The market turbulence of 2022 stands in sharp contrast to the utopian mix of easy money, low volatility and high returns seen in 2021. It is now widely acknowledged that inflation is perhaps the most disruptive theme contributing to economic uncertainty. High inflation can act as a tax and slow growth by itself. It also increases the risk of a policy misstep where overly aggressive tightening by the Fed may trigger a recession.

In this webinar, Sandip Bhagat, Chief Investment Officer at Whittier Trust, and David Shaw, Publishing Director at Family Business Magazine, come together for a discussion on inflation and its impact on your family business.

Contact us to learn more about how our team of advisors can help you.

Whittier Trust Company and The Whittier Trust Company of Nevada, Inc. are state-chartered trust companies, which are wholly owned by Whittier Holdings, Inc., a closely held holding company. All of said companies are referred to herein, individually and collectively, as “Whittier”. The accompanying materials are provided for informational purposes only and are not intended, and should not be construed, as investment, tax or legal advice. Please consult your own investment, legal and/or tax advisors in connection with financial decisions and before engaging in any financial transactions. These materials do not purport to be a complete statement of approaches, which may vary due to individual factors and circumstances. Although the information provided is carefully reviewed, Whittier makes no representations or warranties regarding the information provided and cannot be held responsible for any direct or incidental loss or damage resulting from applying any of the information provided. Past performance is no guarantee of future results and no investment or financial planning strategy can guarantee profit or protection against losses. These materials may not be reproduced or distributed without Whittier’s prior written consent.

From Investments to Family Office to Trustee Services and more, we are your single-source solution.

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Inflation has been a trending topic in the news as supply chains and labor shortages continue to struggle to meet market demands. Though this current climate may reduce an investor’s confidence, there is an upside: larger gift tax exemptions. The increase in gift tax exemptions has increased to $16,000 per donee, which means that tax savvy individuals can reduce the overall tax burden of their estate.

The current lifetime gift tax exemption allows for individuals to give over $12million per donee. While this is set to “sunset” in 2025, there has never been a better time to take advantage of this opportunity. Though taking advantage of this exemption is extremely lucrative, it should not be done without the oversight and guidance of a qualified estate planner, as errors can be incredibly costly. Talk to your advisor to craft an effective strategy about how you can protect your estate for future generations.

From Investments to Family Office to Trustee Services and more, we are your single-source solution.

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Above-trend Growth in 2022 

Introduction

The remarkably short Covid recession of 2020 was followed by a rapid and powerful recovery in 2021. Bolstered by massive policy stimulus, global economies and markets were resilient enough to overcome uncertainty from virus variants and inflation spikes.

The U.S. economy grew by almost 6% in 2021 in real terms even as CPI inflation reached 7% by the end of the year. The S&P 500 index led global equity markets with a stunning total return of 28.7%. In an even more astonishing outcome, stock market volatility remained unusually low. The maximum drawdown from peak to trough in the S&P 500 index was only -5% in 2021.

The strength in the economy and the markets was based on solid fundamentals. Heading into 2022, the Purchasing Managers Index, which serves as a useful leading indicator of economic activity, still remains firmly at expansionary levels.

However, an increasingly hawkish stance from the Fed roiled the stock and bond markets early in the New Year. It wasn’t too long ago that the Fed had appeared overly sanguine about inflation. As recently as September, the Fed was projecting zero rate hikes in 2022. It has since changed its position in a number of ways.

The Fed has stepped up its pace of tapering which is now expected to end in March. It is also projecting 3 rate hikes in 2022 with more to follow in the next two years. These actions were initially met with enthusiasm in the markets as they dispelled fears that the Fed was falling behind the curve in fighting inflation.

However, what came as a shock to the markets on January 5, 2022 was the Fed’s consideration of a reduction in its balance sheet soon after the first rate hike. This trifecta of tapering, rate hikes and now quantitative tightening (QT) was deemed to be an insurmountable “triple threat” for both stocks and bonds.

>We have highlighted for a while now that we have reached an inflection point in policy stimulus and that growth will slow down from its 2021 peak. Our outlook for 2022 focuses on one key question.

Will the decline in growth be exacerbated by a policy mistake around inflation or will growth still come in above trend to sustain the economic cycle and bull market? We assess risks to the economy from the virus, inflation and the Fed. We balance these risks out against the continued tailwinds for growth from prior stimulus, easy financial conditions and a healthy U.S. consumer. Along the way, we also look more closely at earnings growth in light of historically elevated stock valuations.

Omicron, Inflation, and The Fed

Omicron

We believe that Omicron will have limited economic impact despite its high rate of transmission. The current vaccines have been reasonably effective at preventing severe disease. They have also been successfully rolled out; the older, more vulnerable age groups have vaccination rates in excess of 90%.

The Omicron variant of the virus has also mutated significantly. While this makes it more transmissible, it may also make it less potent. The current data shows that a smaller percentage of all infected people have been hospitalized than before. And an even smaller percentage of hospitalized patients have been admitted to the ICU.

Inflation

We do not expect inflation to spiral out of control like it did in the 1970s. That bout of inflation was triggered by a supply side shock in the oil market. We do not see a similar parallel in 2022. We agree with the Fed and the consensus forecast that inflation will peak in the first half of 2022.

Our reason for this view is simple. Prices became so elevated in 2021 from the immediate shock of the pandemic that future price increases are likely to be more muted as the intensity of that shock abates.

Our third observation on inflation is a departure from the consensus view. We expect that inflation will subside at a slower pace than most expectations.

We, therefore, expect inflation to remain higher than consensus or Fed forecasts in 2022 and 2023. Having said this, we do not expect inflation to adversely impact the economy or the markets. When inflation and interest rates go up from extremely low levels towards 3 to 4 percent, stocks generally do well in a robust economic recovery.

The Fed

We do not believe the Fed will commit a major policy mistake any time soon. The hallmark of its policy for over a decade has been an overly accommodative stance.

The Fed has constantly erred on the side of risking inflation from being dovish than on risking another recession from being hawkish. Its recent decision to allow inflation to run well above 2% before raising rates is another example of its desire to go slow instead of going fast.

The Fed can always be data-dependent and we expect it to alter course as necessary.

We move to the more promising drivers of growth in the next couple of sections.

Legacy Tailwind of Prior Stimulus

Investors have worried about the inflection of both monetary and fiscal stimulus for quite a while now. More central banks have raised rates globally than cut them. Fiscal stimulus going forward will be a tiny fraction of what was seen in 2020 and 2021.

We believe, however, that investors are underestimating the powerful legacy of prior stimulus as a tailwind for future growth. We discuss a few examples of how financial conditions are still accommodative on the heels of the Covid policy responses.

We begin with a look at just how massive global monetary stimulus was during the Covid crisis.

Figure 1 shows quantitative easing (QE) from the four major central banks of the world over the last 15 years.

Figure 1: G4 Central Bank Balance Sheets, $ Trillion and % of GDP

A chart showing the G4-Central Bank Balance Sheet.
Source: KKR Global Macro and Asset Allocation, as of 10/31/21

The G4 central banks expanded their balance sheets by more than $9 trillion in the Covid crisis. This injection of liquidity was a staggering 21% of GDP. It was also 3 times bigger than their policy response after the Global Financial Crisis (GFC).

The Fed alone grew its balance sheet by more than $4.5 trillion and is now ready to start reducing it. At what pace might that happen? We turn to the last tightening cycle for a precedent. In 2017, it took the Fed almost 2 years to reduce its balance sheet by about $700 billion. We believe that any quantitative tightening in 2022 will only be a small fraction of the existing stock of liquidity that the Fed created previously through QE.

We believe that the Fed’s balance sheet will still remain sizeable and provide sufficient support and stimulus to aid above-trend growth in 2022.

Global monetary stimulus during Covid also resulted in extremely low interest rates.

We show global real interest rates in Figure 2. Real rates are defined as nominal rates minus long-term inflation expectations.

Figure 2: Real 10-Year Government Bond Yields

A chart showing the Real 10-Year Government Bond Yields.
Source: Bloomberg, as of 11/30/21

As we can see in Figure 2, real rates are negative in most countries. They are also well below their trailing 10-year averages.

We fully expect real rates to rise as growth remains strong, the Fed starts to tighten and inflation begins to subside. But because real rates will rise from such historically low levels, we expect financial conditions to still remain easy and accommodative.

We can also see legacy tailwinds from fiscal stimulus. Savings rates shot up on the heels of the initial rounds of fiscal stimulus as consumers were unable to spend all of their stimulus checks. These excess savings were banked and have since grown into a sizeable pool of reserves for consumers.

By most calculations, cumulative excess savings are estimated to be over $2 trillion. At around 17% of Personal Consumption Expenditures and almost 10% of GDP, this cash on the sidelines bodes well for future consumer spending.

And the consumer is strong in many other ways. Household net worth has grown exponentially from the rapid Covid recovery, a booming stock market and a red-hot housing market. Debt payments as a percent of household income are at an all-time low. The jobs market has almost fully recovered now with the unemployment rate below 4%.

Strong economic fundamentals have sparked reflation and high nominal GDP growth. We expect nominal GDP growth to be around 8% in 2022. At these levels, economic growth will far exceed nominal GDP growth seen in the last 20 years.

The above-trend growth in nominal GDP also bodes well for corporate profits. We look at the outlook for earnings growth and its impact on stock prices in the next section.

Earnings Growth and Stock Returns

We first highlight an important inflection point in stock market leadership.

The initial phase of a new bull market is typically driven by abundant liquidity. Stock prices move higher in anticipation of an eventual recovery. However, this early move in prices can happen even as actual earnings decline or throughout. As a result, P/E multiples expand dramatically in this liquidity induced phase of the bull market. We saw this play out in 2020.

We transitioned to the next phase of the equity bull market in 2021. In this growth-driven phase, earnings growth becomes the main driver of stock prices and P/E multiples begin to decline.

Figure 3 shows this effect with visual intuition.

Figure 3: S&P 500 Return Contributions in 2021

A chart showing the S&P 500 Return Contributions in 2021.
Source: FactSet, as of 12/31/21

Earnings growth reflects change in forward earnings estimates

The green line in the chart shows the S&P 500 price return of 26.9% in 2021. The light blue line at the top shows earnings growth of 34.6%.

The only way to reconcile a lower return than the growth in earnings is through a decline in the P/E multiple. This multiple compression of -7.7% is shown in the dark blue line at the bottom of Figure 3.

We expect this pattern to repeat itself in 2022. The magnitude of the numbers, of course, will be different but we believe the pattern will be similar. We expect earnings growth will be strong enough to more than offset a continued decline in the P/E multiple.

Our optimism for earnings growth stems from a couple of fundamental factors e.g. revenue growth and margin growth.

Revenue growth tends to be highly correlated with nominal GDP growth and is also expected to be around 8% in 2022. At these levels, it will be significantly higher than revenue growth seen in the last two decades. We expect revenue growth to remain above trend in the foreseeable future.

We are even more intrigued by the continued contributions to earnings growth from high profitability. Profit margins for the S&P 500 index continue to rise. Net margins reached an important milestone in 2021 as they crossed the 12% threshold for the first time ever.

In fact, profit margins have grown steadily for the last 20 years from the mid-single digits to the low-double digits. Contrary to conventional wisdom, the trend suggests a structural shift upwards in profitability.

We take a closer look at profitability.

Figure 4 shows trends in profitability over time and across sectors.

Figure 4: Change in Profit Margins over Time by Sector

A chart showing the Change in Profit Margins over Time by Sector.
Source: FactSet, Whittier, as of 12/31/21

We show current profit margins in green and profit margins from 2011 in blue.

The breakdown of profitability by sector reveals several insights.

  • Profitability varies significantly across sectors. The most profitable sector is Technology and the least profitable sector is Consumer Staples.
  • Growth in profit margins over time also varies significantly by sectors.
    •  The most profitable sector, Technology, has also seen a big increase in profitability.
    • So has the Communications sector.
    • The Energy sector is the only sector to see a decline in profit margins.
  • These results are intuitive. Communications has become a more profitable sector after Google and Facebook were added to the sector. Technology includes high margin companies like Apple and Microsoft.
    • Growth in profit margins also helps explain sector and market valuations.
    • The Technology and Communications sectors are more valuable with a bigger market cap because they are more profitable.

Figure 5 highlights the base effects of margin growth over time and the mix effect of margin growth across sectors.

Figure 5: Mix Shift for High Margin Growth Sectors

A chart showing the Mix Shift for High Margin Growth Sectors.
Source: FactSet, Whittier, as of 12/31/21

Figure 5 shows base and mix effects for two sectors with high margin growth. The purple bars show Communications and the grey bars show Technology.

The first pair of bars shows how profit margins have increased for these two sectors in the last 10 years – by 12% for Communications and 9% for Technology. The next pair of bars shows that at the same time, their weight in the index has also increased – by 5% for Communications and 12% for Technology.

On the other hand, sectors with low margin growth, such as Energy and Consumer Staples, show the opposite outcome – no growth in profit margins and a decline in their index weight.

These observations help us understand the recent rise in profit margins.

We believe strong revenue and margin growth will drive above-trend earnings growth and create potential for upside surprises.

We use these insights to inform our economic and market outlook.

Outlook For 2022

We expect the post-Covid economic cycle and bull market to continue in 2022 but with several important distinctions.

This cycle is more likely to resemble the post-Internet Bubble recovery than the post-GFC one. A key characteristic of this cycle will likely be steady reflation instead of the sustained disinflation we saw in the previous cycle. And finally, we expect stock returns in 2022 will likely be lower and more volatile than they were in 2021.

We summarize the key tenets of our 2022 outlook below. We believe:

Economy

  • Virus variants will continue to have limited economic impact
  • Inflation will remain above consensus expectations in 2022 and 2023 but will not meaningfully impede growth or profit margins
  • Fed will avoid a major misstep in 2022
  • Above-trend nominal GDP growth in 2022 may exceed current expectations

Earnings, Revenues, Profits and Valuations

  • Earnings growth will remain significantly above trend in 2022
  • Revenue growth and profit margins will remain well above trend
  • P/E multiples will compress modestly as interest rates rise gradually
  • However, stock valuations will not revert to their long-term mean in the near future

Asset Classes

  • Stocks will handily outperform bonds and cash in 2022
    • Above-trend earnings growth will offset modest P/E compression
    • Equity returns will be in the mid to high single digits with upside potential
  • Select Real Estate is especially attractive at this stage of the cycle
    • Cash yields could exceed bond yields
    • Correlation with nominal GDP creates useful inflation hedge
  • Private market investments should outperform their public market counterparts

Sectors and Themes

  • Value and cyclical stocks will perform well in 2022 e.g. Energy, Financials, Industrials
  • Credit will outperform duration
    •  Credit spreads will remain lower for longer
    • Nominal rates will rise by 50 to 75 basis points
  • The following themes will attract investor interest
    • Pricing power
    • Real assets
    • Energy transition and ESG investing
    • Innovation and disruption

We recognize that inflation is now the main investment risk in 2022. We are mindful that the seismic dislocation of global supply chains may create some unexpected outcomes and pose risks to our views on inflation and the Fed.

Nonetheless, we remain optimistic on the economy and the market. We expect growth to remain above trend and stocks to perform well. At the same time, we exercise restraint and discipline in managing portfolio risk.

Inflation has now emerged as the biggest investment risk in 2022. Will inflation or a related Fed policy mistake exacerbate the deceleration of growth from its 2021 peak?

 

We believe growth will still come in above trend to sustain the economic cycle and bull market.

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The last three years have produced some of the most extreme backdrops in the history of global economies and markets.  We were still in the midst of the longest expansion ever in the U.S. in 2019.  The only cloud on the horizon to disturb the calm back then was the question of when the cycle would eventually end.

We didn’t have to wait long for our answer as a global pandemic tore the world apart in early 2020.  The ensuing chaos was unprecedented as we experienced profound human pain and suffering and also the deepest and shortest recession ever.  Medical innovation and robust policy responses led us out of the abyss and into the remarkable post-Covid recovery of 2021.

Another new normal has emerged in the aftermath of the pandemic.  As we look ahead, we are in unchartered territory in terms of the anticipated decline in stimulus, the speed and nature of recent inflationary pressures, economic and profit growth sustainability, and the risk of reverting to the mean from elevated valuations.

Please join Sandip Bhagat, Whittier’s Chief Investment Officer,  as he discusses our outlook for the economy and markets in 2022.

Whittier Trust Company and The Whittier Trust Company of Nevada, Inc. are state-chartered trust companies, which are wholly owned by Whittier Holdings, Inc., a closely held holding company. All of said companies are referred to herein, individually and collectively, as “Whittier”. The accompanying materials are provided for informational purposes only and are not intended, and should not be construed, as investment, tax or legal advice. Please consult your own investment, legal and/or tax advisors in connection with financial decisions and before engaging in any financial transactions. These materials do not purport to be a complete statement of approaches, which may vary due to individual factors and circumstances. Although the information provided is carefully reviewed, Whittier makes no representations or warranties regarding the information provided and cannot be held responsible for any direct or incidental loss or damage resulting from applying any of the information provided. Past performance is no guarantee of future results and no investment or financial planning strategy can guarantee profit or protection against losses. These materials may not be reproduced or distributed without Whittier’s prior written consent.

From Investments to Family Office to Trustee Services and more, we are your single-source solution.

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Introduction

September is a notoriously volatile month and it certainly held true to form in 2021. Stocks sold off during a seasonally weak period of the calendar as market uncertainty grew. The S&P 500 declined by more than -5% from its previous high while the Nasdaq index fell by more -7% from its prior peak.

We have long held the view that a couple of unusual factors would allow economic and earnings growth to surprise on the upside. Coming out of the Covid recession, we had an unusually strong U.S. consumer and we had unusually massive policy stimulus. In the first half of the year, they did propel growth higher than consensus expectations.

But the tide seems to have turned as the list of investor concerns has grown steadily in recent weeks.

There is a growing fear that supply chain constraints may keep inflation high and raise the specter of stagflation. The proposed reconciliation bill comes bundled with higher taxes that are generally restrictive for growth. Fiscal and monetary policy is approaching an inflection point and investors are now focusing on an anticipated deceleration of growth. Investors also worry that historically high stock valuations may be at risk if growth slows down dramatically.

We focus on the following discussion points to answer one key question.

  • Inflation
  • Spending and taxes
  • Inflection in stimulus
  • Deceleration and valuations

Are these potential headwinds likely to become major disruptors of growth in the coming months? Or will they merely be distractions on a bumpy road to recovery?

We begin our discussion with some brief remarks on a couple of other investor concerns that appear to be fading at the time of this writing. The Delta variant triggered a third wave of the coronavirus and stalled economic activity in the third quarter. However, we appear to have peaked in daily new cases, hospitalization rates and the incidence of deaths and a third round of re-opening may well lie ahead of us in the fourth quarter.

The perennial debate on the debt ceiling surfaced again in September and created angst and uncertainty among investors. At this moment of time, it appears that the Senate has reached an agreement to raise the debt ceiling through early December. We believe that a more permanent deal to resolve this manufactured crisis will also be negotiated in the coming weeks.

Inflation

Inflationary pressures started to build up after vaccination rates gathered momentum in early 2021. The initial spike in inflation was attributed to two pandemic-related effects – pent-up demand and supply chain disruptions.

The U.S. consumer has remained strong through the Covid recession. Disposable incomes are higher as a result of fiscal stimulus. Consumer net worth has soared from higher savings, rising stock prices, a red-hot housing market and low interest rates. The inability to travel or even move freely inhibited spending during the pandemic. The ability to do so after reopening, along with higher savings and incomes, has unleashed significant pent-up demand for goods and services.

At the same time, global supply chains have been in disarray after being brutally disrupted during the pandemic. Lengthy factory shutdowns in Asia and snarled shipping traffic have created a constant shortage of key components for manufacturing. Labor has also remained in short supply and contributed to wage increases.

Many had expected these pandemic effects to be shortlived and, therefore, for inflation to remain transitory. It is now increasingly clear that “transitory” needs to be recalibrated as inflation is proving to be more persistent than initially expected.

As growth begins to decelerate at the same time that inflation remains stubbornly high, investors have now started to worry about stagflation. We will discuss the deceleration of growth in later sections. We set out here to assess the outlook for inflation in the short term and over the long run.

We first rule out the possibility of runaway inflation similar to the levels seen in the 1970s. We do not see any parallels to the types of supply side shocks that were experienced in the oil and food markets back then.

We narrow down our choices of likely inflation regimes to either stubborn or transient and conclude that the answer is both over a 3-year horizon. We explain the rationale and implications of our view.

We show the Fed’s revised outlook on inflation in Figure 1.

Figure 1: Fed Projections of Core PCE Inflation

Source: September Federal Open Markets Committee Minutes
Source: September Federal Open Markets Committee Minutes

The Fed uses the Personal Consumption Expenditures metric as its preferred inflation gauge. The left chart in Figure 1 shows how their forecast for core inflation in 2021 has risen in the last 3 months. It now stands at 3.7% in September … up from 3.0% in June.

On the other hand, their forecasts for the next 3 years in the right chart above show a significant decline. Core inflation is projected to be just above 2% in 2022, 2023 and 2024.

We believe that the Fed’s outlook for core inflation at 2.3% in 2022 is overly benign. We think instead that inflation will remain sticky and stubborn for more than just a few more months. We expect core inflation to be 3% or higher for the next 12 months or so.

Month-over-month inflation has come down in pandemic-affected sectors like cars, airfares and hotels in recent weeks. But that decrease has been offset by an uptick in wage and rent inflation. And any easing of supply-side constraints in the near term will likely be offset by greater demand as the Delta variant continues to recede.

We, therefore, believe that the decline in inflation will be more gradual than the rate at which it spiked up. We are also not troubled by core inflation levels of around 3% in the near term. We know empirically that Price to Earnings (PE) ratios for stocks do well when inflation rises to around 3% from disinflationary levels against a backdrop of higher growth.

Over a longer 3-year horizon, we believe that inflation will end up being transient and recede towards 2.5%. There are powerful secular forces related to technology, demographics and global competition that will inevitably contain inflation in the long run. We are aligned with the Fed over the longer term and the markets which are pricing in lower inflation expectations in the future.

Spending and Taxes

The proposed reconciliation bill for social welfare has generated both support and opposition. Proponents of the bill view it as a significant investment in human and environmental infrastructure with the longterm benefits of greater social equality and a more sustainable planet.

Critics, however, worry about the implications of both higher spending and higher taxes. Some fear that more spending will exacerbate an already significant debt burden and others fret that higher taxes will be restrictive to growth.

We address the topic with a very narrow focus.

We comment simply on the economic impact of higher taxes and higher spending without any adherence to a political or philosophical ideology. We also steer clear of any tax advice.

The $3.5 trillion reconciliation bill has funding for education, housing, child and elder care, healthcare and climate change. The green bars in Figure 2 below show proposed outlays for spending and tax cuts over each of the next ten years.

Figure 2: $3.5T Reconciliation Bill: Spending vs. Pay-Fors

Source: Moody’s Analytics
Source: Moody’s Analytics

These programs offer direct and indirect social, environmental and economic benefits. For example, there is research support for the notion that lower childcare costs can have positive employment effects especially among single and younger mothers. However, we focus more on the concern that the costs of these programs will raise interest rates as debt levels reach a tipping point.

We allay debt fears by pointing out that this spending won’t add materially to the debt burden. It is instead intended to be paid for in almost equal amount by higher taxes and other provisions.

The blue bars in Figure 2 show these pay-fors by each of the next ten years. Total pay-fors aggregate roughly $3 trillion and provide a neat offset to the $3.5 trillion cost of the reconciliation bill.

How onerous will higher taxes be and what impact will they have on growth? Higher taxes account for 70% of total pay-fors or roughly $2.2 trillion. Most of the tax increases are projected to come from higher rates for domestic and international corporate taxes and high-income individual taxes.

We also don’t expect this higher tax burden to weigh significantly on economic growth … for one simple reason.

The restrictive effect of $2.2 trillion in higher taxes is likely to get neutralized by the expansionary effect of $3.5 trillion in higher spending.

We believe that the similar magnitude and inverse impact of higher taxes and higher spending could well offset each other and, therefore, be neutral to growth.

Inflection in Stimulus

The rapid recovery from the Covid recession was driven in large part by unprecedented levels of monetary and fiscal stimulus. The Fed has kept short-term interest rates at zero and expanded its balance sheet by more than $4 trillion. Government spending has also been monumental at $5.8 trillion in the last year and a half.

We are now on the cusp of an inflection point in stimulus. The Fed has clearly signaled its intentions to gradually embark on a tapering and then tightening cycle. The Fed is ready to scale back on its bond purchases and then raise interest rates.

And even though there is future spending proposed in the infrastructure and reconciliation bills, its magnitude pales in comparison to the post-Covid fiscal stimulus. The withdrawal of fiscal stimulus in this magnitude will create a so-called fiscal cliff and reduce future growth.

We assess the likely impact and implications of this shift in monetary and fiscal policy.

We believe that this expected shift in policy comes as no surprise to most market participants. The economic landscape in 2021 is far different than what it was in 2020. Ultra-stimulative policies were appropriate as emergency measures in the throes of a pandemic. But they are likely misdirected today in the midst of a healthy economic recovery and persistent inflationary pressures.

The minutes of the September Fed meeting suggest that it will likely begin to reduce its monthly asset purchases before year-end. This tapering process could see an initial reduction of $15 billion per month in bond purchases from the current monthly pace of $120 billion. It is expected that the target date to end bond purchases altogether will be mid-2022.

We concur that tapering should begin in November or December and last 6 to 9 months. We disagree, however, with the Fed’s latest forecasts for its pace and timing of rate hikes. Based on September data, the Fed projects no rate hikes in 2022 and 4 rate hikes in 2023.

We believe that interest rates need to rise sooner than in 2023. We believe that the strength of the economy, the recovery in the labor market and the persistence of inflation all argue for a liftoff in interest rates in the third quarter of 2022. In this regard, we are more aligned with the market than with the Fed. We remain vigilant for a policy misstep by the Fed in terms of falling behind the curve.

The absence of any “taper tantrums” in the markets so far suggest that these changes in monetary policy have been anticipated and priced in. Long-term interest rates have started to rise ahead of the Fed’s tightening plans.

The impact of fiscal stimulus is generally less understood and is, therefore, worthy of more careful analysis. We measure the impact of fiscal policy on growth with a metric called Fiscal Impact Measure (FIM) developed by the Hutchins Center at Brookings Institution.

FIM is a more comprehensive metric than the federal deficit because it combines the impact of federal, state and local fiscal policy. It specifically measures the differential impact of fiscal policy beyond its normal level in an economy operating at potential GDP and full employment.

FIM is easy to interpret. By definition, it is zero and neutral to growth when government spending and taxes rise in line with potential GDP. When FIM is greater than 0, fiscal policy is expansionary … it pushes growth above potential GDP. Fiscal policy is contractionary when FIM is below 0.

We show the evolution of FIM in Figure 3.

Figure 3: Fiscal Impact Measure

Source: Hutchins Center at Brookings Institution
Source: Hutchins Center at Brookings Institution

Positive FIM levels are typically seen after recessions and they are particularly prominent on the right side of the chart in Figure 3. During the pandemic, fiscal policy was hugely expansionary and added between 4 to 6% to GDP growth.

By the same token, the end of that massive spending spree will create a negative impact on GDP growth in the next year or two. The red negative bars at the far right of Figure 3 show that growth will likely get reduced by a little more than -2%.

We expect that GDP growth will decelerate by -2 to -3% from the upcoming inflection in stimulus. However, we do not despair this drop-off in growth. At well above 3% in 2022, GDP growth will be considerably ahead of pre-Covid levels. In fact, we see these policy shifts as a reason to cheer and celebrate and not as a cause for concern. They simply mean that the U.S. economy is now self-sustaining and can be weaned off life-support measures.

We have already suggested that this upcoming deceleration of growth has been widely expected and is likely priced in. We lend credence to that notion by looking at the impact of decelerating growth on stock valuations.

Deceleration and Valuations

Many investors still worry that stock valuations are too high especially in the context of historical norms. A slowdown in growth is particularly troublesome to them because that would make valuations even less sustainable.

We allay those concerns by pointing out that this feared compression of PE multiples has already started to take place. Future earnings estimates have recently started to decelerate. But the markets had efficiently anticipated this deceleration well in advance of when it took place.

We show this vividly in Figure 4.

Figure 4: S&P 500 Earnings and PE

Source: FactSet
Source: FactSet

The green line in Figure 4 shows S&P 500 forward earnings and the blue line shows the S&P 500 forward PE multiple.

Forward earnings grew rapidly from the second quarter of 2020 and have recently started to grow at a slower pace. PE ratios have correctly anticipated both the initial burst of growth and then the subsequent deceleration … and well in advance by several months.

The current deceleration in earnings growth began to take shape in September 2021. It is remarkable that PE ratios began to price in this eventual deceleration one full year earlier in September 2020! The forward PE ratio peaked at that time at around 24 times. It has continued to compress even as earnings continued to rise but at a progressively slower pace. The forward PE ratio now stands at around 20 times.

We reiterate our belief that the impending slowdown in growth is not a new development and certainly not a surprise for the markets. We also believe that even though PE multiples have come down, they will continue to modestly compress further in the next year or two.

We believe that current stock valuations are reasonable in light of still-low interest rates and above-average growth. We believe that future earnings growth and dividend yields will offset this continued compression of PE multiples and generate positive equity returns.

Summary

We examined a number of concerns that are currently weighing on investors – Delta variant, debt ceiling, inflation, spending and taxes, inflection in stimulus, deceleration of growth and stock valuations.

We do not believe that these factors, individually or collectively, will conspire to significantly disrupt growth. We don’t dismiss them as trivial distractions either. Between the bookends of major disruptors and mere distractions, we position them as modest detractors of growth.

We summarize several beliefs, views and thoughts on this broad array of topics as follows.

  • The Delta variant and future virus strains will have limited economic impact
  • Inflation will remain stubbornly persistent over the next 12 months or so; it will eventually become transient as it drops below 3% by 2024
  • Higher taxes and spending will offset each other … and be neutral to growth
  • The Fed has signaled that tapering will begin by year-end and end in mid-2022
  • We expect the first rate hike to happen earlier than current Fed projections … we may see a liftoff in interest rates in Q3 2022
  • Fiscal and monetary inflections will cause growth to decelerate by -2 to -3%; however, growth will still be robust in 2022 and 2023
  • Inflection in stimulus is not new information and is likely priced in
  • Stock valuations have already compressed … and will do so in 2022 as well

We believe that this new economic cycle and bull market have longer to run. Our constructive outlook lends itself to a pro-growth, pro-cyclical tilt in our asset allocation and portfolio positioning.

We are also mindful that we have just come through some truly unprecedented times and uncertainty still abounds. We, therefore, remain respectfully vigilant and cautious in our optimism.

Investors are worried that stubborn inflation, higher taxes and the end of monetary and fiscal stimulus may become major disruptors of growth.

We believe that is unlikely to happen.

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A new economic cycle and bull market began about a year ago on the heels of a short-lived Covid recession. Buoyed by massive policy stimulus, economic growth has been strong, earnings growth has been stellar and stock market returns have been nothing short of spectacular.

As we approach an inflection point on fiscal and monetary policy, investors are now starting to focus on an anticipated deceleration of growth. Beyond this shift in stimulus, there are other concerns swirling in the market as well.

The proposed infrastructure package comes bundled with higher taxes that are generally restrictive for growth. The perennial debate over the debt ceiling is now front and center. Supply chain constraints may keep inflation high and raise the specter of stagflation. And the Delta variant of the coronavirus continues to circulate and slow down the pace of reopening.

We look at the topics of monetary tapering and tightening, fiscal cliff, higher taxes, debt ceiling and transitory inflation to answer one key question. Are these potential headwinds likely to become major disruptors of growth in the coming months? Or will they merely be distractions on a bumpy road to recovery? Join Sandip Bhagat, Whittier Trust’s Chief Investment Officer, as he discusses our perspectives and outlook.

Whittier Trust Company and The Whittier Trust Company of Nevada, Inc. are state-chartered trust companies, which are wholly owned by Whittier Holdings, Inc., a closely held holding company. All of said companies are referred to herein, individually and collectively, as “Whittier”. The accompanying materials are provided for informational purposes only and are not intended, and should not be construed, as investment, tax or legal advice. Please consult your own investment, legal and/or tax advisors in connection with financial decisions and before engaging in any financial transactions. These materials do not purport to be a complete statement of approaches, which may vary due to individual factors and circumstances. Although the information provided is carefully reviewed, Whittier makes no representations or warranties regarding the information provided and cannot be held responsible for any direct or incidental loss or damage resulting from applying any of the information provided. Past performance is no guarantee of future results and no investment or financial planning strategy can guarantee profit or protection against losses. These materials may not be reproduced or distributed without Whittier’s prior written consent.

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The term alternative investment may sound odd at first, but it is simply any investment outside traditional asset classes which include stocks, bonds and cash. Alternative investments may include a venture capital firm investing in a biotech startup or owning interest in a professional sports team. The practice is much more common than you may think, with approximately 45% of wealth managers investing client money in these unique assets.

Below are outlined three major considerations one should take before investing in alternative investments.

A Value-Add Tool

Perhaps the most obvious reason that people invest their money is to increase the value of their portfolios and build upon their wealth goals. With alternative investments, advisors are able to individually tailor client needs and find investments that may not exist in traditional public offerings. Alternative investments make things like adjusting or improving risk levels, diversifying portfolios and bringing social and environmental considerations into view much more simple.

For example, if a client priority included increasing expected returns of an equity allocation, an advisor might consider investing in venture capital to do so more efficiently.

Access Matters

Before jumping into alternative investments, it is important to be aware of the disparity in performance between different advisors and fund managers. Investing requires a lot of trust, especially as it involves someone else managing your money. Thus it is important to be informed and choose your advisors carefully.

While top managers are able to outperform traditional public markets, less experienced managers will often underperform. Much of investing success depends on the advisor’s ability to pick the right manager and investment. This is especially important in venture capital, where top tier managers most often produce the best funds.

Alternatives are not Mythical Creatures

Alternative investments are not a secret special form of investing. These types of investments follow the same rules of the game as any other investment. This means that economic growth and decline, as well as public debt levels and interest rates are all factors that can impact these alternatives. Taking this into account, wealth advisors must be careful not to oversaturate portfolios with too many investments that may be impacted by the same external economic risks. Even within alternative investments, advisors should be diversifying portfolios.

Finally, a question of complexity arises, as alternative investments can become the cause of a conflict of interest between client and advisor. Because alternatives are much more complex than traditional investment forms, there can be short-term gains and expense fees that come into play. It is important to have an advisor that can weigh these outcomes and choose the most appropriate course of action.

Alternative investments can be a great way to further your portfolio’s goals by offering better returns and diversification. One must keep in mind, however, that market risks are still a factor of consideration, and that much of investment success depends upon the advisor and manager that you choose. It is vital that the wealth advisor you work with is unconflicted and can determine the costs and benefits of these investments in a way that leads to your financial success.

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Investing is a delicate process that takes many different factors into account. The main goal in investing, however, is to pick the right stock, which is easier said than done. For example, if you were tasked with picking between car manufacturer General Motor’s (GM) stock and aftermarket car parts O’Reilly Auto Parts (ORLY) stock in 2013, the “high growth”, cheaper, All-American GM pick might have seemed more attractive than ORLY, which was more expensive and had slow, steady growth. The reality, however, is that O’Reilly’s shares have grown 327% since 2013, while GM’s shares have only grown 44%. The Implication? O’Reilly was a high-quality stock, while GM was not.

Choosing high-quality stocks can be difficult, as they are often hidden in plain sight due to the fact that they are neither “growth” nor “value” stocks, categories often attributed to success in the investing landscape.

How then, can we define these high-quality stocks? By taking two factors into consideration: profitability and consistency.

Profitability

It is profitability, rather than growth, which determines a high-quality stock. Fast-growing companies can be profitable in the short term, but these gains can be deceiving and often leave investors unsatisfied when the company turns out to be unprofitable in the long term.

Profitability is most easily determined by a company’s operating margins. Revisiting our car example above, GM’s operating margins in 2013 were only 2.5%, while O’Reilly’s operating margins were much higher at 15%. O’Reilly’s high margins can be attributed to its position within the “big four” of aftermarket automotive parts. GM on the other hand is just one player within an industry containing dozens of car manufacturers, and its lower profitability clearly reflects this.

Another method of determining stock profitability is by examining a company’s return on invested capital (ROIC). ROIC is a great way to predict a stock’s ability to compound as it allows investors to understand the rate at which a company generates returns based on total debt and equity given by investors. For context, GM’s ROIC in 2013 was 6%, while O’Reilly’s was 22%: almost 4 times the rate of GM. This ultimately means that O’Reilly has more cash on hand to grow its business and reinvest.

Consistency 

The second factor which defines high-quality stocks is consistency, which is sometimes overlooked in favor of “high-value” stocks. For O’Reilly, which sells aftermarket car parts, the demand for such parts is fairly consistent regardless of economic conditions – e.i. cars will continue to break down no matter what. In the investing world, consistency leads to stability, allowing investors to hold on to their ORLY stocks for long periods of time with relatively low worry. Furthermore, this stability gives investors much more freedom and flexibility when it comes to selling decisions and tax rates. For example, investors that hold onto high-quality stocks can wait until they retire to sell the stock, resulting in them paying lower capital gains tax within a lower tax bracket.

Furthermore, with stocks that participate in buybacks, such as O’Reilly, investors can choose to donate their shares to charity, or even hold their shares until death. Both of these circumvent the need to pay taxes on the investment and can be highly beneficial to investors.

To summarize, by combining profitability and consistency factors with patience, investors have the best opportunity to compound their wealth over the long term. While these factors may seem boring or obvious, taking them into account when choosing a stock can have incredible results, as seen with our example of O’Reilly and GM. Adding diversified high-quality stocks to one’s portfolio is the basis for achieving maximized long-term returns, and should under no circumstance be overlooked.

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While high-net-worth individuals are no strangers to hard work, they may find that their time and talent are busy maintaining a complicated portfolio rather than working towards the passions that got them where they are in the first place.

Many high-net-worth individuals don’t see the value or advantages of working with a private wealth management firm, but it allows you to work with someone who is just as capable and competent to ensure everything is properly carried out, along with allowing you to claim back some much-needed assets.

Time

Working with a wealth management firm allows individuals to partner with a like-minded professional, with the opportunity to still provide any given amount of oversight. “People we work with may be working twelve hours a day and flying all over the place, and they can’t seem to get enough time,” says Brian Bissell, Senior Vice President at Whittier Trust. This allows people to get some time back and allocate it to other things like interests or family matters.

Family

Bissel says that estate plans can put a strain on families. By working with a wealth management firm you and your family will have fewer worries, leaving less room for dysfunction over estate planning and asset allocation. It will also ensure that beneficiaries are properly planned out and are good stewards of your family’s wealth.

Legacy

It’s also vital to keep in mind that these objectives may be unrelated to money.  “People don’t often think about what they want their legacy to be, especially when they’re in wealth accumulation mode,” says Bissell. Figuring out what matters to you now is an important step in the foundation of your wealth planning strategy.

While you may already donate to particular organizations, engaging with a wealth management expert can assist you in developing a gifting strategy that works for you now and in the future. Looking at your portfolio through a tax perspective for assets to give. This can include making a charitable trust or DonorAdvised Fund to maximize your benefits.

Having a neutral third party when making decisions regarding balancing gifting wishes from your heirs’ expectations, can make the process easier and less biased. Whittier Trust offers a holistic approach that aims to “bridging the communication gap with the next generation.” In taking this approach passing things down from generations and sharing charitable passions becomes an easy and open conversion.

Education

It takes time to navigate taxes and strategize for asset preservation, and failing to do so might result in huge tax payments. Bissel suggests that “Clients may not be aware of all the wealth preservation strategies available to them, especially when they’re still in growth mode and retirement is years on the horizon. But planning for the future well before retirement, the transition of a family business or the sale of highly-appreciated assets gives clients maximum flexibility.”

An irrevocable life insurance trust, for example, can be used to satisfy an estate tax debt. However, if you wait until your retirement years to start putting together an estate plan, securing insurance may be difficult. Working with a wealth management firm now can implement estate planning strategies before you even need them.

Peace of Mind

According to Bissell, the appropriate adviser can provide you a complete view of your money, giving you more confidence that your strategy represents your goals rather than a jumble of ill-advised assets.

“We all know the headache of gathering information for your CPA at tax time—the litany of hoops you have to jump through to secure the right documents. Your W-2, brokerage statements, charitable deductions, 1099’s from this place and that place. It’s maddening,” he says. These issues typically occur when working in a large team of advisors who lack communication, leading to investments at cross-purposes. We’ve witnessed several instances of inadvertently infringing wash sale laws, or worse, over-allocating to Wall Street darlings, putting you in danger.

A wealth management team may also handle the administrative details, enabling the client to concentrate on the big picture. Working with a financial manager can help with your family dynamic by handling necessary bills and other paperwork. With newfound flexibility after working with a wealth management firm, you can collaborate when you choose and get back some much-needed freedom, without wealth problems taking over your life.

For more information, you can download the full report here or visit Forbes to read more.

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It was the thrill of a lifetime crossing the finish line off of Diamond Head at the conclusion of the 51st Annual Transpacific Race. The Transpac from Long Beach to Honolulu is one of the oldest and longest ocean races.  The race started July 17th and would conclude seven days later after traveling 2,225 nautical miles.  We set sail with all the thrill of excitement and preparation that any team could muster.  You then realize at 1,100 miles offshore, you are closer to the International Space Station than you are to land.  At that moment, your small boat, its provisions and your teammates are the most important things in your life.  Whittier Trust Company was the Heritage Sponsor as numerous Whittier family members and employees have regularly been involved in the Transpac since 1923.  It was 98 years ago that Max Whittier, our founder, purchased the 107-foot Poinsettia and entered her in the race with his sons. Since that date, numerous descendants and employees have completed this epic journey.  As CEO of Whittier Trust it was my honor to continue our heritage and legacy.

A Letter From the CEO

Our agreed upon mission was to sail Fast, be Safe and have Fun.  In the first half of the journey we covered 1,112.5 miles in 3 days, all of which were nearly flawless.  We were succeeding in our mission.  Our strategy, which we had trained for months, was to travel fast to Catalina and then as far north as we could before we would tact to reach the Rhumb line.  We noted the true wind and apparent wind angles and knew we should be fast.  Winds were strong with top speeds of 29 knots, swells were averaging four to six feet, and the team was in high spirits.  My two sons, Michael and Sean were on the deck with me.  As I looked across the boat at them I could not have been prouder.  They are accomplished sailors and young men.  They were sailing with me on a highly competitive long-term race that was an adventure.  It was uniting a tradition of sailing beginning with my grandmother sailing in Paw Paw Lake, Michigan, migrating to my mom and dad sailing at Lake Arrowhead to me and my children sailing in Newport Beach.

On the fourth night around 9:00 p.m., events changed.  Our boom vang broke.  The vang, which holds the boom, is critical to the function of any sailboat – and especially a racing sailboat.  Then the mainsail ripped.  Our team spent hours making repairs.  We improvised and made changes to the sails, our sailing tactics, and strategy.  We raced flying the spinnaker during the day and the storm trysail at night in order to finish the race.  When flying the spinnaker we were still going fast, about 15-18 knots but at night and without the spinnaker we slowed.  We notified, via email, our land crew and race committee, informing them that we were safe but had equipment failures.  We had to notify one boat to cross our stern to avoid an accident.

A Letter From the CEO_Sailing Boat

Despite these setbacks, our team came together.  Many competitors would have motored to Honolulu, but our team was dedicated to our mission – finish the race safely and sailing!    Helmsmen, trimmers, bowmen and the entire crew leaned on their multiple talents and cross-training.  When you have limited tools and spare parts in the middle of the Pacific Ocean, and nowhere to turn, you turn inward.  You look around and take stock of what you have, not only in terms of tools and spare parts, but also in your teammates.  Something I have learned in my 35 years of business is each person has talents and skills; all should be cross-trained, and you look for the competitive advantage of each person.  You align your strategy with those individuals’ competitive advantages.  This was no different.

As a team, we discussed our situation.  Everyone wanted to achieve our mission – finish the race safely sailing across the finish line off Diamond Head.   Each teammate brought an enlightening perspective on the risk and reward of different strategy options.  The collective input was invaluable.  When it appeared that a definite decision was forthcoming, a new voice brought a dimension that had not been considered.  We deliberated the strengths and weaknesses of each option.  We saw opportunities and threats in every decision.  We recognized that without the vang only the weakened sail would hold up the boom.  If the sail were to fail again, the boom would fall and could destroy the helm and seriously injure crew members.  So, we decided to sail conservatively and safely.  Despite everyone being trained to drive the boat and trim the sail, a weakened sail requires your most talented trimmers and helmsmen. We reorganized the rotation and rest schedules – three hours on watch – three hours rest.

On Sunday morning at 9:00 a.m. Team Compadres’ owners all put their hand on the wheel and crossed the finish line together as one.  That moment was second to be greeted by our wives on the dock holding the ceremonial Mai Tai in a hollowed-out pineapple.  Ultimately, the lessons learned are that you must have a quality team, each team member must know their role, and there will never be enough training.

A Letter From the CEO_3 Men

Mental attitude, focus, and commitment are essential components to success.  You can be talented, but if you don’t have the willingness and ability to persevere and lead in difficult times, talent alone will not win the race.

As I reflect on this adventure with Michael and Sean I am only saddened that Emmy and Clare, my two daughters, did not join us.  Emmy and Clare sailed for their respective college teams and are great sailors.  Experiences, especially challenging experiences, unite families by creating a common bond.  The Transpac race is an experience that transcends generations.

We succeeded in our mission while completing one of the most storied races in history!  The spirit of Safe, Fast, and Fun will always ring in our ears and it will be one I continue as the leader of Whittier Trust. While the history of Whittier gives us an edge in uniting generations of children, our independence, culture and spirit give us the advantage.  Whittier succeeds where others only dream – thanks to being safe, responsive, and having fun.

David A. Dahl, President and Chief Executive Officer

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