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Owner Resource Group is pleased to provide the following wealth management insights from Round Table Wealth Management

First Quarter 2022 Review

Before we dive into our quarterly letter, we would like to express our ongoing concern and hope for a peaceful settlement for the people of Ukraine. May our world leaders find resolutions to fortify a lasting peace.

Capital markets retreated in the first quarter, not at an alarming rate, but certainly a deviation from the pattern of positive quarters investors have grown to appreciate. Of the last 50 quarters since the Great Financial Crisis, only 8 quarters generated a negative return and nearly all these quarterly drawdowns were recouped within the following quarter. The most important factor impacting markets during the first quarter was the prospect of continuing rising inflation and the certainty of rising interest rates. While the equity markets rallied into quarter-end, Federal Reserve Governor Brainard (historically a very dovish member of the FOMC) and subsequently the Fed’s minutes stated that it may “rapidly” reduce its balance sheet starting in May, which fostered a selloff in both equity and bond markets.

Our portfolio positioning during the quarter increased exposure to liquid hedged equity, reduced growth-style investments and further reduced longer-duration fixed income. We maintained exposure to commodities, which have performed admirably this year. Recent inflation figures suggest the increase in consumer prices is not over and the Federal Reserve is nearly certain to continue its rate increase strategy. Chairperson Powell mentioned the Fed’s ability to increase rates by 50 basis points (similar to when he discussed a 25 bps increase prior to the official March announcement), which could be viewed as Powell giving the market “long headlights” to see the rate path ahead. Since the market lows in early-March, growth-style valuations have increased back to significant premium valuation levels. Combined with the path of interest rates, increasing inflation and the ongoing conflict in Ukraine, we are maintaining our current allocations with a greater emphasis on hedged equities.

The Big Picture

The U.S. economy generated real gross domestic product growth (GDP) of 5.7% in 2021 and was expected to grow 1.8% in the first quarter of 2022. Many economists were surprised when the initial reading of first quarter GDP growth registered a negative 1.4%. The dramatic change in outcome was primarily due to a material increase in net imports, which detract from GDP. On the positive side, consumer spending was rather strong. Looking forward, issues such as inflation, higher interest rates and employment costs will be closely monitored by the Federal Reserve as they attempt a “soft landing” for the U.S. economy as it transitions out of easy-money policy. While the near-term GDP outlook has been tempered, there remains an optimistic view for the second quarter of 2022 with a projected GDP growth rate of 4.7% and, ultimately, anticipated 3.7% U.S. GDP growth for calendar year 2022. We suspect some adjustments may be forthcoming.

Global economic growth for this year is expected to be 3.5% based on projections by Fitch. In the same report, the Eurozone, not surprisingly, had its economic growth reduced by 1.5% to 3.0% considering economic complications from the Ukraine/Russia War. The Eurozone’s largest economy, Germany, is heavily dependent on Russian oil and natural gas, the latter of which accounts for 40% of its supply. According to Bloomberg, about 50% of homes in Germany are heated with natural gas and a large swath of industry is beholden to gas for manufacturing. Higher costs in Germany, which is a large exporter to China, will likely (ultimately) be reflected in higher prices (inflation) in the U.S. This has fed into weakening consumer confidence, as the European Commission’s consumer sentiment index fell to its lowest level since April 2020, the height of the pandemic.

U.S. inflation based on the differential between nominal U.S. Treasury Notes and U.S. Treasury Inflation Protected Securities is expected to average about 4.3% and 3.4% over the next 2-years and 5-years, respectively. Our outlook is that inflation, interest rates and the War will continue to have a dampening impact on capital markets in the near term. Any indication of any of these factors easing will likely be met with a drop in market volatility measures and rising share prices. We witnessed this several times this year on news of potential negotiations between Ukraine and Russia.

Rising inflation and the Ukraine War has driven the commodities market skyward. The notable aspect of commodity markets is the marginal unit; when marginal demand is not met by marginal supply, prices go up. For example, in crude oil, a global commodity, Russia produces 10% of global supply. The sanctions placed on Russia removes many of those barrels from satisfying demand, and consequently the world becomes very short of oil barrels, very quickly. Global oil prices jumped on news of Ukraine and remain around $100/barrel today. Other commodities such as wheat (Ukraine supplies about 10% of global wheat), nickel and fertilizer all are experiencing supply deficits, which is driving prices of these commodities higher. We expect that these dynamics will find their way into everyday consumer prices, which were already impacted by global supply chain issues. An adage in commodity markets states that “nothing cures high prices, like high prices” meaning the current high commodity prices will ultimately lead to greater production, which satisfies demand, and eventually lowers prices. For consumers and the Federal Reserve, this couldn’t happen fast enough.

While the market focused on geopolitical and macro risks, financial analysts did something that many investors did not anticipate– they raised S&P 500 FY2022 earnings estimates. If current earnings estimates materialize for the S&P 500, the result will be a 2022 earnings growth rate of 16.2%. Even greater growth is expected in U.S. small cap. The S&P 500 Equal Weighted Index (the largest company in the index is held at the same weight as the smallest company) highlights projected 2022 earnings growth of 25.8%. Current estimates combined with stable valuations imply strong returns for this year, but our view is more tempered. There remains plenty of time for earnings estimates to change prior to year-end. Issues to consider include the pace of consumer spending in the face of higher prices as discussed above. Everyday purchases such as gas and food are up materially and are expected to remain so for the foreseeable future. Thus far higher prices have not negatively impacted the strong growth in consumer spending, which translates into company earnings, but we are watchful of signs the trajectory is turning. Consumer confidence recently surprised above economic estimates, but remains well below pre-Covid levels. We believe equity markets could end the year on a positive note, but we maintain hedged equity exposure due to potential “tail risk” events and value-style investments with lower relative valuations.

Bonds are not providing the “safe haven” investors expect. During the first quarter the Bloomberg U.S. Aggregate Index (a proxy for the broader U.S. bond market) was down 5.9% and the Bloomberg Municipal Bond Index was down 6.2%. The simple explanation for this is bond math. As market interest rates increase, bond prices decline to allow for a given bond’s yield to come back into equilibrium with the market rate. (The opposite held true in 2020 as market rates declined). This dynamic has a compounding effect on those bonds with longer duration (found in the Bloomberg U.S. Aggregate and Municipal indices) as the larger number of future coupon payments are discounted at a higher interest rate, reducing their present value and the bond’s market price. (This same math applies to high growth companies whose large projected cash flows are further out in the future). In contrast to fixed rate bonds that largely comprise the Bloomberg U.S. Aggregate, floating rate loans have interest rates that reset as market rates increase (or decrease) alleviating much of the interest rate risk of fixed rate bonds. We will continue to hold shorter-durations bonds subject to a client’s immediate liquidity needs.

The Outlook

We continue to hold a slight overweight to U.S. Large Cap equities. The large cap asset class captures several attributes we believe are important given the state of geopolitics and macroeconomic factors. First, U.S. large cap companies continue to have strong balance sheets and by their status, more commanding market positions. For example, the S&P 500 in aggregate has a net debt to EBITDA ratio of 0.98x at YE 2021 and a projected FY 2022 ratio of 0.88x. These ratios are the lowest since 1995. Large cap’s position of strength can provide shareholder friendly financial strategies such as share buybacks, accretive acquisitions, and the capacity to adjust supply chains that reduce longer-term business risk. Within the large cap asset class, we are maintaining our bias to value-style investments driven primarily by our valuation concerns. Value, vis-à-vis the Russell 1000 Value Index is trading at a modest premium to its 10-year trailing price-to-earnings ratio, while its growth counterpart is trading at a valuation representing a 35% premium. The premium valuations in growth-style investments are at risk given the Federal Reserve’s focus on inflation and the growing chorus of economists calling on the Fed to be more aggressive against inflation.

We maintain a slight overweight recommendation to the small and mid-cap asset class as the relative fundamental backdrop remains supportive. While the Russell 2000 Index suffered a nearly 10% drawdown in January as the market priced in a faster and more aggressive rate rising cycle to combat inflation, it made up some ground as the quarter progressed. SMID Cap, like much of the U.S. equity market, eventually shook off geopolitical risks associated with the Russian invasion of Ukraine. Earnings expectations jumped around during the volatile quarter, but changes were relatively muted and calendar year earnings expectations were 2% higher at quarter-end for the S&P 600 Index compared to where they started the year. Overall earnings growth is still anticipated to be over 19% this year for the S&P 600 Index as of early-April according to Bloomberg. However, the disruptions from the war in Ukraine will undoubtedly impact the global economy and the small cap universe despite very little direct exposure to the region. We are less concerned about this impact as the asset class is in a strong position to digest disruptions but would not be surprised to see calendar year earnings come in as the year progresses. As such, during the quarter, we increased exposure to areas where we see less risk of downward earnings revisions like value sectors and have reduced the growth exposure where downward earnings revisions have already started. Year-to-date, small cap sectors like consumer discretionary and technology have experienced a decrease in earnings expectations as GDP estimates were revised lower while other sectors like materials and energy have seen earnings expectations increase due to global commodity supply chain disruptions brought on by the war iin Ukraine.

We recommend an underweight allocation to international developed market equities. Developed markets fell 4.7% during the quarter, which was roughly in line with the S&P 500. International markets experienced a more pronounced drawdown in the back half of the quarter due to Russia’s invasion of Ukraine, particularly Europe due to the region’s dependence on Russian natural gas and oil. As a result of the ongoing conflict, the economic outlook for international markets has been reset at a time when economic activity had been steadily improving over the last year. In Europe, where natural gas prices have nearly doubled over the last month and inflation is at record highs, the economy is likely to retreat from recent levels. While economic growth is expected to remain positive, it has been noticeably reduced. According to Fitch, European GDP growth for 2022 has been revised down from 4.5% to 3.0%. Surging inflation has also spurred the European Central Bank to accelerate policy tightening by ending bond purchases in Q3 and expectations that rate hikes may begin in early 2023. These tightening actions as well as the pace of tightening could add further constraints to future economic growth in the region. In recent weeks, we reduced our allocation to growth in favor of adding dedicated value and hedged equity exposure in the asset class.

In emerging markets, we also hold an underweight allocation to the asset class. Emerging markets declined 6.9% during the first quarter, dragged down by the conflict in Ukraine. The widespread condemnation and sanctions against Russia resulted in Russian equities becoming effectively uninvestable for foreign investors. As a result, Russia has been broadly removed from emerging market indices, even though the country only comprises less than 4% of these market benchmarks. Performance across the rest of the asset class has been varied. In China, markets pulled back 14.2% during the first quarter, and are now down 32.5% over the trailing one-year. Chinese equities were most recently unsettled after the SEC named five companies under scrutiny for potential delisting if they failed to meet U.S. listing audit requirement, sparking concerns over the future of Chinese companies remaining listed on U.S. exchanges. Chinese regulators were quick to respond and alleviate fears, stating that they are working with their U.S. counterparts to resolve the audit dispute as well as signaling that the campaign of regulatory crackdowns was nearing its end. Additionally, increased monetary easing in China is anticipated throughout the year to combat a softening economy. Elsewhere, the boom in commodity prices has been a welcomed respite. Resource-driven economies, such as in Latin America and South Africa, have posted positive performance year-to-date and are noticeably outperforming the rest of the world. During the quarter we reduced the overweight to Asian emerging markets in favor of a more balanced regional allocation.

We increased our underweight to fixed income during the quarter as it became clearer that the Fed intends to be more aggressive in raising the Fed Fund Rates and reducing their balance sheet as compared to past rate rising cycles. While our allocation was biased towards short-duration strategies to mitigate the impact of higher rates, we further reduced intermediate exposure held in portfolios where rate risk was the highest. We continue to find the below investment grade floating rate loan universe to have the most attractive attributes in the current environment due to stable corporate fundamentals and insulation from rate risk.

We are maintaining client portfolio exposure to real assets/commodities via liquid exchange traded funds and mutual funds. While it is true that many commodity prices hit recent record highs during this past quarter following the invasion of Ukraine, future upside in commodity prices is not contingent on prices getting back to these record highs. Rather, prices would only need to stay elevated as the futures curves suggest lower prices in the future. Given the lack of progress towards a resolution and damage done to international relations even if a resolution is agreed upon, a higher for longer scenario appears to be more and more probable in the commodity complex.

*The content herein is provided to you by unaffiliated sources believed to be reliable, but not guaranteed on an as-is basis without any warranties of any kind. In no event shall Owner Resource Group, LLC be liable for any direct, indirect, incidental, punitive, or consequential damages of any kind whatsoever with respect to this content. The content is distributed for informational purposes only and not intended to provide investment advice. The information contained in this article is accurate as of the data submitted, but is subject to change. We strongly recommend you consult your professional business advisors before making any financial or investment decisions.

The post Wealth Management – Q1 2022 Review appeared first on Owner Resource Group.

Owner Resource Group is pleased to provide the following wealth management insights from Round Table Wealth Management

Fourth Quarter 2021 Review

Once again, equity markets had a great year with the S&P 500 posting a 29% return and a 3-year annualized return of 26%! The equity market returns are even more impressive in light of inflation concerns throughout the year, labor shortages, supply bottlenecks and the mutating COVID-19 virus. As we look toward 2022, our view is that many of these risks will continue and some specifically will have a more critical influence on market returns. While we would love to see a repeat of 2021 markets, our expectations for the year ahead calls for more moderate equity market returns, as well as investment grade fixed income returns being somewhat muted due to the high probability of rising interest rates. 

The Big Picture

According to the Federal Reserve, the U.S. economy is expected to grow at 5.5% in 2021 and continue its strength through 2022 with an expansion of 4.4%, which will be recorded as some of the strongest U.S. GDP growth in several decades. During its most recent press conference, Federal Reserve Chair Jerome Powell’s disposition towards inflation pivoted as he cited the strength of the U.S. economy, the improving labor and employment picture and the resiliency of household balance sheets. He specifically stated with respect to the Fed’s dual mandate that inflation had achieved its long-term average above 2% and the labor market was “rapidly approaching full employment.” This development was consistent with our 4Q 2021 Investment Outlook and Positioning webinar statement when we pointed out historical periods of inflation and employment and coincident Fed actions implied the Fed effectively had “–permission to act.” With inflation no longer viewed as “transitory” and the Fed’s marginally more hawkish view, investors are correctly focusing on the Fed’s views of inflation and the trajectory and intent to increase interest rates. The Fed minutes from its December 15, 2021 meeting state that the Fed Committee voted to approve accelerating its reduction in bond purchases and end them by March 31, 2022.

While the Fed unanimously approved keeping its Fed Funds Rate unchanged at 0% to 0.25%, they kept the option to raise rates sooner and implied that it would occur after it ceases bond purchases. The Fed made no mention of when they would raise rates, but market participants are expecting three interest rate increases in 2022 with a number of economists anticipating the first rate increase in March. The Fed Committee consensus is that the Fed Funds Rate will reach about 90 bps by year-end 2022 and reach its longer-term range by year-end 2024. As you may have witnessed, markets interpreted the Fed’s statements negatively. Growth-style investments with high equity valuations and more distanced future cash flows sold-off materially. It is this type of macro-induced volatility that we believe will be more pronounced in the year ahead as changes to the Fed’s inflation outlook and management of interest rates comes into greater focus.

Inflation does not happen without strong consumer demand. The U.S. consumer, the backbone of the U.S. economy, continues to spend as evidenced by the latest official reports showing retail spending increased 18.2% year-over-year (YoY) through November 2021. The December 2021 Retail Sales growth figure was negative, reducing the YoY figure to 16.9%, but was likely influenced by the rapid spread of the Omicron virus and inventory shortfalls.  A key concern with respect to consumer spending is the termination of many direct government cash transfers and other policies that sustained and increased consumer cash balances and therefore spending power during the pandemic. Policies such as mortgage forbearance, rent deferment, student loan payment deferrals, and enhanced unemployment benefits have ended or will soon. These policies allowed households to save about $1.6 trillion and had an immediate impact of putting cash back into the economy directly as cash recipients or policy beneficiaries used the cash/savings to meet expenditures. Whether or not such spending continues at the same pace is a dynamic we are monitoring. An important dynamic offsetting this concern is rising wages.

According to the Bureau of Labor Statistics, hourly wages for employees rose at 4.8% YoY, which is higher than any period pre-pandemic going back to 2007. Further to the point, a survey by the National Federation of Independent Businesses shows that 48% of small businesses are raising compensation and 32% plan on boosting compensation in the next three months; both are at record levels by significant amounts. It could be that rising wages and improving workforce participation will provide the needed support for continuing consumer spending while Federal policy trails off. If this is the case, and we suspect it is, then we would expect goods and services demand to remain strong, inflation to remain elevated and the Fed to act accordingly. In such a scenario, corporate earnings could materialize in line with analysts’ projections, and provided valuations are not materially impacted by rising rates and inflation, we would expect equity market returns to be positive.

The Outlook

We continue to hold a slight overweight to U.S. Large Cap equities. We believe large cap equity market returns will be more in line with historical averages in 2022 and yet may continue to outpace non-U.S. developed market peers. Equity market valuations, in general and by style specifically, lead us to recommend an overweight to value-style investments relative to growth-style investments. While growth companies are likely to maintain healthy earnings momentum in the coming year, rising interest rates and inflation may act to depress premium valuations and therefore restrain positive share price performance relative to value-style investments. (This was clearly demonstrated in early-January 2022). Based on Bloomberg data, the Russell 1000 Growth Index (RLG) is anticipated to increase earnings by about 13.2% in 2022, while the Russell 1000 Value Index (RLV) is expected to increase earnings by 9.3%. With that said, the RLG is trading at a trailing 12-month price-to-earnings ratio (P/E) of 38.3x relative to a comparable 20.1x for the RLV. If the respective P/Es of RLG and RLV migrate towards their 10-year averages of 24.8x and 17.4x, we would expect growth-style investment performances to trail those of value-style investments.

We continue to hold an overweight to small and mid cap equities. While the asset class failed to keep up with the S&P 500 in 2021, it managed to generate returns of 14.8% and 22.6%, respectively, as measured by the Russell 2000 Index and Russell MidCap Index. Importantly, the underperformance relative to large cap was driven by multiple compression and not disappointing fundamentals. In fact, small caps far exceeded the annual revenue expectations that were set out at the beginning of 2021 of around 7% and are now expected to see annual revenue growth of about 17% in 2021. According to Bloomberg Intelligence, revenue growth is anticipated to remain above average in 2022 with forecasted annual growth of 7.6%, an estimate that incorporates rising yields and 4.5% real GDP growth. This is a material premium to the 1.9% average annual revenue growth since 2001 and we anticipate it will be a key driver of returns for the year ahead as we are not anticipating multiples to contract further from here. Instead, we would anticipate valuations to be stable as multiple expansion will be difficult in an environment with less accommodative monetary policy. However, with the asset class trading at a 26% discount to large caps and a 16% discount to its 5-year historical average as measured by S&P indices, we believe this can help establish a valuation floor within the asset class, clearing the way for fundamentals to drive prices.

With the beginning of a new year, we maintain a neutral allocation to non-U.S. developed market equities. Developed markets delivered strong absolute returns in 2021, gaining 13.2%, but materially trailed another stellar year for the S&P 500. Currency was one of the contributors to the underperformance of developed market equities, detracting roughly 6% from U.S. Dollar-denominated returns. While performance trailed the U.S. over the course of 2021, earnings growth overseas rebounded strongly and is expected to keep pace in 2022. As a result of strong earnings yet subdued price appreciation, valuation multiples compressed and led to a significant discount of developed market valuations compared to domestic markets. For example, at yearend, the forward-looking P/E ratio of the MSCI World ex USA Index was trading at a 30% discount compared to the S&P 500, more than two standard deviations below the historical average discount of 12%. Additionally, with expectations that supply chain bottlenecks should ease as the year progresses as well as moderating news around the Omicron variant, the global economy should carry on its recovery and provide a cyclical tailwind to non-U.S. markets. While we believe there are improving opportunities in developed markets, a variety of risks remain ranging from continued inflation, additional COVID variants, missteps in central bank policy, or geopolitical risks (e.g. Russia/Ukraine or China/Taiwan).

Within emerging markets, we are improving our recommendation to a neutral allocation. Returns in emerging markets were negative in 2021, a stark contrast to the rest of the world. The negative performance was primarily due to the volatility within China. Regulatory crackdowns, restrictive COVID policies, and surging energy costs created a perfect storm that resulted in Chinese equities declining 22% in 2021. These risks remain as we head into 2022, but it appears that regulatory action may have peaked in the second half of last year and the Chinese central bank, the People’s Bank of China, is likely to introduce stimulus measures to support the economy and capital markets. Emerging markets present intriguing long-term investment opportunities with relative valuations to developed markets at historical lows and earnings growth on par with U.S. equities.

We recommend an underweight to fixed income as we enter 2022, although we recognize this outlook can reverse quickly should rates continue their trend higher from the post-Omicron lows. By early-January, the 10-Year Treasury bond had breached 1.75%, taking out 2021 highs and back to levels last seen pre-pandemic. As we see elevated volatility in all bond maturities, we continue to concentrate capital in short-term bond and floating rate loan strategies. Short-term bond strategies provided capital preservation in the face of higher rates in 2021 but did not generate much in terms of yield as rates were depressed for much of the year. However, with the market pricing in the anticipated hawkish actions of the Fed mentioned above, short-term rates have risen in recent months, allowing for investors in short-term strategies to earn a reasonable yield while continuing to sidestep much of the rate volatility we have seen over the last few months. Our allocation to floating rate strategies provided a much-needed boost to fixed income yields in 2021 and we continue to expect that they will provide an attractive income stream for portfolios in 2022 as the expectation is that yields will increase as short-term rates increase. We see this two-pronged approach to fixed income investing as an appropriate strategy in a year where rate volatility is expected to remain elevated.

We are maintaining client portfolio exposure to real assets/commodities via liquid exchange traded funds and mutual funds. Our exposure takes into consideration the commodities value chain from raw commodities to transportation to infrastructure companies. We believe the allocation takes into consideration the potential for rising inflation as well as “following the money” with respect to governmental largesse.

*The content herein is provided to you by unaffiliated sources believed to be reliable, but not guaranteed on an as-is basis without any warranties of any kind. In no event shall Owner Resource Group, LLC be liable for any direct, indirect, incidental, punitive, or consequential damages of any kind whatsoever with respect to this content. The content is distributed for informational purposes only and not intended to provide investment advice. The information contained in this article is accurate as of the data submitted, but is subject to change. We strongly recommend you consult your professional business advisors before making any financial or investment decisions.

The post Wealth Management – Fourth Quarter 2021 Review appeared first on Owner Resource Group.