liquidity, but the reason this is important to all of us and all of you on the call is that this also helps to push up interest rate throughout the US economy because the supply of dollars is slowly shrinking.

K?

I think the last thing I’ll touch on this ties back just to our recession question is where are interest rates today? And one way that financial economists like us look at interest rates is through the lens of what we call a yield curve. So what does that really mean? Well, on the up and down axis here, This is the level of interest rates.

And from left to right, this is the the maturity, the duration, let’s just call it, or the tenor of the bonds. So for example, a one year treasury bond, these are US treasury bonds, is currently yielding, somewhere around five point four percent. It’s actually a little bit less than that. A normally a normal healthy yield curve is what we call upward sloping like the one down here. It logically follows that if you lend out your money for a longer period of time, that you should be paid a higher interest rate. The way to think about this is if you barred money for a thirty year mortgage, typically, that interest rate is higher than if you took out a fifteen year mortgage.

So that’s what the yield curve looks like when you have a healthy functioning economy.

This inverted yield curve is a classic sign that a recession is coming. So back to that recession conversation.

Now In finance, there are no laws. Right? There’s no laws. It’s not physics. Right? So this does not mean that a recession must happen.

And in fact, the the professor, the economist at the University of Chicago, who actually identified this trend. I was actually in a meeting with him listening to him, give a panel discussion not too long ago, and he was actually asked, hey, you know, you’re you’re the professor who identified this relationship between an inverted yield curve and a future recession, do you think that we are heading into a recession And that professor actually said, no. It’s different this time. So I thought that was really interesting to hear that opinion from the faculty member who had identified this trend.

The reality is we have a downward sloping yield curve. That is not healthy for the economy. At some point, that needs to right size. It needs to be upward sloping.

And so this is something that our investment committee spends a significant amount of time debating, discussing, and thinking through. And And, you know, we do think the yield curve will, right size at some point in the future, but at least for the time being, it remains inverted.

Thank you, Don. So that was in response to what the Fed is gonna do and what impact having on the economy what they have then and will do.

I think good news is that the Fed’s moves seem to at least be having some positive impact on inflation It’s certainly not something that’s dominating the headlines like it once was. We actually got very few questions about inflation for our webinar today coming into our call. But nevertheless, give us an update on where inflation stands and whether we should still be concerned.

Yes. I think we should always be concerned about inflation, especially those of us on the cusp of retirement. Right? Inflation, I would argue is probably the single biggest risk to the financial security of retirees, and it’s one of those things. It’s not always obvious, but I know that our financial advisors know that it is a very real risk, especially for our clients who are transitioning into retirement.

It’s something that the Fed is laser focused on. And so for that reason, I think we should all, be be at least a little concerned about it. Reality is, look, inflation peaked in June of last year. It has come down quite steadily since then And as recently as last month, inflation was running at about three percent over the past twelve months.

So these numbers are annualized numbers. That’s the first thing to keep in mind. So when we say that inflation was at three percent in June, we don’t mean that prices rose three percent in June. We mean that prices rose three percent, as of June thirtieth over the prior twelve months going back.

To June of, actually, July first of twenty two. Okay? But it’s interesting. You’ll see that it has come down, but this tells us that the Fed’s interest rate hikes, perhaps, are working.

Right? Now there’s an argument that inflation may have come down naturally anyway. That’s a bit of an academic argument. But at the end of the day, objectively, we know inflation is coming down.

And in fact, we’re already seeing deflation in certain categories. That’s a term we I think we kind of forgot that term over the past year and a half. Right? Deflation is when prices decline, right, when they’re actually going down.

Disinflation is when the rate of growth in prices is coming down. So this has been a disinflationary environment. Prices the growth in prices have been coming down. But we have been seeing absolute declines in things like new and used vehicles over the past six months and certainly in energy.

So, you know, perhaps ironically, despite the war in Ukraine, and despite a lot of different things going on, you know, prices have actually come down for energy, overall. So inflation is coming down objectively. That’s a good thing.

This is a very busy slide, but I’ll just highlight that, you know, you’ll see all this reddish and orange in here in the middle. This was twenty twenty two. This is when inflation was really piping hot, to when the fed, was very aggressive with raising interest rates, but you’ll see where we’re at today. As of June, things have really cooled off green is good. Red is bad. That’s how you wanna read this chart. And you can see that we have it broken out by all of these different categories.

Most categories now over here on the on the right have really cooled off. So I think directionally, we’re moving in the right direction. The Fed, Still concerned, they feel like there’s more work to be done, hence their decision. I predict they’re gonna raise interest rates twenty five basis points, which is one quarter of one percent. That they’re gonna do that later today.

Thank you, Don. So I think that’s a good segue to talk about where I think you’re going next, which is market so far this year. So talk to us about how the market in general has gone and how different asset classes have performed so far this year.

Yeah. I think I think overall markets have done amazingly well this year given, you know, given the headwinds, given the that the Fed has continued to raise interest rates this year. And so you’ll see that we’ve broken down the different asset class returns here. These are the asset class on the left. We have US stocks and non US developed market stocks and emerging markets and and taxable and muni bonds. And then we broke it out by, you know, the second quarter, year to date, and trailing three years and so on, and so forth.

And so I’m gonna focus on the year to date. Just to give us a a high level overview. But you’ll see that US equities broadly are up over sixteen percent. This data is through the end of June.

Markets have continued to rise a little bit more here in July so far for the month. And, you know, we’ll see if we’ll see if they keep those gains. We still have several trading days here the month is out.

But, you know, by and far, every asset class, is positive on a year to date basis, and these are very healthy returns. Coming on the heels of last year, which was a very, a pretty poor year. And I think, you know, Jess, this underscores an important point, and this is why investors have to be. Long term investors.

I know it’s painful last year. US equities were down, quite dramatically, and that that hurt. And there was I I know a lot of clients and a lot of investors were just worried, you know, gee, should I continue to be invested in equities given that inflation is running at five, six, seven percent. Given that interest rates are now up to five percent, should I still own equities Well, if we were asking that question back in January, the answer is yes, and we can come back to that question perhaps in a little bit.

But here we are six months on, sixteen point two percent, not only does that really help us recover last year’s losses, but certainly does a a great job overcoming the risk free hurdle of about five percent and overcoming inflation.

So, you know, equities have done well. Even non US buddies have done very well on a year to date basis. Ironically, despite the war in Ukraine, despite concerns about you know, Brexit, there’s still a lot of energy around Brexit for those of you who follow that issue, and it’s creating a lot of disruption. There’s also tensions across the Taiwan straight tensions between the US and China.

The reality is global equity markets have still done, quite well delivering positive returns to investors. We’ve even seen US bonds, muni bonds, taxable bonds recover some of their losses from last year. And over time investors should recover all of those losses just given the much higher yields now that exist on those types of security. So I think by and large, when you look across the whole market chest, we’ve seen great returns.

We’ve seen better returns in technology stocks this year. Technology was last year’s absolute worst performing sector. It got absolutely hammered. This year, it has recovered and then some and done quite well.

And energy. Energy was last year’s biggest winner, and I think come December, everybody was asking me, why do we not own more energy stocks? And yet this year energy is the worst performing sector through June thirtieth. So it just goes to show this is why you gotta be really careful chasing yet days returns, and you really wanna maintain an exceptionally well diversified portfolio.

So, so with that, Jess, maybe we can maybe we can just open it up for some open some open Q and A. Yeah. Yeah. I wanna I wanna get to maybe our second most asked question, which is about market outlook going forward.

But actually before we go there, I wanna stay on this year to date performance a bit. We have a question coming in from audience member about US large cap momentum. We also had a question from the from the registration on value stocks. You’re talking here about broad asset classes, but can you give us a little bit more information on what’s going on within factors and how factors have been performing this year?

Yeah. Absolutely. So let let me start with momentum since that is the poorest performing factor so far this year. It’s important to remember what momentum is.

Momentum is taking advantage of a very well documented finding in virtually all asset classes that asset class returns, tend to have momentum. Right? So my momentum is this phenomenon that objects in motion tend to stay in motion for a period of time. And we see that in financial assets, the world over.

And what’s really interesting, again, think about how momentum works is it’ll identify those stocks or, in this case, stocks that have really rapid upward price appreciation, and they will pivot the portfolio to own those types of assets.

And a lot of momentum strategies, if you think about how they work, they have to look at the momentum over a prior three month or a prior six month period. A lot of momentum strategies were caught a little flat footed at the end of the year because they were pivoting into energy very quickly. Because energy was the best performer in twenty twenty two. And so they said, look, we gotta own energy because this is what our momentum strategy does.

Well, the challenges is come January, markets pivoted very quickly, and that’s because markets were beginning to expect that the fed was gonna hit the brakes on their interest rate hiking policy. And so what happened in January is we started to see, you know, lots of Lots of discussion around AI and chat GPT and all that stuff, and the market quickly pivoted. And we also see a saw a very dramatic collapse.

In energy prices. I mean, despite winter in Europe and despite the war in Ukraine, natural gas prices actually declined. That’s not what anybody had expected. So momentum, doesn’t work all the time.

No factor strategy. No investment strategy. I don’t care what investment strategy it is. No investment strategy.

Works a hundred percent of the time. And I think this is one of those times where momentum, it’s just not working. Doesn’t mean that it’s not gonna work going forward. In fact, we have every reason to expect that it will work going forward.

But at least so far for the first six months of this year, it has not worked. And momentum strategies are generally flat.

For the most part this year. Now the factors that are doing really well, things like profitability and quality. These are companies with high, profits relative to what we call their book equity. We don’t have to get into all that, but these are different fundamentals that analysts use to gauge whether or not stocks are good investments. So the profitability factor or the quality factor, depending on how you measure that, because there’s a lot of ways we we can measure that. That’s up about twenty, twenty two percent for the year.

So we’re seeing good strong returns in that factor. This is why it’s important to diversify across factors. So really strong returns and profitability and quality, value somewhere, somewhere in the mid to high single digits, value stocks. Those are a lot of those energy stocks They’re the kind of the unloved companies, all of a sudden, so financials, energy stocks, things like things like that still positive returns, but, you know, not as good as those AI stocks that we’re all reading about in the Wall Street Journal, for sure.

But within the factor space. That’s generally what we’re seeing. Profitability doing really well. The value is mid to high single digits.

Momentum’s pretty flat.

But overall, that that’s what we’re seeing from a fact sector perspective, if we just step back for a moment, what we’re observing, Jess, is that these traditional growth stocks, like technology companies, they’ve really knocked the cover off the ball. They’ve done exceptionally well so far this year so much so that of those companies are up twenty five to thirty five to forty percent. And some of those valuations, defy gravity.

Just when you look at their profits, I think some of that is is hype. But at the end of the day, look, investors are really excited about AI, and they’ve really bid up those prices to nosebleed levels. Whether those prices stay there, you know, remains to me to be seen. I mean, to me personally, somebody who’s been in the market for a pretty long time, it kind of feels like nineteen ninety nine, two thousand, all over again. We’re all excited about the promise of the internet or in this case AI, eventually, I think some of those companies are probably gonna come back down to planet Earth.

Okay. So that’s actually where I wanted to go next is, not looking backwards at year to date performance, but looking forward towards what could happen relative to outlook going forward the rest of the year. So we got a lot of questions coming into this about where the market might be headed, if there’s areas other market that might be overvalued or undervalued.

So I kinda wanna go through a few different segments of the market I’m seeing some questions coming here, and I’m gonna try to answer those live and tie in some of the questions from our registration. So where I want to start is on bonds. I see a question here about sort of outlook for corporate bonds. We got a lot of questions in general about based on where the yield curve is, how should investors be thinking about positioning their fixed income allocation these days?

Yeah. That’s a that’s a great question. So with respect to the positioning on the yield curve, you know, Jess, I think it’s a function first and foremost of what is the investor solving for? Right. What’s the goal of the fixed income part of an allocation?

I think invariably for the vast majority of our clients. What they’re looking to do is to have bonds act as a ballast in the portfolio. They’re looking to lock in a certain income stream for a period of time. And so if if you are looking to lock in income for a certain period of time, if you’re looking to hedge against future changes in interest rates, which as I just showed you a few moments ago, the fed themselves is forecasting that those rates are gonna come back down in early next year.

Okay? So if what you wanna do is if you wanna lock in today’s higher interest rates, you would wanna own some longer term bonds. Maybe what you do is you you go out three to five years and build a five year ladder, for example, for a as part of your portfolio. So that’s what you would do if you’re looking to lock in that income.

And if you’re looking to hedge out or hedge against significant future changes and interest rates, if instead you’re just looking to maximize your yield and maximize what we call your sharp ratio, you would only go out about six months right now for treasure fries. Right? Because at six months, that’s where the the yield curve is is kinked. Right?

I I showed you that yield curve slide a few moments ago where it kinda went up for the first six months, and then it came down. It was inverted. You would wanna go out to the peak of that mountain. That’s where the sharpe ratio is highest.

That’s where the risk return ratio is is highest. So that’s what you would want to do if you’re just looking to maximize the return relative to a given unit of duration risk in a portfolio Most clients don’t think about their bond part of their portfolio that way. That’s certainly how we think about it. But at the same time, you know, we are a financial planning firm, so we’re helping clients hedge out that interest rate risk over over time and try to lock in that income.

So again, Jess, the short answer is it really depends on what the investor is trying to solve for. And I think most investors are better served by having, I would say, a one to five year bond ladder versus trying to trying to pick and try to monitor exactly where the kink is in the yield curve. Mhmm. Mhmm.

Yeah. I I personally get that question a lot from clients that hey, if I can get five percent in a CD or a T bill, why wouldn’t I just own only that? And I think the reality is we don’t know what rates are gonna like exactly when that comes due and you have a bit of that reinvestment risk that if your bond portfolio is meant to cover you for the next five, ten years of retirement and you’re looking for that, that cushion in the portfolio, then that really, really short term CD or T bill or whatever it might be is really a band aid. That’s a really good band aid for the next six months.

But it doesn’t really solve the bigger term, need or goal for what that money is. So it’s really important to kind of have that conversation with your advisor and figure out what, Don, to your point you’re trying to solve for. Yeah. Agreed.

Okay. Let’s pivot and talk about equities.

Equity market has certainly shifted a lot from the beginning of the year. And just in general, I wanna talk on a few specific themes, but can you just give us a an outlook generally for the market moving forward if there’s any places we should be overweight or underweight or if you don’t think about it that way at all.

And we can we can come back to the question of weights in a moment. What I would say, just looking at the equity market as a whole, I I look at it in terms of what are the headwinds and what are the tailwinds?

Right? And in terms of tailwinds, there’s a couple things I think the market has going for it at the moment. And that is I think it is clear that the Fed is towards the end of their interest rate hiking cycle. We can debate exactly when that’s gonna be.

But I think we’re towards the end, obviously, certainly closer than we were a year ago. And and even the Fed themselves is forecasting that they’re gonna cut interest rates beginning in January. Now you don’t wanna wait till January to take advantage of that trend because the market is already pricing that information in now. Right?

The market isn’t gonna wait till January to price that in. The market is pricing that in, right now. So that’s a very powerful tailwind. That’s gonna help markets when when, not if, but when rates start to come back down.

That’s a good thing. Another tailwind is that, you know, depending on the sector and depending on, the report that you reference, for the most part, over the next, I’ll say twelve to eighteen to twenty four months, We are forecasting, you know, pretty attractive earnings growth. I mean, it’s not stellar, but it’s good. So companies are still growing their earnings.

They’re growing. The US economy is still growing. I showed you that data. You know, we’re not in a recession.

There’s a debate around whether or not we’re gonna land in a recession.

But I think the odds of recession are percent on the high side, we’ll see what happens.

But you don’t wanna invest based on whether or not you think you’re heading into a recession. Recessions are not good predictors of stock terms. In fact, it’s the other way around. The stock market predicts recessions, not recessions predict, you know, stock declines.

So again, I think, you know, when you look at positive earnings growth, when you look at the prospect of future rate declines, I think those are pretty nice tailwinds for having a diversified exposure to equities. And this gets me to the headwinds. And, Jess, this gets to the second part of your question. I do think you have to be careful and look inside the market. And so when you look at AI stocks, I know there’s a lot of questions around AI stocks and technology, I do think that there are sections of the market that are significantly overvalued based on their prospects for earnings growth.

Right? We own technology.

We own generally a market weight give or take a few points to technology. So we’re not saying not to own technology. We’re not saying not to own some of these growth of your stocks. What we’re saying is I would not go overweight those companies because they’re trading at thirty, forty, fifty. Some of these companies are trading at over a hundred times earnings.

That that defies common sense. And the only way those companies can justify those dramatic stock prices is to really post sig substantial, earnings growth. And I’m not saying that want. I’m not saying that they can’t. I think AI has enormous promise.

But those that’s a pretty tall order. Alright. As investors, we don’t care about what product it is you sell, what we care about is earnings. Right?

A dollar of earnings from a tech company is the same as a dollar of earnings from an energy company. Right? A dollar is a dollar. Right?

And what we care about is the growth of those actual dollars that you’re gonna ultimately return to your shareholders.

And so, again, I think there are parts of the market that are significantly overvalued that I think investors should be very cautious of. And then there are parts of the market just in the US and certainly globally. That are undervalued, that are trading at fourteen times earnings. Right?

So think about that. A company trading at forty times earnings versus a company trading at fourteen times earnings. And in fact, some companies are trading at eight, nine, and ten times earnings. So as an investor, you wanna pay close attention to those things because that’s important.

That’s gonna be the single most powerful predictor of what your future returns are gonna look like. So I think value stocks, I I I think generally you’re looking pretty attractive. The market as a whole right now, Just the S and P is trading at about twenty times next year’s earnings. That’s a little frothy.

That’s a little frothy given where interest rates are today. But to be fair, earnings growth is good. And if earnings growth continues to come in at eight, nine, ten percent, that that effective, multiple, that valuation is gonna come come down. So I think for long term investors, equities are still a a a great place to be.

Non US equities, I think, are especially attractive. I know we’ve been saying it for a long time, and non US equities have given us mediocre returns relative to US stock.

But you gotta look at European stocks, emerging market stocks. They’re trading at low double digits, twelve times earnings, fourteen times earnings, They are trading at maybe a fifty percent discount or more relative to large sections of the US equity market. And if you’re also looking to diversify around the US dollar, I know we had a lot of questions on the US dollar. It’s been in the news, but if you’re looking to diversify around any potential decline in the value of the dollar, the classic and most cost efficient way to do that is to own non US assets, especially non US equities, which like I said, are at a at a very attractive valuation at the moment.

Okay. Thank you, Don. That was actually the two places I wanted wanted to go next as we had a lot of questions on AI companies. I think you covered that.

Essentially the idea that you have to remember that, yes, these things are gonna grow, but that doesn’t necessarily mean that they’re gonna grow fast than the market has already priced in that they’re going to grow. And so, absolutely, let’s make an investment in that area of the market, but does that justify an overweight? And what I hear you saying is at the time. No.

On the dollar, I see actually a couple of questions here live about gold standard, the fall of the US dollar. Lots of questions came in prior to this around, just how to protect against and what what someone called the emerging threat to the US dollar value. Can you just talk a little bit more about that? You touch on it just now, but as that relates to investing in Better, I’ll maybe international investing as well.

Yeah. That’s actually one of my favorite topics is the US dollar relative to non US currencies. And, you know, it’s interesting. If you’re to go back, thirty years, the US dollar made up about sixty five, seventy percent of global central bank reserves.

That that means another way to say that, Jess, is the dollar was the US or the world’s preferred reserve currency. Right? It was the king dollar. So it was about sixty five to seventy percent of global reserves, As of today, it’s around sixty percent of global reserves. So it’s it’s going down a little bit, and I think there’s this sense that, oh, my gosh, it went down because of the rise of China, and, you know, China’s been, you know, quite aggressive with promoting their currency, the yuan, globally as a reserve currency.

But the dollar really didn’t go down five percent or seven percent because of the rise of the yuan. It actually went down because of the rise of the euro.

So it was in the late nineteen nineties and the early two thousands that the euro zone really began to come in to, and the European Union really began to solidify, and I forget the exact year when they launched the euro.

But it’s the euro. The euro went from zero percent of global reserve currencies because it didn’t exist at one point in in the nineties. To today, it’s over twenty percent. So the euro has done phenomenally well growing as a global reserve currency. So, I know there’s this concern and, you know, I think as a as an American citizen, I share this concern sort of our relationship with with the People’s Republic of China.

But it would be disingenuous to attribute, you know, that slight decline in the dollar’s global reserve status to the rise of the yuan. The yuan to be fair today makes up, I think, about, excuse me, two percent of global reserve currencies, which is really a rounding error in the grand scheme of things. Over ninety percent of foreign currency transactions globally that businesses are engaged in occurs in dollars. Oil priced in dollars.

Are there efforts by China, Brazil, and a couple of others to try to set up markets that are priced in yuan? Yes. There are. And, you know, whether those are successful, remains to be seen.

I think most economists don’t think it’ll be successful because China’s currency is so heavily manipulated by Beijing. That’ll be interesting to see if investor confidence in the yuan, will will grow. Here’s the reality. Every time there’s a financial crisis, globally investors flock to the US dollar.

I’m not saying that that will persist indefinitely forever.

But I think by any objective measure, the US dollar remains by far and away the world’s most preferred global reserve currency. That could change. But as I showed you a little while ago, the Fed is shrinking the balance sheet. We’re they’re bringing inflation in line Our central bank has shown the world that they take inflation very seriously, and they did not flinch.

Lord knows that. They did not flinch. When it come when it came to raising interest rates. And so those are all good things when it comes to protecting the value of the US dollar.

There’s certainly still other concerns, but I think by and far, the dollar will remain in the world’s, favored global reserve currency. Doesn’t mean that it may not come down in value. The value of the dollar relative to other currencies is a different discussion, and that’s gonna be a function of investor supply and demand. And it’s also a function of interest rates.

So, so Jess, I hope that answers the question. If there’s anything else you wanted to double click on there, happy to happy to do so. Yeah. That’s that’s great.

Thanks, Don. I think I’d like to switch gears. We talked about the market as a whole. We talked about fixed income.

We talked about stocks and different types of stocks. We talked about US versus international on the dollar. We’re also getting a lot of questions about real estate. I see a question from the registration about whereas residential real estate headed.

I see a question about outlook on commercial real estate, some questions live hear in the chat, about, yeah, commercial real estate, that REITs, residential investments, thoughts on what’s going on in the real estate market?

Yes. Certainly. And I think, you know, the real estate market is a first off, it’s such a broad market, and there’s public real estate, you know, real estate investment trust that are public traded. And then you have private real estate.

And so I think you need to disaggregate it a little bit, and you need to separate some of these sub asset classes. You know, just to be candid, I think commercial real estate is in serious trouble. I think the market knows that. The market is pricing that in, like I said, markets are very efficient.

They’re very quick to price in new information. It’s not like any of us has an edge and that we’ve thought of something that the other, you know, millions of other participants have not thought of. The market as a whole is concerned about commercial real estate, and that I think is pushing down commercial real estate prices But the market is also very adept at repurposing commercial real estate. And this gets me to my comments on residential.

So even though interest rates have gone up, we still have a huge lack of supply of of residential real estate in the United States and indeed globally. This is a global not just a US problem.

And so what we’re observing in fact, one of our buildings in Houston, a big commercial building And, the the tenant, the the owner of that building is basically, kicking out all the commercial tenants and they’re gonna turn it into condos. I mean, this is I forget how many stories. This is like a fifteen, twenty story building in downtown Houston that they’re gonna carve up into into condos. And and so markets are very adept at repurposing assets.

And so I think that’s the future for a lot of commercial real estate, you know, given this hybrid work environment as the economy has changed over the last couple of years, the need for significant commercial real estate in these downtown hubs the demand has gone away. And so the market naturally is gonna repurpose those assets into meeting, the demand for residential real estate. So the the the residential real estate side of the equation, you know, perhaps much to the shock and dismay of observers, has remained pretty resilient despite the fact that mortgage interest rates went from what, two and a half percent last year to you know, where they’re at today, seven and and change, that’s a significant rise in residential mortgage interest rates yet at, yet, yet home prices have been pretty sticky in most markets around the country.

We’ve seen some softening in some markets But I think that’s just a testament to the fact that there’s still significant unmet demand. And I think that demand will be met through the commercial real estate market as well as, you know, greenfield development by builders and building multifamily housing and things like that. One of the challenges for all of real estate at the moment is the fact that interest rates are exceptionally high. So the cap rates that investors are earning which is the effective yield that they’re earning on those investments is quite low.

And so until rates come down, I have a suspicion that we’re gonna see limits in, any increases in future supply other than the repurposing of commercial real estate, personally.

So it is it’s a challenged asset class, but you really need to look under the hood to see where those opportunities are at. I actually think there is a lot of opportunity in commercial.

For new investors. For investors who’ve been in commercial for a long time, they’re certainly feeling some of the pain right now as those prices take into account the fact that the demand curve has fundamentally changed for commercial real estate.

And on that point, Don, there’s a question here about how that may impact the rest of the equity markets or the rest of the capital markets. If there’s some stress in the future of being felt on commercial real estate or currently in commercial real estate, how does that affect the rest of the broad market?

I think it depends on the companies. I mean, I think as a as a high level comment, you know, this is why diversification is so critically important, Jeff, because I don’t care if it’s a good year or bad year. If you look inside the market, you’re gonna see some sectors, some industries that are doing well, some companies that are doing well, and others that aren’t doing well. Right?

And trying to predict those relationships over the next twelve to eighteen to twenty four months is exceptionally difficult. Right? If you went back to December, everybody thought in December that energy was gonna, was gonna continue to do well in two thousand twenty three, and that was not the case. So this is why I think you have to diversify very broadly.

So that’s that’s point number one. Point number two is, you know, it’s you you gotta keep in mind that companies that rent lots of real estate, right? This is actually helping them.

Right? So this is this is savings that’s gonna fall to their bottom line. Right? So there are companies that are publicly traded where they have lots of employees now work from home, and that does not cost Microsoft rent rental dollars.

And so if Microsoft is gonna shrink their commercial real estate footprint, you know, in theory, that should fall to the benefit of shareholders of a company like Microsoft. So I think it just depends on the company, the sector, and So I think trying to draw a very simplistic linear relationship, I think that would be a flawed analysis by any, by any measure. And, again, back to my point, number one is why you wanna diversify. So companies that are exclusively in the business of servicing or providing commercial real estate, Yeah.

They’re gonna be in trouble. Now the question is can those companies reinvent themselves by condoizing for lack of a better word their commercial real estate. And if they can do that, then I think they have a much brighter future. So it depends on the company.

Thank you, Don.

Another topic for you is energy.

I see some questions in here about sort of what causes the change in energy prices How is, what one attendee referred to as the US energy transition? We got a lot of questions about, different types of energy, oil and gas versus solar, wind power, etcetera.

Talk to us about how how the energy markets are shifting, and I know that’s been a big theme going from twenty two to twenty three. How is that gonna impact the markets going forward? Or is there anything investors should do about that?

Yeah. I mean, I look, I mean, energy prices, and I I think this is true of prices of all goods and services is ultimately a function of supply and demand.

And when energy prices rose dramatically, when was that early last year when when Russia invaded Ukraine, I mean, prices are a signal to producers. Right? Now it takes a little bit of time. It’s not like they have a spigot that they can just open up and bringing more oil or natural gas to market.

Actually, some producers do, and that they could do that. But I think what we saw is we saw more rig come online. Right? So investors responded to those higher prices.

And if you actually look at where we are today, the United States is a major producer. In fact, I gotta double check my on this, but I believe we are now the world’s largest producer of oil and natural gas. So I’d have to just double check that statistic.

But we are a major producer. And certainly Russia is a significant producer, but they’ve also been hit with sanctions. And so that is removed supply from the western markets, but Russia has found markets for that in India and China, but that still influences market prices because that that’s less that India and China need to buy from western producers or from the same producers that the West is purchasing from. So at the end of the day, this is all supply and demand driven.

I think what’s interesting is that oil prices have continued to come down despite the fact that OPEC plus, which includes Russia, have been trying to reduce supply and yet the United States or for whatever reason through technological innovation and efficiency or whatnot, perhaps even some renewable energy coming online has found a way to push prices down. Right? So that tells us I mean, the the demand is certainly there, economy has been growing. China’s been coming back online.

You know, they had their zero COVID policy, but now that they’ve reopened their economy, their demand for oil, has increased. But despite all of that, prices have continued, to come down from from where from where they were. So, you know, I think at the end of the day, capitalism is a wonderful thing. It’s dynamic. Markets are dynamic. Companies respond to prices.

And it just took a little bit of time, and and here we are. So despite despite all the disruptions to the energy market, Is that a tradable, is that tradable information? I don’t think so. I think you should still have a market weight generally to energy companies, maybe even a little bit overweight given that they trade at low valuations, and and we do.

If you look at our portfolios, we have a slight generally speaking, we have a slight overweight to energy and value stocks generally, but that’s based on the premise that they trade at very low valuations, not because we think that they are necessarily gonna grow their earnings more so than than anybody else in the marketplace. So I don’t think that’s a tradable us. The other thing that I didn’t mention, Jess, is one of the things that was really hurting us at the pump, because I think a lot of our clients equate energy prices to what they pay at the pump, need to keep in mind that what shows up at the pump has to go through a supply chain that includes refineries.

And there was a significant limit on refinery capacity in the United States. And, I I have to go back and look at some of the some of the data on this, but I think we’ve been expanding our refinery capacity here over the past twelve months or so due to improvements and efficiencies and things like that. So The price we see at the pump isn’t necessarily indicative of the price per barrel that’s coming out of the Persian Gulf or WTI or anything like that. Okay.

Thank you for that. We’ve spent a lot of time here in the last few minutes talking about some really specific parts of the market, whether it’s AI, energy, real estate, we talk to international, value versus momentum, but we actually got a kind of more general questions about positioning. So I thought I’d actually read some of these out loud and then ask how you’d start to respond to these. So, we have someone asking the current environment, should I be in sixty percent stock or forty percent stock? Another question is what should I do with my extra cash? Another question is where should my long term savings be going? Should I invest more in treasuries and CDs versus stocks?

Someone says I’m fifty six and retiring in four years should I still be invested in the market? So all these questions about sort of what should my broad asset allocation look like given this current market environment would you start to think about how to answer those types of questions?

Yes. That that first and foremost comes back to the financial plan. What is the client trying to solve? Right? What’s the objective? Right? How old are you?

Where are you today? Where do you wanna be tomorrow? And by tomorrow? I mean, whatever the time horizon is, five years from now, ten years from now, thirty years from now. So that’s a function of time horizon. That is a function of risk tolerance.

That’s also a function of the client’s balance sheet. Right? What’s their balance sheet capacity to assume risk? And from a financial planning perspective, there’s a question in there around What kind of real return over and above inflation do does the client need to earn in order to sustain their lifestyle?

What are their goals? How much do they wanna leave to charity? How much do they wanna leave to their children? What’s their lifestyle today?

Right? So that’s that’s really a financial planning answer.

I don’t think that’s a market driven answer. The At the end of the day, long term, stocks have higher expected returns than treasury bonds and CDs, they have to because they are skier. And in order to earn the right to your capital, they have to promise you a higher return on those dollars. Now they can’t promise that legally.

Right? But as investors, you’re you’re the one providing capital to that company in exchange for a higher return, and the market takes that into account when it prices the stock price of every stock in the market. Right? So but that’s you’re only gonna earn those higher returns with longer horizons.

And so that ultimately comes back to the investor.

What is the time horizon? What’s your stomach? What’s your risk tolerance, for assuming investment risk? So sixty forty versus forty, sixty.

All of that question can be answered by nailing down those variables, building a financial plan, revisiting that financial plan. And, you know, same thing with that question around. If you had excess cash, what would you do today? Well, you’d have to look at that financial plan. What are you trying to accomplish? Once we know that, then we can solve for what you should be doing with that extra cash.

Yep. Love that. Maybe a little bias as an but I love that answer.

I would agree that how your portfolio should be invested is really like Don said based on your specific goals your objectives, your time horizon, really looking at what’s the plan and purpose for this money, when an advisor meets with a client to figure out how they should invest there’s a lot of variables we’re looking at, but quite honestly, current market and economic conditions are not the most important one there. What’s much more important is what’s the purpose of this money? How quickly are you gonna start drawing from the funds? What are you gonna use this for? How much risk are you comfortable taking? And those are questions that your advisor would be more than happy to have with you.

Don, I’m gonna go ahead and skip here in our last two minutes to our final question and ask if there was just one thing that investors should do looking forward to the second half of twenty twenty three, what would it be?

Meet with your advisor. Update your financial plan, revisit your risk tolerance, make sure you’re on track. Right? And make sure you do that with your partner, your life partner, your spouse, your family.

Right? Do that, as a partnership. Meet with your advisor. And double check all of your assumptions about the world, about your financial plan.

Right? It’s it’s okay to be worried about recession. It’s okay to be worried about the dollar. Perfectly normal, perfectly human.

Right? But have that conversation with, with a with a trusted advisor to help you think through. What’s the best way to address how you’re feeling about the world, your plan, your future, your family, and, make sure you’re on track, on, on target. That’s that’s what we’re here for.

Well, thank you, Don. And thank you everyone for joining us today and lending us an hour of your time. A replay of our conversation is gonna be posted on our website at merceradvisors dot com in the insights section. If for any reason, one of your questions today was not answered live, please feel free to reach out to your adviser team.

We are here. We’re ready to help. And I know I speak for our entire advisory team here at Mercer Advisors when I say that we really do consider it a great privilege and honor to be trusted with your hard earned wealth. We don’t take that responsibility lightly.

And so, we appreciate all of you for being clients of the firm. And we will see you back here next quarter. Have a great rest of your day.