The Margin of Safety Quarterly Summer 2021
Second Quarter 2021 Key Takeaways
- Global equities continued to generate good returns, generally double digits for the first half of 2021
- U.S. value stocks continue their strong outperformance relative to U.S. growth stocks, which started in 2020, year to date
- Core U.S. bonds had strong returns for the quarter, 2%, but returns are negative for the year and our flexible fixed income managers continue to outperform
- Inflation expectations are getting a lot of media attention and we discuss our thoughts in the newsletter
- Our multi-strategy alternatives position continues to add to portfolio returns, handily outperforming core U.S. bonds year to date by over 6%
- Our international bond position outperformed core U.S. bonds for the quarter but returns are still negative year to date
Second Quarter 2021 Investment Commentary
Equities around the globe continued to surge in the second quarter. The U.S. and developed international markets led the way, with the S&P 500 Index gaining 8.5% and developed international stocks rising 5.7%. Emerging-market stocks trailed in terms of progress on the COVID-19 front and in turn rose by a more modest 4.9%.
Within the U.S. stock market, the rotation from growth to value stocks took a pause during the quarter, with the Russell 1000 Growth Index gaining 11.9% versus a 5.1% rise for the Value index. Smaller-cap value stocks slightly outperformed their growth counterparts and have been the top-performing segment of the U.S. market this year. Year to date, however, value stocks continue to have better returns than growth stocks, large and small.
In fixed-income markets, the 10-year Treasury rose as yields dipped below 1.50% in June, ending the quarter at 1.45%, down from 1.75% at the end of March, despite higher inflation readings during the quarter. This contributed to a solid 2.0% return for the core bond index. In fact, inflation fears were felt more strongly last quarter, and core bonds remain down 1.6% for the year as a result of the first quarter selloff. Flexible actively managed bond funds also posted solid gains for the quarter in the 2% to 3% range. Floating-rate loans were up 1.5%, which we use in our more conservative portfolios.
Our multi-strategy alternatives position, funded partially from core bonds, continued to outperform core bonds, generally in line with core bonds for the quarter but returning over 4% year to date versus negative bond returns.
As COVID-19 vaccinations and immunity spread across the globe, we continue to expect a strong global economic recovery contributing to healthy corporate earnings growth. This should bode well for riskier but higher-returning asset classes over the near term (next 12 months) at least. Credit markets should benefit as well. Even though the Federal Reserve is now signaling it is moving closer to beginning to taper its quantitative easing asset purchases, monetary policy and interest rates should still remain accommodative for a while.
Our portfolio positioning reflects this view, with a modest overweight to global equities in most portfolios. We believe non-U.S. equities, which are generally more economically sensitive and trading at cheaper valuations, are likely to outperform. From a valuation perspective, emerging market stocks are also attractively priced, and we have meaningful allocations in client portfolios. We also have meaningful allocations to flexible bond strategies, managers that can invest in a range of fixed income securities. Given current low interest rates, our research indicates that the flexible strategies will do better than core bonds, as well as floating-rate loan funds that are not sensitive to rising rates. Although our international bond position has more price fluctuations due to currency movements, the position will benefit from a weaker dollar and the current yield is attractive, over 5% on a trailing basis.
Inflation is a topic that we continue to get questions about, from clients and prospects. Inflation is also getting a lot of attention in the media, which can be good and bad, depending on your perspective. We shared detailed comments on inflation last quarter and given the importance and interest in this topic, we are providing additional thoughts in this newsletter.
On the major question of whether recent signals are harbingers of a sustained period of meaningfully higher inflation, we believe it is too early to tell. Based on our research and discussions with investors we trust, the current base case is that inflation does not get out of control. The U.S. economy still appears to have significant slack before aggregate demand would start overwhelming the economy’s productive capacity (the supply side), leading to the economic “overheating” that could cause significant, sustained, and broad-based inflation. Some inflation is necessary for economic growth – without it, an economy is stagnant.
The labor market is a key supply-side indicator. There were nearly 8 million fewer non-farm jobs at the end of May compared to February 2020. Meanwhile, more than 9 million people are currently unemployed and potentially available to work immediately.
While there have been recent reports of businesses unable to hire enough workers, this looks to be driven by temporary factors related to COVID-19. As long as there is slack in the labor market, wage inflation is unlikely to surge. This means there is low risk of a wage-price spiral such as the United States experienced in the 1970s.
Meanwhile, consumer price index (CPI) inflation numbers have been surprisingly high recently, and longer-term CPI inflation expectations have increased from their pandemic lows. That said, they still remain well within their 20-year historical range and consistent with the Fed’s long-term 2% core inflation objective. Digging deeper into the numbers reveals that some of the bigger drivers (like spiking used car prices and a sharp rebound in prices for travel and leisure services) are clearly driven by pandemic disruptions and the economy reopening. In all, we think it is more likely that most of the recent sharp price increases will prove temporary, as current supply shortages catch up to demand as the pandemic recedes. The Fed recently used lumber prices as an example of this, as prices have declined materially from their high as supply has increased and demanded lessened due to higher prices.
The path of fiscal policy in the United States is less certain, given the political dynamics and polarization. The expiration of the pandemic support programs will turn from a fiscal boost to a fiscal drag later this year and in 2022. But this should also lead to increased labor supply, mitigating wage inflation pressures.
With the likelihood of a U.S. recession very low—absent a severe external shock—we see low risk of a near-term bear market. Of course, 10%-plus stock market corrections can and will occur. A recent Schwab study looking at the time period 2000-2019 noted that a 10% pull back occurred in 11 out of 20 years or 55% of the time. However, in that same time period, full year U.S. returns were negative only 5 out of the 20 years. As we move further into the U.S. earnings cycle, the odds of a typical mid-cycle market correction increase. The periods of price declines allow our active stock managers to buy good companies at attractive prices. But despite elevated S&P 500 valuations and a likely deceleration in S&P 500 earnings growth, we believe global equities have additional return potential in this market cycle. More specifically, we continue to see superior shorter- to medium-term return prospects in developed international and emerging equity markets, where earnings have more room for positive surprises and valuations are more reasonable. We are starting to see more written about attractive valuations outside the U.S., including a recent Barron’s article on European equities.
As always, though, equity investors should be prepared for a bumpy ride. The bumpy ride is why we spend significant time talking with clients and prospects about their temperament, the ability to stay with a long-term investment plan, when the inevitable “bumps” appear. We also talk with our clients regularly about their cash flow and cash flow needs, to ensure that they have adequate reserves outside of their long-term portfolio, so that dollars do not need to be raised from a portfolio when stock prices are lower.
Closing Portfolio and Market Thoughts
While our base case is positive, the range of possible outcomes is always wide, and these are far from ordinary times. As a result, when constructing portfolios, we do not focus on positioning for a single outcome even if our analysis suggests it is more likely. We are tilted modestly toward reflationary, return-generating assets. We remind clients and prospects that we talk with, that stocks are a good inflation hedge, if inflation is not unusually high. Company profits and stock valuations can do well in a low to moderate inflation environment, which generally leads to higher prices. This is why stocks are needed in a portfolio for almost all individuals, to provide growth above inflation and to maintain the purchasing power of their long-term assets. But we acknowledge there are scenarios that could drive inflation to be higher and occur sooner than we expect. There could also be shorter-term deflationary shocks like more-dangerous COVID-19 variants or political unrest that leads to a market correction or worse.
While a sustained period of high inflation would be bad initially for most equities, over time many areas would likely do well, including emerging-market and value stocks, areas that we have meaningful allocations to in our global portfolios. In the event of a macro shock and deflationary pressure, we maintain meaningful positions in core bonds, which would help offset declines elsewhere. Put simply, we are diversified, as always.
Potential Tax Changes
Confusion remains around the prospect for tax hikes related to President Biden’s ambitions for infrastructure and other spending. While a bipartisan deal was announced on more-modest infrastructure spending that used means other than tax increases to raise revenue (some would joke smoke and mirrors), a second spending package is also under consideration that would employ some of the tax proposals of the original American Families Plan announced back in April. Those include an increase in the top federal tax bracket to 39.6% for families earning more than $400,000, an increase in the capital gains tax rate for those with annual income above $1 million, and the elimination of the 1031 like-kind exchange rules for real estate.
Specifics have and will continue to change amidst the sausage making of legislation, including around the effective date of any tax changes. And it’s no certainty that anything will pass, given the slimmest of margins in the Congress for the Democrats. Still, the possibility exists that one or both measures could be passed along party lines using the “reconciliation” process, which would not require bipartisan support. What that would look like in final form will not be known for some time. We continue to monitor the tax situation and are talking with clients about provisions that may impact them. Tax planning is made more difficult when we do not know what the law will be nor the effective date.
River Capital Advisor News
We are always looking to improve our range of client services and expand our trusted network of like-minded financial professions. We are pleased to announce that RCA is now part of the Garrett Planning Network. As our clients know, RCA is also a member of NAPFA, the National Association of Personal Financial Advisors. Garrett member firms must be “fee only”, which means the firm receives no commissions or any other compensation from anyone other than our clients. RCA has been fee only since its inception in 1998. Garrett firms are also financial fiduciaries, which RCA has also been since its inception in 1998 – being a financial fiduciary means that we are ethically and legally obligated to place the best interests of our clients ahead of our own. Being independent and a part of Smoak, Davis & Nixon, LLP, CPAs and tax advisors, results in RCA being the exception and not the norm in the financial services industry.
The firm recently added Candis B. Brinkley to our team, as a Client Service Specialist. Candis has over six years of client service experience mostly in the banking/financial services industry. As RCA continues to grow, we want to ensure that our clients continue to experience superior client service.
We are humbled by the client provided referrals we receive. We are not the right advisory firm for everyone. However, for individuals who are looking for a fee only, independent, objective, financial fiduciary to help them prudently plan their financial life, to put them in a position to achieve their financial goals and be able to help them in all areas of their financial and tax life, we welcome the opportunity to discuss how we can help.
Stay cool for the summer!