Acumen's Market Insights & Commentaries

The bond market is experiencing one of the worst drawdowns in recent history. Figure 2 below illustrates the magnitude of the drawdown and helps put the severity into perspective. We have not seen price decreases like this since the bond bear market of the late 1970’s and the financial crisis of 2008. A hawkish Federal Reserve, looking to abate decade high inflation, has been the catalyst for pushing yields higher.

Over a typical market cycle, bond yields will fluctuate depending on expectations of economic growth and inflation. As yields move up, fixed income prices come down. Since the late 80’s, bond yields have trended lower with a few short-term exceptions. This long-term trend of lower yields has allowed bonds to perform extremely well over the past 40 years. When yields move sharply higher, like in today’s market, prices move down. Like mentioned earlier, the first quarter of 2022 has been one of the worst quarters for fixed income returns in recent history because bond yields have risen so much.

In our core fixed income allocation, we currently prefer high quality municipal bonds. We look for value within this investment universe, and when possible, purchase individual bonds instead of using a bond ETF or mutual fund. We believe purchasing individual bonds, in the long run, provides opportunity for higher income and lower expense cost for our clients. Buying individual bonds allows us to lock in yields when we find value. When an investor holds a bond, they receive that bond’s coupon payment each year. No matter how much the price of the bond moves, the coupon payment stays the same. As the bond moves toward maturity, the price will converge to par. Bonds with longer maturity are more price sensitive than those with shorter maturity dates. While the price is more sensitive, longer maturity bonds have the advantage of locking in higher yields for longer periods of time.

Last year, until December, short term yields were extremely low, and the yield curve was steep (see orange line in chart below). Investors were rewarded for buying longer maturities. At that time, our inflation expectations were in line with the Federal Reserve’s. We believed any inflation we would experience would be transitory and, even if inflation were to stick around, we expected long-term inflation expectations to remain anchored. With the steepness of the curve, and the belief long-term inflation expectations were anchored, we saw an opportunity to pick up higher yields at longer maturities. As the reality of more persistent inflation presented itself, we slowed bond purchases in expectations of higher yields across the curve.

Headwinds in the bond market are still present; central bank policy changes, tighter financial conditions, geopolitical issues, and higher inflation could all present more trouble for the bond market. This bond market repricing has been difficult to digest, but opportunities for higher income are finally presenting themselves. Current yields, when compared to recent history, seem reasonably priced and the risk/return appears to be favorable for the first time in many years. Below is the current taxable AA Muni yield curve.

Over the long term we still believe yields will continue their downward trend, but in the short term we expect to see yields continue to drift higher. As long as supply chains remain broken and the Russia/Ukraine conflict continues to put upward pressure on food and energy costs, we should expect inflation to remain present. The longer inflation sticks around, the higher yields will rise. In the short term, the volatility in the bond market can be tough to handle. Fortunately, our investments in bonds are long term in nature and yields we lock in today we still expect to be higher than yields we might see in 4 to 5 years.

Major Takeaway:

Inflation has proven to be more persistent that most economists had originally anticipated. To counter this, the Fed is aggressively implementing restrictive policy. The combination of higher inflation and restrictive monetary policy has brought bond yields, especially short-term bond yields higher. The recent surge in yields has contributed to one of the worst bond drawdowns in the past 40 years. We do not believe the recent increase in yields is the beginning of a long-term trend, but rather an opportunity to lock in higher yields.

Information used in this commentary was obtained via Bloomberg L.P.

The opinions expressed in this commentary should not be considered as fact. All opinions expressed are as of the published date and are subject to change. Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. Investments in securities involves risk, will fluctuate in price, and may result in losses. The information has been obtained from sources we believe to be reliable; however no guarantee is made or implied with respect to its accuracy, timeliness, or completeness. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results. Diversification does not protect against loss of principal.

Any charts, graphs, and descriptions of investment and market history and performance contained herein are not a representation that such history or performance will continue in the future or that any investment scenario or performance will even be similar to such chart, graph, or description.

All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not include fees or expenses.

Acumen Wealth Advisors, LLC® is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Acumen Wealth Advisors, LLC® and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Acumen Wealth Advisors, LLC® unless a client service agreement is in place.

The first quarter of 2022 moved quickly and brought us new uncertainty with the potential impact of inflation, monetary tightening, and the war in Ukraine. The consequences of war are hard to fully reconcile. The deep humanitarian crisis of the Ukrainian invasion has implications on the people of Ukraine and around the globe. Our team has been following the developments and is assessing the impact within the context of the broad global economy. Our job is to understand the potential long-term impact of these and other factors in client portfolios. Our hearts continue to go out to all those affected by the conflict in Ukraine and hope for a peaceful resolution.

The Business Cycle Outlook

To help us determine how clients should be allocated from an asset class perspective (stocks versus bonds versus alternatives), we use a framework to help us identify where we are positioned in the current Business Cycle. Throughout history, the risk and return characteristics of different assets have proven to be cyclical. Developing a framework for the business outlook prevents us from making unfounded guesses about where we may be headed in the future. This outlook allows us to focus on where we are today and how we believe assets will be affected moving forward.

Where does Acumen believe we are in the current Business Cycle?

Right now, we believe we are situated in the Late Cycle.

Leading economic indicators are beginning to slow in terms of rate of change. While we are still seeing upward movement in many leading economic datapoints, the pace of the growth is slowing. Notably, the current outlook, painted by leading indicators, is more Expansionary and less Late Cycle; current economic growth is much higher than it has been throughout history.

Inflation has proven to be more persistent than the Federal Reserve had originally anticipated which is starting to drag on economic growth. Price pressures from supply chain issues and the Russia/Ukraine conflict are to blame for the recent surge in prices. Food, energy, and service prices are expected to continue to increase throughout 2022. Inflation of goods is expected to moderate soon; tighter financial conditions and stretched consumer budgets will most likely help moderate prices. We expect overall inflation to peak in the second half of 2022 as supply chains continue to ease, the Fed implements restrictive policy, and consumers spending habits shift.

Monetary Policy has recently shifted from extremely accommodative to very restrictive. The Fed is expected to raise interest rates aggressively throughout 2022 and will begin a cycle of quantitative tightening (the selling of assets from the Fed’s balance sheet) later this year. Restrictive monetary policy will lead to tighter financial conditions hoping to moderate price levels without completely stopping the economy. Restrictive policy is intended to slow demand and we expect this policy to slow economic growth.

Business confidence is also beginning to wane, shown by lower PMI (Purchasing Managers’ Index) readings throughout the globe.

What are Acumen’s thoughts on the Equity Market right now?

The S&P 500 has returned 26%, 90%, and 112% over the previous one, three, and five years as of 12/31/2021. We have witnessed some astonishing years of gains for equity investors, and the highest across longer time frames than we have seen over the previous 20 years. We do not necessarily use historical returns to assess the probabilities of what might happen in the future, but it is at least noteworthy to point out equity investors have had quite a ride post Great Financial Crisis.

We choose to be forward looking in our approach. From this perspective, there are a few questions we would like to answer to determine if we are a buyer or seller of equity risk in portfolios. On one hand, our Late Cycle forecast inherently causes us to be less constructive on risky assets. During the later stages of the Business Cycle, riskier assets are not able to digest volatility as well. A perfect example of this was 2020 when there were plenty of volatile headlines and risk events for financial markets, but equities were notorious at digesting this volatility because of the newly formed expansion. Essentially, the stage of the Business Cycle had brought equity valuations to a point where enough risk was priced in, and which is not normally the case during the later stages.

This stage of the Business Cycle is a perfect segway into our outlook for valuations and equity market fundamentals. Essentially, we can break up our forecast for the return on equities into two components – the growth in expected earnings and the valuation multiple investors will pay for these earnings – which multiplied together gives us our forecasted price. We believe there are headwinds to both factors today. Unlike many investors, we believe the valuation multiple investors should pay for equity investments is fluid and depends on a few factors. Today, we see restrictive monetary policy, slower forecasted economic growth, and higher bond yields causing headwinds to this multiple. In turn, growth in expected earnings would have to make up for this contraction in valuation multiples. We believe we will see earnings growth normalize to the lower range of the long-term average – around 8%. While we steer clear of making a strict forecast for these variables, we believe we can identify a range of outcomes, and, as a result, build a risk/reward profile. The risk reward profile, given our forecasted range for both variables, spell more downside for equity risk than upside. As a result, we believe investors should be underweight equity risk in their portfolios, and we are managing portfolios accordingly at Acumen.

This belief, of course, is a tactical perspective and we believe investors should continue to buy into equity market weakness. On one hand, there are demographic factors causing us to believe equities will be long-term outperformers over other asset classes. At the same time, the relative valuation for equities is still attractive in the long term, and most businesses are much better capitalized and have higher earnings growth rates than what we have seen historically.

What are we doing within Equity exposure to represent this viewpoint?

Of course, we do not believe in attempting to “time” the market. Instead, we observe the risk/reward profile for different assets and move tactically around targets based on this. Right now, based on fundamentals and our outlook on the Business Cycle, we see more risk than reward for equities. As a result, we have positioned portfolios to be underweight their typical equity target and underweight equity risk as a whole. However, because we do not want to try to time the market, equity exposure will remain in portfolios. Within this exposure, we are allocated to areas of the equity market we believe will outperform on a relative basis during this phase of the cycle. While 2020 and even some of 2021 saw high growth and speculative equity investments outperform in a large way, we are more focused on identifying high quality companies traded at a fair price. These are investments in companies we believe will last throughout different phases of the market cycle. This belief is our current primary focus within equity exposure.

What are Acumen’s thoughts on the Bond Market?

The bond market is experiencing one of the worst drawdowns in recent history. We have not seen price decreases like this since the bond bear market of the late 1970’s and the Great Financial Crisis of 2008. A hawkish Federal Reserve, looking to abate decade high inflation, has been the catalyst for pushing yields higher. As a result, volatility in fixed income markets should be expected to continue throughout the year; the Fed is embarking on a very quick rate hike cycle, credit spreads are widening, and geopolitical tensions are high. Higher credit risk should also be expected as tighter financial conditions and lower growth expectations raises credit risk. U.S. companies have benefited from years of low-cost financing and have healthy balance sheets. Therefore, most companies should be set up to avoid default, but as financial conditions do become worse, credit spreads should expect to widen.

Even though volatility is expected to remain, yields have risen significantly and there are opportunities to lock in higher yields. Going forward, headwinds for bonds are still present, but the risk/return in fixed income is looking better than we have seen in recent years.

What are we doing within Fixed Income exposure?

Our core fixed income exposure will continue to be investment grade municipal bonds. As financial conditions tighten, we feel comfortable with the capacity of municipal governments to service their debt. Most state and local governments still have unspent federal aid from 2021 that will continue to provide some fiscal cushion. Yields have risen significantly, and valuations for munis are attractive. We want to take advantage of opportunities to lock in higher yields when they are available.

If we are underweighted in Equities and Bonds, what are we allocating?

Our views going in to 2022 was to be underweight both equities and bonds. This decision has turned out to be a good asset allocation as the S&P 500 is down more than 3.00% and the Bloomberg Barclays U.S. Aggregate Bond Index is down 6.30% year to date (as of 3/30/2022). However, to be underweight in both of the primary asset classes, we need to be overweight something else. Over the last year, as both the equity market and the bond market have looked more overvalued, we have been allocating a portion of portfolios to Alternatives. Now, Alternative Assets is a technical term with different meanings to various money managers, but to us, this just means something other than traditional equity or bond exposure. Alternative Assets could include commodities, private assets, hedge strategies, etc. During this environment, we have favored strategies that provide some equity market exposure, but also provide income opportunity through options strategies. We continue to favor similar strategies in the current environment.

Acumen’s Investment Views

Information used in this commentary was obtained via Bloomberg L.P.

A business cycle, sometimes called a “trade cycle” or “economic cycle,” refers to a series of stages in the economy as it expands and contracts. Constantly repeating, it is primarily measured by the rise and fall of gross domestic product (GDP) in a country.

All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not include fees or expenses.

Over the previous two weeks, we have watched Russia launch a full-scale invasion of Ukraine. We have researched the many potential reasons why Putin is choosing to do this, but for whatever reason, it is evident this invasion has taken a major turn in severity closer to a full-scale humanitarian crisis on the Ukrainian people. This became abundantly clear as Russia no longer shows restraint on attacking Ukrainian civilians – something Putin promised multiple world leaders would not happen. The severity of this conflict has left us in disbelief – both in solidarity for the people of Ukraine and their future, and in the economic toll Russia is willing to put their people through as a result.

Our Portfolio Management Committee (PMC) strives to prevent making investment decisions in client portfolios based on fear or emotion. Instead, we try to determine the long-term effects on financial markets because of these events. We believe long-term views based on objective information and a risk-first mindset work out much better for client portfolios than attempting to make short-term investment decisions on imperfect knowledge for events where nobody knows the final outcome. Going into 2022, our PMC team had begun reassessing the risk that was being priced into financial markets. We believed economic growth would begin to slow, monetary policy would become more restrictive, and inflation would remain high but move lower in the pace of price increases. After the last few weeks, our viewpoints haven’t necessarily changed, but have been amplified by what we believe the long-term effects on this war will be on financial markets. We still believe economic growth will be slower and the current conflict could exacerbate this trend. We believe inflation will remain elevated as major energy and agricultural supply chains are further disrupted, and uncertainty is also being priced into monetary policy expectations. All these views still culminate in the idea we are in the late stage of the current economic cycle.

These viewpoints have effects on portfolios. For these reasons, we want our clients to be aware we are currently implementing changes to portfolio allocations. One of our major tilts going into the year has been to overweight international equities relative to domestic. This was predicated on a generational valuation gap between international and domestic stocks. While this valuation gap continues to exist, we want to be more selective going forward in our international exposure as we believe the European Union will be more adversely affected by the ongoing conflict.

The EU is Russia’s main trade partner in six out of their eight major traded goods. Additionally, the EU has a high exposure to the financial crisis Russia will experience. We trimmed our international-focused equities and are directing the proceeds toward lower risk and higher quality equity securities that are more focused on domestic and international exposure outside of the EU. Secondly, because of our high conviction we are in a late cycle, we divested of REIT exposure. Publicly traded REITs tend to do very well in environments when the economy is growing, inflation is moving higher, and credit is cheap. Two out of these three factors are moving in a less favorable direction for REITs, so we believe we can find opportunity elsewhere. We are comfortable holding the proceeds from this sell in a short-term cash position as we assess what opportunities currently best fit our forward-looking investment thesis. Overall, we continue to move forward in a risk-first mindset regarding our outlook for financial markets, and also plan to continue to take a lower risk approach moving forward.

We believe making investment decisions on long-term ideas will help provide exposure on the upside to favorable trends, but more importantly provide downside protection to client portfolios. We continue to pray the current conflict between Russia and Ukraine moves towards a peaceful resolution, and that the people of Ukraine find justice and relief.

Sincerely,

Your Acumen Team

Given the careful consideration to financial planning and changing tax legislation, Acumen Wealth Advisors would like to provide some general tax reminders as well as guidance regarding the reporting of strategies you may have implemented in the 2021 tax year. As a courtesy, we have tried to include information which may pertain to you. However, we are not tax professionals and encourage you to consult with one in filing your return.

Charitable Deduction – The CARES Act allowed for individuals to take up to a $300 and those filing jointly to take up to $600 above-the-line deduction for cash donations made to qualified non-profit organizations in 2021. If you are taking the standard deduction, be sure to claim this deduction if you have donated. If you are itemizing your deductions, be sure to report all charitable contributions made for the year.

HSA Deduction – We believe an HSA is one of the most tax efficient accounts available as contributions (up to the limit) are deductible on federal taxes (and some state taxes), growth is tax free, and distributions for qualified medical expenses are non-taxable. If you are a participant in a high-deductible health plan which is HSA eligible, you should be able to contribute to the plan for the 2021 tax year until April 15^th. The individual limit for 2021 is $3,600 and $7,200 for family coverage. If you are age 55 or older you can contribute an additional catch-up contribution of $1,000 per year.

Capital Gains – With the increased need for active portfolio management, Acumen’s Portfolio Management Committee implemented many changes in 2021 to client portfolios. As a result, there may be additional capital gains liability for the 2021 tax year. Nonetheless, Acumen strives to minimize short-term gains and defer gains to another year when and if appropriate and in line with our investment thesis.

529 Plan Contribution – You may reside in a state and have a state-sponsored 529 plan for which contributions are deductible from state income tax, up to a limit. Tennessee is not a state for which 529 plan contributions are deductible on a state tax return. Since we are not able to track contributions for 529 plans for which we are not the investment adviser, it is up to you to report contributions yourself, to your tax preparer, or to us so we can research the deductibility of contributions for your state.

2021 RMDs – Remember you can direct some or all your RMD amount to a qualified non-profit organization for a Qualified Charitable Distribution. These funds will result in a distribution which will not count as taxable income while also fulfilling your RMD. Charles Schwab will not track the taxability of these distributions.

IRA Contributions – The deadline to contribute to a Traditional, SEP, or Roth IRA for the 2021 tax year is April 15, 2022. For Traditional and ROTH IRAs, the limit is $6,000 unless you are 50 or older which allows you to contribute $7,000. Contribution eligibility, amount, and deductibility is based upon income. Please reach out to us if you would like to make this contribution so we can assess which IRA type is appropriate to fund.

Please feel free to reach out regarding any questions you may have.

This document is provided as a courtesy for informational purposes only. The information has been obtained from sources we believe to be reliable; however, no guarantee is made or implied with respect to its accuracy, timeliness, or completeness. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.

Thoughts of the Portfolio Management Team on the Russia and Ukraine Conflict

Overview of the Conflict

Over the last few months, Russia has built a large military force of approximately 150,000 to 200,000 troops and heavy military equipment around Ukraine’s border. The United States and its allies proceeded to warn Russia there would be severe repercussions of a Ukraine invasion. Russia denied the idea they were going to invade Ukraine. However, shortly after, they presented detailed security demands to the West. One of these demands was Ukraine or other former Soviet nations could never join NATO. Given NATO has an “open-door policy,” the United States stated this wasn’t possible.

Although Russia has repeatedly stated it would not invade Ukraine, it is important to note two regions, Donetsk and Luhansk, declared “independence” from Ukraine in 2014. These two regions have a long history of Russian-backed rebels versus the Ukrainians since 2014. As of February 21, 2022, Russia declared these two regions independent states and gave a fiery speech about Ukraine’s developing security relations with the West. In stating they were independent states, he proceeded to order troops into the pro-Russian regions of eastern Ukraine for “peacekeeping” reasons.

Many world leaders strongly opposed this move and the U.S., alongside allies, have quickly imposed economic sanctions, moved additional troops in NATO territories surrounding Ukraine, and closed a big pipeline project. Biden recently stated, “He’s (Putin) setting up a rationale to take more territory by force,” and “This is the beginning of a Russian invasion of Ukraine”.

As of February 23^rd, further escalation included cyberattacks on Ukraine’s Parliament’s website, additional Russian forces entering the independent states, and a larger military presence around Ukraine’s border. At 10 PM EST, February 23^rd, Russia had officially invaded Ukraine. This came after Vladimir Putin delivered a speech in which he said Ukraine is Russia’s “historical territory”. Immediately after the speech, rocket attacks began on Ukraine’s capital, Kyiv, as well as other large cities in the country.

Portfolio Implications

We entered 2022 with underweight equity market risk in client portfolios. This strategic move was accomplished through a slight underweight of equities as an asset class, but also underweight equity beta. We believed there was a high probability volatility would be much greater in 2022 than previous years because of slower economic growth and more restrictive policy due to higher inflation.

It is often impossible to accurately predict where geopolitical conflict will head, and we are of the opinion that once we do, it is likely priced into financial markets. Instead, we believe it is important to have an action plan with an array of possible outcomes and understand what the portfolio implications are for each.

Throughout history, we have seen the lead up to conflict introduce volatility to financial markets, but a recovery in asset prices long before the conflict is over. Riding out the initial volatility coming from geopolitical conflict has typically been a good strategy over the long term. History has shown just one year after most conflict-induced selloffs, equity markets have risen. This conflict could have more severe implications than past because of the current economic environment. This conflict starts at a point where we are seeing higher inflationary pressures than we have seen since the 1970s and a shift to restrictive policy as a result.

If it becomes clear this conflict will persist for some time, we could see the Federal Reserve adopt an even more hawkish approach to monetary policy as inflation expectations would likely move even higher, which would have negative implications on riskier assets like stocks. We can already see the reaction in major commodity markets such as oil (Figure 1). The other outcome is this conflict could subside very quickly. If this happens, then we believe we will return to the environment we saw going into the year – more restrictive policy and high but slowing growth. In either circumstance, we stick to our original outlook that financial markets will face higher volatility in 2022 and are prepared to manage portfolios accordingly.

Please feel free to reach out regarding any questions you may have.

Your Acumen Team

Information used in this commentary was obtained via Bloomberg L.P.

The opinions expressed in this commentary should not be considered as fact. All opinions expressed are as of the published date and are subject to change. Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. Investments in securities involves risk, will fluctuate in price, and may result in losses. The information has been obtained from sources we believe to be reliable; however, no guarantee is made or implied with respect to its accuracy, timeliness, or completeness. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results. Diversification does not protect against loss of principal.

Macroeconomic Outlook – The Covid-19 pandemic and resulting economic shutdown quickly threw the global economy into a deep recession. Within a very short period, economic growth was in a steep decline, business and consumer confidence was at all-time lows, and we faced a steep deflationary environment. Monetary and fiscal policy authorities deployed massive accommodative policies to help bridge the economic gap to a post-Covid world, and we quickly started a new economic recovery. We do not want to continuously rehash the events that unfolded in 2020 and 2021, but we believe it is important to understand the transition from one stage of the economic cycle to another which happened quicker than normal. We think this is an incredibly important factor to note as, looking forward, we believe we are once again likely to be looking towards a transition in the economic cycle during the next 12 to 24 months – from Mid to Late cycle.

Leading Economic Indicators – These indicators continue to point towards positive economic growth over the next 12 to 18 months. The Conference Board’s Leading Economic Index, a basket of ten economic data points that tend to lead changes in the economic cycle, has exhibited positive month over month growth for the 19^th time in a row. However, the pace of growth in major leading economic indicators is beginning to slow across various time horizons. So, we are experiencing higher than average economic growth with a slowing pace. To us, this points to being Mid Cycle and likely transitioning towards Late Cycle in the next 12 to 18 months.
Policy – A key theme for 2022 will be a less accommodative monetary policy. The Federal Reserve is coming off almost two years of implementing historically ultra-supportive policies. Interest rates have been set at 0% since March of 2020 and the Fed more than doubled the size of their balance sheet in hopes to provide liquidity to financial markets. These policy decisions allowed for quicker than expected recoveries in both the economy and in the labor market. All the stimulus has also led to higher-than-expected inflation. Due to the rise in inflation, the Fed must react by switching from ultra-accommodative policies to more restive ones in hopes to safely slow the pace of the economy. To combat inflation, the Fed plans to raise interest rates at least three times in 2022 and is even considering selling assets from its balance sheet, a task the Fed calls “balance sheet normalization”. Raising interest rates and shrinking its balance sheet will be a top concern for the Fed, but they must implement these policies carefully, as switching from an accommodation stance to a more restrictive one, can be a daunting task. If the Fed moves too quickly, they run the risk of throwing the U.S. into a recession. If they move too slowly, inflation, over time, can eat away real purchasing power.
Inflation – Inflation is likely to once again be another polarizing factor for financial markets in 2022. The reopening of the global economy came at a unique time when there was a boom in demand created by pent up savings and never before seen monetary and fiscal stimulus measures, a broken supply chain caused by Covid-19 disruptions, and a falling labor force participation rate. The resulting imbalance between supply and demand caused inflation readings to produce the hottest numbers we have seen since the 1970s. Supply chain disruptions have shown signs of easing in recent months, but we believe we are in for higher-than-average inflation readings for the short-term because of labor imbalances. However, financial markets have likely priced in higher short-term price increases. The Two-Year Breakeven is currently just above 3% – indicating market participants are currently pricing in an inflation rate over the next two years of approximately 3%. What is interesting is longer-term readings of expected inflation are pricing in a much more moderate rate of inflation. For instance, the Five-Year Breakeven is closer to 2.75% and the Ten-Year Breakeven is around 2.5%. Not only are these measures of longer-term inflation expectations closer to the Fed’s 2% target, but they have all exhibited downward pressure since the beginning of 4Q 2021 – a result of what we believe is a longer-term disinflationary trend. In the decade leading up to the Covid-19 pandemic, central banks struggled to reach inflation targets as an aging demographic and the greater adoption of technology provided a deflationary headwind. We believe the pandemic will exacerbate these trends in the long term, but the supply imbalance caused by labor shortages will keep price changes higher than what we have grown accustomed. This imbalance is likely the factor we are watching most in 2022. But, as of right now, we do not believe we will reach the level of inflation seen in the 1970s many investors have been weary of late.

Equity Market Outlook

Source: Bloomberg. Data as of December 31, 2021

2021 was a year of resilience for equity markets. Amidst some of the highest uncertainty, we have seen since 2008, major equity indexes posted strong returns with the exception of Emerging Markets. For the third year in a row, the S&P 500 climbed more than 15%. While 2020 generated large dispersion in returns between styles, sectors, and themes, 2021 saw a more united rise across approaches to equity investing. Our outlook for the next 12 to 18 months remains constructive for equities, but less so than recent periods. We believe relative valuations, the lack of alternatives, and an expected rise in profits point to long-term upside for equity prices. However, we are taking a more defensive approach to equity exposure as we mature in the economic cycle, monetary policy measures become more restrictive and absolute valuations remain very high. We delineate these viewpoints below in greater detail:

Our Macro Outlook is we are Mid Cycle. While economic growth is likely to remain high, the pace of the growth should slow as we get closer to full employment and closer to our pre-pandemic stage of trend growth. The primary point is equities are less likely to easily digest volatility as this happens. Equity prices climbed walls of worry created by uncertainty behind Covid, politics, and inflation as there was clear upside in terms of how high economic growth was expected to be.
Another key point of our Macro Outlook is the central bank policy is likely to become more restrictive. During 2020 and most of 2021, monetary policy across global central banks was incredibly expansionary and helped drive investors to spend more money and purchase financial assets. This policy framework began changing in late 2021 as the Fed started tapering the amount of assets being added to the balance sheet, and investors began pricing in a higher chance of interest rate hikes in the near term. This change to a more restrictive policy framework is important for a few reasons. Most importantly to stocks, the expansion of the Fed’s balance sheet and cutting of interest rates to near zero incentivized investors to pay a higher price (in terms of valuation) for stocks by being a source of liquidity and taking away the opportunity cost from other investments (bonds). This rate of change to a more restrictive policy framework is less constructive for equities moving forward.
When comparing current equity valuations to their average over the last two decades, they look expensive on almost every level. However, we have been large proponents of the idea high valuations do not necessarily create bear markets in stocks which led us to continue to be long equities in 2021 when the market continued to rise amid skepticism in how high valuations were. However, as the Fed’s policy becomes more restrictive, investors will be less willing to pay as high of a multiple for stocks, causing us to believe 2022 will likely be a year of multiple contraction. We remain constructive on stocks in the long-term as their relative valuation versus bonds remains attractive. Our preferred way to compare the valuations between stocks and bonds is the Equity Risk Premium, which compares the yield that a dollar of investor capital is generating in earnings to the yield investors, are receiving off popular bond investments. By this measure, stocks remain attractive in the long term. The chart below shows the Equity Risk Premium for the S&P 500 to the Ten-Year Treasury Yield, the 30-Year Treasury Yield, and the yield on investment grade corporate bonds.

Our outlook on valuations, described above, has a couple of important implications for equity portfolios. For one, we want portfolios to have equity exposure to companies that do not exhibit valuations detached from underlying fundamentals. 2020 and most of 2021 showed investors were very willing to pile into more speculative areas of the equity market. That trend began reversing in late 2021 and we believe it will continue to do so in 2022. We believe equity exposure should be positioned towards high quality companies whose earnings growth can generate positive returns amidst the multiple contraction we believe will come in the next 12 to 18 months.
Two other tilts we have within equity portfolios moving into 2022 is to be lower beta and higher exposure to international equities relative to target. Our decision to lower the beta of equity exposure comes as we believe higher speculation will continue to fall out of favor, and the broad equity market could move more sideways with multiple contraction and higher volatility. Our decision to overweight international stocks comes as the price investors are paying for International Equity exposure versus that of Domestic exposure has reached an all-time high. This trend in the valuation spread between the two exposures have been building for years, but we believe a tailwind finally exists in the international space to close this gap as major international economies are expected to have higher GDP growth and higher earnings growth than their long-term average. This upside is aided by the slower reopening in international economies post-Covid.

Fixed-Income Market Outlook

2021 was a historically bad year for bonds. The Ten-year Treasury yield ended the year up over 60 basis points. This yield was the biggest annual rise since 2013. Yields rose across the curve and especially at the short end. The Bloomberg Barclays Agg returned -1.61% in 2021. Our stance going in to 2021 was to be underweight fixed income due to low real yields, rising economic growth and inflation, and range-bound yields. Going into 2022, we expect to remain underweight fixed income.

A key to our fixed-income outlook is understanding the current shape of the yield curve and how it is expected to change going forward. The shape of the yield curve is determined by expectations on inflation, economic growth, and Fed policy changes. Throughout 2021, we saw the yield curve become flatter. Yields rose across the curve but rose more for shorter term bonds. We expect this trend to continue into 2022 and is a primary reason we are going into this year with a negative outlook on fixed income.
Federal Reserve policy is quickly becoming less accommodative. For the past two years, the Fed has provided financial markets with massive amounts of liquidity through quantitative easing and remained very accommodative by keeping interest rates anchored at 0%. This period of extreme accommodation is over. The Fed is now on pace to end quantitative easing by late March 2022 and is expected to raise interest rates quickly after. The consensus is the Fed will raise the federal funds rate at least three times in 2022. Along with raising interest rates, the Fed is also expected to begin quantitative tightening (the Fed selling government securities) sometime this year. This switch from easy, accommodative policy to restrictive policy will have a significant impact on financial markets.
While yields are expected to rise in 2022, with some expecting the yield on the Ten-Year Treasury to rise to 2.25-2.5%. We differ in this viewpoint and believe yields will remain low in the long-term as long-term inflation expectations are anchored near 2%, short-term inflation expectations are decelerating, and the Fed is expected to slow inflation even more. As yields do rise, we see this as an opportunity to extend duration and lock in higher yields. In terms of positions within fixed income, we favor high quality over low quality, and we prefer to not take on excess risk from bond positions. We expect slower economic growth and higher volatility going forward and having a tilt toward high quality can help protect portfolios during volatile periods. We also favor taking a bar-belled approach to duration to help take advantage of a flattening yield curve. A more bar-belled strategy involves concentrations in short- and long-dated securities. The allocation to longer dated securities allows us to average into higher yields over time while the allocation to short, dated securities helps reduce interest rate risk by reducing price sensitivity.
While we have been underweight in bonds for a while, and continue to be into 2022, we still believe bonds are essential to investment portfolios in the long term. Bonds offer diversification and capital preservation benefits are important to overall portfolio performance.

Asset Class Views

All indexes are unmanaged, and an individual cannot invest directly in an index. Index returns do not include fees or expenses.

The Conference Board Leading Economic Index® (LEI) for the U.S. – The composite economic indexes are the key elements in an analytic system designed to signal peaks and troughs in the business cycle. The leading, coincident, and lagging economic indexes are essentially composite averages of several individual leading, coincident, or lagging indicators. They are constructed to summarize and reveal common turning point patterns in economic data in a clearer and more convincing manner than any individual component – primarily because they smooth out some of the volatility of individual components.

The ten components of The Conference Board Leading Economic Index® for the U.S. include:

• Average weekly hours, manufacturing

• Average weekly initial claims for unemployment insurance

• Manufacturers’ new orders, consumer goods and materials

• ISM® Index of New Orders

• Manufacturers’ new orders, nondefense capital goods, excluding aircraft orders

• Building permits, new private housing units

• Stock prices, 500 common stocks

• Leading Credit Index™

• Interest rate spread, 10-year Treasury bonds less federal funds

• Average consumer expectations for business conditions

Gross Domestic Product (GDP) is the monetary value of all finished goods and services made within a country during a specific period.

The 10-year Treasury Yield is used as a proxy for mortgage rates. It’s also seen as a sign of investor sentiment about the economy.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.

Fed Funds Rate is the interest rate U.S. banks charge each other to lend funds overnight

The velocity of money is a measure of the number of times that the average unit of currency is used to purchase goods and services within a given time period.

The opinions expressed in this commentary should not be considered as fact. All opinions expressed are as of the published date and are subject to change. This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure they obtain all available relevant information before making any investment. Any forecast, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given, and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results. Diversification does not protect against loss of principal.

Debate continues in Washington over the proposed tax changes contained in the Build Back Better Act and the Bipartisan Infrastructure Bill. These tax proposals would raise the top marginal income tax rate from 37% to 39.6%. The increased top marginal rate, combined with the expanded 3.8% net investment income tax, would apply to active business income. In addition, a new 3% surcharge for high-income taxpayers with adjusted gross income above $2.5 million ($5 million for married couples) creates a maximum federal tax rate of 46.4%. The maximum capital gains tax rate would increase from 20% to 25%, but earlier the proposed rate was as high as 39.6%. While both proposals contain numerous provisions affecting both individuals and businesses, one key area under scrutiny in both proposals are Roth IRAs.

You may have seen news articles pointing out Peter Thiel’s $5 billion Roth IRA was originally funded with $2,000 worth of his initial PayPal shares. Coincidence or not, restrictions on Roth IRAs are very likely to be implemented under the current tax proposals. Wealthy savers won’t be allowed to contribute to Roth or traditional IRAs if the combined value of their defined contribution plans exceed $10 million in the prior year. This would apply to single individuals earning more than $400,000 or married joint filers earning more than $450,000. Furthermore, “back-door” Roth conversions of after-tax traditional IRA or 401(k) will be off limits for those earning more than $400,000 per year. Historically through “Mega-backdoor” Roth conversions, wage earners could contribute up to $58,000 in after-tax money to a 401(k), roll it into an IRA, and then make a Roth conversion. This process would be banned for everyone. “Backdoor” and “mega-backdoor” limitations would be banned starting in January 2022. All Roth conversions would be banned for high-income earners starting in 2032.

If the combined balance of an investor’s IRA, Roth IRA, 401(k) and other defined benefit plans exceeds $10 million, they would be required to distribute the excess balances. The new required minimum distribution (RMD) would be 50% of any amount over $10 million. An RMD of 100% would apply to any balance beyond $20 million. Mr. Thiel could be facing a rather large RMD with a 40% tax rate.

It is important to note the estate tax exemption is proposed to return to the pre-Tax Cuts and Jobs Act limit of $5 million in 2022. This exemption creates a significant estate tax issue for some who were not previously exposed to estate taxes under the higher estate tax exemption. With more estates being affected by estate tax, it is possible to avoid an estate tax trap using Roth accounts. Traditional IRAs are subject to estate tax and essentially taxed on an embedded income tax liability. To help illustrate this scenario, assume a $1 million traditional IRA is within an estate subject to estate tax. The $1 million traditional IRA would be subject to a 40% estate tax. However, when the $1 million is distributed to the beneficiaries, the distribution would be subject to ordinary income tax, potentially at 39.6%. The net cash after estate tax and ordinary income tax on $1,000,000 would only leave $204,000 remaining. If this $1 million traditional IRA was converted to a Roth IRA in 2021 and we assume the highest tax rate of 37%, the resulting Roth would be subject to estate tax, but not the ordinary income tax on distribution. While it’s never fun to pay a 37% tax rate, this strategy could generate $174,000 in tax savings as shown here:

Example Savings

Traditional IRA	$1,000,000	Roth IRA	$1,000,000
Cash outside of IRA	$370,000	Cash outside of IRA (After Tax on conversion)	$0
Estate Tax	($548,000)		($400,000)
Ordinary Income tax on distribution	($396,000)		$0
Net Cash	$426,000		$600,000

Savings

$174,000

There may be an extra incentive for 2021 Roth conversions even at higher ordinary income tax rates, especially for those with estate tax considerations. Keep in mind the tax proposals are still being negotiated. However, Roth conversions and the estate tax exemption are both known points of scrutiny.

This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. The opinions expressed in this commentary should not be considered as fact. All opinions expressed are as of the published date and are subject to change. The information has been obtained from sources we believe to be reliable; however no guarantee is made or implied with respect to its accuracy, timeliness, or completeness. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.

During the last 18 months, we have become accustomed to pessimistic narratives. And, while the third quarter of this year didn’t include a new pandemic, revived social unrest, or Prince Harry and Meghan Markle leaving the royal family, the NUMBER of pessimistic narratives surrounding the third quarter was significant. Volatility across foreign policy, the Delta wave, supply shortages, and the debt ceiling debate, all contributed to a stock market (S&P 500) that was up approximately a half of a percent and a bond market (Bloomberg Barclays U.S. Agg) that was flat in the third quarter. While a look at the third quarter might provide a negative view for financial markets volatility was actually introduced in September as the S&P 500 fell more than 4% during the month. However, we are reminded there was an average drawdown of close to 14% every year since 1980 in the S&P 500 [1], and we believe the bull market, started on March 23^rd of 2020, is still intact. Below, we outline our view on major topics surrounding financial markets today.

Economic Growth

One variable, used to help construct our outlook on future economic growth, is leading economic indicators. Leading indicators are economic datapoints tending to move before major changes in the business cycle. Changes in the business cycle can have drastic implications for how we allocate assets. We like to use a basket of leading indicators constructed by the Conference Board – the Leading Economic Index (LEI). The LEI has continued to advance and continues to create a constructive outlook for economic growth. However, one important point we believe should be noted is the upward rate of change has begun to slow. This change causes us to believe we could be transitioning from an early expansion phase of the business cycle to a more mature phase of the business cycle. Other indicators of economic growth support this view as well. While we believe the level of economic growth will continue to increase, there is evidence the rate of change will slow over the next 12 to 18 months. This slowdown/decrease has implications on our asset allocation. With the transition of the business cycle from an early expansion to mature, the market will typically not be able to digest volatility as well. But we typically do not see sustained bear markets without a transition in the business cycle from a period of growth to a period of decline.

Inflation

The original catalyst for the idea of higher inflation was the increase in government deficits across most major economies driven by large amounts of stimulus. At the same time, the Federal Reserve changed its policy framework to allow for higher inflation in the short-term. This unfamiliar policy shift, coupled with the idea that pent up demand would cause supply bottlenecks, caused inflation to become the most hotly debated topic amongst investors and economists. While we believed supply chain disruptions would cause short- to medium-term higher inflation, we adhered to the idea high inflation would not become a structural problem. Current inflation readings have been higher than the long-term average, as we have seen major supply chain disruptions. We believe a few reasons for the disruptions across supply chains are the reliance on Just in Time inventory, a greater need on a globalized supply chain in today’s world, and the labor market dynamics of higher unemployment as demand has surged post Covid lockdowns. Our opinion remains that these pressures will subside as labor market dynamics heal and the surge in demand subsides. Our long-term view remains; there are too many structural headwinds to higher inflation – two of which are aging demographics across major economies and the further adoption of technology in the modern economy. However, we believe the most important factor causing inflation to be transitory is recent history telling us higher government deficits are a drag on growth and, as a result, inflation. While higher debt and stimulus may provide a sugar high for a moment, the long-term effects have been largely disinflationary. We believe inflation cannot become a long-term factor unless we see the Velocity of Money increase – the measurement of the rate at which money is exchanged in an economy. This variable has been falling for years as banks have been disincentivized to lend more capital. This relationship can be seen from the deviation in loans and deposits in major banks. While headline inflation readings have risen to their highest levels in over a decade, we have started to see them begin to cool over the previous two months. We have some tactical allocations to asset classes that do better in an inflationary environment, but our long-term outlook for inflation has kept us from changing portfolio allocations in a sizable way to be geared more toward a higher inflationary environment.

Asset Class Views

After a more volatile third quarter, major stock indices are still up more than 10% for the year. We believe the equity market is still showing a green light due to various fundamental factors. Positive economic growth, relative valuations to bonds, and high forecasted earnings growth all create a positive backdrop for equity performance over the next 12 to18 months. Risks to this outlook are the relatively high valuations from a historical perspective that equities show and the withdraw of Monetary Policy support many speculate could happen soon. Typically, the withdrawal of Monetary Policy will compress the premium investors are willing to pay for equities, and this leads to downside in equity prices when corporate profits are not growing. Today, while the decrease in Monetary Policy could create some headwinds for equities, we believe investors should be positioned at their target weight for equities as expected earnings growth is higher than what we typically see. Within equity allocations, we see a reason to be slightly overweight in International Equities, as valuations look much less stretched across the space than for Domestic Equities. We continue to favor an overweight to high quality companies with long-term earnings growth, and we believe a portion of equity allocations should be to areas doing better when economic growth is strong, and inflation is higher – such as Small Cap Equities and real estate. Overall, we are neutral weight to equities as a whole and have a slight defensive tilt toward high quality and lower beta [2].

Our outlook for bonds continues to be less constructive and we remain underweight in Fixed Income relative to targets. While yields have risen during 2021, they remain at all-time lows across maturities; there is a direct correlation in the total return investors have made across the Fixed Income market over the previous 40 to 50 years and the level of yields. This relationship can be seen in the chart below comparing the 10-Year Yield with the 5-Year Total Return for the Bloomberg Barclays U.S. Aggregate Bond Index over the last 45 years. One area we tend to deviate from conventional thinking amongst investors is that most have positioned bond allocations for rising interest rates. However, we believe rates will continue to fall in the long-term, which is why we have been buyers of the recent rise in interest rates during the year. Our outlook is moderating growth and inflation will begin to create a backdrop for lower rates. Since the United States is one of the only major economies with positive interest rates, drawing investors in could be a major catalyst for lower rates as well. Consequently, while we are underweight in fixed income, we have been lengthening duration in fixed income allocations to take advantage of higher rates in the short-term.

Chart created via Bloomberg, L.P. as of 8/31/2021.

The opinions expressed in this commentary should not be considered as fact. All opinions expressed are as of the published date and are subject to change. Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. Investments in securities involves risk, will fluctuate in price, and may result in losses. The information has been obtained from sources we believe to be reliable; however no guarantee is made or implied with respect to its accuracy, timeliness, or completeness. It is suggested you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results. Diversification does not protect against loss of principal.

The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. The index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. The S&P 500 Index focuses on the large-cap segment of the market; however, since it includes a significant portion of the total value of the market, it also represents the market. The Nasdaq Composite is a stock market index that includes almost all stocks listed on the Nasdaq stock exchange. Along with the Dow Jones Industrial Average and S&P 500, it is one of the three most followed stock market indices in the United States. The Russell 2000 Index® measures the performance of the 2,000 smallest companies in the Russell 3000 Index. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The Bloomberg Barclays Intermediate US Government/Credit Bond Index is a broad-based flagship benchmark that measures the non-securitized component of the US Aggregate Index with less than 10 years to maturity. The Composite Index of Leading Indicators, otherwise known as the Leading Economic Index (LEI), is an index published monthly by The Conference Board. It is used to predict the direction of global economic movements in future months. The Index is composed of 10 economic components whose changes tend to precede changes in the overall economy

All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not include fees or expenses.

[1] Source: https://fulfillment.lordabbett.com/file/16cc35ecc5b8ad2d36de025222fcca40/filename/Volatility_Brochure#:~:text=In%20fact%2C%20in%20any%20given,Index%20historically%20has%20been%2014%25

[2] Beta is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole.

First Quarter Recap

The first quarter brought political change and increased optimism that reprieve from the global pandemic is within reach. President Biden assumed office with a Democrat-controlled legislature, Congress passed a $1.9 trillion stimulus package, and vaccine distribution accelerated across the country with nearly 100 million Americans receiving at least one dose. New daily Covid cases peaked at the beginning of January before rapidly declining through March, and states continued lifting restrictions allowing businesses to welcome more customers in person.

The Bureau of Labor Statistics reported the U.S. added 916,000 jobs in March, and the unemployment rate declined to 6.0% (down from last April’s rate of 14.8%) with leisure and hospitality posting the largest gains. The Consumer Confidence Index (CCI) from the Conference Board reached its highest level since the beginning of the pandemic. Also, business sentiment, measured by the Institute of Supply Management’s Manufacturing Purchasing Managers Index (PMI), registered its highest reading since 1983. Demand for manufacturing industries was strong as the recovery gained a foothold. But supply and labor constraints caused some pricing pressures; as a result, inflation indicators are likely to rise in the coming months especially as prices are compared to last year’s price levels which were driven lower by the pandemic. Despite all of this positive momentum, the Federal Reserve committed to remaining accommodative to support the recovery by leaving rates low and continuing asset purchases until further progress is made towards full employment.

Cyclical sectors, such as energy and financials, continued their outperformance in the first quarter as the outlook for economically sensitive industries improved. The second round of direct payments will likely help spur consumption as businesses reopen and consumers have extra cash from the stimulus and higher savings rates. Among asset classes, small cap equities and real estate outperformed as investors priced in a robust economic recovery for 2021. Investors trimmed their holdings in large technology companies and other crowded trades as analysts had to assess whether future earnings growth could support all-time high valuations or if earnings had been pulled forward due to Covid trends. Still, U.S. equity valuations remain above their historical averages with the S&P 500 up nearly 6% in the first quarter. These valuations underline the need for portfolio diversification and careful security selection.

Outlook

While we attempt to steer clear of making matter of fact statements about what WILL happen, we believe investors must be aware of the current environment and where it is likely to lead us. This, of course, is how we derive our investment thesis and position portfolios. We remain objective about the range of possibilities, assigning probabilities, and diversifying amongst them to generate the best risk-adjusted return. We believe there are a few possibilities in this current environment that have higher probabilities than others. For one, from a top-down perspective, we believe equities will outperform bonds. Our research tells us we are at the start of a new economic expansion, while the monetary policy framework, adopted during 2020, has brought us to 2021 with historically low interest rates. During the fourth quarter of last year, when the world was on the verge of opening again due to positive vaccine news, we decided to underweight fixed income relative to target-weight in client portfolios. We believed drawing closer to the reopening of the global economy would cause nominal bond yields to move drastically higher.

When yields move up, the price of bonds go down, which then generates a negative return. We continue to hold the view bond investors will receive a lower return than what they have historically experienced, and higher inflationary pressures will generate negative real returns for bond investors. However, we adhere to the idea bonds play a key role in portfolio construction across longer time horizons, and another dramatic move in interest rates could create attractive buying opportunities. While we have remained underweight in fixed income, we do not currently believe in significantly overweighting equities. Our belief is there must be both a top-down reason and bottom-up reason for significantly overweighting an asset or asset class. While the new economic expansion and easy monetary policy provides an optimistic backdrop for global equities, their valuations cause them to be expensive. We like to use the Federal Model to value equities relative to bonds. This measure takes the reciprocal of the Price/Earnings ratio, generating an Earnings Yield, and compares the ratio to the yield investors receive on a risk-free bond – typically the 10-Year Treasury. When the Earnings Yield for stocks is greater than the yield investors are getting on their respective risk-free bond, then stocks are relatively attractive, as is the case today. In the chart below, we can see the Earnings Yield for the S&P 500 minus the 10-Year Treasury Yield. While the spread between the two is currently positive, signaling attractive valuation for stocks relative to bonds, the measure is below its 20-year average line.

While stocks are relatively attractive to bonds, they are expensive on an absolute basis when we look at other measures such as the Price/Earnings ratio, or the Cyclically Adjusted Price to Earnings (CAPE) ratio. We have also attempted to diversify some of this risk by investing more heavily in international stocks, and emerging market stocks. These stocks have valuations which are less extreme and have tailwinds if we see higher inflationary pressures. If we are underweight in fixed income, but not overweight in equities, then where do we believe investors should invest the rest of their capital? We have looked to alternative assets, typically having much lower correlations to the broad equity market, to look for both opportunities and diversification benefits. Even within the equity allocation in client portfolios, we have a targeted allocation to real estate which has historically displayed lower correlation to the rest of the equity market and a higher correlation to economic growth. Other areas of the market we consider alternatives are commodities and hedged equity. These alternatives are exposures in portfolios we find provide greater downside protection in periods of heightened volatility. We believe volatility will be a key player over the next few years since we have seen political uncertainty rise across the globe and financial assets are priced richly. To us, coupled with a positive macroeconomic backdrop, this volatility will generate substantial buying opportunities as did the Covid pandemic generated within financial markets in 2020.

To learn more about how Acumen can help you Invest Intentionally®, please contact us.

Information and charts used in this commentary was obtained via Bloomberg L.P.

The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. The index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. The S&P 500 Index focuses on the large-cap segment of the market; however, since it includes a significant portion of the total value of the market, it also represents the market. The Russell 2000 Index® measures the performance of the 2,000 smallest companies in the Russell 3000 Index. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The Bloomberg Barclays Global High Yield Index is a multi-currency flagship measure of the global high yield debt market. The index represents the union of the US High Yield, the Pan-European High Yield, and Emerging Markets (EM) Hard Currency High Yield Indices. The Bloomberg Barclays Aggregate Bond Index is an index used by bond traders, mutual funds, and ETFs as a benchmark to measure their relative performance. The index is broadly considered to be the best total market bond index, as it is used by more than 90% of investors in the United States. 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.

The Purchasing Managers Index (PMI) is a measure of the prevailing direction of economic trends in manufacturing. The PMI is based on a monthly survey of supply chain managers across 19 industries, covering both upstream and downstream activity. Price to forward earnings is a measure of the price-to-earnings ratio (P/E) using forecasted earnings. The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. The CCI is based on the premise that if consumers are optimistic, they will spend more and stimulate the economy but if they are pessimistic then their spending patterns could lead to a recession. The CAPE ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.

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When considering real estate as an investment, there are two predominant questions to consider. What is the best TYPE of real estate to own and is NOW a good time to invest? We believe single-family residential rentals represent a growth opportunity for now and the future. According to a Gallup Poll, real estate remains one of the most favored investment to Americans and has ranked in the top spot every year since 2013.^[1] However, it can be a barrier for most investors because it can be considerable work. We believe residential single-family housing is an ideal real estate investment and an important method to diversify an asset portfolio.

Inventory at All-time Lows – The availability of single-family “for-sale” homes has dwindled as the Coronavirus pandemic fueled demand for single-family homes. The average 2020 for-sale inventory is 63% of the 1982 level.^[2] According to the World Bank, the United States population in 1982 was around 231 million compared to 2019 with a population of 328 million. With almost an additional 100 million people in America, the for-sale inventory is considerably less than nearly 40 years ago. Dr. Frank Nothaft, Chief Economist for CoreLogic says, “The demographic tailwind has arrived as Generation X and Millennials drive housing demand. Lower-priced home values increased about one and a half times faster than higher-priced home values in November, as first-time buyers tend to seek out homes within the lower price ranges.”² Housing demand should continue to be fueled by a large generational move into prime home buying age and low mortgage rates. We anticipate continued supply constraints as both building materials and labor experience Coronavirus-related tension. Builders worked to provide new housing starts, particularly the latter half of 2020, but volatile material prices (extremely high lumber prices in August) and lack of available land kept homebuilders from meeting much of the demand. Additionally, based on the National Home Builders Association, home construction has yet to return to levels seen prior to the 2008 Great Recession.[3]

Income is Scarcer than Ever – Bonds have long been a favored investment because they paid income and mitigated risk over equities. The United States 10-year Treasury currently sits around 1.5% and remains at historic lows. Compare this rate to 15% in 1981 when the baby boomers were in accumulation phase. Fixed income does not offer the preservation of capital it once did. We believe residential real estate meets a long-term need and the single-family “type” of real estate meets a changing-need list to provide consistent rental income. Could single-family real estate be the new proxy for bonds?

Residential Real Estate Meets a Need – People will always need a place to live. Residential real estate benefits from a large pool of potential tenants compared to commercial which relies on businesses. As businesses and consumers acclimate to virtual marketplaces and remote work opportunities, we believe the demand for single-family homes will increase. The pandemic has created a change in housing needs. The time spent at home has placed an emphasis on additional space – indoors and out. Remote work has unlocked new home considerations outside of typical criteria such as commute ranges or city specific cost-of-living. One of the most searched Zillow words of 2020 was “pool” and a dedicated home office space remains at the top of surveys.[4] A Zillow survey shows 31% of respondents wish to live in a home with a dedicated office space, 30% desire to live in a larger home, 29% to live in a home with more rooms, and 25% to live in a less-dense area with fewer neighbors.^[5] In a Freddie Mac survey, respondents listed the top factors influencing single-family housing as their preferred rental choice. The top three factors were laundry, privacy, and parking.^[6] These factors make a compelling case for why single-family home demand will continue and shift away from large multi-housing buildings.

Value – Multifamily housing has long been a hot sector for large hedge funds as they can acquire 100+ units in a single transaction. While multifamily housing has performed well, there might be an abundance of capital chasing a small pool of opportunities and creating a “priced-to-perfection” scenario. Conversely, by purchasing a single-family residence, the buyer can capitalize on the undervalued anomalies in the market as a “one off” transaction. The rise in remote work has sparked a suburban boom creating buying opportunity further away from the urban core. What was previously considered too far of a commute is now on the search radar. According to Corelogic, the United States single-family rents increased 2.9% year over year, which is more than double the rate of inflation over the same time period.^[7] There is immense demand for single-family rentals with general occupancy rates at just over 95%, indicating the highest rate since 1994.^[8] Some industry experts believe the single-family rental home sector will outpace multifamily housing in terms of rent and revenue. Additionally, institutional owners are estimated to own less than 2% of the total SFR housing stock.^[9]

Location, Location, Location – The best real estate opportunities may exist in smaller markets as affordability becomes more of a driver. Many workers no longer report to the office, so there is increased mobility in the workforce. Business-friendly states with low taxes will likely continue to experience growth. Increasingly, densely populated cities and states are becoming “move out” markets. For the seventh straight year, more people left California than moved in. In a recent UC Berkeley poll, 52% of registered voters say they have considered leaving the state.^[10] The top reasons are high cost of housing, high taxes, and political culture. A recent United Van Lines migration study listed metros with the highest move out/move in for 2020. New York, New Jersey, and Illinois were the top three spots on the outbound list in 2020. Tennessee was seventh on the inbound states with South Carolina, North Carolina, Alabama, and Florida also making the list. Understandably, Tennessee presents a continued opportunity to invest in residential real estate because of the increased desire to live in our great state.^[11]

It is our opinion there will be continued demand for single-family homes, particularly in a strong market like Tennessee. Opportunity exists to capitalize on price and location in a time when Tennessee cities are projected to attract more business and generate employment opportunities. While the future is bright for Tennessee real estate, there are also numerous barriers to entry. Unlike other investments, real estate is not a passive investment. From tenant relations to rent collection to maintenance requests, real estate can be very time consuming. Procuring the right real estate investment requires knowledge and contacts in individual markets, particularly in high growth markets. These investments also require a strong overview of industry knowledge relative to local zoning and ordinances, boundary and surveys, covenants, restrictions, HOAs, and property maintenance. Many good opportunities require some cosmetic updates and remodeling and can also require improvements after tenants vacate. The many factors and complexities to successful real estate investing serve to eliminate many would be investors from entering. Conversely, having the knowledge and resources needed to navigate those same complexities and barriers can set the stage for a great investment with the potential to generate great returns and appreciation.

To learn more about how Acumen can help you Invest Intentionally®, please contact us.

The opinions expressed in this commentary should not be considered as fact. All opinions expressed are as of the published date and are subject to change. Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. Investments in securities involves risk, will fluctuate in price, and may result in losses. The information has been obtained from sources we believe to be reliable; however, no guarantee is made or implied with respect to its accuracy, timeliness, or completeness. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results.

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[2] “US Home Price Insights: Through Nov 2020 with Forecasts from Dec 2020 and November 2021”, Corelogic, Jan 2020

[3] A Decade of Home Building: The Long Recovery of the 2010s | Eye On Housing

[4] From ‘Zoom Rooms’ to Chef Kitchens: Zillow’s Top 10 Home Trends for 2021 – Dec 10, 2020 (mediaroom.com)

[5] “More Remote Work Opportunities May Make Suburbs More Desirable”, Zillow Research, May 13, 2020

[6] “Single Family Rental: An Evolving Market”, Freddie Mac Multifamily, October 2018

[7] “Single-Family Rents Increasing Twice As Fast As Inflation”, Corelogic, March 2020

[8] “Q3 02 Single -Family Rental Investment Trends Report”, Arbor Research, Q3 2020

[9] “Where Is The New Class Of Investors Buying Single-Family Rentals?”, Forbes, Nov 2019

[10] “For 7^th Year in A Row, More People Left CA than Moved In”, nbcbayarea.com, Nov 2019

[11] “United Van Lines’ National Migration Study Reveals Where and Why Americans Moved in 2020”, Unitedvanlines.com, January 2021