Q2 2020 Investor Letter

Quarterly commentaries give us the opportunity for reflection. They allow us to think about what has, and is happening, in the markets and economies around the world. To consider what we have done well, where we can improve, and how we can be better fiduciaries. If you know anything about us, you know we are constantly challenging the status quo and innovating in pursuit of better outcomes for our clients.

With this in mind there is much to discuss this quarter, but I’d like to start by acknowledging the 119,761 people who have died in our country as of June 30, 2020 from the coronavirus. It’s been an especially difficult time for me, as one of those people was my 78-year-old father Richard who had been in an assisted living facility for the past 9 months. We had a loving relationship and I’m grateful to have many special memories. My hope is that you and your family are safe and well, and remain so, as we work to move past this health crisis.

I’d also like to say something about the social and economic struggles of many in our country. I believe it is our responsibility, to be part of the solution. We are committed to listening, learning, and finding ways to do just that. I strongly agree with Larry Fink, Founder and Chief Executive of Blackrock, who recently said, “Society is demanding that companies, both public and private, serve a social purpose… To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society.” Whether investing on behalf of our clients or running our business, we will continue to push forward in this direction.

This is especially true today as the emergence of the global pandemic has caused severe economic shocks. U.S. GDP for the first half of 2020 was down -22% annualized from Q2 2019. The Conference Board’s base case estimate, which excludes a second wave and any additional shut down of the economy, projects that U.S. GDP will contract by -7% for the entire year.¹ To put this into perspective, during the Credit Crisis U.S. GDP fell –4.8% from its peak in Q4 2007 to its trough in Q2 2009.²

U.S. GDP 2007-2020

At this point, our national priorities seem clear: flatten the virus curve; reverse the economic decline curve; and maintain stability in the financial markets until there is a vaccine and the majority of the country is vaccinated. But what happens if people don’t follow social distancing and a second wave takes over? Or the vaccine takes longer than anticipated to create and/or widely distribute? Or Congress doesn’t easily agree to new fiscal stimulus when the current programs ended in July or in the future until we are post-pandemic? We also have global supply chain problems, issues with China, unemployment at an untenable level, and a presidential election — all posing additional risk. Anyone of these could break the wrong way and cause another round of significant turmoil in the markets.

Given all the variables, it is unlikely that as a country we’ll execute on all these without some missteps. That said, the market has climbed the proverbial “wall of worry” in the second quarter and I remain bullish on America, our economy, and the market’s long-term prospects; but in the short-term anything can happen. Which is why we don’t try to predict the future; we prepare for it. Now more than ever, as we are facing extreme uncertainty, I think this approach is essential to avoid making critical mistakes. When the unexpected happens, we follow our game plan versus reacting emotionally, as many investors do, which has proven time and time again to lead to poor outcomes.

Personally, I’m excited NYC is reopening. It’s been difficult these past few months and New Yorkers have done their part to flatten the curve. But as I venture out, I’m struck by the large number of vacant storefronts and can only imagine what is going on inside the commercial buildings. I’ve experienced a number of severe economic recessions over my professional career, and I’m certain we’ll get through this, but the damage caused by this one to date is something I’ve never witnessed before – I’m not sure any of us have. I am happy to see traffic returning to the highways and welcome the endless number of construction projects I see and hear (things I thought I’d never say), it’s good that people are getting back to work. Slowly but surely there seems to be a recovery occurring in many of the nation’s largest cities.

While a small number of companies are flourishing from the pandemic economic landscape, many have seen their businesses destroyed. Yet I’m amazed at the never-ending ingenuity from companies as they adapt and innovative to stay in business. When faced with enormous and unthinkable challenges we, as Americans, have always found a way to persevere. With so many people that will need assistance in years to come, I’m hopeful we will create a more inclusive economy as we rebuild and flourish in the future.

In order to minimize the economic impact of the pandemic, we need to be vigilant today. Our ability to control the spread of the virus is ultimately the single largest factor in determining the continuation of the economic recovery. As different parts of the country have reopened before NY, the renewed surge in cases is not encouraging and, in some places, it is downright scary. This is extremely unfortunate, especially when other countries have been able to reopen their economies more sustainably. While the market seems to be predicting a vaccine is around the corner, we won’t presume to know when it will arrive, even though we are confident one will.

What’s Happened Year-To-Date

As we all know the negative economic impact of this pandemic has been large to say the least. In response, the Federal Reserve slashed interest rates to almost zero, ramped up large-scale asset purchases and launched numerous programs designed to provide stability to the U.S. financial system. Our recent article Putting Economic Intervention Into Perspective discusses these programs, as well as what they mean for investors and the economy going forward. These actions provided much needed assistance to individuals, small businesses, corporations and the markets that were all being impacted by the pandemic.

While these programs have had an immediate impact and have done a tremendous job keeping the U.S. economy out of a depression, unfortunately we are still in a very difficult position. The initial economic shutdown caused significant unemployment. After the massive stimulus, we still find ourselves with a slightly over 11% unemployment rate – which is much better but still very problematic. To put this into perspective, the peak unemployment rate during the Financial Crisis was around 10%. We are now in a similar position but with interest rates at or near zero and having already built up a lot of debt.³

As the current fiscal stimulus ran out at the end of July, companies are realizing that this is not a short-term economic downturn. Recipients of PPP loans, who have kept people employed to meet the terms of their loan forgiveness, may start another round of layoffs causing unemployment to rise again. Either the government will have to continue the fiscal stimulus, or the economy may quickly move from a recession to a depression – the exact outcome the government has been intent on avoiding.

There are no easy solutions. However, the impact of these actions, both current and future, will play a significant role in what occurs over the foreseeable future and has already impacted our approach towards portfolio diversification – I’ll discuss this in greater detail a bit later.

Market Reaction to Fed’s Stimulus

The Federal Reserve’s $3 trillion effort since March to minimize the economic crisis is creating excesses across U.S. markets. While stimulus by other central banks is similarly influencing international markets. The U.S. central bank has pledged unlimited financial asset purchases to maintain market liquidity, increasing its balance sheet to approximately $7 trillion by the end of the second quarter. To put this into perspective, the Fed increased its balance sheet $3 trillion over the last 12 years to manage the impact of the Financial Crisis and has now done the same over the last three months. Its mind blowing the extent to which they’ve needed to prop up the markets.⁴

While most of the buying has been focused on treasuries and mortgage-backed securities, a small amount to date has been allocated to corporate bonds. The Fed’s commitment to support the corporate bond market has created a strong appetite for bonds and stocks. While it seems counter intuitive, as the pandemic has gotten worse in the U.S., we have seen a significant recovery in the markets. Investors have grown confident that the Fed will continue to provide massive stimulus and maintain extremely low interest rates for the foreseeable future. With tremendous liquidity and the need to put the money somewhere, individuals and corporations are putting some of it into stocks pushing the markets higher and stretching valuations.

Since its bottom on March 23, the S&P 500 Index rose more than 40%⁵, the MSCI All-Country World Index (“ACWI”) has gained over 40%⁶ and the Bloomberg Barclays Aggregate US Bond Index (“AGG”) is up over 6%.⁷ However, the S&P 500’s cyclically adjusted P/E ratio is currently at its highest level since the 2000 tech bubble, and at its 3rd highest ever, close behind the level reached in 1929.⁸ This rally has created a surge in equity issuance with $137.7B in the second quarter (+85.7% Y/Y) and $193B YTD putting 2020 on track to be the single biggest year since 2000.⁹

U.S. Corporate Bond Issuance Over the Past 10 Years

With its interest rate policy and massive appetite to buy bonds, the Fed’s stimulus has also unleashed a wave of corporate debt issuance with $868B in the second quarter ( +151.7% Y/Y ) and $1.427T YTD already surpassing the total for all of 2019. However, if there isn’t a significant economic recovery, many of these indebted companies won’t be bringing in enough revenue to service and pay back their debt. As a result, even as they are shoring up their balance sheets today, we believe it’s only a matter of time until there is a wave of bankruptcies.

Where Does This Leave Us?

The markets have clearly disconnected from the economy and there is tremendous uncertainty. In a typical recession, the economy usually hits bottom and you can feel somewhat certain it’s going to rebound. At the current levels, the market seems to be pricing in a return to normal by next Spring. With the economic data, unemployment numbers, jobless claims, consumer confidence, and economic indicators all far off where they were prior to the onset of the pandemic, and more broadly the uncertainty of the pandemic itself, it’s not possible at this time to know how typical this economic recovery is going to be.

Consumer Sentiment Over The Last 5 Years

At this time we are relying on the government to bridge the economic gap until a vaccine is in place and its well established. Congress needs to act decisively with the current stimulus and unemployment benefits that expire at the end of July. I’m hopeful, but not optimistic, that the next package will happen quickly and have a longer time frame as 2-to-3 month stop gaps are short sighted and add to the uncertainty in the marketplace.

Additionally, let’s assume the optimistic projections prove true and we have a vaccine by the end of the year (fingers crossed), I still have a hard time believing the Federal Government has the competence or infrastructure to pull off a large-scale vaccination program in 3 to 6 months. Again, even if they do, we will still be left with:

• Tremendous economic damage
• An enormous government deficit
• A bloated Federal Reserve balance sheet
• Near zero interest rates
• A Government that wants to keep interest rates near zero for a long time
• Very difficult/important social and economic inequality issues that need to be addressed

Let’s not forget about global warming and China vying to overtake us as the world’s economic power. In other words, it isn’t as if the pandemic will end and the economy will miraculously return to pre-pandemic levels. Quit the opposite, once we get to the other side of this there will be a number of difficult issues that will need to be addressed.

While this all may sound bearish, the truth is I’m agnostic and a realist. No one knows where the markets are headed, and I’ve been surprised and humbled over my career time and time again, which is why we rely on our process. That said, we are making adjustments to the portfolio to better diversify and prepare for what we believe may come next.

Adjustments We Have Made and Current Model Allocations

When faced with a dramatic shift in economic and business realities, we take a hard look at our asset allocation models and portfolio diversification based on the changing circumstances. As such, there have been several changes during the quarter, resulting in the following allocation models as of the end of the 2nd quarter:

Gold

One of the most fundamental changes to our Asset Allocations in the quarter, was the addition of gold to both our Growth and Balanced models. In the near-term, there is little choice but for aggressive fiscal and monetary stimulus to continue which will cause government debt levels to rise and the Fed to continue printing money. To service the debt, the Fed is intent on keeping interest rates low. However, given supply chain disruptions, fiscal stimulus, a renewed emphasis on bringing back certain essential manufacturing to the U.S., as well as other influences, inflation has been moderate but may start to rise. This has created negative real interest rates (interest rate – inflation rate). According to a study done by State Street Global Advisors, when real interest rates are low or negative, gold has performed well. If low or negative real interest rates persist, we may look to increase our exposure to gold.

Bonds

The Fed has indicated interest rates will remain at or close to zero for a considerable time and some developed countries have adopted or experienced negative interest rate policies in an attempt to stimulate their economies. While I’m not predicting this will occur in the U.S., it certainly can’t be ruled out.

We have been observing factors in the economy that do not seem to bode well for bonds. Low interest rates paired with high inflation are typically a bad environment for bonds as inflation can negate their return. This lack of yield paired with overall poor prospective risk/return characteristics led us to eliminate short duration bonds from our portfolios while reducing our weighting to intermediate bonds.

In order to still maintain bond exposures with favorable risk return characteristics, we have added long-duration, international developed and inflation adjusted bonds to the Balanced Allocation. The rationale behind these moves was our belief that in order to capture some yield, we needed to move further out on the curve with long dated bonds. If we see negative interest rates in the US, then long duration will benefit through price appreciation; if not, then we will capture additional yield. If we see inflation sometime in the near future (which we believe is a possibility contrary to conventional thinking), then TIPS will benefit. Seeing that international developed economies have been better at curbing the virus, we see their bonds as more attractive and we expect those economies to be less sensitive to the economic impacts of the virus going forward.

We feel all these changes come together to provide better risk/return characteristics and hedge the bond exposure to potential future risks. Applying our risk management approach to the bonds provides an additional level of comfort to what has traditionally been but, in our opinion, is no longer a safe-haven asset.

Stocks

There are several fundamental changes that have influenced our equity allocations and specific investments in our actively managed portfolios over the second quarter. With most employees being required to work from home, companies have made significant investments in technology to enable this. The longer it continues, the more company dynamics and employee preferences will change, creating a shift in the amount of time they will spend in the office. With most people stuck at home for a prolonged period and offices shut down, this has sped up what was already an ever-increasing shift in consumer and business buying habits from brick and mortar to e-commerce. As we mentioned earlier, some manufacturing will be moving back to the U.S. and North America to avoid future supply chain disruptions. While this will take a number of years to facilitate and may contribute to consumer price increases and inflation, on the flip side it will create construction and manufacturing jobs. During our upcoming quarterly review, we will discuss how these may apply to your portfolio holdings.

From an asset allocation standpoint, after significant outperformance in US Large Cap equities, we made a moderate reduction to this asset class and increased the exposure to US Mid Cap and Small Cap, as well as International Developed and Emerging Markets. While our portfolios benefitted from this allocation, we still ended the quarter in a defensive position. This conservative position served us well during the downturn in Q1 but has reduced some of the return as the markets recovered from their lows.

What Comes Next?

We remain confident heading into the second half of the year that our conservative, rules-based approach will help us navigate this storm. As we have mentioned before, we believe that many financial firms will not be properly positioned for what lies ahead. In our opinion, traditional forms of risk management such as diversification are only going to go so far should conditions deteriorate substantially across markets.

Please feel free to share this market commentary with those you believe would benefit from it and know we will do our best to be available to assist anyone you refer to us. As always, we know and respect the enormous amount of trust and faith you have placed in us, and I assure you we are more than up to the task. Please feel free to reach out at any time – we are all here for you and eager to assist however we can.

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