Q3 2021 Quarterly Commentary
Things turn out best for the people who make the best of the way things turn out.
As professional investors, we are constantly aware of the short-term, unpredictable nature of markets, as well as the need to be prepared, to the best of our ability, for any unforeseen or black swan events. With this in mind, who could have imagined the events of the past 12-18 months:
- A global pandemic, mask mandates, stay at home orders, and economies partially or almost entirely shut down at various times.
- The scientific community coming together to develop, manufacture, and distribute vaccines to billions around the world in what was previously believed to be an impossible timeframe.
- A swift and painful market crash followed by a swift (and painful for those who sold and didn’t buy back in), market rally that as of the end of the second quarter has many assets at, or in some instances, well beyond their pre-pandemic levels.
Talk about black swan events and the unpredictable nature of markets in the short-term!
Markets are always easier to understand and rationalize in hindsight, but when things are unfolding in real-time, it is an entirely different matter. Clearly, this trying period has been another formidable stress test of our proprietary investment process as well as a reminder of why we are so steadfast in relying on it. Having a systematic, rules-based approach, proved to be extremely valuable as we have been able to navigate the market’s volatility and uncertainty to capture, what I believe to be, more than our fair share of risk adjusted return.
On the investment front, we received some exciting news at the end of the second quarter. Our Managed Volatility US Large Cap Strategy, which many of you are invested in either directly or as part of one of our hybrid asset allocation portfolios, was recognized for the second straight quarter for its 3 and 5-year risk adjusted returns by Zephyr (a database used by institutional investors to track and compare money manager performance). The strategy ranked in the top 10 out of the 246 they track in the US Large Cap Core category. You can read the press release here. While we appreciate the recognition, what I am most proud of is that we have been able to execute for our clients at such a high-level. Our most important accolade has, and always will be, helping our clients reach their long-term goals while providing a more comfortable and confident investment experience versus traditional approaches. You can be sure that we will continue to challenge the status quo and work tirelessly to do everything in our power in pursuit of this outcome.
Reflecting on the first three quarters of the year, I remain very optimistic about the future. While we may not be fully out of the woods as we race to get the US and global population vaccinated before new variants take hold, and the possibility of a 10-20% correction is always lurking around the corner, I have been impressed by how much we, as a global community, have accomplished working together. Our collaborative efforts coupled with the exponential pace of innovation in science and technology, leave me confident we can tackle even the most difficult of problems our society faces. While we certainly have no shortage of economic, social, and environmental challenges, the multi-decade efforts underway to solve them are creating many compelling macro long-term investment opportunities
The re-opening of global economies and a return to a more normalized lifestyle in much of the developed world has led to a significant increase in economic activity, although we have recently begun to see a slowdown. This backdrop, coupled with historically low interest rates has proved to be a productive environment for stocks during the first three quarters of 2021 as US Stocks (as measured by the S&P 500 TR Index) were up 15.92%1 and Developed International Stocks (as measured by the MSCI All Country World ex-US TR Index) were up 5.90%1. However, US Bonds (as measured by the Barclays Intermediate Aggregate Bond TR Index) finished -1.55%1 as of the end of the quarter as interest rates experienced a bout of volatility. As a refresher, generally bond prices and interest rates move in an inverse relationship so as rates rise, bond prices decline.
This outcome was driven primarily by successful vaccine rollouts and unprecedented amounts of global stimulus. The monetary and quantitative easing was necessary to address the economic disruptions caused by the pandemic and to maintain stability in the markets. That said, there is a feeling that we are now in an endless cycle where central banks will permanently backstop the financial markets. This does change the complexion of the risk characteristics of assets which is something we need to be mindful of. However, there is an old saying in the financial markets “Don’t fight the Fed.” This means when the Federal Reserve is flooding the economy with money and buying financial assets, it’s a good idea for investors to follow their lead. This time has been no different.
Inflation has been a major discussion point throughout the year as the Federal Reserve has continued to buy government backed bonds to the tune of $120 Billion/month. These purchases, a continuation from their initial support last March when the pandemic struck, has contributed to a more than doubling of their balance sheet to $7 Trillion, and a year over year increase in the money supply of 26% as the end of February, the largest increase since 1943. This increase effectively translates into a debasement of the US currency. The result of such unprecedented money printing has historically been inflation. If you believe the Federal Reserve and Chairman Jerome Powell, this inflation is just transitory, a result of the supply chain disruptions caused by the economy effectively shutting down last March. Others believe that the inflation we are currently experiencing is more permanent and that the wage increases we are seeing will result in higher costs for companies which will eventually be passed on to the consumer in everything from groceries, to gas prices, to airfare, and lodging. With this as a backdrop, some asset prices have risen substantially over the past 18 months such as real estate and the stock market.
It is hard to determine how much the stimulus, corporate profitability, and/or currency debasement is playing a role in today’s asset prices. However, the Federal Reserve’s unlimited ability and willingness to print money, purchase treasuries and other marketable securities, and devalue the US dollar is, we believe, one of the most serious issues the economy and investment markets face today. How the Fed manages to reduce its balance sheet and stop or reduce the increase in money supply, if it ever does (one could argue this is now the new normal), may be critical moving forward.
The surge in asset prices has many investment firms predicting future returns will be muted over the next decade. Many have been taking this position for a number of years. While their thesis may ultimately prove true, it hasn’t yet. However, isn’t it equally plausible that currency debasement, technology innovation, and continued monetary, quantitative, and fiscal stimulus focused on infrastructure and building a green economy will lead to the exact opposite outcome? This is why we don’t try to predict what the markets will do in the short-term as it is a fool’s game in our professional option. Instead, we will continue to focus on long-term macro trends in our asset allocation and portfolio implementations, knowing that we are prepared to implement our proprietary risk management approach to navigate whatever direction the market takes. Until then, we will continue to be grateful for the market’s resiliency and actively position client portfolios to capture what we believe will continue to be their fair share of risk-adjusted future returns.
What We Have Done
From an asset allocation standpoint, the biggest changes in our Managed Volatility Growth and Balanced portfolios YTD have been a reduction in gold and bonds, and the addition of Digital Assets.
From an equity standpoint, our US and International strategies have not shifted dramatically during the quarter and continue to focus predominantly on the long-term macro trends we believe will be paramount moving forward such as: decarbonization and green energy (wind, solar, rebuilding the electrical grid, electric vehicles), technology and science innovation, digital transformation in consumer and business behaviors, infrastructure, and the reopening trade. More specifically, many of the companies in the sectors hardest hit by the pandemic, like hospitality, financial services, and consumer discretionary, are re-emerging, however, not all of them have fully reopened or recovered to pre-pandemic business activity. We have been deploying capital selectively when we see opportunities based on our long-term macro trend thesis and in some of the companies where we believe post-pandemic realities are not currently reflected in their stock prices.
It is also worth commenting on the year-to-date underperformance of the international markets in general and our Managed Volatility International Large Cap strategy on a relative basis (which is a sleeve within some of your portfolios). While we continue to believe that the international markets are an important component of a prudently diversified portfolio and the current valuations are more reasonable in general than many parts of the US equity markets, they have been more challenging. The regulatory crackdowns by the Chinese government on several their largest industries has caused confusion and significant decline in many stocks. We have exposure to some of these names but have reduced them over the quarter, however, the strategy was impacted. In addition, with the uneven rollout of Covid-19 vaccinations, varying degrees of impact from the Delta variant, and multiple economic and political agendas among the developed European countries, there has been a divergence in performance within those countries and the stocks we own. Despite this, we are not altering our overall weighting to the asset class, and instead have been active in taking advantage of the opportunity to reallocate into higher quality names that represent better values and that are in line with the long-term macro trends we believe will continue to materialize moving forward. That said, our Managed Volatility INTL Large Cap Strategy is a concentrated portfolio of 35-50 stocks as compared to the benchmark which has over 1800 names. Historically, the strategy has produced divergent returns from its benchmark yet still provided productive risk-adjusted returns on a relative basis. We feel strongly this will continue to be the case over the long term.
One shift we have made recently is an initial investment in digital assets, specifically bitcoin and Ethereum, an area we believe has established itself as a new asset class and that will have major implications for the financial services industry in the years to come. We believe many people are uncertain about crypto currencies, or digital assets, and they struggle to understand their value proposition. We have spent a lot of time over the past few years researching and analyzing blockchain technology and how it will impact businesses, the economy, and the global financial and monetary systems. Digital Assets are one of those investments that an individual’s perception and understanding has a lot to do with the amount of due diligence they have done to understand the space. Mixed messages from traditional and social media tends to cause a lot of confusion around the asset, which often ends up resulting in uncertainty, nervousness, and in many cases creates a false impression of the asset class. However, armed with a proper understanding, it can create a sense of calm about digital currencies and their many potential uses such as a store of value, a hedge against inflation, a viable currency, and an investable, yet albeit more volatile asset. To take this one step further, a fundamental confusion lies between Bitcoin the network and bitcoin the token. Most individuals, and media alike, merely reference bitcoin the token and its inherent volatility, but fail to make the connection that bitcoin the token only represents the value of the Bitcoin network.
We view digital assets essentially as a technological transformation that has experienced a breakthrough in an area of computer science called distributed consensus. This means that several computer programmers using the same blockchain technology are able to see all the information that comes to the blockchain, and all have to agree that the information is correct and that no one can alter it. The movement of money, also called remittance, is one application of distributed consensus but it is only just the beginning and why we believe so strongly that this technology will have such a transformational impact. Having said that, we are still early in the development and adoption of this technology and thus, have only recently gained a comfort level with its maturity in order to make an investment for our clients in the portfolios.
What Comes Next?
As we look to close out the year over the next few months, we reflect back on the year that was 2020, the rebound and optimism we have seen in 2021 as millions of Americans, and citizens around the world have been vaccinated, and the bright future we believe we will see in the coming years. Of course, with optimism also comes the uncertainty of what lies ahead. Rising bond yields as the Federal Reserve plans for an unwinding of their unprecedented financial stimulus and an eventual increase in interest rates, fears of rising inflation and whether it is transitory or more permanent, global supply chain issues, and the Chinese Evergrande crisis were among the headlines during September. Inevitably, there will be some other headline down the road that will stir the markets in one direction or another. However, we will not be distracted and remain steadfast in our dedication to you, and trust in our investment process that does not try to predict the future, but instead aims to prepare for it. We believe our portfolios are properly allocated and positioned for whatever conditions may lie ahead and will adjust accordingly as/if the situation changes.
& Chief Investment Officer
1) Source: Morningstar 1/1/2021 – 9/30/2021
2) Source: The Wall Street Journal
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