The Margin of Safety Quarterly Fall 2021
Third Quarter 2021 Key Takeaways
- The S&P 500 hit an all-time high during September
- However, the S&P 500 quickly sold off after the high due to concerns about the delta variant, the federal debt shenanigans, to name two concerns
- Global value stocks, large and small, continue to outpace global growth stocks
- U.S. bonds were flat for the quarter, little change to yields
- Credit sensitive bonds continue to outperform core bonds
- Inflation continues to be top of mind
Third Quarter 2021 Investment Commentary
A September slump put a pause on the global equity bull market. The S&P 500 Index dropped 4.7% for the month, developed international equities (MSCI EAFE Index) fell 2.9%, and emerging-market (EM) stocks (MSCI EM Index) dropped 4.0%. For the third quarter, the S&P 500 was up just 0.6%, MSCI EAFE was down 0.4%, and EM stocks declined 8.1%. Year to date, the S&P
500 is up an impressive 15.9%, MSCI EAFE is up 8.3%, and the MSCI EM Index is down 1.2%. Our EM stock managers continue to outperform the EM benchmark, both for the quarter and year to date, with our EM value position generating just under a 12% return year to date.
Value stocks, which we have meaningful exposure to globally, continue to earn good returns. Value stocks outperformed growth across the U.S. market cap spectrum. Value stocks outperformed growth during September, with smaller declines. Value stocks continue to outperform growth across the U.S. market spectrum year to date as well. Outside the U.S., the trend continues with foreign large and small cap stocks outperforming their growth counterparts in September and year to date.
The culprit behind the poor emerging-market stock benchmark return is China (more on this below). The MSCI China Index was by far the worst-performing stock market in the third quarter, down 18.2%. For the year to date it is down 16.7%. Chinese stocks comprise roughly 35% of the EM equity index.
In the bond markets, core bond returns were essentially flat, and yields were
little changed for the quarter. But it was a roller-coaster ride, with the 10-year Treasury yield plunging below 1.2% in early August, and then shooting back up in the last two weeks of September. Credit-sensitive bond segments outperformed core bonds, and for the year to date, core bonds are now down 1.6%. High-yield bonds and floating-rate loans are up 4.6% and 4.4%, respectively.
Our international bond position was down slightly more than U.S. core bonds, down 2.65% for the quarter. Our multi-strategy alternatives position was slightly negative for the quarter, but
year to date it is comfortably ahead of U.S. core bonds, from which it was partially funded.
Last quarter we summarized our view that higher inflation is more likely a transitory effect of COVID-19 and supply-chain disruptions versus the start of a new regime where higher wages and inflation create a damaging inflationary spiral. We do expect modestly higher inflation in the years ahead but it is not a significant concern.
In all, we are satisfied that our portfolio positioning, which includes allocations away from core bonds in favor of flexible credit strategies and liquid alternatives, is appropriate for a return to more historically normal levels of inflation in the years ahead. We will continue to monitor inflation closely and adjust our views and positioning as needed.
A new concern that emerged in the third quarter is around the excessive borrowing in China’s property sector and within Evergrande Group, one of the country’s largest property developers. Moreover, this has come amidst other regulatory crackdowns in China (such as in the for-profit education industry).
We are following these events closely as part of our ongoing research on China and emerging markets. Thus far, based on the research and discussions with investors that we trust, we are of the view that these risks will be contained, and therefore we are not currently contemplating any changes to our portfolio positioning. Looking further ahead, the short-term pain could result in new opportunities for investors in China.
We take higher risk into account when assessing the relative attractiveness of equities outside the U.S., such as emerging markets, by requiring a significantly higher extra return (return premium) than we would for a less volatile asset class.
We remain comfortable with our current emerging markets allocation after considering the risks we see in China along with the diversification benefits and long term return potential it brings. Portfolio position sizing and the managers we use are also considerations for our client portfolio construction. For EM, our managers have slightly less China exposure than the 35% weighting in the benchmark. In addition, for our balanced portfolios, EM equities range from 5-11%. Using 30% as the China allocation based on the most recent portfolio statistics available from our managers, our equity exposure to China is less than 5%, which we think is reasonable. Ultimately the reality in investing is that information like the problems facing Evergrande is quickly priced in (and more often over-priced in). So, the question is whether this is a shorter-term disruption or whether it is revealing a more fundamental long-term change that deserves to impact our long-term risk and return assumptions. Below are some additions comments on Evergrande.
A catalyst for the Evergrande related turmoil is the Chinese government’s steps to rein in speculation that they believe is leading housing to become increasingly unaffordable, which is contrary to their long-term sustainability goals, such as reducing inequality. This in turn is surfacing issues related to excessive leverage in the property sector that have built over many years. We are focused on understanding how large the problem is and whether China will manage this adjustment well.
At present, it appears to us that a Lehman like disruption locally in China or globally is unlikely. (The 2008 collapse of Lehman Brothers set off a negative chain reaction in the financial sector.) For one, we don’t see the same feedback loop between China’s property sector and the global economy. In addition, Chinese citizens have a lot of wealth tied up in property, so it is in the government’s interest to avoid a chaotic wave of defaults and the government has the means to stabilize the financial system since it is the majority owner. A more orderly restructuring still seems the more likely scenario.
Closing Portfolio and Market Thoughts
Our base case for the next several years remains relatively sanguine, as we expect the economic and earnings growth cycle, interest rates, and government policy to remain broadly supportive of equities and other risk asset markets. However, our analysis also suggests we should be prepared for an extended period of lower absolute investment returns—certainly, in our base case, much lower for U.S. stock and core bond market indexes than the last five to 10 years. (The S&P 500 has gained 17% annualized over the past 10 years and core bonds are up 3% annualized.)
Absent significant further U.S. equity valuation expansion (higher price-to-earnings multiples), from already near-record-high levels, double-digit U.S. market annualized returns are extremely unlikely. Record low bond yields and above-trend earnings growth (driven by mega-cap tech/Internet leaders) have driven strong returns but mathematically and economically, that is extremely unlikely, if not impossible, to repeat over the next five to 10 years, given where we are now starting from in terms of yields, profit margins, and earnings growth.
Nevertheless, in our medium-term “upside” scenario we estimate still attractive upper-single-digit returns for U.S. stocks. And in our base case, while their absolute returns are uninspiring, we expect U.S. stock returns to be attractive relative to core bonds.
Meanwhile, expected returns for non-U.S. equities— EM equities in particular—remain attractive, which is the primary reason for our overweight to them versus U.S. equities. Our overweight to global value equity strategies should be a positive over the long term, given current valuations. Value stocks also traditionally do well in a reasonable inflation environment and should also perform well as global economies continue to reopen.
Income Tax Matters
On Saturday, September 25, 2021, the House Budget Committee voted to advance a $3.5 trillion spending package to the House floor for debate. Shortly thereafter, however, push back on the size and scale of the legislation and related tax proposals occurred and continues as we write this newsletter. Recent news flow indicates that the size of the spending package will decline to $2.0 trillion or possibly less, which should mean that the corresponding tax law changes will be less as well.
The recent proposal provides insight into what a future bill might include for tax law changes. Corporate rates are proposed to increase to 26.5% from the current flat 21% rate for corporate profits over $5 million and there is a proposal for personal service corporations to pay 26.5% on all of their taxable income. For individuals, the top rate is proposed to increase from 37% to 39.6%
for “high income” individuals. Capital gains are proposed to increase from a maximum of 20% to 25% (these rates are exclusive of the 3.8% net investment income surtax), effective for sales after September 30, 2021 (we expect this date to change with any new legislation). There is also a new proposal for a 3% income surtax when modified adjusted gross income is over $5 million.
The tax proposal also looks to expand the 3.8% net investment income surtax. Currently, there is a 3.8% net investment income tax on high-income individuals. This tax would be expanded to cover certain other income derived in the ordinary course of a trade or business for single taxpayers with taxable income greater than $400,000 ($500,000 for joint filers). This would generally affect certain income of S corporation shareholders, partners, and limited liability company (LLC) members that are currently not subject to the net investment income tax.
Changes were also proposed to limit contributions to ROTH and traditional IRAs when taxable income exceeds $400,000, provide for new required minimum distributions for large aggregate retirement accounts ($10 million or more) and prohibit ROTH conversions when taxable income exceeds $400,000 along with limitations on “back door” ROTH conversions.
Lastly, significant changes were proposed for estates and trusts: roughly reducing by half the current $11.7 million exclusion, inclusion of grantor trusts in the grantor’s estate at death, taxation of sales of appreciated assets to a grantor trust and, prohibition of valuation discounts for closely held businesses for gift/estate tax purposes.
The tax proposal and related negotiations will change some or all of what we briefly described above. We will continue to monitor the tax environment closely. As we know more, we will be discussing with various clients strategies to reduce future taxation. In particular we may want to accelerate Roth conversion strategies while we still can.
River Capital Advisor News
Developing a financial plan that is consistent with an individual or family goals has never been more important. Financial and non-financial environments change, sometimes quickly, and for our clients, we can help them think through and model the impact of changes in financial circumstances, spending and the tax law. Our financial planning website and related modeling tools are key to helping our clients achieve their financial goals. We work closely with our clients to develop a customized financial plan and although our clients are busy, they understand the benefits of investing the time and energy to provide the best information possible for their customized financial plan.
The firm recently added Andy Claudio, as an Associate Wealth Manager, to our team. He has been in the financial services industry for approximately 3 years and has passed the CFP® exam. He graduated from University of North Florida with degrees in Finance and Financial Services. As RCA continues to grow, we want to ensure that our clients continue to experience superior client service.
We know that we are not the right advisory firm for everyone. However, being 100% fee-only, being flexible in how we work with clients and our affiliation with the Jacksonville CPA firm of Smoak, Davis & Nixon LLP, along with being a financial fiduciary, makes us the exception and not the norm in the financial services industry.
Enjoy the cooler weather and stay safe!