The Margin of Safety Quarterly Winter 2021

 In Client Bulletins, News

Fourth Quarter 2021 Key Takeaways

  • The S&P 500 continued to gain in the quarter compared to muted returns in most other global assets classes
  • COVID concerns increased as the highly contagious Omicron variant is discovered and spreads around the globe
  • Inflation seems less transitory and averaged 7% for the year, the largest 12 month gain since 1982
  • Treasury yields are still muted with the 10 year at 1.5% at the end of the year
  • Credit sensitive bonds did well as the economy continued to recover
  • Tax policy for 2021 did not change as some had feared, Build Back Better Act fails to pass
  • Large Bipartisan infrastructure bill did pass which should lead to more Federal spending over next several years

Fourth Quarter 2021 Investment Commentary

It’s been another remarkable year for most stocks in general and the U.S. stock market as embodied by the S&P 500 Index in particular, with the index of large-cap U.S. stocks returning a stunning 28.7%. U.S. small-cap stocks were up a still substantial 14.8% (Russell 2000 Index), developed international stocks also did well up 11.3% (MSCI EAFE Index) while only emerging market stocks lagged, down 2.5% (MSCI EM Index) for the year. Much of the outperformance for the S&P occurred in the fourth quarter, with the S&P 500 gaining 11.0%, compared to 2.1%, 2.7%, and -1.3% for small caps, developed international stocks, and EM stocks, respectively.

A strong dollar, the renewed surge in COVID-19 infections late in the year (particularly in Europe and emerging markets), and China’s policy-induced economic slowdown and stock market decline drove the disparity of returns. The MSCI China Index sank 21.7% for the year and lost 6.1% in the fourth quarter. Chinese stocks comprise roughly 35% of the MSCI EM Index. The MSCI EM ex-China Index gained 10.0% for the year.

Turning to the bond markets, the core bond index (Bloomberg US Aggregate Bond Index) lost 1.5% for the year, as interest rates rose moderately. The benchmark 10-year Treasury bond yield ended the year at 1.51%, compared to a 0.92% yield at the end of 2020. Given the very sharp rise in inflation, most pundits would not have predicted such a mild increase in bond yields. Finally, credit markets fared much better than core bonds in 2021. The U.S. high-yield bond index returned 5.4% (ICE BofA ML High Yield Cash Pay Index) and the floating-rate loan index gained 5.2% (S&P/LSTA Leveraged Loan Index). These returns were consistent with our expectations for a recovering and growing economy.

Investment Outlook

As always there are a lot of different things that can happen but if we assume a few items:

  • That the pandemic recedes in significance over the next year but doesn’t disappear,
  • That the global economy slows but that growth continues above average,
  • That U.S. interest rates rise modestly because U.S inflation is contained.

The above would be a positive scenario for the economy, global equity and credit markets, although not for the core bond market.

However, even in the best case, it likely won’t be a smooth journey: The pandemic remains uncontained, domestic and global political and social tensions are elevated, the risks of an economic policy mistake have risen, and any number of other bumps in the road (or worse) may occur. And were we to see a sharply inflationary environment that is well above current consensus expectations it would undoubtedly be damaging for both stocks and bonds, as interest rates rise and equity market valuations fall.

All these considerations (and more) factor into our analysis and current portfolio positioning. We would benefit nicely from our highest-conviction shifts (outlined below) in the case outlined above but our portfolios are also strategically balanced and well-diversified across a range of global asset classes, alternative strategies, and risk-factor exposures. This should enable our portfolios to be resilient should a shock outside the case above occur.

Overall, our portfolios are positioned with:

  • a slight overweight to global equities;
  • a large overweight to flexible, actively managed fixed-income funds;
  • positions in lower-risk and diversifying alternative strategies; and
  • a large underweight to core bonds (interest rate/duration risk).

Within our global equity allocation, we continue to maintain balanced allocations across the “value-blend-growth” style spectrum (either via active managers or diversified passive funds), with a bit more of a tilt to value than growth. We see potential for value and cyclical stocks to rebound (again) as COVID-19 recedes and interest rates rise. And value stocks in aggregate still look very cheap versus growth. But we also want to maintain exposure to high-quality, innovative growth companies with strong competitive advantages that are priced at lower valuations (there are still some out there). We do believe that some-times too much emphasis is placed on the growth versus value debate. The way we see it is that all of our managers want growth and a value manager is more concerned with how much they pay for growth than a growth manager is. A value manager’s portfolio may contain “growth” stocks like Alphabet (Google), Meta (Facebook), Netflix, and in fact many of our manager portfolios do.

Some have questioned why we continue to allocate globally when the U.S. market has been the strongest global market for a long period of time. This question gets asked more often in a period like last year when the U.S. index outperformed the developed international index by 17%! It is for the reasons outlined above regarding the unpredictability of global events that we don’t think we can try to pick the absolute winning market for a year. So many events last year could have led to very different outcomes. No pundits that we are aware of predicted that inflation would be surging in the country to its highest level in 40 years, that COVID would eclipse it’s previous peak set last winter, but that U.S. markets would be strong. As we outlined earlier there are a number of global events that could still shift dramatically. We think that global diversification helps smooth returns given the unpredictable nature of the environment we are in. We also continue to believe that it is better to buy assets where they are underpriced (Europe and EM) than put more money into an increasingly expensive U.S. market.

We have also received questions about Chinese exposure within our emerging markets position. China is a large part of the EM index, about 35% of the total. However, we feel that we have fairly minimal exposure as even in our most aggressive client portfolios our total EM exposure is 15%. So that means that no more than 5% of anyone’s portfolio is exposed to China. There are a lot of political problems with China now as it has cracked down on companies that it feels were abusing the system. These actions were unanticipated by the market and so a lot of money has been flowing out of China. However, there is reason for long term optimism (a growing population, high education levels, continued urbanization, to name just a few). China is also the second largest economy in the world—we are comfortable at the present with the minimal exposure we have to the Chinese market.

Our fixed-income positioning reflects the poor return outlook core bonds: The index is starting from a low sub-2% yield and interest rates are likely to rise over the coming quarters, at least until a recession hits. Our active, flexible fixed-income managers have a strong likelihood, in our view, of outperforming the index without taking imprudent risks. But we still maintain a meaningful core bond allocation in our more conservative balanced portfolios as ballast in the event of a recessionary scenario, which would hurt flexible, credit-oriented bond funds as well as stocks.

Finally, our allocations to alternative strategies are largely a substitute for some fixed-income exposure. Again, we believe these “alt” positions offer better return prospects plus beneficial diversification across a range of scenarios beyond a traditional recession where core bonds shine.

Planning Considerations

We have been hard at work helping clients with Roth conversions or backdoor Roth conversions late last year as we waited on Congress to decide if backdoor Roths were going to be allowed for high income earners or not. It looks unlikely now that the current tax law will change anytime soon, although we note that the current legislative environment in Congress can change quickly. We do not think that the “backdoor” to conversions will be open forever though. For those that have not heard the term, a backdoor Roth is completed by first contributing to an IRA and then immediately converting to a Roth. This is done for someone that does not meet the income limits for a making a direct Roth contribution. As always, the client’s tax professional should be consulted on this transaction. This is not a complete discussion of the income tax aspects of a backdoor and/or Roth conversion. If you want to know more about this planning strategy, please contact us.

Another planning area that is taking more prominence is efficient charitable giving. Since itemization is no longer something that is possible for most tax filers due to higher standard deductions, giving away dollars to charity using cash may result in very little tax benefit for most. We have been talking to many of our clients about different ways to give money to charity either through appreciated assets (like stocks), IRA distributions (only for those age 70 1/2 and older), or Donor Advised Funds (DAFs) which could allow for bunching. If you give a significant amount to charity (over $5,000) and want to discuss how to get a tax benefit for doing so, please contact us.

Finally, we have seen a number of people who were not using their Health Savings Accounts (HSAs) to their maximum benefit. HSAs are a great investment and financial planning tool. They have a triple tax advantage as money going in is tax deductible, the funds grow tax deferred, and if withdrawals are used for medical expenses, then it is tax free. This is not available on any other type of account. Too often we see where either an HSA is not setup when there is a qualifying high deductible health plan, the HSA is not funded, the HSA dollars are kept in cash, or current year medical expenses are paid from the HSA instead of from after tax cash flow.

Ideally, the HSA should be used as another investment account to grow into retirement and then be used for medical at that point. Also, what a lot of people don’t know is that their HSAs can be moved to any custodian for investment (even if not tied to a current employer), unlike a 401(k) plan. We now have the ability to offer HSA accounts directly at Schwab through a partnership with Optum Bank. If you think you have the ability to have an HSA and want to know more let us know.

Firm News

River Capital Advisors has been working on a number of exciting initiatives over the past several months. As of the time of the writing of this newsletter we are in the last stages of onboarding several 401(k) plans that will form the new Pooled Employer Plan (PEP) that River Capital Advisors will be able to offer to other employers. PEPs are a great way for employers to come together and get a better, cheaper, plan for themselves and their employees. We can now offer our services to individuals, small employers, and even medium sized employers.

Also on the 401(k) side we have been testing new software that will enable us to manage and report on 401(k)s and other accounts (other employer plans, HSAs, etc.) that in the past have been outside of our management. This will enable us to offer both current and new clients a more seamless way of helping them with this very important asset. This will enable the client to never need to provide us with any 401(k) information again or place any trades themselves after the initial setup! An employer 401(k) is a large retirement asset for many individuals and in our opinion, the 401(k) should be managed consistent with the other long term retirement accounts. If you are interested in this new service please contact us and we can get started.

Starting in 2022, we will be opening an office in sunny Miami! This is in conjunction with our affiliated CPA firm, Smoak, Davis & Nixon (“SDN”) and its expansion of its business consulting and advisory services. We think it is a great fit for us to have a presence in Miami with SDN, to bring business owners a one stop shop for all areas of their financial life. Of course Jacksonville will continue to be our home base.

Lastly, we are pleased to announce that effective January 1, 2022, Stephen Kyle has been promoted to the role of Senior Wealth Manager and Bradley Miller has been promoted to the role of Wealth Manager. Stephen and Bradley have both been with River Capital Advisors for almost seven years and their dedication to serving our clients has made them an integral part of the team.

Closing Thoughts

The last two years have been extraordinary in many respects. Amidst the COVID-19 pandemic and all the chaos it has wrought, we have been reminded that at some point everything becomes normal again. Maybe the normal that comes is different than the past normal that existed but it becomes familiar.

We hope that you too are finding some normalcy in your lives and were able to spend your holiday with your family and friends.

We are sure that the new year will contain more surprises and many reminders that markets commonly defy consensus predictions and confound investors in the short term. In the face of a deep drop in economic activity early in the pandemic, markets rebounded and have racked up remarkable gains since. More recently, as supply chain and labor market disruptions have been among the contributors to a spike in inflation, increases in bond yields have been surprisingly mild.

Of course, surprises that defy prediction happen in both directions, and this is why we maintain broad diversification and focus squarely on the long term, which can be analyzed with much higher confidence—even while we work hard day in and day out to understand how the never-ending stream of new developments will impact the portfolios we manage. We encourage you to leave this analysis to us so you can concentrate on trying to figure out your own way of creating the normalcy that we all want, whether it is going on a walk, going out to eat, or taking your first trip since COVID. We will get back to some version of how things used to be and possibly even better!

We wish you a happy and successful 2022! As always let us know if we can help in any way. For our clients, we are enclosing our annual Privacy Notice for their review.

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