The Margin of Safety Quarterly Spring 2022
First Quarter 2022 Key Takeaways
- The biggest headline from the past quarter is Russia’s invasion of Ukraine. This has resulted in devastating human suffering and has also had an impact on the global markets and economy.
- The high rate of inflation and rising interest rates continue to also grab headlines.
- In positive news, COVID seems to be waning (only time will tell if this lasts), but it has nonetheless been a positive for the economy as consumers return to normal behavior.
- The big news out of Washington is the House of Representatives passed SECURE Act 2.0, which could enhance the ability for individuals to save for retirement.
- In uncertain times like this, individuals tend to lose focus of their long term planning and instead focus on “noise”. We provide several thoughts on goal planning for clients.
First Quarter 2022 Investment Commentary
A lot has happened since our fourth quarter newsletter just three months ago. The biggest macro event is Russia’s brutal invasion of Ukraine. While the human impact has been devastating and tragic—and our hearts and support are with the Ukrainian people—our job is to focus here on the economic and financial market impact of this event.
It was a rough first quarter across the board, with stocks, bonds, U.S., international, and emerging markets all hurt by rising interest rates, inflation and the war in Ukraine. Global stocks (MSCI ACWI Index) fell 5.4% for the quarter. Among major global markets, the S&P 500 was a relative outperformer, dropping 4.6%, compared to a 5.9% loss for developed international markets (MSCI EAFE Index) and a drop of 7.0% for Emerging Market (EM) stocks. The relatively mild declines for the full quarter masked the intra-quarter volatility, where peak-to-trough declines were much larger.
Unusually, the damage was worse in the U.S. core bond market than the U.S. stock market. The benchmark Bloomberg U.S. Aggregate Bond Index (the “Agg”) fell 5.9% for the quarter. This was the second-worst quarter for the Agg since Q1 of 1980, when Paul Volcker’s Fed was in full-bore tightening mode. In the fixed-income markets outside of core bonds, high-yield (lower credit quality) bonds lost 4.5%, while floating-rate loans had just a 0.1% decline.
The COVID-19 pandemic is another wildcard but here the news has been getting better. Over time, the economic damage and disruption should continue to recede, which would support economic growth and mitigate some of the inflationary pressures coming from supply chain disruption and the subpar recovery in the U.S. labor force participation rate. Unfortunately, this also has contributed to higher U.S. wage inflation and increased the risk of a self-reinforcing wage-price spiral taking hold.
We continue to believe that a range of scenarios and outcomes are plausible. We construct our client portfolios to be balanced, diversified and resilient across this range. We also proceed with a large dose of humility. The future is inherently uncertain. We should be prepared (expect) to be surprised again and again as events unfolds. As Nobel Prize winner Daniel Kahneman put it: “The correct lesson to learn from surprises is that the world is surprising.” In short, we want to build portfolios that are resilient in the face of surprises rather than ones whose success depends on predicting them.
Our job as a long-term investor for our clients is to sift through the shorter-term market noise, stand back from the emotional whipsaw of the day-to-day headlines, and remain focused on the interplay between underlying economic fundamentals and the financial markets’ current pricing. The key question for a fundamental investor is, what’s in the price? What consensus expectations and assumptions are implicitly being discounted in current market prices? And then, do we have a different view? If so, what is the basis for that view, and do we have high conviction based on our research, analysis and judgment that we have a high probability of being right and the market wrong?”
When we gain conviction that the current market pricing is significantly out of whack with our view of the fundamentals, as expressed across our range of plausible scenarios, we will tactically re-position our portfolios. Otherwise, we stay the course, confident that our portfolios have a well-diversified balance of defensive assets (depending on the portfolio risk profile) able to withstand shorter-term negative outcomes or shocks, and riskier “offensive” assets that are the primary long-term return generators and wealth builders.
For our equity allocation, our philosophy has always been to tilt towards fund managers that care more about the underlying fundamentals of the companies they are investing in (strong balance sheets and profitability, strong corporate governance, and a long term growth focus) versus companies that grow for growth’s sake without any underlying fundamentals to support the price being demanded on the market.
While growth strategies have outperformed value strategies over the past 10-plus years (as measured by the Russell 1000 Growth versus the Russell 1000 Value indices), it is important to remember that value strategies have outperformed growth over the past 100 years of market history. While value is slightly negative year to date in 2022 (Russell 1000 Value Index), we also may be seeing a turnaround as value has outperformed growth (Russell 1000 Growth Index) by over 8% year to date.
Only time will tell if this represents a long-term shift in markets. This is another reminder for investors that looking in the rearview mirror (past performance) is not a good way to determine a successful long-term investment strategy.
In terms of our fixed-income allocation, our tactical positions in flexible, actively managed bond funds and floating-rate loan funds again added value relative to the core bond index from which the positions are funded, although they posted absolute losses. This was not surprising given the interest rate and credit market backdrop during the period, with Treasury yields sharply rising and corporate bonds spreads widening.
We think this serves as another good reminder to investors that not all bond strategies are created equal. In a rising interest rate environment, longer dated bonds are going to be hurt the most and will lose value as investors would rather buy short-dated bonds that can take advantage of higher yields. If you were to invest in the core bond index (Bloomberg U.S. Aggregate Index), the effective duration or maturity is approximately 6 1/2 years. We will never completely eliminate core bond exposure in our client accounts (for those that are not in 100% stock profiles) as they serve a defensive purpose, but the fund managers we use have a duration shorter than the core index which will help reduce (but not eliminate) the risk of rising rates. As the underlying bonds in these funds mature, the cash can be reinvested in higher yielding bonds more quickly.
Some of the biggest news to come out of Washington in the past month surrounds the Securing A Strong Retirement Act (SECURE 2.0). At the end of 2019, Congress passed the original SECURE Act which changed many rules for saving for retirement and withdrawing from retirement accounts including:
- Delaying the required beginning date for required minimum distributions for qualified retirement accounts to age 72 (from age 70 1/2);
- Allowing individuals to contributing to their IRA past age 70 1/2 as long as you have earned income (previously this was prohibited); and
- Changing the mandatory distribution rules for inherited IRAs (when inherited by a non-spouse beneficiary) to a 10-year distribution requirement from the year the original account owner died
SECURE Act 2.0 passed the House of Representatives by almost unanimous consent on March 29, 2022. If passed by the Senate and signed by the President, this Act would take many of the provisions from the original SECURE Act further, including:
- SIMPLE IRA plans (usually setup by small business owners) would now allow for Roth contributions;
- Changing all “catch-up” contributions to qualified retirement plans to now be subject to Roth tax treatment (as opposed to being able to choose between pre-tax or Roth treatment);
- Creating automatic enrollment for employees in 401(k) and 403(b) retirement plans;
- Increasing the required minimum distribution age for qualified retirement accounts to 75 (this would be phased in over several years); and
- Allowing employees to pay down their student loans (in lieu of retirement plan contributions) while still receiving an employer match to their retirement plan.
Only time will tell what the final version will be, but we think it is very likely that this bipartisan act will pass with many of the provisions currently being considered. Overall this will probably be a positive for individuals and families trying to reach their retirement goals.
The 2021 tax filing season is rapidly coming to a close (except for those who have filed extensions) and we wanted to provide a few quick reminders to help clients with their tax planning in the upcoming year.
- If you received a large refund—Consider decreasing your withholding if you are a W-2 employee or decreasing your quarterly tax estimates if you do not otherwise have withholding on your regular income sources. The IRS will not pay you interest for the time they held onto “your” money, so it’s better to pay yourself than give the U.S. government an interest-free loan. Consider taking this extra cash flow to bolster your cash reserves, save for a short-term goal, or add to your long term investments.
- If you owed taxes and you expect your income to remain higher—Now is the time to consider increasing your W-2 withholding, quarterly tax estimates, and/or both. If you are a W-2 employee, you need to contact the HR or payroll department at your employer to ask for a form W-4 to elect a proper withholding amount. If you pay quarterly tax estimates, consult with your tax advisor on how much you need to pay to remain in the IRS “safe harbor” to avoid penalties for underpayment.
- Maximizing retirement savings—We often get asked by clients how they can reduce their taxes today. One of the best ways you can do this while paying your future self is to maximize your pre-tax retirement contributions. This is especially true for those in a high income tax bracket (24% or more). If you are in a low income tax bracket, you may want to consider Roth contributions if this is an option.
- Use your Health Savings Account wisely—Most Americans underutilize their health savings account if they have access to one. They will either use it to pay current medical expenses, keep the account in cash, or they will not contribute to it in the first place. An HSA is the only savings vehicle in the U.S. that allows you to receive a tax deduction for contributions (employer contributions do not receive a deduction), receive tax deferred growth on investments, and can be utilized for tax-free withdrawals when used to pay for qualified medical expenses (even years into the future). You are required to have a high deductible health plan in order to open an HSA and those enrolled in Medicare cannot contribute to an HSA (although the account can still be used to pay for qualified medical expenses).
- Make tax efficient charitable gifts—Did you make material charitable gifts last year only to receive little to no tax deduction? Many individuals who already plan to give to charity may not be able to receive a tax deduction for their charitable gifts if their itemized deductions do not exceed the standard deduction ($12,950 for single filers and $25,900 for married filing jointly in 2022; the deduction is higher for those 65 and older and blind tax filers). Many options exist for making tax efficient charitable gifts such as donating appreciated stock, making qualified charitable distributions from an IRA, and establishing a donor advised fund. If you are interested in learning about ways that you can make your charitable giving more tax efficient, let us know. Note: donating to charity just to receive a tax deduction (just as with any business expense or personal expenditure that can be itemized on taxes) is not financially optimal if you wouldn’t have otherwise made that expenditure.
We have the experience and knowledge in tax planning areas to help you find optimal tax planning strategies for now and the future. If your current tax advisor is not helping you in this way or if you would like us to partner with your tax advisor in ensuring you have optimized your future tax planning, let us know.
Our society is very focused on the here and now which is evidenced by the plethora of advertising on television, the internet, social media, and more. It doesn’t help that these outlets encourage individuals to have things now without giving any consideration for how this affects one’s ability to meet their intermediate and long-term goals.
At any stage in life, there is planning you can do now to help you reach your goals, whether that be purchasing a car or home, funding a child or grandchild’s college education, aspiring to reach a goal of financial independence, or planning for how to give to the next generation while reducing taxes paid (both income and estate). This can be accomplished by:
- Listing out your short-, intermediate, and long-term goals;
- Assigning priority to your goals (perhaps it’s more important to you to go on a family vacation each year than live in the biggest house);
- Planning for emergencies by having an adequate cash reserve;
- Establishing a plan to reach your goals including determining what needs to be set aside in savings today to take advantage of the power of compound growth;
- Focusing on what you can control and ignoring short term noise such as media outlets, social media, and other societal pressures; and
- Working with professionals like River Capital Advisors and our affiliated CPA firm, Smoak, Davis, & Nixon, to help you build your financial plan and reduce your taxes.
We are actively trying to engage our clients in helping them plan for their current and future goals (whether it be cash flow and debt management, retirement, education, tax, investment, and/or estate and legacy planning). If you have not begun in-depth planning with us, we encourage you to contact us to establish a financial plan to help you reach your goals, protect your family, and reduce taxes. For many of our clients, we include this planning at no additional cost.
We are excited to announce that Rob Simon, the Vice President and a Partner, in River Capital Advisors has recently achieved the designation of Chartered Advisor in Philanthropy® (CAP®) in addition to already holding the CERTIFIED FINANCIAL PROFESIONAL™ designation. The CAP® designation further enhances Rob’s ability to collaborate with clients on their legacy goals including charitable planning strategies. He is additionally working towards his Masters of Science degree in Financial Services and the Accredited Estate Planner® (AEP®) designation. These additional designations and education will further enhance the ability of River Capital Advisors to collaborate with clients in any area of their financial lives.
As a client of River Capital Advisors, we like to say that when you hire us as your advisor, we work for your family. If you have any family members who can benefit from speaking with us about establishing good financial habits, deciding what employer group benefits are needed, and reaching long term goals, we welcome the opportunity to speak with them.
Graduation is coming up for high school and college students and we would love to send you a free copy of the book The Psychology of Money by Morgan Housel for your graduate (or yourself personally). This book contains timeless lessons about money, greed, wealth, and happiness that anyone would enjoy reading. For those with younger children or grandchildren, we also will be glad to send you a free copy of The Four Money Bears that teaches young children (ideally ages 5-12) about how you can wisely use money: to spend, to give, to save, and to invest. This book was written by a CFP® that we personally know and it’s a great primer for children on how to use money!
We greatly appreciate the client referrals that you provide to us. This is an indication to us that the services and planning we have provided to clients since 1998 are greatly valued. If you know anyone who can benefit from our services, please do not hesitate to refer them to us.
The war in Ukraine has caused massive human suffering. From an economic and investment perspective, it has added to already-high uncertainty, degraded the near-term growth outlook, and added additional fuel to the inflationary fire. Crises, as painful as they are, often create opportunities. However, the equity and fixed-income markets have reacted quickly to the headlines, and as currently priced aren’t offering any compelling new top-down tactical asset allocation opportunities, in our view.
We will continue to provide our clients exceptional value both in investment management and financial planning so they can reach their goals. River Capital Advisors has existed for almost 25 years and has experienced many macro events during this time that have shaken the economy, markets, and the personal lives of our clients. Our goal is to be that calm, guiding voice in uncertain and stressful times so you can reach your financial goals and focus on what you desire to do most.