I’ll begin the year’s first with 2 important aspects of portfolio management, which even astute investors tend to overlook in the throes of what transpires in the financial markets and baffles their common investment sense which isn’t that common during these trying times. The first is omni-important to dynamic investment management, which is risk management and the second is defensive diversification with a tax advantage, both of which I’ve addressed in the same order below.
With inflation’s possible decline and it’s stalling by third quarter 2023, interest rates will be retained higher for longer and markets will be stuck in a uncertain waiting game.
Investors have begun this year with marginal gains and over the first 9 trading days, the SPX rose over 4%, while Nasdaq advanced a little under 6%. Treasuries were 3% up on average, while yields fell as investors lowered expectations of how high the Fed would raise interest rates.
Inflation might be tamed and the Fed may pause its rate hikes soon. Investors are currently expecting that the Fed will raise rates by 25 bps in Feb as opposed to the 50 or 75 it delivered in recent months. Two points supporting these points are;
- CPI report for Dec as expected showed headline inflation easing to 6.5% year-over-year and core inflation which excludes volatile food and energy prices, cooling to 5.7%.
- Recent NFP report suggested that average wage gains decelerated to an annual pace of 4.6% in Dec.
Inflation has likely peaked and is moving toward a more manageable range, but this doesn’t mean “goal achieved” for the Fed and markets in the inflation fight. Investors’ recent enthusiasm may be premature. Here are 3 key risks investors may be overlooking;
- Energy costs could climb after surging in early 2022 while oil and gas prices plummeted through year-end amid weakening demand. A number of factors drove the decline: recessionary conditions in emerging markets, European conservation efforts against the Russian oil embargo and a mild start to winter in both Europe and the eastern U.S. Looking ahead, however, we anticipate a rebound in oil and gas prices, driven by a re-acceleration in global economic growth and a relaxation of European austerity practices.
- Import prices may continue to rise. Last year, the continued strength of the U.S. dollar helped to shelter U.S. consumers from higher prices of imported goods. But that effect may be fading as the Fed’s tightening cycle matures and the dollar depreciates. In fact, December import prices rose 3.5%, more than expected. Excluding energy products, import prices increased by 0.8% for the month, an annualized pace of 9.6%.
- Services inflation could persist. While airline costs fell in the latest CPI report, other factors could slow recent progress in curbing price pressures. These include structural labor shortages, strong owner-occupied housing and rent inflation, and resurgent medical services costs.
The implication of these risks, along with many investors’ failure to acknowledge them, is that core inflation is unlikely to decline in a straight line through year-end toward the Fed’s target of 2%. Rather, the decline is more likely to stall out mid-year, with inflation staying closer to 4%, a development that could keep rates higher for longer and markets possibly stuck in a volatile waiting game.
Investors should consider keeping their portfolios overweight in fixed income versus US equities in this scenario. Hedging portfolios against inflation that could prove more persistent than currently forecast by owning value-oriented plays in energy, financials, real assets, enterprise technology and consumer services, in addition to gold and non-US stocks.
Several investors find that their portfolio has an outsized amount of a single stock. They may have received shares as compensation through work, inherited the shares or simply made a fortunate early investment in a successful company. While such concentrated holdings have the potential to generate a great deal of wealth, they can also pose significant risks.
Take, for example, an investor who rises to a senior management role at a major retail chain and builds a sizable equity position in the company. He retires at 65, when the stock price is $50 per share. However, the company’s failure to adapt to the shift to e-commerce and the sudden departure of a longtime CEO causes the share price to plummet to $10 several years later. Because he has large amounts of his net worth concentrated in the stock, this disruptive change threatens to wipe out much of his wealth and put his financial goals in jeopardy.
While this example may seem extreme, the risks of concentrated stock positions are quite real, and they are not limited to losses. If the stock performs well, investors can trigger big income tax liabilities when they sell, because they will likely owe income taxes on the difference between the price at which the shares were acquired and at which they are sold.
To beat this, there are 4 strategies that can help you successfully diversify out of a concentrated position in a tax-smart way;
- Equity exchange funds, for example, offer qualified investors1 a tax-deferred option, allowing them to place a stock that has gained significant value into a pooled vehicle with other investors in similar situations. Each investor can receive interests in the exchange fund, representing a proportional share of the newly created diversified basket of securities. The aim is to provide immediate diversification without incurring immediate capital gains taxes. The downside to exchange funds is limited liquidity. If you hold the interests for seven years, you can withdraw your share of the pool, with realized gains calculated pro-rata over the entire portfolio. However, if you withdraw early, you’ll likely face hefty fees.
- Tax-loss harvesting with separately managed accounts allow investors to employ a staged diversification strategy that may reduce the net capital gains of a concentrated stock or security position over time for federal income tax purposes. The investor can harvest unrealized investment losses in one account to offset net capital gains from the sale of concentrated stock or securities in another account, potentially reducing the federal income tax liability.
- Giving shares to family members using annual federal exclusions and lifetime gift tax exemptions, offers diversification and an opportunity to support loved ones. For 2023, the annual federal gift tax exclusion is $17,000 per individual or $34,000 per married couple who elect to split gifts, and the lifetime estate and gift tax exemption is $12.92 million per individual or $25.84 million per couple.
- Donating shares to charity is an option for investors looking to combine their philanthropic intentions with opportunities to minimize taxes.
- Donor Advised Funds (DAFs) are accounts held by public charities to which you can donate and receive an immediate federal income tax deduction, and which hold the donated assets until they are distributed to the ultimate charitable recipients. You can recommend how the DAF invests the donated assets, and those assets can stay invested and potentially grow, tax-free, until you recommend which charities you want to receive a cash donation. You can name a successor to recommend investments and grants after your death.
- Charitable gift annuities are annuities offered by some public charities. You transfer assets to the charity in exchange for an annuity interest for yourself or someone else. The charity invests the assets and retains anything not used to satisfy the required annuity payments. You may receive an immediate federal income tax deduction for the value of the property donated, less the value of the annuity interest.
- Charitable remainder trusts are irrevocable trusts in which you retain an income interest (or give the income interest to someone else) for life or for a term of up to 20 years. At the end of the trust term, the remaining property goes to charity. You may receive an immediate federal income tax deduction for the present value of the charitable remainder interest.
- Pooled income funds invest your donation alongside those of other donors. You (or someone you designate) will receive an income stream for life, after which the remainder of your donation will be transferred to charity. You may receive an immediate federal income tax deduction for the present value of the charitable remainder interest.
Taking steps to manage a concentrated position can help you avoid additional risks in your portfolio.
In 2022 both US stocks and long-term bonds declined more than 10% for the first time since the 1870s. This reminder that correlations can change offers lessons for the year ahead.
The investing landscape in 2022 was notable not only for the severity of losses but also their breadth: It was the first year, since at least the 1870s, that US stocks and long term bonds both fell by more than 10%.
That historical anomaly hints at a broader theme: The notion of safety as it relates to investments did not always apply as usual. Some traditional defensive assets worked as expected. However, some traits associated with higher risk actually protected portfolios. It was a good reminder that correlations can change, and it offers some important lessons for the year ahead.
First, let’s look at the assets that stuck to the script. In a poor year for equity returns, defensive stocks companies with relatively steady demand for their products—outperformed as expected. US defensives returned 6% (with dividends) over the last 12 months while the broader market was down 17%. I expect continued strong performance from US defensive stocks, while we remain cautious on European cyclicals, which we anticipate will remain more volatile than the overall market.
The USD is a traditional safe haven and also behaved as expected, offering diversification for investors’ portfolios with a negative correlation to global equities throughout 2022. Indeed, despite the dollar’s recent weakness, its diversifying power has been increasing, with the 120-day correlation between the dollar and US stocks at its lowest level since April 2012.
But there were also plenty of areas where traditional correlations were less predictable:
- Small cap and value equities, often noted for their volatility, outperformed in a year in which markets fell considerably. The same goes for stocks in Europe and Japan, which declined significantly less than US stocks last year, after hedging currency risk.
- Energy was the only sector that did better than defensives. This typically volatile sector rose 64% in the US and 30% in Europe in 2022. Financials, another risky sector, was the second-best performer in Europe, Japan and emerging markets.
- In Mexico and Brazil, Latin America’s two largest economies, equities are up over the last 12 months (in USD terms), and both countries’ currencies are stronger against the mighty USD.
- High-quality bonds were riskier than generally expected. The Bloomberg US Aggregate 10yr+ bond index, the definition of a “safe” asset with an average credit rating of AA-, is down more than 20% over the last 12 months, more than the SPX.
What should investors take away from these contrarian results as they look at the year ahead?
- First, a year like 2022 doesn’t come around very often. But it is a good reminder that concepts like volatility and defensiveness aren’t as cast iron as they may seem. Correlations can change.
- Second, some of those seemingly reliable diversifiers remain important. We continue to prefer defensives over cyclicals in the US and Europe. And while we anticipate that the dollar will continue to weaken, it still provides diversification and high “carry” (the return generated by holding an asset).
- Third, a common theme among market outliers was valuation. Energy, financials and Mexican and Brazilian equities performed relatively well because of low valuations. Bonds, which did poorly, were at some of their richest valuations in centuries (though real yields have now normalized significantly).
- Keep the importance of valuation in mind. In a still tough US equity environment, equities in the rest of the world are likely to do better, boosted by attractive relative valuation. In fact, high-grade bonds could outperform equities in the US and Europe and return to a much more diversifying role within cross-asset portfolios.
Wishing you a very profitable year on this day of the Chinese lunar new year.
Risk warning – As with all investing, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance and the contents of this outlook is not a reliable indicator of future performance. This article/print is protected through international copyright & print laws and may not be reproduced, distributed or copied without exclusive permission from the writer.
Authored by: Geoffrey Muns is an Independent Financial Advisor and Planner certified from the UK, US and UAE based out of Dubai for the past 20 years. He also works in the PE/VC space and is a seasoned investment banker having worked with international banks and investment firms in the region.