The Margin of Safety Quarterly Winter 2023
- Markets had an extremely difficult year in 2022 and there were few places to hide including traditionally safer assets like bonds.
- Despite the likely volatility ahead returns in future years are now better given the drop in prices.
- Emerging markets and international stocks greatly outperformed U.S. stocks in the fourth quarter. Could this be the start of a turn for these markets?
- Value stocks did significantly better than growth stocks in 2022.
Quarterly Investment Commentary Fourth Quarter 2022
An extremely difficult year in the financial markets ended with a thud for U.S. stocks. After a 14% rally in October and November, the S&P 500 Index dropped 5.8% in December to close out the year with an 18.1% loss, its largest annual decline since 2008.
Foreign stock markets held up much better in the fourth quarter. Developed international stocks (MSCI EAFE Index) gained 17.3% – one of their best quarters ever — and emerging market stocks (MSCI EM Index) were up 9.7 %. For the full year, developed international stocks were down 14.5% in dollar terms (almost four percentage points better than the S&P 500), while EM stocks were down a bit more than the S&P 500 with a 20.1% drop. These annual returns were despite the U.S. dollar (DXY Index) appreciating 8.3% for the year, which reduces dollar-based foreign equity returns one-for-one. In the fourth quarter, however, the dollar dropped 7.7%, providing a tailwind to EM and international equity returns for U.S. investors.
Turning to the fixed-income markets, core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index, aka the “Agg”) had a solid fourth quarter, gaining 1.9%. But this was still the worst year for core bonds in at least 95 years, with the Agg dropping 13.0%. The key driver, of course, was the sharp rise in bond yields; the 10-year Treasury yield ended the year at 3.9%, up from just 1.5% a year prior. High-yield bonds (ICE BofA Merrill Lynch U.S. High Yield Index) had a strong fourth quarter, up 4.0%, but were down 11.2% for the year. Floating rate loans (Morningstar LSTA Leveraged Loan index) were the best segment within the bond markets, down less than 1% for the year. Municipal Bonds were down 8% (Morningstar National Muni Bond Category).
Alternative strategies and nontraditional asset classes generally outperformed traditional stock and bond indexes. The standout was trend-following managed futures strategies, which gained roughly 27% (SG Trend Index) for the year. Flexible/nontraditional bond funds (Morningstar Nontraditional Bond category) declined 6.3%, roughly half as much as core bonds.
Investment Outlook and Portfolio Positioning
Inflation and monetary policy remain the financial markets’ key macro focus. U.S. headline inflation data have improved, suggesting we’ve seen the peak in inflation for this cycle. Various measures of core inflation (i.e., excluding food and energy) have flattened, but remain at 5% or 6%, far above the Federal Reserve’s 2% target. The Fed’s message has been clear that it intends to maintain restrictive (tight) monetary policy throughout 2023. Indeed, at its December 14, 2022 meeting, the Fed raised the fed funds rate by 0.5% to a target range of 4.25% to 4.50%. It also forecasted 0.75% of additional rate hikes in 2023.
Inflation is not just a U.S. problem. Nearly all the other major global central banks (except Japan and China) are also continuing to hike interest rates in their countries. For example, both the European Central Bank (ECB) and the Bank of England hiked their policy rates another 0.5% in December. These synchronized global rate hikes will further depress global aggregate demand and economic growth over the shorter term. It’s also typically a headwind for stocks.
On the economic growth front, key leading indicators deteriorated further in the fourth quarter. The Leading Economic Indicator (below), which has a long track record of “calling” recessions, has fallen for nine consecutive months (and likely will again in December). This has never happened without an ensuing recession.
While we weigh the evidence as leaning strongly towards recession, there are some positives supporting the economy that should mitigate the severity of a U.S. recession if and when it happens. First and foremost, the labor market remains strong, enabling consumer income and spending growth; monthly job growth (nonfarm payrolls) has also remained solid, increasing by 263,000 in November; weekly new unemployment claims (a leading indicator for the labor market) remain low, though they are ticking higher.
Households also still have huge “excess savings” stemming from the pandemic – about $1.5 trillion (down from $2.3 trillion) that can support additional spending even as the Fed tightens. Business balance sheets are also generally in good shape, with many firms having refinanced their debt at low rates prior to this year’s sharp rise. More broadly, there don’t appear to be any major, systemic, economic/financial icebergs lurking under the surface, e.g., unlike in 2007-08 with the housing/mortgage derivatives market.
To the above list of macro positives, we would add a significant new development in the fourth quarter: the unexpected and sudden abandonment of China’s highly restrictive zero-COVID policy. Zero-COVID has been the key driver of China’s economic slump the past two years. But now the most repressive measures – mandatory testing, quarantines, community lockdowns and travel restrictions – are being revoked. The reopening of China’s economy for domestic consumers should be a catalyst for a growth rebound in 2023.
The bottom line is that a U.S. recession next year is not a certainty. But based on the evidence, we think it is highly likely. On the positive side, it should be milder than the 2007-08 and 2000-01 recessions.
At present, we believe the current price of U.S. Stocks (S&P 500 index) do not adequately discount the likelihood and severity of an economic and corporate earnings recession. This was our view one quarter ago, and since that time the S&P 500 has climbed a few percent while the economic data has worsened. Our analysis of past data on recessions, earnings declines and stock valuations suggest a real possibility of further double-digit declines in the S&P 500 from current levels. This is why we continue to believe our tilt to value stocks will benefit clients. Value stocks significantly outperformed growth stocks for the year. Value stocks were only off about 6% for the year versus the 18% drop experienced by the S&P 500.
Foreign stock markets and earnings are also at-risk from a U.S. and global recession next year. However, unlike the S&P 500, our five-year base case expected return estimates for developed international and EM stocks are reasonably attractive in absolute terms, ranging from the mid-single digits to the low-double digits, with EM the highest (see the table above). These returns are even more attractive relative to U.S. stocks and core bonds.
We continue to favor EM stocks based on their higher expected returns, which are a function of what we expect will be faster sales growth and improving profit margins over the next several years. This comes after more than 10 years of stagnant EM earnings growth. Monetary policy is also likely to start loosening next year across many EM countries as inflation comes down, which should be another support for EM equity markets.
Turning to our outlook for fixed income, given the sharp rise in yields, bonds haven’t been this attractive in over a decade. When estimating returns for core bonds (the Agg) over longer periods of time, the starting yield is a good approximation of subsequent returns. At year-end, the Agg was yielding 4.7% and our 5-year expected return for core bonds is now in a range of 5% to 5.6%. Moreover, we expect core bonds to deliver a positive return if a recession plays out, providing valuable downside protection while riskier assets such as stocks get hit. Beyond core bonds, there are other segments of the bond markets, including high-yield that offer attractive risk/return potential which we access via our selected active managers.
We also believe that there are attractive opportunities in the private market and we are starting to selectively add these for clients that do not need liquidity from all of their assets and who meet the requirements of these type of investments.
The most important thing is not to panic if markets do go down in the short term.
Secure Act 2.0 Changes for Retirement
Late in the year Congress passed new positive changes for people saving for retirement. The biggest change is that the age for required minimum distributions (RMD) has been pushed back again. For those that turn 72 after December 2022 they can now defer their first withdrawal until 73. The RMD age will eventually be 75 in 2033.
For those age 50 or older they can now contribute more to work 401(k) plans as the annual catch up limit (50 and older) has been increased to $7,500 and for those aged 60-63 they will be able to contribute $10,000 extra after 2024.
Also, for younger generations, employers are now able to match student loan repayments for purposes of computing 401(k) employer contributions. For businesses starting new employer plans, automatic enrollment is now a must with contributions of at least 3% for employees.
All of these changes should make it easier to meet retirement goals for those that can put away additional funds. Also, the change to RMD age helps allow for more tax planning opportunities.
What is Long Term Care Insurance and Do I Need It?
At River Capital Advisors, we specialize in a lot more than just investments. One of the areas that we help many of our clients on is uncovering risks and helping to insure against loss.
Long term care insurance is one of these products that can be helpful for those that do not have adequate funds to self insure but also have the ability to pay the premiums without it being a burden.
Long term care insurance pays for care for an extended period of time for someone that can’t take care of themselves. This care can be provided in a facility, like an assisted living facility or nursing home or under many policies in the person’s home.
We find that typically the best candidates for the insurance are between those between the ages of 55 and 62 and have between $750,000 and $3,000,000 of liquid assets. For those with less assets, they can spend down and qualify for Medicaid. For those with more, they can often pay for the cost out of pocket.
Premiums typically range from $3,000-$7,000 annually. This sounds like a large amount until one looks into the cost of a typical nursing home stay which can be around $100,000 a year!
We can help you evaluate this important topic and provide an objective opinion as part of your overall risk and financial plan. Let us know if you would like more information.
How Much Should I Be Saving for Retirement?
Many times we are asked about how much someone should be saving or have accumulated in assets by various ages and the answer as with many things is that it depends. For starters the savings need is very dependent on what you earn and what you expect to be able to spend in retirement. The more that you earn—which also usually equals to more that you desire to spend in retirement—the more that you will need to save.
If we start from the end in mind for each $1,000,000 that you have saved you will be able to spend around $40,000 a year in retirement from your portfolio. So if you earn around $200,000 a year and want to keep a similar lifestyle you will need to have saved around $2,500,000 by retirement. This is based on a married couple, receiving Social Security for each spouse and needing $100,000 per year from their portfolio. This can sound very daunting but is very doable, especially if you start early.
On average if you start saving at an early age (in your twenties) then you can probably save around 10% of your wages and have enough to retire by the time that you are 65. This savings percentage increases with age and by someone is in their thirties, it has increased to 15%-20% needing to be saved. If you are in your forties, then savings probably needs to be at 25%-35%. However, it is never too late to start and there are always options available, such as delaying retirement a few years or spending less in retirement.
We also find that retirement means different things for different people. We see many people that want to have part-time jobs into their late sixties and sometimes even seventies. There is no right answer on what your retirement has to look like. The old viewpoint that retirement equaled sitting on a beach and enjoying your golden years is changing. Many find that they desire some purpose as the period that people are likely to be in retirement has lengthened. It used to be that a person might retire at 65 and expect to have only 10 years of good health and then maybe another 5 years of life after that. However, we see many people that are living in good health into their late eighties and in some cases nineties.
Although some may relish the idea of sitting on a beach for 20 years others would find that to not be stimulating enough. Whatever your retirement desire we can help you make it a reality. We look forward to helping you make your retirement dream become a reality!
Closing Thoughts & Firm News
As many of you know Ed Schmitzer, the founder of River Capital Advisors retired at the end of 2022. We wish Ed well in his retirement and hope that it is everything he wants it to be. We are grateful for his leadership and everything that we learned from him. Ed founded River Capital in 1998 with the vision of being a resource to clients in a world where conflicts of interest were high (and still are) and a desire to provide independent, objective, and fee-only advice. We carry on his belief in these matters and look forward to building on his legacy. We know that we have big shoes to fill and we don’t take our duty to our clients lightly.
As we move into 2023 we are working on many new exciting initiatives as a firm. One of which is the ability to manage 401(k) accounts for clients in the same way that we can manage internal accounts. We have already started doing this for a number of clients in 2022 and look forward to expanding this to more clients in 2023. Another relatively new ability is that we can offer 401(k) management for firms through a “Pooled Employer Plan”. If your company is wanting better service and better plan design contact us and we can provide a quote on this service. Finally, we are now able to offer more private investment offerings to our clients in partnership with some of the biggest names in investing (BlackRock, Blackstone, Ares, PIMCO, and others). These products can add return with limited additional risk. They are suitable for investors that don’t need immediate liquidity. We believe that the private market is an important extension of the public market and we want to be able to provide our clients with the same access that they could obtain with institutional advisory firms. We think that all of these new initiatives are additive to the strong base that we already have.
In terms of the markets, as 2022 has reminded investors, we should “expect the unexpected, and expect to be surprised.” This is expressed in our portfolio construction and investment management via balanced risk exposures, diversification, and forward-looking analysis that considers a wide range of potential scenarios and outcomes. We believe 2023 will likely present us with some excellent long-term investment opportunities. While challenging, it is critical for long-term investors to stay the course through these rough periods. The shorter-term discomfort is the price one pays to earn the long-term “equity risk premium” – the additional return from owning riskier assets such as stocks that most investors need to build long-term wealth and achieve their financial objectives.
We think the most important thing is to have a plan for your investments that aligns with your goals. If you have this and follow it you will reach them. We wish all of you well in the new year and hope it is a good one in all respects.