We are pleased to share our 2022 Capital Markets Forecast. This annual research piece is the foundation of our investment process, and the projections herein form the basis of the strategies we design to help our clients achieve their goals.

This year’s edition, “Beyond the Horizon,” updates our longer-run views of the opportunity set and addresses critical questions two years after the 2020 market bottom:

• How have secular cycles, a multi-million dollar stimulus, and central bank intervention affected the economic cycle? Within this context, how will inflation and interest rates affect portfolios?
• What portfolio diversification and asset allocations match your financial goals?
• In what sectors do we see opportunity as we look beyond the horizon?
• Where should you invest in the private markets and how should you construct your portfolio?

Our forecast provides the quantitative blueprint for the steps we are taking designed to both manage risk and maximize opportunities in 2022 and beyond.

We hope you find this year’s Capital Markets Forecast informative in understanding what is realistic to expect from today’s starting point.

Please reach out to a relationship manager or any member of the Investment Strategy Team with questions.

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About J.F. Lehman & Company

J.F. Lehman & Company, LLC is a middle-market private equity investment firm that conducts buyouts, acquisitions, corporate divestitures, and equity investments. Across decades of operating in the environmental services, industrial, aerospace, and defense sectors, J.F. Lehman & Company has employed a well-known discipline of paying fair prices for good businesses. We find that investing in steady growth companies with single digit enterprise multiples can provide good value for our clients by protecting capital while providing for growth, which is one of the reasons we have partnered with them for many years.

About NorthStar Group

NorthStar Group is a unique company and a global leader in infrastructure and environmental solutions. For over twenty years it has been one of the top ten global wrecking and demolition companies as ranked by Engineering News-Record. With nearly $700 million in average annual revenue, NorthStar Group is relied upon for complicated operations ranging from the demolition of J.P. Morgan’s 70-story headquarters at 270 Park Avenue to the decommissioning of the Crystal City Nuclear plant. Key clients for the company include NASA and The National Park Service.

This recently announced acquisition of NorthStar Group in Fund V positions J.F. Lehman & Company, and by extension our investors, to benefit from a potential wave of infrastructure spending that will require the highly unique and technical skills of NorthStar Group. Read more in the press release here.

Our Private Capital Program

At Balentine, we help our clients reach their financial objectives with a proper balance of risk and return. Protection of capital is paramount, which makes the price investors pay for assets important, especially as multiples of earnings paid for private companies continue to expand at a dizzying pace. In the next market cycle, we believe active asset management will be crucial to navigating the challenging environment created by high equity valuations and low interest rates successfully. For more considerations around investing in private capital and how to select a private capital manager, we invite you to download our newly released Capital Markets Forecast, which provides our outlook for the next seven years and beyond.

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It can be difficult to see a friend get rich, and to “Keep Up with the Joneses,” some people take on high risk with a low probability of success. This effort to take a small amount of money and grow the capital base aggressively is called speculation. Investment, on the other hand, is an effort to grow money relatively slowly in a methodical manner or prevent a lot of money from becoming a little (i.e., creating income or growing the capital base slowly through reinvestment of proceeds).

Several prominent economists have commented on the difference between speculation and investment. Adam Smith, in his Magnum Opus Wealth of Nations wrote that speculation is less about investment and more about a businessman’s willingness to pursue short-term opportunities for profits, which contrasts with a standard businessman who makes consistent longer-term investments in his business ventures. John Maynard Keynes said that while investors look at forecasting the prospective returns of assets over the entire life cycle, speculators tend to look at the psychology of the markets.

Rational Speculation 

When you imagine a speculator, you probably envision someone like Gordon Gekko from the movie Wall Street who famously said “Greed, for lack of a better word, is good.” Despite the sometimes negative image portrayed in popular media, speculators are actually a very important part of the market function when they’re acting prudently and taking on calculated risks.

For example, without speculators, we would have a lot of sad farmers when commodities prices plunge out of nowhere. In this situation, farmers have many commodities, whether it’s corn or cotton or soybeans, that they want to sell. Unfortunately, they are unable to sell because the price has plunged, and they will not be able to make a profit. So, speculators will help them out by making bets on whether commodities will rise or fall; by making this speculation, they allow these farmers to hedge out their exposure to commodity crisis.

Irrational Speculation

As demonstrated above, rational speculation can contribute to a healthy market. Irrational speculation, however, frequently devolves into a financial crisis – why?

Some would suggest the Federal Reserve is the driver. There is good reason to suggest that their loose money policy has embedded some speculative dynamics over the last few decades. In our opinion, that is a bit of a recency bias because anyone would be hard-pressed to suggest they are responsible in general for speculation, given that has existed for hundreds, if not thousands of years.

The real driver is very simple: human behavior. Like lemmings, humans like to behave like the crowd. When some people jump, other people say “yes, I’ll fall into that hole with you.” Rewards of the bubble make people cognitively dissonant until the greatest fool buys the product for the highest price. The sequence of events in irrational speculation looks like this:

• When a novel idea takes hold, demand outpaces supply, so prices rise. A few recent examples of novel ideas are “clicks and eyeballs” or “housing prices have never gone down en masse across the entire country.”
• To satisfy this increase in demand, producers increase supply. Amazingly, increases in demand stay consistently ahead of the supply increases, and prices continue to ascend.
• The “new paradigm” takes hold; people who used to distrust speculation now embrace it. The popular consensus is that there’s a great reason for the new paradigm, that it’s different this time.
• Markets are no longer efficient. People are buying in the hopes that they can sell to some “greater fool.”
• Demand dries up. The greatest fools buy, draining the pool of potential buyers.
• Prices Decline. If you have a very liquid asset, such as stocks, the fall comes very quickly. If it’s something less liquid like real estate, then the fall takes more time. Then, we get the reverse situation where everybody else realizes that they spent way too much on the item.

Figure 01. The Life Cycle of Speculative Bubbles

Source: thestreet.com

Speculative Bubbles in History

While people like to blame the Federal Reserve for bubbles, the reality is that this phenomenon has been going on for much longer than the Federal Reserve has existed.

Speculative Bubbles have happened throughout history. Below, you can see some examples from a 375-year period, the early 1600s through the late 1900s. The important point here is that they cover all kinds of geographies and all kinds of assets. We have coins; the famous tulip mania in Holland; lotteries; new companies as IPOs; treasury bonds; real estate; and commodities. Many countries are represented: England, Germany, France. You’ll notice from the dates that speculative bubbles happen every few years.

In the United States in the most recent century, there was the speculative bubble in the early 1920s, which led to the great depression. And of course, we know of our most two most recent episodes, the internet stock bubble in the 1990s and the housing bubble in the early 2000s.

Also, consider Japan in the 1980s. There was a bubble in everything, stocks, real estate, art, you name it. They called it the bubble economy. So much so, that, as stocks went up, people bid up real estate, which made stocks go up more. And what’s so amazing is at its peak price in 1989, the land under the emperor’s palace was worth more than the entire state of California. We laugh at this now, but at the time, people felt that was rational because that’s what people do in these moments, they rationalize them.

Figure 02. Selected Speculative Bubbles Throughout History

Source: Manics, Panics and Crashes: A History of Financial Crises by: Charles P. Kindleberger

Conclusion

As long as human mind is swayed by greed and fear, speculation will persist. It will start as healthy speculation and transition to unhealthy speculation, leading to the booms and busts that have characterized history for centuries.

 

While Balentine is not necessarily looking for booms and busts, understanding how greed and fear play into financial decisions drives our Tier I process and allows us to remain overweight or underweight equities, as appropriate through our market cycles.

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First you must calculate what you owe or pay someone to do it.  Then you have to write a check or make an electronic transfer.  If you miss a quarterly deadline or cannot pay the full amount right away, you could face steep penalties and interest.  Moreover, by essentially prepaying most of the tax you will owe on your year-end earnings total, you could be missing an opportunity to maximize the value of your money.

However, if you have an Individual Retirement Account (IRA), you may not have to bother with quarterly estimated taxes at all.  By “borrowing” from your IRA to make a single payment at the end of the year, you can pay Uncle Sam just once—and keep your money invested and hopefully growing for the majority of the year.

Here’s how it works:

If you have income sources that require you to pay estimated federal tax, you can “borrow” from your IRA at the end of the year and direct those funds to the IRS.  Under current tax law, the IRS will treat the payment as satisfying the requirement for quarterly estimated payments throughout the year.  You can then use cash you have set aside in a savings account to replenish the IRA within 60 days.

Technically, you are not borrowing from your IRA.  Rather, you request a distribution from the account that is equal to your estimated tax liability and direct the account custodian to withhold 100% of the distribution for federal income taxes.  If you withhold $50,000, for instance, the IRS will deem it to be the equivalent of four quarterly payments of $12,500 each.  As long as equivalent funds are redeposited into the account, or a different IRA, within 60 days, the transactions qualify as a tax-free rollover transaction.

Taxpayers 72 and older are required to take minimum distributions (RMDs) from their IRAs on an annual basis.  RMDs can be used to satisfy quarterly estimated tax requirements using the same withholding process and, in such cases, funds do not need to be redeposited.

There are many favorable reasons to use IRA funds to pay federal taxes.  To start, you pay once instead of on four occasions, which adds time back to your life.  If you have forgotten or have failed to make full quarterly payments, “borrowing” from your IRA at the end of the year allows you to avoid interest and penalties which would otherwise apply.  Last but not least, this strategy enables you to keep your savings in an interest-bearing account throughout the course of the year as opposed to making 4 interest-free loans to the government.

However, the devil is in the details, and you should be mindful of potential pitfalls to this technique.  If you fail to replenish your IRA commensurately within 60 days after disbursement, you could face substantial IRS penalties and interest.  This is a particular hazard for high earners whose taxable income has risen sharply from the previous year since the IRS requires estimated taxes to equal 110% of last year’s taxes or be subject to underpayment.  And of course, interest and penalties would ensue if you do not have sufficient funds in IRAs to cover your total tax liability assuming you skipped quarterly payments along the way.

With the end of the year approaching, it may make sense to look further into using IRA funds for estimated tax purposes.  Bear in mind that each taxpayer’s situation is unique, and I encourage you to consult with your tax professional before taking action.  If this strategy is of interest or if you have any questions, please feel free to reach out to your team at Balentine.

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Cryptocurrencies remain an exciting and emerging asset class. Given their high volatility and inability to generate an expected return at present, Balentine does not recommend cryptocurrencies as part of an asset allocation.¹ However, increasing numbers of clients hold such assets on a speculative basis—certainly more exciting than the traditional lottery ticket. Even though few, if any, hold more than 5% of their wealth in cryptocurrency, the rise of how and where such assets are held has prompted the question: what happens to my crypto when I die?

The Issue at Hand

While physical assets can be passed on through a will, the decentralization of digital assets makes this task much more difficult. Typically, digital assets, like cryptocurrencies or NFTs (non-fungible tokens, such as digital art), are accessed via a private key (64-digit code) known only by the owner of the crypto account. If that knowledge dies with the owner of the account or falls into the wrong hands, it may be lost forever. To prevent either of these issues from materializing and disrupting your inheritance planning, it’s important to consider how to properly store digital assets and prepare cryptocurrencies for transfer in the event that you pass away unexpectedly.

Storing Cryptocurrencies 

Cryptocurrencies are traded and stored in one of two ways. Hot wallets are platforms used to trade cryptocurrencies, acting as free and convenient vehicles for holding these digital assets. However, to access your tokens, an Internet connection is required meaning you are dependent on the platform’s functionality. Should that platform be the victim of a cybersecurity attack, or cease to exist, your funds are out of your control. This potential problem lends itself to the second most common form of digital asset storage – cold wallets. Cold wallets exist offline, usually in the form of a USB drive, and can be kept in home safes, deposit boxes, or stored in other secure locations. Regardless, you must know your private key to access funds and, in the case of cold storage, a PIN code and recovery phrase are also required. As such, cold backup of your hot wallet and specific instructions for any heirs are vital. Additional tips and best practices include:

• Most hot wallet companies are new; spread your bets, PayPal is a well-known and common wallet and Coinbase is very large in size.
• Set a recovery phrase for your cold wallet.
• Don’t overcomplicate the system (i.e. storing key the PIN, and the recovery phrase in different places).

When someone dies, they either have a will that dictates how their assets will be distributed, or, if they die without a will, a government formula outlines how their assets will be divided. While a will outlines who should receive what, it typically doesn’t have an up-to-date asset list, nor does it contain passwords or access keys.

How to pass on cryptocurrency to loved ones:

• Name a beneficiary in your will if appropriate.
• Add a document to your estate plan that lists your crypto assets and any passwords, PINs, keys, and instructions to find your cold wallet.
• Naming a beneficiary to your “hot” wallet is important because a named beneficiary can access your account information after you are deceased.

Updating your plan and wallet:

• Keep your plan updated after life changes like marriage or divorce.
• Check with your wallet provider to make sure your information is up-to-date and that beneficiaries are properly noted.
• Make sure to install all updates for hot wallets and log in at least four times a year to see if you need updates.

The large growth in value of cryptocurrencies has made them a more commonplace aspect of people’s net worth and something that they should be thoughtful about protecting and potentially passing on in the event of their untimely demise.

¹You can read more about Balentine’s recommendations surrounding cryptocurrency in these blog posts: Making Sense of the Bitcoin Buzz & Beyond Abstraction: Bitcoin Practicalities.

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Contextualizing Current Market Strength

We start by revisiting the state of the current ascent, 19 months off the bottom. Figure 1 shows rallies off the bottom in 1982, 2009, and 2020. The gap between the 2021 ascent and prior ascents remains wide, despite a plateau between July 20 and October 5 (indicated by the red line).

Figure 1. The current rally remains historically dominant even with the seasonal pause.

Source: FactSet and Balentine

With this weak seasonal period in the rearview mirror, the market under the surface is looking stronger. The graphs in Figure 2 indicate that breadth is improving as more stocks show strength, evidenced by the growing percentage of stocks above average market prices in the past few months. Over the summer, index levels improved on less and less involvement. Now we are seeing the market ascend on improved participation, as the equal-weighted S&P index broke a new high (Figure 3). Note that this is not just a U.S. phenomenon. Global markets are showing absolute strength and broadening participation as well.

In addition to onsetting seasonal tailwinds, reasons for the strength include:

1. monetary policy that remains accommodative even as global central banks discuss tapers and potential interest rate increases, and
2. economies that, while not overly robust, are surpassing relatively low expectations owing to structural concerns about rolling virus waves and supply chain bottlenecks.

Figure 2. More stocks are showing up trends and strong momentum.

Source: FactSet and Balentine

Figure 3. The equal-weight S&P has punched to new highs, speaking to how broad the advance is.

Source: FactSet

Considerations Moving Forward

So, under the context of a market that looks like it’s getting going again, following are some brief thoughts of which to be mindful.

1. In the fixed income market, yields appear to be moving higher, and we suspect it is only a matter of time before they break through the to-date cycle high of 1.77% from March (Figure 4). Rising yields are likely is a function of inflation expectations and a result of economic growth resuming above heretofore lowered expectations. And, as with the equity markets, this is a global phenomenon; yields are breaking out across the globe, in some cases with yields that had gone negative now turning back positive. This should have a disproportionately positive impact on stocks of the more cyclical companies.
2. On the back of rising interest rates, it is not surprising that two areas leveraged to lower rates, utilities and staples, are struggling. However, we think there is more to the weakness in these areas than just the rate story, as stock prices in those sectors struggled as rates fell, which should not have been the case. It’s just a general environment where investors are shunning lower beta securities.
3. The price of WTI crude oil remains strong although it seems to have hit a bit of a wall over the last two weeks in the $82-$85 range. The key question is: how much is the higher oil price impacting consumers and the economy? We suspect consumer discretionary stocks will be the first to tell us when the oil price is becoming a problem. So far, these stocks do not indicate that there is an issue. The state of restaurant stocks could foretell what an issue may look like in the consumer discretionary space; they are being hit with a double whammy of a higher input costs (e.g., energy, food, and labor) and supply chain bottlenecks.
4. Concerns in China remain regarding 1) government intervention in the markets (particularly in the education space, and 2) debt concerns and their impact on the property market. With that said, the Hong Kong property index is up about 20% since the Evergrande crash, bringing it back to around the level prior to the crash. We do not think the debt problems are out of the woods yet, but things have stabilized for the moment, and importantly credit spreads are not indicating anything sinister is on the imminent horizon. Additionally, the recent strengthening of the offshore Chinese yuan provides further evidence that things are relatively copacetic in China at the moment, especially given the context of a weakening yen.

Figure 4. Seems to be just a matter of time for interest rates before they break recent highs.

Source: FactSet

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News stories of clogged ports and soaring prices for shipping and energy abound. Transporting goods across the Pacific is now reported to take about 80 days, twice the pre-pandemic norm. After a very rapid recovery from the shortest and sharpest recession ever experienced, the economy now appears to be straining against its capacity to grow. Meanwhile, job openings are going unfilled while wages begin to rise.

The latest New York Fed Survey of Consumer Expectations shows the expected rate of inflation one year ahead at 5.2%, and 4.0% in three years. During the second quarter, inflation was mentioned on 45% of earnings calls, according to FactSet, well above the 28% five-year average. Amid mounting inflation concerns, long-term interest rates began to climb. While the Federal Reserve has not yet moved to raise short-term interest rates, it has made it clear that the time to remove its foot from the accelerator, by tapering its monthly bond purchases, is drawing near.

As companies adapt to doing business in this high-pressure economy, output-per-hour (productivity) gains are beginning to occur. Business processes are quickly evolving out of necessity, and firms are incorporating game-changing technologies such as automation, artificial intelligence and virtual communications.

Higher rates of productivity growth, conspicuously absent in the slow-growth decade of 2010 through 2019, allow the economy to grow faster for longer without creating additional inflationary pressure. They give the Federal Reserve an opportunity to try to orchestrate a slow, patient normalization of monetary policy without triggering a sudden, sharp increase in interest rates. The Fed is clearly determined to wait until it sees the whites of sustained inflation’s eyes, as it still views today’s rising prices as a temporary phenomenon.

Against this backdrop, Gross Domestic Product (GDP) growth has slowed. According to the Atlanta Fed’s GDPNow real-time estimate, the economy is set to expand around 1.8% this quarter, significantly slower than its breakneck 6% pace of just a few months ago. For the economy to resume above-trend growth, the Delta variant of COVID-19 must continue to subside, supply chain bottlenecks need to continue to clear, and more fiscal support has to be provided from Washington, D.C. While the contours of the next stimulus package have emerged, the final details of the legislation are in flux as Democrats seek compromises that will allow a bill to pass with a narrow majority.

Meanwhile, corporate profits continue to grow robustly, if a bit more slowly. The consensus estimate for S&P 500 earnings growth in 2022 is more than 9%, according to FactSet. Long-term interest rates have been rising slowly, which, in our view, has kept stocks from becoming extremely expensive relative to bonds; that’s good news because a big gap might prompt worry about an impending sustained bear market. Other market indicators appear to confirm that stresses in the economy are not yet seeping into capital markets: The yield curve remains positively sloped, for example, and credit spreads–the difference in yield between bonds of differing credit quality–remain tight.

We remain near the top end of our ranges in equities and near the bottom end of our ranges in fixed income, despite the “wall of worry” that the market continues to climb. As always, we maintain two years’ worth of cash needs net of portfolio yield, so that we do not have to sell assets at artificially depressed prices to meet spending needs during the inevitable corrections that will occur as this bull stock market ages.

Anchoring on Domestic Value stocks

One theme that has driven stock markets this year is the sharp tug-of-war between Value and Growth stocks. In many ways, it’s been a contest between the pandemic era, where economic growth and interest rates were low and technology and health care ruled the stock market, and the post-pandemic era, with its sustained higher growth and interest rates, where cyclicals, financials, and resource stocks have benefitted.

The COVID-19 pandemic and subsequent lockdown were the largest blow to the global economy since World War II. Investors shunned Value stocks in that environment, because these capital- and labor-intensive companies tend to have anemic growth and thin profit margins. Very legitimate bankruptcy fears caused Growth stocks to outperform, even more dramatically than during the “tech bubble” of 1999–2000. Today the market capitalization of the combined Energy sector is still smaller than the market cap of Apple! The COVID-19 pandemic accelerated a multi-year period of Growth outperformance, which benefited our strategies.

In September 2020, after a prolonged period of underperformance, Value began to experience a strong rebound, driven by anticipation of a sharp economic recovery. This Value rally was sustained through the spring of 2021, sufficient for our discipline to conclude that a multi-year period of Value outperformance was dawning. Yet just as we had reduced our long standing and highly successful emphasis on Growth over Value stocks, Value gave up much of its gains over Growth due to the emergence of the Delta variant of COVID -19 and ensuing concerns about renewed lockdowns and a potentially faltering economy.

Unlike 2020, when our strategies outperformed rising markets, this year our strategies have made solid absolute gains but have lagged in relative terms due to being late to the start of a new cycle of Value outperformance. At this point we are comfortable maintaining our Value bias for several reasons. Our discipline shows that the cycle of performance between Value and Growth typically lasts for several years, and that once a trend-change signal has occurred, a long period of outperformance should be expected, despite corrections along the way. By design, we are always late to the start of a new cycle, as we wait for several months of sustained outperformance from a new trend to confirm that a portfolio shift needs to occur.*

Value stocks also remain very attractively y valued relative to Growth stocks: Having hit an all-time low during the pandemic, they are still cheaper relative to Growth stocks than during the “Tech bubble” of the late 1990s (which preceded a multi-year period of strong Value outperformance in the early 2000s). That remains the case even after their partial rebound over the past year. Value stocks are therefore priced for better returns over the long term and also for a cushion in the next sustained bear market. Importantly, the rate of Growth’s outperformance over Value has decelerated sharply since June; September ended with Value outperforming. The catalyst for Value’s renewed outperformance has been the demonstrated effectiveness of COVID-19 vaccines, particularly in reducing the risks of hospitalization and mortality.

Finally, as elevated inflation remains sticky and long-term interest rates rise, future profitability from Growth stocks must be discounted back to the present at a higher rate when assessing their worth. This poses a stronger headwind to their valuations expanding further from today’s frothy levels. In the meantime, we are being rewarded for being patient, as Value stocks return a larger share of their total return in the form of dividends. This allows us to generate more income and hold less cash, net of portfolio yield, to meet spending needs.

Policy Change

Elsewhere, we did make one change to policy by reducing our emphasis of Emerging Market stocks. Emerging Markets’ outperformance late last year, which continued early into this year, looked durable, as it was propelled by improvements in fundamentals in local currency terms. However, by mid-summer, momentum had stalled dramatically, signaling that something else was afoot. Over the years, we have learned to be decisive when our discipline calls for us to reduce our exposure to this area. We pulled back as concerns about government intervention in China escalated, and before the collapse of Evergrande- a highly leveraged real estate company in that economy – signaled that debt levels could spell contagion risk for the broader Emerging Markets sector for the foreseeable future.

Private Markets: From “Nice to Have” to “Must Have if You Can”

If public market Growth stock valuations look elevated, some of the valuations in private markets look quite frothy. Outside of domestic Value stocks, today’s starting point for above-average returns from public bond and stock markets remains challenged due to low interest rates and high valuations. Private market exposure has moved from a “nice to have” to a “must have,” for those who can tolerate illiquidity, to help meet portfolios’ after-tax income and capital growth goals.

In this environment, discipline is key. Given the long-lived commitments we make in this area and the likelihood that another recession will occur within the next decade, we are focused on managers with track records of managing through prior downturns. We believe that smaller firms can provide a unique idiosyncratic competitive advantage, while larger firms may feel the pressure of having to deploy large amounts of capital quickly. And we are pursuing a broad private capital program that avoids direct deals and concentration in a small handful of managers and strategies.

We are currently pleased with the progress of all our managers. Monroe, our Senior Secured Loan Manager, is now 40% called. It has been able to be selective in this market due to its smaller fund size and focus on the lower middle market. This has allowed it to originate loans at higher-than-average rates with protections, or covenants, in the event the borrower begins to flounder. This contrasts with the broader loan market, where the trend is for lower rates and no protections on loans.

We were busy in the venture space in the third quarter, as we approved two venture funds for portfolios. The first is Panoramic V, which is a rebranding of the BIP Capital Venture team, whose fund IV has been a part of our stable. While it is early, fund IV continues to outpace our expectations as it concludes its investment period. Panoramic has grown its team and capabilities for fund V, and we remain confident in its ability to deliver results for portfolios.

The other Venture fund we approved is the Adams Street Innovation Fund. In this investment, Adams Street is leveraging their 40 years of venture investing to gain access to the top managers around the world. Top-tier venture is still very difficult to access, but our relationship with Adams Street has offered an access point at very favorable terms. We believe Panoramic and Adams Street are a good blend of focused Southeast exposure and diversified global access to venture capital.

We continue our work on infrastructure and real estate, as we believe these two asset classes represent meaningful hedges against elevated inflation in the coming years. Market pressures are also supportive in certain areas as the world struggles with the need to become more energy efficient and shuffle real estate square footage amid changing office, retail, residential, and industrial dynamics. We expect to have additional offerings in real assets in the coming months.

We remain pleased with the pace with which our managers have put money to work and the returns they have generated for your portfolios. We believe the need for this type of access is greater than ever, as the level of liquidity in the market can easily push pockets of the public markets to head-scratching extremes. The patience and discipline our private managers deploy allows them to remain focused on adding value through efficiency, expertise and growth, and not just financial leverage¹.

Outlook

Last year was one in which our strategies delivered outsized absolute and relative gains as our discipline helped us lean against the excessive emotions of a traumatic year. By contrast, 2021 has been a year of continued, steady progress as we are comfortable forfeiting some of the upside relative to the broader market in exchange for positioning portfolios for elevated inflation and higher interest rates in a post-pandemic world. As for the capital markets as a whole, the wall of worry that investors have been climbing became more daunting as summer turned into fall this year, and that looks likely to persist in 2022.

We are very grateful for the trust and confidence you place in our team and process. Thank you. Please do not hesitate to call if we can answer any questions you may have.

*Past performance is not indicative of future results

¹Please ask your Relationship Manager for more details on a private capital “roadmap” that can be used to increase the probability of your strategy to meet the goals outlined in your financial plan.

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2021 has been an interesting year for our economy and politically alike. The current administration has focused on supporting the economy while debating two separate bills with significant tax implications. In the interim, this has created a good amount of uncertainty for taxpayers trying to determine what strategies they should utilize before December 31st. Despite the uncertainty, there are still many strategies that individuals can explore to execute their year-end planning effectively.

Here are a few:

Donor-Advised Fund

Donor-Advised Funds are a philanthropic strategy that comes with a tax incentive. Placing assets, such as stocks, personal property, or cash in a donor-advised fund allows for a deduction of the entire amount contributed the year of the contribution. You, as the donor, can decide how you would like to distribute the assets in future years. These assets can also continue to grow over time, thus increasing the initial donation’s charitable impact. If 2021 has been a high-income year, contributing one lump sum this year will help increase your overall deductions.

Tax Loss Harvesting

Tax-loss harvesting involves selling off investments such as stocks or mutual funds that underperformed in your portfolio and are now worth less than when you bought them. You can then use these losses to offset any gains that you have in your portfolio. If you have more losses than gains, you can use up to $3,000 of those losses to offset other types of income, carrying over any losses over $3,000 to the following year.

However, individuals intending to sell an asset to realize the loss and then repurchase it should be aware of the “wash sale rules,” which prevent someone from deducting a loss if they repurchase “substantially identical” investments within 30 days.

Roth Conversions 

Roth conversions allow you to convert funds in a pre-tax individual retirement account, or other qualified accounts, to an after-tax Roth IRA. You will have to pay tax on the converted money, but the Roth IRA provides future tax-free growth. As converting an entire IRA may bump you into a higher tax bracket, individuals can spread conversions over many years. Also, a large conversion made within two years of signing up for Medicare may trigger the necessity to pay for the more expensive Medicare Part B.

Doing this now may also be a good idea since the House Democrats are deciding whether they should end Roth Conversions for those making $400,000 per year ($450,000 for married couples filing jointly).

Deferring Income

Deferring income is another strategy that many people focus on during their year-end planning. You may not be able to defer your salary or wage income; however, delaying a year-end bonus could be very beneficial. Note, however, this is only beneficial if you think you will be in the same or lower tax bracket in the following year. If not, you could end up paying more in taxes.

If you are self-employed, do freelance or consulting work, you should consider delaying billings until late December to ensure payment is not made until the following year, thus reducing the current year’s income.

Conclusion 

These are only some of the strategies that individuals use to effectuate their end-of-year planning. Many other strategies exist; however, utilizing more straightforward strategies may be prudent in an uncertain climate.

If these strategies interest you or you have questions, please feel free to reach out to your team at Balentine.

The post Year End Tax Planning Strategies appeared first on Balentine.

1. The financial media is all over the place with a housing bubble call: a bubble is coming, a bubble is here, a bubble has come and gone. Consensus remains elusive.
2. Why current housing prices do not constitute a bubble, despite their pervasive narrative.

In Part 2 of this blog, we would like to focus on two important follow-ons:

1. Why bubbles happen and the effects post-bubble PTSD.
2. Why fundamentals justify most of the price appreciation in housing to date and why, looking forward, further gains should accrue.

Why bubbles happen and the effects post-bubble PTSD

Perhaps the foremost expert on financial bubbles is Charles Kindleberger via his bible on financial dislocations: Manias, Panics, and Crashes: A History of Financial Crises. In assessing the various bubbles and subsequent calamities from over the last few centuries, he notes similar patterns:

1. Excesses begin as a novel idea takes hold. Some examples from our recent include the idea of “clicks and eyeballs” as well as the assertion that “housing prices have never gone down en masse across the entire country.”
2. Credit and foreign capital inflows expand. This creates additional demand for the desired product relative to its supply. This begets even further expansions in both categories on the back of the newly-created money. Of course, as the quantity demanded rises faster than the supply, prices rise.
3. Capitalists jump into the market. Seeing the newly-formed demand for the product, capitalists take advantage of the price hikes, both on the demand side and on the supply side:
   1. On the demand side, people purchase either with the intent of reselling at a higher price or bring forward their own demand curves because purchasing it today would be more cost-effective than waiting to buy it when the product is truly needed and prices are even higher.
   2. On the supply side, manufacturers see an opportunity to accrue super-normal profits and take on capital to build more production facilities with the intent of satisfying the increased demand.
4. Prices continue to ascend because demand increases consistently to stay ahead of supply increases. It is at this point that a “new paradigm” takes hold, many justifications and rationalizations for the price increases coming to pass. These beget even further expansions in credit and eventual price increases as those inside the bubble on both the demand side and the supply side are blissfully unaware of their peril.
5. Demand eventually dries up because much of the demand was not organic demand but rather self-fulfilling demand banking on higher prices to beget further higher prices. This comes from combination of reduced credit and/or no more “greater fools” left in the pool of potential buyers. Additionally, market insiders, recognizing the current prices left value in the dust a while ago, begin to take their balls and go home, exacerbating demand and supply imbalances. At this point, the price ascent runs into an air pocket, morphing into a sharp decline as a swath of sellers, fueled by expansion in excess capacity, are greeted with a dearth of buyers.
6. There is a rush for the exits as the rest of the market finally catches onto the fraud that was the “new paradigm.” If the asset is more liquid (e.g., stocks), much the fall comes imminently, with some residual fall afterward. If the asset is less liquid (e.g., real estate), the fall takes much more time. Regardless of which, the feedback loop we saw on the way up (i.e., rising prices beget more demand, which beget even further price increases) reverses into an analogous dynamic on the way down: falling prices beget more desire to sell, begetting additional price depreciation.

With the benefit of hindsight, we can see that the internet bubble and housing bubble followed this exact script. So, what is the distinction between what occurred then and what is occurring now? There are two main issues: post-bubble PTSD and fundamentals.

Post-bubble PTSD

Post-bubble PTSD happens after EVERY bubble. In essence, those burned by the bubble are constantly on guard for a repeat of the bubble, which effectively prevents the bubble from happening. This is why bubbles do not happen with regularity, and when bubbles reoccur, they are either with different assets or in a different geography. Some of the most famous bubbles such as Tulip mania and the South Sea and Mississippi bubbles occurred 300-400 years ago. Of more recent vintage, we have noteworthy examples (in chronological order): 1920s U.S. stock market bubble; late 1970s precious metals bubble; late 1980s Japanese economy, stock, and real estate bubble; late 1990s internet stock bubble; and the mid-2000s U.S. housing bubble.

As the historical pattern shows with each boom and subsequent bust, investors shun the prior area, whether that be asset class, geography, or both. They develop a bunker mentality for the asset that prompted the crisis; we all know the dynamic: once bitten, twice shy. Of course, the rational thing to do is to increase risk after crises, yet behaviorally it is such a hard thing to do. In fact, investors often go so far as to go in the opposite direction by betting against the crisis well after the crisis has ended. Think about all the investors who invested in hedge funds and tail-risk strategies well after the Global Financial Crisis ended (and in some cases continue to do so), which is the reverse of the optimal investment strategy. The lasting effects of the most recent crisis persistently cause investors to erroneously fight the last war rather than following the historical template of the next war, which ironically causes them to miss out on what generally end up being tremendous investment opportunities. We call this post-bubble PTSD, which is why it is so hard for a bubble to be re-blown.

A perfect example is the plethora of bubble calls for the technology sector in the early-to-mid-2010s:

• 2012: Facebook’s IPO and the New Tech Bubble
• 2013: Evidence That the Tech Sector is in a Massive Bubble
• 2014: Silicon Valley Heading Toward Another Tech Bubble
• 2015: Cuban: Tech Bubble Now Worse Than 15 Years Ago

Investors were still so traumatized from the internet stock bust on the heels of the 1990s bubble that the obvious call was that another tech bubble had developed. However, we can see in retrospect how that call went: the 2010s was a technology-dominated decade, causing many apprehensive investors to underweight the juggernaut.

We believe the current housing market and the underlying mentality is analogous. A sector that blew up less than 15 years ago begins to find its legs, and “pundits” are ready to make the “obvious” call that a new bubble is forming, especially because of a relatively short period in which the housing market was extremely hot. Thus, the Pavlovian call for a bubble owing to recency bias, a call which we referenced in Part 1 of the blog and which we are likely to see ad nauseum over the coming years as the housing market continues its ascent.

Why fundamentals justify most of the price appreciation to date and why, looking forward, further gains should accrue

This can be distilled primarily to one statistic, with two important secondary statistics: Housing starts, demographics, and mortgages.

Reduced Supply of Houses. In the wake of the overbuilding that occurred during the housing bubble, housing starts plunged (Figure 1).

Of course, this was necessary, as a housing surplus developed during both the ascent of the housing bubble (houses were being built for both owners who were destined not to be able to remain in them as well as speculators trying to make a quick buck) and during the decline (as the foreclosure glut mounted and then went through the process). A plunge in housing starts was just what the doctor ordered to clear the glut while builders and speculators who were left holding the proverbial bag cleared their inventory.

However, as with all pendulums, the housing glut swung too far, becoming a housing deficit as millennials who had theretofore been shacking with their parents were now on the prowl for housing as household formation took off. So, while the coronavirus exacerbated this dynamic with a mad scramble for housing, the demand-supply imbalance was already in place. This in not unlike what we saw in the oil market as oil prices plunged – rigs were taken offline as excess capacity became apparent in the wake of plunging oil demand.

Most people are unaware of exactly how few homes have been built in this country over the last decade or so. To put the figures from Figure 1 in perspective, from March 1977 through November 1978, we averaged ~1.5 million single-family housing starts per month when the U.S. population was around 220 million. In December 2020, the U.S. population was 330 million, yet the “bubble” of housing starts in the wake of the coronavirus scramble was merely 1.3 million – 50% more people yet fewer housing starts! And to take things to a real extreme, housing starts in March 2009 were just 353,000, which compares to 1.3 million built 50 years earlier when the U.S. population of 175 million was merely half the March 2009 population. Put differently, at its most extreme, 75% fewer homes were being built for twice the population!

Figure 1. 60+ Years of U.S. Housing Starts Show the Last Decade Plus have defied historical precedent

Source: St. Louis Federal Reserve

Increased Demand for Houses. Not only do we have reduced supply, but we have additional demand drivers. Importantly, these demand drivers are not ephemeral like the coronavirus bump. Rather U.S. demographics indicate that there is a strong pent-up need for housing. Figure 2 shows historical and projected age brackets. Ages are grouped as follows:

• Green: Ages with likely strong demand for housing
• Yellow: Ages with modest demand for housing or the potential beginning to scale out
• Red: Ages with potential for selling housing
• Black: Ages with little to no direct effect on the housing market

As we progress from the earlier dates to the later dates, we can see a growing number of age brackets with higher housing demand growing as a percentage of the U.S. population. While many assumed that millennials scarred by the Global Financial Crisis would live in apartments or with their parents ad infinitum, 2020 data suggest the process of millennial homebuying is well underway. And if what we have seen of late is indicative of the future trend (excluding the effect of the coronavirus bounce), we are going to need a lot more houses in the country, a spigot that will take many years to turn on in its full effect.

Moreover, as the home-buying groups grow, we are not seeing a large growth in the Baby Boomer cohort, which would likely be sellers (i.e., the groups in red). While it’s possible that some inventory may come onto the market late in the 2020s and into the 2030s, this is by no means a guarantee and would likely take time to play out. So, the idea that there is going to be a huge flood of supply to hit the market imminently is highly unlikely.

Combining the effects of these two dynamics, simple supply and demand dynamics would dictate that housing prices should not only be rising now but also set for further gains in the future merely on the lower supply generated over the last 12-13 years.

Figure 2. The future of the housing market has strong demographic tailwinds, both present and future.

Source: U.S. Census Bureau

Differences in Mortgages. A key cog in the wheel that drove the housing bubble 15 years ago was the poor quality of mortgages. Option ARMs, NINJA loans, and other assorted subprime dreck led to an artificial increase in demand for housing. Today, things are much different. We would point to three components of today’s mortgages that make things different now than they were 15 years ago:

1. Mortgage quality is far superior, as shown in Figure 3. During the climax and denouement of the housing bubble, people with poor credit were originating more mortgages than people with strong credit. Now, however, the gap between high credit and low credit mortgages is higher than it has been in the last two decades.
2. Mortgage servicing is far less onerous to households, as shown in Figure 4. Far less disposable income is required to make mortgage payments, with current levels almost 40% lower than they were in the fourth quarter of 2007 (i.e., down from 13.2% to 8.2%). Of course, some of this is due to lower interest rates, but that doesn’t change the fact that servicing mortgages is easier than it has been in the forty years of data, despite the fact that housing prices are higher than they were at that time.Another important facet of this is that even if rates were to move higher, many homeowners have locked into long term payments at their current low interest rates. This is a strong contrast with 2007, when many originated interest-only loans that were due to reset as rates went higher.
3. Mortage cash outs are fewer, as shown on the Freddie Mac website in Figure 7.

Of course, none of this precludes this situation from eventually becoming a bubble. Although, history suggests that a repeat bubble will not be the case, we must acknowledge that is a possibility. However, the data point to no bubble at this time and nothing imminent.

Figure 3. Mortgage quality is far superior to that of 15 years ago

Source: New York Fed Consumer Credit Panel

Figure 4. Mortgage servicing is far less onerous to households

Source: St. Louis Federal Reserve

The post U.S. Housing – Déjà vu All Over Again? Part 2 appeared first on Balentine.

Investors of today are asking a similar question in “Where have all the good small caps gone?” Small cap stocks were once an asset class full of hopeful companies that the market knew little about, promising above average returns for those willing to hold a basket of these stocks. The idea was first documented by Rolf Banz in 1981 and famously used in the 1992 Fama-French factor model.

Since that research, however, the outperformance of small cap stocks over large cap stocks has been non-existent. Below we show the ratio of small cap to large cap back to 1979. After a brief stint of outperformance in the early 80s, small caps have by and large underperformed large caps. This has left investors scratching their heads and wondering: where are the good cap small companies?

Source: Factset, Balentine

The literature on attempting to answer “why” the small cap premium has essentially disappeared is prolific. Instead of looking to add to the “why,” we attempt to answer the “now what?”

For investors seeking return premium in smaller companies, we highlight two potential approaches different than simply buying a broad basket of small cap stocks. The first of those approaches is an allocation to private equity.

Private Equity

Private equity is the ownership of private companies that seek outside capital and expertise to grow or reposition. That capital and expertise can be a venture capital manager, who for a minority stake in the company can help develop the product and roll it out to the market. It can also be a growth equity manager, who provides capital to expand operations or product lines. Or it can be a buyout manager, who looks to streamline operations of an older company to unlock value.

We believe investing in private companies versus public companies has two main advantages that can bring the small company premium to portfolios:

1. Companies can focus on the long-term versus just trying to hit quarterly earnings, and
2. Companies can leverage the talent and experience of the general partners of the private equity firm.

The typical private equity fund is 10 years in length to ensure these two things can play out. Private companies can invest in products and markets that do not need to show immediate return because they do not have to worry about their stock temporarily falling. General partners can develop a multiyear plan for the company and do not have to worry about investors demanding their money back if things are going slower than expected. This long-term approach can unlock value for which the impatient daily liquid stock market does not have tolerance.

We believe this is a main driver in why companies are staying private for longer. December 2020 saw Airbnb and Doordash both go public in the same week at $100 billion and $55 billion valuations. Microsoft went public at $777 million… Airbnb and DoorDash skipped the small cap arena altogether and debuted as large cap companies. All the growth that typically would have occurred in the public small cap space occurred in the private markets. Regardless of how good Airbnb and DoorDash are as companies, delivering a 2,805x return to public investors seems unlikely from this starting point.

Fast growing companies’ preference to stay private longer leaves the broad public small cap index in a pinch. According to Strategas, over 40% of small cap companies are not profitable. That is up from 10% – 15% in the late 1990s. It is quite possible the public markets have become a place for small caps to raise money as a last resort, making it crucial to be selective. This selectivity is our other path to consider for investors looking to gain access into good small cap companies.

Small Cap Managers

For those unwilling or unable to invest in the private markets, finding an active small cap manager who takes a private equity approach can be fruitful. This manager would look to take a meaningful stake in the public company to have a material influence at the board level. This is something that can only be done in smaller companies as 5% of a company like Microsoft with a $2 trillion dollar market cap is larger than almost all active funds.

The manager would have a long holding period for companies. To unlock value in public companies, managers need to be able to see a catalyst for change and then give time for that to play out. They need to not be worried if the company misses a quarterly earnings number, as long as they are working towards the long-term plan. Managers with short holding periods tend to be trading more than investing, and are unlikely to be able to unlock that value.

The manager would also be well-aligned. Be willing to invest in funds with reasonable lock up periods (1 – 4 quarters.) This alignment allows the manager to let his thesis play out without having to worry about investors running for the door after a quarter or two of bad performance. A low management fee and reasonable performance fee can also align the manager. This drives them to not gather assets, but seek true excess return, aligning themselves with investors.

A Happy Ending

While the woman in Paula Cole’s song never found her cowboy, we believe happy endings are still possible for investors seeking good small cap companies. Though buying a broad basket of small cap stocks may not give investors the premium they want, they may still seek these companies in the private markets or through a selective in the public equity managers.

The post Where Have All the Small Caps Gone? appeared first on Balentine.

Our goal as advisors is to help clients balance the knowns and unknowns of planning and investing so that we can help them make the very best choices with the information available, knowing that we’ll never have the full suite of data to make the “perfect” decision.

With that, there are four principles to keep in mind during the decision-making process:

1. Keep your Options Open
2. Read the Fine Print
3. Make Decisions out of Clarity, Not Certainty
4. Let Enough be Enough

Keep your Options Open

Think about choices that give you the maximum flexibility. For example, let’s say you would like to simply consider how to reduce your taxes. If you are a private business owner with flexibility on when to incur income or expenses and you separately own diversified portfolio investments in both taxable and tax-exempt investment accounts, then you have a host of distinct ways to attack the same goal as you await for legislative decisions to be made. To save taxes, you could gift appreciated stock, make a Qualified Charitable Contribution (QCD) from an IRA, accelerate business expenses, or postpone income.  Having a variety of choices is always preferable to not having them!

Read the Fine Print

Let’s say for a second you would like to remove some assets from your estate. You could work with an attorney to set up a Qualified Personal Residence Trust (QPRT) to utilize your home to do so or Intentionally Defective Grantor Trust (IDGT) that could use other assets to accomplish that goal. But wait a second, how do you feel about potentially having to pay rent to your children, or having to ask a duly authorized Trustee to approve a transaction for you? Is that a headache, ignominy, or no big deal? Ask yourself, “Is the juice worth the squeeze?” Simplicity is a wealth in and of itself, and more often than not, it is best to let go of an additional 1% in returns or tax savings if it requires an 10x increase in complexity.

Make Decisions Out of Clarity, Not Certainty

Patrick Lencioni, in his book, The Five Temptations of a CEO, deftly illustrates that we will never have 100% knowledge or certainty about the decisions we are weighing, though we can have clarity about why we are making these decisions. This clarity will help guide us in the future. From a planning perspective, if we know that we own appreciated investments that have increased in value, we can have clarity that it is prudent to bank profits as a matter of course, and we don’t need certainty as to the precise capital gains rate on dollars of that magnitude. Alternatively, one will never know if it is the absolute right time to sell a stock or a fund or whether it is at or beneath, its all-time high, but you can know whether the net proceeds is enough to put the deposit down on your dream home, pay off a debt, save enough for a child’s education and so on. Let the big things be your guide, not the madness of uncertainty.

Let Enough be Enough

Some time ago, a study was released that the average salary coming out of a top 25 M.B.A. school in the U.S. put that individual in the top 1% of wage earners worldwide. This statistic helps us understand that a “millionaire’s” tax or surcharge decision would be made in rarified air. While not belittling or diminishing the value of saving nickels and dimes where you are able and having a process to utilize for investments and taxes, it is important to keep the big picture in context. There is no end to the amount of investment or planning decisions an individual could theoretically make, so don’t drive yourself mad trying to figure out how to save every penny. Visit relatives, enjoy the autumn sun, and be mindful and thankful to be in a position to make decisions about such matters.

“You waste years by not being able to waste hours.”

Psychologist Amos Tversky

If you call any investment advisor, accountant or lawyer and say “what can I do?” the choices and decisions could go on forever. If you take time to be clear about your own personal goals, then you can be clear about what you want to do before you ask your advisors what you can or should do. It will also help you take bumps in the road in stride. Former United States Secretary of State George Shultz famously locked himself in his office for an hour every week with only a pen and legal pad to give himself time to think strategically. Like Shultz, I encourage you to carve out an hour each week, sit down with a blank legal pad, and let thoughts come to you. The question you should ask yourself is: “What should I do, and why?” Spend the hard time answering these questions and let the details take care of themselves.

The post Planning Amidst Uncertainty appeared first on Balentine.

Private debt/credit is non-bank lending where the debt is not issued or traded on the public markets. Within the private debt universe, there are different strategies with varying risk/return profiles. Major types include: Asset Backed Lending, Senior Secured, Mezzanine Funds, Distressed Debt, and Special Situations—such as bridge loans.

A sample Middle Market Senior Lending fund will originate and make floating rate loans to companies based on their cash flow (rather than a traditional loan which will look at hard assets). The loan is secured by a senior-lien on the company’s assets and often a pledge of the company stock. The loan is often used for a recapitalization, acquisition, growth capital or other strategic need. While the terms of the loan will vary depending on the specifics of the company, the rates are often higher than the average borrowing rate from depository banks.

Why does private debt exist?

The private debt asset class grew dramatically following the regulatory tightening after the Great Financial Crisis. As regulators in the U.S. and E.U. made it more difficult for commercial banks to lend directly to middle market companies, private funds filled the capital void.

How are returns generated?

Direct lending returns are primarily generated through the floating interest rate charged on the loan (let’s say Libor + 700bps) and fees, but there can also be additional return provided through warrants or other equity linked structures that allow the lender to participate in the company’s stock.

The post Private Debt: Direct vs. Commercial Lending appeared first on Balentine.