Investment Report: Headwinds and Crosscurrents

Aoifinn Devitt | Chief Investment Officer
Chris Kamykowski CFA®, CFP® | Head of Investment Strategy & Research
David Wickenhauser CFA®, CFP®,MBA | Investment Strategist

The first quarter was not the auspicious start to 2022 that many hoped to see. Markets remained on edge at the beginning of year despite ending 2021 on a brief high note, and the first quarter was dominated by market volatility, geopolitical risk, rising evidence of inflation and a more assertive stance by global central banks to address it.

Highlights

Volatility: Several market-jarring events in early 2022 led to sustained market volatility. Equity and interest rate volatility increased dramatically as markets contended with geopolitical events in Eastern Europe,
sharply higher inflation, economic growth concerns and rapidly shifting expectations for Fed action to tighten monetary policy. Despite these spikes, equity market volatility was still lower than during previous crises,
while interest rate volatility remained well above its historic averages and seemed likely to remain that way due to the rising rate environment that has been telegraphed.

Events in Russia and Ukraine: A key driver of consternation this quarter was Russia’s invasion of Ukraine, which upended the narratives of rising globalization and geopolitical order that had prevailed in recent years. Most of the developed world was quick to initiate sanctions across a slew of industries and individuals. Effects of this were felt particularly in commodity prices, with oil rising substantially given Russia represents 10% of oil export supply. A key component for steel – pig iron – rose substantially given Ukraine and Russia provide 50% of the total global exports.

Inflation: While already headed higher due to a pandemic-induced imbalance in the economy between supply and demand, the events in Ukraine and subsequent sanctions added “fuel” to the rise in inflation
globally. US inflation hit a four-decade high in March with core inflation (ex food and energy) higher as well, highlighting the broadening of price pressures to housing and services. So far, long-term inflation expectations remain constrained, but the stickiness of the various components will be essential to watch to assess the longer-term trajectory.

Federal Reserve: With one part of their mandate fulfilled (maximum employment), the Fed had to shift to more aggressively addressing rising inflation while attempting to engineer a soft-landing for the economy as
monetary policy tightens. Additionally, quantitative tightening through reduced bond purchases will begin to reverse liquidity provided by quantitative easing (QE) and shrink the substantial increase in the Fed’s balance sheet.

Macro Overview

The U.S. unemployment rate fell to 3.6% in March, which is close to the pre-COVID (February 2020) levels of 3.5%. Payrolls for the quarter were up 1.7 million in the first three months of 2022 and now sit only 1.5 million short of pre-pandemic payroll levels. The participation rate continues to modestly improve with more people seeking jobs, which remain abundant. Consumer prices hit a new four-decade high of 8.5% in March with inflation broadening to housing and services, which are historically stickier as they change price relatively infrequently. Long-term inflation expectations remain stable for now as investors still expect inflation
to be attended to by the Fed and improvement in supply-chains to continue.

Expected rate hikes have moved from 4-5 to nearly 9 by the end of 2022 with the Fed likely to move at 50 bps increments over the next two meetings. Markets are currently assessing the potential risk of a pending recession, especially since the US yield curve inverted in late March (10 Year US Treasury vs 2 Year US Treasury). However, the Federal Reserve of New York’s recession indicator sees a slim chance of a recession in the next 12 months.

Monetary policy direction has diverged in the recent months across countries although it remains globally accommodative. Numerous central banks are addressing inflation head-on through tighter monetary policy while others require more flexibility in addressing inflation and slower growth due to the impact of an ongoing war (Europe) or COVID lockdowns (China). Still, growth uncertainty has entered 2022 forecasts across the board, although forecasted growth remains above trend. The US dollar remained strong throughout the quarter and recently hit its highest level in more than two years, amid expectations of interest rate rises by the Fed and a demand for safe-haven assets.

Asset Class Performance

Across all maturities, Treasury yields have dramatically increased. While this means that investors can expect better yields on newly issued bonds, it also applies significant negative pressure on existing bond prices. This was clear in the first quarter as the Bloomberg Aggregate Bond index posted its third-worst quarter in history. Equity performance across the globe was broadly negative. Russian stocks experienced a -100% decline due to the heightened risk premiums and trade restrictions placed on the country’s equity securities, while commodity-linked emerging market countries, such as Brazil and Chile, bucked the trend with positive returns.

The S&P 500 posted a -4.6% decline for the quarter, primarily driven by significant drawdowns in the technology and consumer discretionary sectors. These sectors tend to be more growth focused over the long-term, meaning higher rates negatively impact the value of future earnings; this led to tech’s first drawdown since Q1 2020. The energy sector posted a 37%* return for the quarter as commodity prices surged, while utilities also had a modest gain of 4%*; the latter is currently the only sector that has not had a negative quarterly return since Q1 2020. (*Russell 1000 sector indices)

Large cap value stocks finished the quarter ahead of growth stocks with a +8.3% return advantage, marking one of the best relative quarterly returns by value versus growth. Both large and small cap growth sold off in the quarter, reaching bear market territory in mid-March before rebounding.

Following a banner year in REITs, rising rates brought returns down from recent highs for nearly all REIT sectors. Soaring commodity prices helped drive inflation higher but MLPs and infrastructure participated alongside the moves up, providing diversification to traditional equities and fixed income.

Final Thoughts

As the era of accommodative monetary policy comes to an end, there is considerable uncertainty around the trajectory and impact of the next cycle of rising interest rates. While low unemployment levels and still-strong levels of consumer spending may ward off a recession for now, the specter of slowing economic growth and pressure on earnings is adding to the stress on markets. Geopolitical concerns have, for the moment, moved from the headlines but have the potential to flare up again, which points to a period of sustained market volatility.

Tech stocks and their dramas have provided numerous headlines over the quarter, with Elon Musk’s audacious bid for Twitter and its ultimate acceptance as the latest chapter. Sensational coverage of these developments will most likely drive more volatility in growth stocks and fuel the rotation into value.

Yet, there are some green shoots amid the sea of stressors. Increased interest rates do not mean monetary policy is no longer accommodative, only less so than the emergency levels put in place due to the pandemic. While higher interest rates are certain to slow mortgage applications, housing, a key component of the economic growth, remains on a solid footing with demand still outpacing supply. Lastly, the economy appears geared to exit the pandemic-induced constraints as supply-chains are brought back in order and the service sector regains its share of the economic pie from the goods-producing sector.

Definitions & Disclosure

Alerian MLP Index: The Alerian MLP Index is a capped, float-adjusted, capitalization-weighted index, whose constituents earn the majority of their cash flow from midstream activities involving energy commodities.
Bloomberg US Aggregate: The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollardenominated, fixed-rate taxable bond market.
Bloomberg High Yield: The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market.
Bloomberg US Treasury: The Bloomberg Barclays US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury.
FTSE Nareit Equity REITs: The FTSE Nareit All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. equity REITs. Constituents of the index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property.
MSCI EAFE: The MSCI EAFE Index is an equity index which captures large and mid-cap representation across 21 Developed Markets countries around the world, excluding the US and Canada.
MSCI Emerging Markets: The MSCI Emerging Markets Index captures large and mid-cap representation across 27 Emerging Markets (EM) countries.
Russell 2000: The Russell 2000 Index is a small-cap stock market index of the smallest 2,000 stocks in the Russell 3000 Index.
S&P 500: The S&P 500 Index is a market-capitalization-weighted index of the 500 largest domestic U.S. stocks.
S&P Global Infrastructure: The S&P Global Infrastructure Index provides liquid and tradable exposure to 75 companies from around the world that represent the listed infrastructure universe. The index has balanced weights across three distinct infrastructure clusters: Utilities, Transportation, and Energy.
Real GDP: Real gross domestic product is an inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given year (expressed in base-year prices) and is often referred to as constant-price GDP, inflation-corrected GDP, or constant dollar GDP. Forecasts for 2022 real GDP growth are based on 76 contributions from leading banks and financial institutions.

© 2022 Moneta Group Investment Advisors, LLC. All rights reserved. These materials were prepared for informational purposes only based on materials deemed reliable, but the accuracy of which has not been verified. Trademarks and copyrights of materials referenced herein are the property of their respective owners. Given the dynamic nature of the subject matter and the environment in which this communication was written, the information contained herein is subject to change. This is not an offer to sell or buy securities, nor does it represent any specific recommendation. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. You cannot invest directly in an index. Past performance is not indicative of future returns. All investments are subject to a risk of loss. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. These materials do not take into consideration your personal circumstances, financial or otherwise.

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Revisiting the Emerging Markets Allocation

Tim Side | Research Analyst

Introduction

Recent market events have created a significant amount of uncertainty in global markets. A year that began with concerns over tighter monetary policy amidst rampant inflation has now been exacerbated by the upending of world order with Russia invading Ukraine and Western countries implementing significant sanctions in response. This post seeks to address several of the questions that we have received from clients regarding Russia and the reasoning behind retaining an emerging market allocation in one’s portfolio. We do not know what will happen, but we do know that over time, staying the course with one’s deliberate investment plan has proven to provide the best chance for investors to achieve their goals, even when it seems like near-term certainty has become unhinged.

Recent Volatility

Emerging markets are no stranger to uncertainty or volatility. Certain regions in emerging markets have been hit hard recently by geopolitical events, most notably in Eastern Europe which has borne the brunt of the downside effects from the invasion. However, while Russian stocks have effectively dropped to zero and been removed from major indices, it is worth noting that the recent underperformance in broad emerging markets has been quite contained in the context of emerging markets’ longer history.

Since the inception of the MSCI Emerging Markets Index in 1987, the average rolling 12-month return has been 13.1% with a standard deviation of 27.6%. This means that 68% of the time, rolling 12-month emerging market returns have fallen between -14.5% to +40.7%. With a trailing 12-month return of -11.1% as of March 31^st, 2022, we are well within expectations for the asset class historically.

One can see how this recent downdraft fairs relative to rolling 12-month periods since inception with the highlighted column in Figure 1 showing where today’s returns fall.

Is this time different?

China’s outsized presence in emerging market indices and the increasingly pervasive idea of markets becoming “uninvestable” are certainly topics that cannot be ignored, but these concerns are not new to emerging markets. By definition, these are emerging economies with a range of countries subject to varying degrees of unstable governments, poor shareholder protections, human rights violations, barriers to capital flows, etc. Despite these issues and periods of deep drawdowns, emerging markets have proven to be a diversifying source of returns and a good complement in investors’ portfolios.

Valuations

In the words of Warren Buffet: “Be greedy when others are fearful, and fearful when others are greedy.” This approach necessitates a strong discipline since it often requires buying in the midst of uncertainty. The normal course of rebalancing allows investors to remove emotion and fear and take advantage of emerging markets trading at a significant discount to fair value, as seen in Figure 2.

Total Return

A long-term mindset is needed in these markets given emerging markets are at various stages of maturation in their market, political, regulatory, legal, and economic systems. This is key to why markets demand a higher risk premium relative to developed markets. Sharp drawdowns often occur over short time-periods, but over the long-run, emerging markets have consistently been a strong source of returns. The long-term success can be seen in total returns since the MSCI Emerging Market Index’s inception in Figure 3.

These long-term return results combined with forward-looking estimates (Moneta’s Capital Market Assumptions are available upon request) make emerging markets one of the highest return/risk allocations in investors’ portfolios and a key component to achieving long-term investment objectives.

Diversification

In addition to the return component, emerging markets also bring a high level of diversification to equity returns. Following recent market events, it is tempting to think about emerging markets as only Russia and China; while sizable, these two countries, respectively, made up approximately 3% and 32% of the index before Russia invaded Ukraine. The rest of the index is widely diversified across regions, countries, and sectors; this was clearly seen in February when Russia and other Eastern European countries sold off, but other areas such as South Africa and Brazil had positive performance, benefitting from their exposure to commodities. While shorter time periods can see correlations between all equity asset classes rise, emerging markets have proven to be a strong diversifier over long periods.

Following a decade-long run where US markets have significantly outperformed non-US markets, the diversification benefits are harder to see. But it is important to step back and look at longer time periods. A clear example can be seen in the first decade of the 2000s, where US equities were almost flat while emerging markets returned more than 150% (see Figure 4).

Growth Opportunities

There is strong rationale for the higher return expectations in emerging markets beyond the risk-premium story. In the near-term, there is a robust case for the benefits of emerging markets’ commodities production (which typically perform well in inflationary environments), but longer-term there are also strong structural growth opportunities in emerging markets.

The growth opportunities are driven by large countries (from a population perspective) seeing rapid improvements in education and technology leading to a growing middle class, and importantly, one that shifts into more discretionary spending. Figure 5 comes from J.P. Morgan and Brookings Institution and highlights these growth expectations.

As a result, GDPs are expected to grow much faster in these emerging economies versus developed economies, which are saddled with demographic drags. We are already seeing an increase in US companies’ revenue coming from these regions, primarily from China.

The Importance of China in Emerging Markets Exposure

The emerging markets universe has undergone significant changes since the launch of MSCI’s Emerging Markets Index in December 1987. At that time, the index covered ten countries, making up less than 1% of the global equity market. Today, the index covers twenty-five countries and accounts for 8-10% of the global equity market.

In late 2001, Jim O’Neil, Head of Global Economic Research at Goldman Sachs, put forward a research paper that projected four emerging market economies would achieve higher real GDP growth than that of the G7. These four countries included Brazil, Russia, India, and China; hence the acronym “BRIC” was formed.

Fast forwarding to the end of 2020, we can see that from a dollar-GDP perspective, O’Neil was correct as BRIC countries saw an average annualized growth rate of 9% vs the G7 countries’ average annualized growth rate of 3%. Additionally, BRICs total percentage of global GDP increased from 8% in 2001 to 24% in 2020. The growth of BRICs has been primarily driven by China, which ended 2020 with a GDP of $15 trillion and captured more than 17% of global GDP (the US had a GDP of $21 trillion and made up almost 25% of global GDP).

While the role of BRICs appears to be diminishing as sanctions are likely to hinder Russian growth and Brazil continues to face political and economic challenges, China’s presence as a dominant global economic entity has been well established. The growth of China’s market has been reflected in global equity markets, but not nearly to the same degree as GDP contribution. On a global equity market basis, China is just over 3% of the MSCI All Country World Index (ACWI); significantly less than the US’s exposure of 61%.

In recent months, there has been a heightened concern regarding China and Taiwan and whether we will see a similar outcome to Russia and Ukraine. Given China’s large weight in the index, the question is frequently asked if one should divest from China given the global economic response to Russia’s actions in Ukraine?

It is far beyond anyone’s ability to predict what will happen with China and Taiwan, but it is important to guard against extrapolating the fat-tail (lower probability, higher risk) event of Russia invading Ukraine and assuming a worst-case scenario will occur with China and Taiwan. China and Russia are not the same and enacting the same sanctions on China would be far more difficult to implement than with Russia (in 2021, the US had a net-import balance of $355 billion from China vs $23 billion from Russia). This is not to say it cannot happen, but rather that it is a fat-tail event that can be mitigated rather than entirely avoided.

With a 32% weight in emerging markets, divesting from China by going into an ex-China strategy would be a massive macroeconomic country bet that are notoriously difficult (perhaps impossible) to correctly predict with any level of consistency. Given China’s generally strong performance over the last decade, the MSCI EM ex China Index has underperformed the MSCI EM; to be sure, in periods like 2021, the ex-China strategy outperformed by more than 12% due to China’s selloff following tighter industry regulations.

For better or worse, China’s size makes it impossible to ignore. To stay invested introduces the risk of a Russia/Ukraine type scenario, while divesting risks missing out on a prominent return component in one’s portfolio. In a well-diversified portfolio, we view the upside potential well worth the downside risk.

Conclusion

While emerging markets are seen as a single asset class, there is tremendous diversity within it. The spheres of influence appear to be rapidly shifting, but rapid change and reshaping of geopolitics are nothing new to the asset class. Argentina is vastly different from South Korea. Russia is vastly different from India. Given this diversity and the nature of emerging markets, one never has to look far to find a crisis, but over time, investors who have stayed the course have been rewarded with strong returns and diversification benefits.

Disclosures

© 2022 Moneta Group Investment Advisors, LLC. All rights reserved. These materials were prepared for informational purposes only based on materials deemed reliable, but the accuracy of which has not been verified; trademarks and copyrights of materials referenced herein are the property of their respective owners.  Examples contained herein are for illustrative purposes only based on generic assumptions. Given the dynamic nature of the subject matter and the environment in which this communication was written, the information contained herein is subject to change.  This is not an offer to sell or buy securities, nor does it represent any specific recommendation.  You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. You cannot invest directly in an index. Past performance is not indicative of future returns. All investments are subject to a risk of loss. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. These materials do not take into consideration your personal circumstances, financial or otherwise.

The Russell 1000® Index is an index of 1000 issues representative of the U.S. large capitalization securities market.

The Russell 2000® Index is an index of 2000 issues representative of the U.S. small capitalization securities market.

The MSCI EAFE Index is a free float-adjusted market capitalization index designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.

The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices in 21 emerging economies.

Gross Domestic Product (GDP) at purchaser’s prices is the sum of gross value added by all resident producers in the economy plus any product taxes and minus any subsidies not included in the value of the products. It is calculated without making deductions for depreciation of fabricated assets or for depletion and degradation of natural resources. Data are in current U.S. dollars. Dollar figures for GDP are converted from domestic currencies using single year official exchange rates. For a few countries where the official exchange rate does not reflect the rate effectively applied to actual foreign exchange transactions, an alternative conversion factor is used.

World Bank Data as of 2/15/2022: https://data.worldbank.org/indicator/NY.GDP.MKTP.CD

Kharas, Homi. “The Unprecedented Expansion of the Global Middle Class, An Update.” Global Economy & Working Paper 100. Brookings Institution, February 2017. https://www.brookings.edu/wp-content/uploads/2017/02/global_20170228_global-middle-class.pdf.

J.P. Morgan U.S. 2Q 2022, Guide to the Markets, As of March 31, 2022.   https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/

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Ask the CFP: How Can I Avoid the Net Investment Income Tax?

 

Hello everyone and welcome to this month’s Ask the CFP segment. This month’s question is, “How can I avoid the Net Investment Income Tax?” For those not familiar with this tax, the Net Investment Income Tax is assessed on net investment income from capital gains, dividends, taxable interest, certain rents and royalties and certain non-qualified annuity payments. Essentially, it’s triggered by passive investment activity instead of earned income. However, it doesn’t apply to everyone. The tax applies when someone has net investment income and their modified adjusted gross income is over $200,000 for individuals and $250,000 for married couples filing jointly. The tax originated in 2012 to help pay for Medicare costs.

If this tax applies to you, it may be difficult to completely avoid it, but here are four ideas on how you may be able to reduce it. First, since the tax doesn’t apply to incomes under the levels mentioned earlier, reducing your modified adjusted gross income may be the ideal strategy. Timeless strategies such as tax loss harvesting, tax deferral and donating appreciated stock to charity may be enough to reduce income below this limit. Donating appreciated stock in particular can be a valuable strategy with both an income tax deduction and avoiding long-term capital gains taxes.

Second, if you own bonds in a non-qualified investment account, consider using municipal bonds. Muni bonds are generally tax-exempt at the Federal level and may also be exempt at the state level too if you buy muni bonds from your state. Third, consider using a no-load variable annuity for a portion of your portfolio if the majority of your assets are in taxable, non-qualified accounts. You’ll generally need to wait until age 59 and a half to withdraw the funds from a variable annuity, but deferring gains into the future may allow you to better control your taxes, including the net investment income tax.

Lastly, if you have assets in both retirement accounts and taxable, non-qualified accounts, consider using the retirement accounts for investments that generate passive income, such as bonds and high dividend investments. Then more growth-oriented investments that pay little to no dividends could be held in the non-qualified accounts instead. This strategy may allow you to hold a diversified pool of investments, but in a way that’s more favorable for your tax situation. We call this asset location. Essentially, tax efficient investments would be placed in taxable accounts while tax inefficient investments that generate income would be placed in tax-deferred accounts.

Aside from these four strategies, remember that Roth IRA distributions are also exempt from the Net Investment Income Tax. As a long-term strategy, consider ways to increase your Roth assets over time. Overall, tax planning can be difficult, but various strategies do exist to manage taxes like the Net Investment Income tax. If you have a question about this topic or have a question for next month’s video, please send it to TFreeman@MonetaGroup.com. Thanks for watching and we’ll see you next month.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Please speak with a qualified tax or legal professional before making any changes to your personal situation.

©2022, Moneta Group Investment Advisors, LLC. Trademarks and copyrights of materials referenced herein are the property of their respective owners. These materials have been prepared for informational purposes only based on materials deemed reliable, but the accuracy of which has not been verified. Past performance is not indicative of future returns. You cannot invest directly in an index. These materials do not constitute an offer or recommendation to buy or sell securities, and do not take into consideration your circumstances, financial or otherwise. You should consult with an appropriately credentialed investment professional before making any investment decision.

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Moneta Moneywise – A Conversation with Cathie Wood of ARK Invest – Disruptive Innovation Under the Microscope

Aoifinn Devitt | Chief Investment Officer 

This episode of the Moneta Moneywise Podcast is a robust and packed discussion on topics that are gripping markets today as Moneta’s CIO Aoifinn Devitt shares a conversation with legendary tech investor Cathie Wood, the founder and CEO of ARK Invest.

• We delve into some of Wood’s current investing themes and what drives them – such as the adoption of digital wallets, the rise in artificial intelligence, and the future of cryptocurrencies, autonomous vehicles and other technology.
• We look at some of the assumptions underlying those themes and ask what probabilities they are based on and what the likely outcomes are going to be in the short, medium and long term.
• We examine where past assumptions have not always worked out and why while examining some of the times when the ARK Invest team was early but ultimately mistaken in a thesis.
• Wood describes her path into the world of investing, why she started ARK and her career-long focus on innovation.

This conversation took place at a Moneta CIO tea in late March 2022. Moneta’s CIO teas are weekly conversation sessions hosted by Devitt for the Partner and Advisor teams across the firm. We are making this conversation available as a podcast so you, too, can sit in on the insightful discussion.

 

 

 

These materials have been gathered for informational purposes only based on sources deemed reliable, but the accuracy of which has not been verified. The views expressed in the attached materials do not necessarily reflect the views of Moneta. Given the dynamic nature of the subject matter and the environment in which this article was written, the information contained herein is subject to change without notice. Trademarks and copyrights of materials attached herein are the property of their respective owners. Past performance is not indicative of future returns. You cannot invest directly in an index. This is not an offer to sell or buy securities, nor does it represent any specific recommendation. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. All investments are subject to a risk of loss. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. These materials do not take into consideration your personal circumstances, financial or otherwise.

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