March Market Update: February’s Swoon

March Market Update: Februarys Swoon

 

00:00:06 – 00:05:01

 

Welcome to Wealthy Behavior, talking money and wealth with Heritage Financial. The podcast that digs into topics strategies and behaviors that help busy successful people build and protect their personal wealth. I’m your host, Sammy Azzouz president of Heritage Financial, a Boston based wealth management firm working with business owners, executives, and retirees for longer than 25 years. Now, let’s talk about the wealthy behaviors that are key to a rich life.

 

Welcome to the March edition of the Wealthy Behavior podcast where I talk to our Chief Investment Officer Bob Weiss about what’s going on in the markets and the economy today. Bob, how’s it going? It’s going well Sammy. How are you? Pretty good. I feel like we’ve recorded maybe 7 to 8 versions of this podcast where we talk about the fed and inflation, the markets, and now we’re going to record another edition where we talk about the fed, the inflation, and markets. Is that the story is that the case is there more to say or are we just kind of muddling through this time period where we need to see how market shake out and how inflation goes and what the fed ends up doing? Yeah, I think that’s the case inflation is critically important to the financial markets to the economy. It’s not just some little side story. It’s we’re seeing heightened inflation that we haven’t seen in about 40 years and navigating through the economy is difficult. So, it’s definitely story and as I mentioned to you is I was in California last week and studying up on this a little bit. So, I think we can talk about it today, but hopefully it does become the past. We get back down to a more normal 2% level. Soon. So, what’s been interesting is January was very strong in the markets which we talked about last month and then February not so much in February swoon is what people are calling it and then lately the markets have been, I would say steadier and more resilient. So, one thing that is a little bit unique from my vantage point that I wanted to get your perspective on is it does seem like given all the concerns and the fed is hawkish and the fed is going to raise rates and inflation is not great and we may have a recession, etc., etc., the markets seem very resilient or surprisingly resilient. Are we whistling past the graveyard here or are there reasons for this resiliency? Assuming you would even agree that they have been resilient. Well, to start the year, they were, but yeah, February has been a little rocky. And, there were some somewhat concerning data points that came out in February related to heightened inflation and a strong jobs market. The unemployment rate is now down to the lowest level. It’s been since 1969 at 3.4%. And market’s been expecting to see that number actually go up, not see unemployment go down. And when you have a very strong jobs market that can lead to higher inflation, not disinflation, like the feds trying to accomplish. So that just seeing the data can point in the wrong direction in February did lead to a bit of a sell off. And any new data points in March or are we left with the February numbers at this point? February numbers at this point. February, inflation report is coming out in jobs and jobs February unemployment is this Friday that will be a big one. And then I think it’s next week is February inflation. So, within the next week, we’ve got two big numbers coming out. So, what did you learn on your trip to California, Bob? Yeah, so I was out there for the DFA dimensional fund advisers has a CIO forum for chief investment officers of some of their largest clients. And it was in Palo Alto because they had Professor John Corcoran join. John is a fellow at the Hoover institute, which is kind of like a think tank and also a fellow researcher at Stanford. Also, a member of the national bureau of economic research used to be a University of Chicago finance professor. And recently, he’s been doing a lot of work on inflation. He just published a book that’s almost 600 pages on inflation and it’s geared towards academics. He’s basically said, don’t read it, I’m not trying to sell it to you. This is for academics because we don’t know what causes inflation. And when you think about that, yeah, you have and our listeners can’t see your puzzle reaction. We don’t know what causes inflation. And we don’t. There’s been some work on it. Milton Friedman famous economist won a Nobel Prize in the 70s for his work. And his equation is that money supply times velocity of money equals change in price.

 

 

00:05:02 – 00:10:09

 

So basically, how much money is out there times velocity, how quick people turn it over, how quick they spend it. Equals inflation. So, as you have more money, you have higher inflation or as people spend more of higher inflation. And professor Cochran was saying, I love milled Friedman, but he’s wrong. He has a different view. So, his view is relates to he calls it the fiscal theory of the price level and it basically takes the dividend discount model for stocks, where you value a stock based on the present value of future dividends. And so as the change in the price level is to an extent discounting mechanism inflation of government deficits or surpluses. So, it’s looking at government fiscal action. So, running at a deficit and building up debt, leading to higher inflation. So, when you kind of unpack it a little bit and look at what’s been going on through COVID, the government basically created about $5 trillion of stimulus of deficits that were distributed through various programs in his theory is that that $5 trillion of new debt leads to inflation. As opposed to a $5 trillion increase in the money supply. But isn’t it the same thing? I mean, not to, I guess, I’m not going to read the 600-page book, so please just tell me to be quiet if you want. But isn’t deficit spending and borrowing to spend the same thing as increasing the money supply. It’s just more money in the system. So, what’s so unique? So perfect question. That’s the exact right question to ask. And where the test comes in is because either way you get inflation, whether it’s because I gave you $5 trillion or created 5 trillion, you have inflation. So, he and Milton Friedman would agree, you’d have the same outcome. His deference is to an individual level. If I give you a $1000. But then I went into your IRA and withdrew a $1000 of government bonds. What do you spend in change? And Milton Friedman would say, yes, because I increased the money supply the cash. He would say no because I paid for it by taking the bonds out. So, say that one more time, the government gives you a $1000. But they also go into your 401k and take out a $1000 of government bonds that you have saved. The net wealth effect to you is zero. Yep, you just have more cash. Okay? It’s that an inflationary action. Probably not. So that’s what he would say. That’s what his theory says. It’s not because it’s not creating debt. The money supply people would say it is because you have more cash. And you’re more likely to spend the cash. So, where it gets to a little bit is a concern about the amount of government debt. That’s outstanding $30 trillion in government debt. And when you look at that, plus higher interest rates as interest rates are now in the 4’s and today as we’re recording this, the fed funds terminal rate where markets price and that the peak of the rate hikes is now approaching six percent. As you get up to those levels, the interest cost is quite high. If it’s the government has to roll debt if we see levels in the 5 and 6s on 30 trillion in debt, you’re looking at 1 to $2 trillion, just of interest expense. And that’s pretty steep to put that in a perspective personal income tax receipts around two and a half trillion. So, he’s concerned about the level of debt deficit and then what happens at the next crisis the next recession the next time we need another $5 trillion bailout, the sun shining on the economy right now with unemployment being low, which should be running out of surplus. And instead we’re running out of $1 trillion deficit right now. So in his framework, though, Bob, does that mean the fed really isn’t the institution that should be combating inflation? Does he think there’s anything that the fed can be doing about it? Yeah, that’s a good point. And he thinks it should be joint action. He wrote a Wall Street Journal op-ed that there should be a consumption tax right now. Which to me makes perfect sense. You want to slow down, spending, by having a consumption tax because sales tax. That goes towards paying down debt while discouraging people to buy a second home or buy a new car, put the deck down the house, doing those things, adding tax to it, which helps improve the government’s balance sheet and discourage spending to me makes a lot more sense than raising the cost of borrowing for the government.

 

 

00:10:09 – 00:15:01

 

So let me push back on this one a little bit because I’ve been in my career somewhat frustrated by the deficit debt worries and the angst and hand wringing around it, not from a political standpoint, but more because it led people to be pessimistic about markets and miss their fair share of returns. Is it a little convenient that, you know, we’ve reached this tipping point where inflation was next to nothing and then it spiked at 9 and he’s pointing to 5 trillion of COVID related spending. That happened right before it, because we’ve been deficit spending and building up our debt for a long time. And if he was out kind of touting these theories for the last 13 years, he’d have been wrong 12 out of the 13. So is his view that there’s just a tipping point that broke things or is this just a little bit of having seen something’s going to happen and it finally happened now people are inviting me to conferences. Yeah, he must have received that question from other people because he had a slide on that with the timeline of when he started writing his book. The book, the first draft of the book was complete before inflation started given rising in 2022 and the intro talked about, well, we’re not seeing inflation anywhere. Here’s what I think about. Here’s my theory. But now that it’s actually playing into it, he’s, I think, being invited to speak a little more and getting more attention. So as a Chief Investment Officer and you were in a room with other successful chief investment officers of large firms, what did that presentation tell you? What did it do to influence your investment outlook? I think there’s two general takeaways from it. One is it’s that first point that gave you the puzzle book that we don’t know where inflation comes from. And it is still it’s complicated. And it’s not as easy as, oh, I just raise rates to 5%, and that’ll take care of it. There’s a lot of animal spirits involved; some people call it emotions. And a lot of complexity. So, to not be overconfident in just, we’ll just lay on this plane at 2% and things will be fixed. And we’re seeing that right now is the fed’s talking about race and rates higher and for longer. And the second is just when you think about allocating having exposure overseas to non-U.S. equities, which we do. But that is one area where if his concerns do play out, you’d have a weak dollar and foreign investments would probably outperform. So, okay, that’s helpful. That’s actionable and we’ve been talking about global investing for a while and so is there an opportunity now basically to see whether his theories can be proven correctly. So, I mean, basically what I’m saying is if the fed does raise rates, which it has been, sorry, if it continues to raise rates and keeps rates elevated, but we see no change on the fiscal revenue generation side. And inflation improves dramatically and gets down to the fed’s targets in a time period where they’re thinking it will get. Does that somewhat debunk the, hey, this is what causes inflation, and this is how to fix inflation narrative. I think you would have a very good case, yes. Come to debunk his theory. I imagine he would have a comeback, but I think that that would be tough. So, to argue. But in any event, you need to be aware longer term about the impact of debt and deficits for a variety of reasons and you need to diversify globally for the reasons that you kind of walked us toward the end of that exchange. Yes. How about fixed income? Does this have any impact on bonds or how you would invest in bonds? With fixed income it gets to the risk of rising rates as if inflation isn’t brought under control. So, the thinking of extending duration, we’ve increased duration closer to market, but we’re still a little under. And as we’re seeing rates rise this year right now, that’s helping. On a relative basis. So, it does, it’s a support not going too far out in duration. Because rates may rise if there’s a if the market’s underplaying how long this inflation story could continue. Correct. Okay. And rates have been going up as you mentioned.

 

 

00:15:02 – 00:20:03

 

Can you walk us through a little bit why that would be and what the implications have been for portfolios? Yeah, so why rates have been going up? It gets to the inflation not coming down as much as the fed would like and the jobs market being stronger than the fed would like. And the tool that they are using is raising interest rate. So, they’re just going to have to raise interest rates. Higher and higher and higher for longer and longer and longer. Until they see a tick up in unemployment and inflation, disinflation, inflation getting back down to around the 2% level. And it’s been stubborn. So that’s it in a nutshell. Okay. What else is on your mind as it relates to portfolios and investments in what’s already been a busy year for you? I mean, in general, we’ve been doing a lot of work on different vehicle types. This gets in the weeds, but mutual funds versus ETFs, our managed accounts talks about an exchange fund as an investment option. And then within bonds also taxable bonds versus municipal bonds, so those are some of the things we could talk about if they’re of interest. Sure. Yeah, I think just looking at vehicle choice your approach has been, you know, the most important thing is the investment strategy, and the vehicle of choices is secondary. What do you mean by that and how is that influencing your thinking in terms of how people should be allocating amongst mutual funds, ETFs, separately managed accounts, or other approaches? Yeah, so I guess just to step back on different vehicle types, mutual funds, most people are familiar with mutual fund. One of the drawbacks of a mutual fund is they can make capital gain distributions, typically at year-end. So, within the fund, if the managers trade in stocks and sell stocks at a gain, they have to make a distribution to investors and that’s taxable. So, it’s tax inefficient. ETFs work are similar to mutual fund, but they work with what’s called authorized participants to rebalance the portfolio. So, they’re able to really throw loophole to get around the issue of making a capital gain distribution. So, when compared to mutual funds, they have a tax advantage. And we have been using more and more ETFs for taxable investors. So that’s a trend that heritage clients have seen and it’s something we’re working on and we’re talking to managers we work with and encouraging them to launch ETFs if they don’t have ETFs already. So, we’re doing more and more on that front. It is an advantage, but we’re not a great strategy in a mutual fund, and I guess just stepping back, what there’s well, there’s a nice tax advantage for ETFs. You don’t see as many active managers launch in ETFs. One of the reasons is they have to report their holdings daily. So, there’s full transparency. So, these managers think that they have this great research that leads to owning 30 stocks or so. And to have to tell the world every day what those 30 stocks are, other investors could basically follow their trades. With a one-day delay, you could copy the portfolio for free. Sure. That’s one drawback in a second is they can’t close the fund and restrict flows. We talked about this at the conference. The firm arc run by Kathy Wood got into some trouble. They launched an ETF and I think it grew to over $30 billion and then couldn’t close it, which they should have. And as a result, they were owning well north of 10% of many company’s retail investors are just flooding into that fund. So, investors may not be aware of why that is important to you as a Chief Investment Officer or other chief investment officers. Closing funds, closing vehicles, managing a reasonable capital base. You want to see some funds not get too big because what? Because if you get too big, so you’re managing a $30 billion fund. If part of your investment approach involves buying small companies, companies that are under a $1 billion. And aren’t very liquid. So, if you want to buy $30 million of a $1 billion company, a 3% ownership of the company, that doesn’t do the math and apply that 3% ownership of the company is only 1% of your fund. It doesn’t move the needle. So, you want to be able to be of a size where you can implement your strategy still in a meaningful way without moving markets. And so that’s one drawback to the ETFs on the plus side. It’s favorable for taxes on the negative, gives investors full transparency, which a lot of managers don’t like, and they can’t control flows.

 

 

00:20:03 – 00:25:00

 

And then the last type of structure is separately managed account. So, it’s an account where in a mutual fund you own the stocks and an ETF, you own the stocks, but you just see the one name. But a separately managed account is where you actually own the underlying stocks. So, the managers trading the stocks in your account for you. One type of separately managed account that that’s getting popular these days is called direct indexing. So that’s where you say to a manager. I want to own the S&P 500. Like that index. And they’ll buy 500 stocks for you or they’ll do what’s called a sampling approach for though by 300 stocks, like they may buy Coke, but not Pepsi, and Costco and not BJs, things like that. So, you get the exposure and you get basically the exact return to the index falling in 300, not 500. So that’s something that as technologies improved. It’s becoming more implementable for clients with minimums and 500,000 range. A couple of advantages of that are in the tax front. It gives you great control for taxes. So, you can, at the company level, sell your losers for tax loss harvesting, so in that example, you buy Coke and not Pepsi. Well, if markets go down, sell Coke and buy Pepsi. And you just book a loss. A loss for taxes and your exposure basically didn’t change. For those charitably inclined, you can donate the most appreciated stocks to donor advised funds and for those with investor preferences like ESG, if you want to be very specific, you can implement that as well so you can customize it in many different ways based on different company characteristics that you’re looking for or not looking for. So, the landscape is evolving or changing I guess as more of these direct index approaches come into play and more strategies are available through ETF format and you didn’t say this, but the mutual fund vehicles tried and true and there’s a lot to like there as a manager of a mutual fund compared to those other things. Where are you thinking is the right profile for certain investors to be between those three options? Yeah, the preference, the benefits for ETFs and direct indexing over mutual funds are mainly around taxes. Simplified a little bit in retirement accounts or tax-exempt tax deferred accounts, nonprofit accounts. That’s where the mutual fund’s tough to beat. One of the beauties of the mutual fund is executes at net asset value at 4 o’clock every day. So, you put the order through and you get great execution. ETFs you are dealing with bid ask spreads and without taxes being issued. So then focusing on taxes for clients who are in taxable accounts and tax sensitive within stocks, the ETF vehicle is preferred over the mutual fund. All else equal. So, we’re doing our best to own more ETFs there. Direct indexing can be a good option for U.S. equities for clients who are in a high tax bracket, have large capital gains, especially if you have capital gains from other sources. Like if you’re selling a business and have a 8 year earnout where you’re looking at 6 figures of capital gains every year for the next 8 years, having a direct indexing approach paired with that can be nice. Or for someone who wants a real customized approach around ESG is another case where you really want to get into the nitty Gritty of what 300 U.S. stocks are you going to own. You have that control extract index and makes a lot of sense. It’s a good deep overview of the more common vehicles that you can utilize in publicly traded markets, and you said your team is spending some time on this now. Is that because from an investment standpoint, things haven’t changed even though the markets have seen volatile and we have January, which is different than February, which is different than March and different than December. For the most part, your outlook on the markets hasn’t changed and you’re just waiting for things to play out. It’s more it’s important. Heritage every detail matters. And this is getting into the weeds of something that matters. So that’s I mean, we did recently reallocate our portfolios for comfortable with our allocation. So, there’s some of that too that it’s something to focus on. It just I was looking to improve, and this is one area where we think we’re I think we’re on top of it and the market needs to come to us a little bit.

 

 

00:25:01 – 00:30:02

 

That’s where we’re working with managers on launching products here. So, where we reallocated our portfolios for the most part in December. And the outlook that drove that hasn’t evolved. It’s the same outlook three months later. What are you most optimistic about in markets today? Or as an investor today? I think it’s foreign markets overseas markets. The valuations there are attractive. So, seeing that we have allocations and where those portfolios are trading in the low double digit price to earnings rate ratio, like 10 to 13 times. That’s a good level to be investing. So I think those markets are due, the U.S. has outperformed foreign for a while now and we’re seeing that starting to turn. I think that’s very solid positioning. And what are you most pessimistic about or most concerned about as an investor? I’m still concerned about U.S. growth. U.S. unprofitable growth, the companies that growth stocks in the U.S. not the growth of the U.S. economy. Correct. And not growth like a Google or Apple, but I saw something like DoorDash and their earnings and revenue over the last 5 years and it’s just every year the revenue goes up but their losses are just greater and greater and greater. I think they’re losing like over a $1 billion. It’s like it’s convenient for the customer to get a burrito delivered to your door. But if they’re losing a $1 billion, a yea doing it. That’s not sustainable. So, investors just in these businesses that aren’t making money and aren’t going to be making money anytime soon. Amazon got away with it for a long time, and it’s worked out well for them. But in general, it’s not a good business model. And there’s still a lot of them out there. Okay, I mix a lot of sense. And I wanted to get your perspective on an investment related question that has been coming up more and more and it’s because the world has changed around debt and interest rates. So, prior to 2022, there was a lot of cheap, virtually free money out there, right? Variable rate loans were very low, mortgage rates were in the twos. Car loans were very attractive. And people were going through if they were allocating capital well personally, they were going through this exercise of, I’m going to take out low interest debt because I think my long-term investment portfolio will not have an issue beating that low hurdle, whether it was 2,3, 4%, whatever it is. Well, now you fast forward and that’s changed completely. Prime is in the 7s. I believe, and mortgage rates are not that far behind. I don’t know what car loans are doing. I haven’t bought a car in a while. What would you advise people now when it comes to that hurdle rate of what you should be doing, making up an extra debt payment? If they’re rates are in the 6s or 7s or not and continuing to invest and pay down the debt on the predetermined schedule. Have things changed in your mind. Yeah, no, it’s a good question. One thing I’d look at is it tax deductible or not. And that gets on what type of loan is it like a car loan not, but mortgage depends on if you itemize or do the standard deduction, but if you’re itemizing and it’s tax deductible and look at your tax rate, you know, in my mind, I would use about like a 5% hurdle rate. And so if it’s tax deductible and you’re the loan is 6, but then the effectiveness of it, depending on your rate, it might be more like a three or four. But if it’s not tax deductible and you have debt at sex plus percent, I would be looking to pay that down. So, mortgages still maybe not yet, particularly if you’re itemizing the other thing is as rates go down, which hopefully they will in the future will have the opportunity to refinance that mortgage to a lower rate. But consumer related debt where you’re not getting a tax break and you’re in the 6s and the 7s, you know, your advice is pay that down. You could earn more than that in your portfolio, but you’re going to pay taxes on those gains as well and the hurdle rate is definitely not where it used to be. Yeah, and it’s like a risk free of return. Do we expect, say, 7, 8% of the stocks, yes, as it risk free? No, is debt at 7% paying it down, that is like getting a risk for a 7% return. Okay. Yeah, the world has changed. And that’s more like a 4% return. So that is the big question. Is it a tax deduction or not? I feel like the world has changed so much with those decisions in just in just a year. Yes. So I know you’re not reading the 600 page treatise on inflation.

 

 

00:30:03 – 00:32:32

 

Are you reading anything interesting these days that you would want to recommend to our listeners? I haven’t picked it up, but one guy who I respect a lot. It reminds me of you a little bit. He’s a JD and CFP. Recommended a book that he gives out to clients called the coffeehouse investor. Okay. Said it’s a great his mom can read it in an afternoon and it’s a great educational investment book. So, share that with the audience, I might pick it up. I’ve personally been reading about real estate, just an area that always has interested me. Just investment real estate commercial real estate or all the above. Different books on investment real estate. We have a number of clients and it’s a common situation for us to see clients who have investment real estate and hey, what do you think about this like rental property? So just getting more familiarity with that market. Great. Well, Bob, first of all, flattery will get you everywhere. So, thank you for the kind words. I will check out the coffeehouse investor and if it lives up to the hype, I definitely will share it as a recommended book through the Wednesday reading list at some point. Thank you so much for this conversation, Bob. I think our listeners will get a lot out of your overview, some of the industry feedback that you’re hearing, the understanding that you shared on the different investment vehicles and how you would incorporate some of that information that you’ve been gathering into actionable portfolio steps. So, thank you very much. You’re welcome, Sammy.

 

Thank you all for listening. If you’re enjoying wealthy behavior, please subscribe and leave us a review wherever you get your podcasts. Please send in any questions or feedback to wealthybehavior@heritagefinancial.net. Thank you for listening to Wealthy Behavior. If you found the conversation useful, please consider leaving us a review wherever you listen to your podcast and sharing this episode so those around you can live a rich life too. For more insights, subscribe to our weekly blog at heritagefinancial.net and follow heritage financial on Facebook, Twitter, and LinkedIn. Check out my personal finance blog at thebostonadvisor.com. Wealthy behavior is produced by Kristin Castner and Michele Caccamise. This educational podcast is brought to you by Heritage Financial Services, LLC located in the greater Boston area. The views and opinions expressed in this podcast are that of the speaker, are subject to change and do not constitute investment advice or a recommendation regarding any specific product or security. There is no guarantee that any investment or strategy discussed will be successful or will achieve any particular level of results. Investing involves risks including the potential loss of principle. *This automated transcript may contain grammatical errors.