As an investor, having perspective beyond the recent market volatility and the latest news headline is important. Let’s look back to just twelve months ago. We began 2021 with a massive market disruption caused by a highly contagious virus that we did not fully understand. The rapid downward market spiral was tempered, surprisingly quickly, with news that multiple vaccines were being developed with high efficacy with the qualification that the vaccines would take time to develop and distribute. In early 2021 the way we worked, shopped, traveled, and spent time together had all changed. Fast forward to the end of year. Effective vaccines had been developed and had been made widely available. Schools reopened, workers headed back to the office and our lives started to return to a new “Normal”. As the world saw light at the end of the tunnel, the markets, to include equities, bonds, commodities and private equity continued their steady move upward. The equity markets ended the year with a remarkable gain of +20% for the Dow, +25% for the NASDAQ and +11% for the international markets.
For 2022, the consensus among most market strategists, and our firm’s view, is that the strong equity market returns of 2021 will be difficult to achieve as fiscal and monetary policy support fades. The expression that “The Federal Reserve is going to take away the punchbowl” is accurate. Inflation will require that the Federal Reserve raise rates, halt its bond buying more quickly and reduce its balance sheet. Expectations are that the Fed will raise short term rates three to four times in 2002, perhaps as early as March 2022. As we have seen before in 2018, concerns about rising rates have prompted a drop in growth stocks and, in particular, “high growth technology”. While we urge caution with the tech highfliers, we are still optimistic about “Big Tech” and “Older Tech”, in particular Apple, Amazon, Google and Microsoft. These four massive companies have comparatively low trading multiples, strong growth prospects, billions of cash on the balance sheet and make a strong case for investors maintaining and or adding to the positions.
Industries and Sectors for 2022
Our top sector picks for 2022 are: U.S. Financials, Metals and Mining (Lithium), Energy, Health Care, Agriculture, Industrials and high-grade North America Technology. Financials currently have low Price Earnings multiples relative to the overall S&P 500 average, and do well during periods of gradually rising rates and a rising yield curve. A rising yield curve increases the net interest income that a bank earns, and the strong economy bodes well for loan demand and credit quality. Industrials and other cyclicals also tend to do well during this period of the economic cycle. While we will continue to be more heavily weighted towards U.S. equities, we are adding to specific international countries and foreign sectors as the pandemic moves more to an endemic state. We also continue to believe in several smaller “transformational sectors” that have the ability to change the way we live, work and the ability to disrupt entire industries. Some of these include Fintech, Electric Vehicles and Green Energy, Quantum Computing, Artificial Intelligence and Cryptocurrencies. Please see the asset class returns for 2021 below in relation to prior years.
Fixed Income (Bonds)
With the 10-year Treasury bond currently yielding 1.76% and the AGG (ishares Core U.S. Aggregate Bond ETF) yielding 1.95%, investing in U.S. Treasuries and investment grade corporate bonds, in the near term, will generate negative real returns given the current rate of inflation. The FOMC (Federal Open Market Committee) of the Federal Reserve estimates that inflation will average 4.2% in 2022 and, over the longer term, up to 2024, 2.1%. It is important to note that clients that have kept a material percentage of their portfolio in medium-to-longer duration bond funds now have significant unrealized gains in their portfolio. Since there is an inverse correlation between bond prices and yields, these gains will decline as interest rates rise, all other factors held constant. For those clients, who maintain a position in corporate bonds, we moved to shorten the underlying duration to reduce interest rate risk. Of importance is that our client bond positions are in individual bonds that are laddered in terms of maturity date. A bond held to maturity in a bond ladder will be paid full face value upon maturity, absent default. Recent news headlines like the January 11th, 2022 article in Bloomberg “Buyers Strike Funds Sees Bond ETFs of Every Stripe Bleed Billions” does not impact our approach as we hold individual bonds for our investors and not bond funds, and/or bond ETFs.
Private Equity
Private Equity is considered an “Alternative” asset class consisting of capital separate, and distinct, from securities, commodities, bonds, etc., that are traded on public exchanges. Private Equity firms invest in private companies, credit, venture capital, leveraged buyouts and real estate. This asset class can be an excellent addition to one’s asset allocation in that it can enhance returns, provide asset class diversification, and reduce portfolio volatility. However, investments in private equity are illiquid for a minimum time period and require investment time horizons ranging from one-year to longer than five years before capital can be returned. In addition, shareholders are required to be “accredited” and/or “qualified” for the investment and the investor needs to meet minimum net worth and/or net income requirements. Because of the high due diligence and vetting of the investment the best funds raise capital most often exclusively from institutional investors such as pension funds, endowments, and sovereign wealth funds. Some PE funds have recently started offering windows of investment to high-net-worth investors through Registered Investment Advisory firms (RIA) that cater to High-Net-Worth investors.
While there is the potential for attractive returns in PE, a potential investor must take into consideration the capital lock-up periods, liquidity constraints and overall net worth. Copper River has clients invested in several “Alternative Asset” strategies including Private Real Estate Investment Trusts, Private Credit, Growth Equity, Global Secondaries, Multi-Strategy Funds, and Emerging Bio-Tech. We would be glad to discuss with you how this asset class might add value and long-term price stability to your investment portfolio. Below we will highlight two of the major PE holdings for our high-net-worth investors.
BREIT is a private real estate income trust managed by The Blackstone Group. Blackstone is the largest owner of real estate in the world. BREIT has a Total Asset Value of $78 Billion (as of November 2021) and is invested in 2,226 properties across the U.S. BREIT has paid a dividend for 55 consecutive months at an annualized rate between 4.5% -5.0% for Class D shares. The most significant real estate holdings in the fund consist of residential 46% (multi-family housing in the high growth south and southwestern U.S) and Industrial 34% (mostly ecommerce warehouses). For 2021, 90% – 100% of BREIT dividends will not be subject to federal taxation. Total Class D returns for 2021 were 26.4%. For reference, here is the link to BREIT: http://www.breit.com
BCRED is a Blackstone private credit fund with $25.1 billion under management as of 11/30/2021. Private Credit is an asset defined as non-bank lending where the debt is not issued or traded on the public markets. Private Credit has grown rapidly since the financial crisis in 2008 as banks have scaled back their lending to middle market companies and private equity firms have moved in to fill the space. BCRED’s loan portfolio is diversified by issuer (424 positions) and across industry sector (51). 99% of the portfolio is floating rate and 97% is senior secured with 90% secured, first lien. Loan-To-Value is < 50% which equates to better than 2:1 collateral coverage. The targeted pool of borrowers consists of U.S. middle market companies with EBITDA > $30 million p.a. The fund is targeting a total return + 8.0% which compares well with fixed income alternatives. For example, the 10-year U.S. Treasury was yielding 1.76% in early January 2022 and the U.S. Aggregate Bond ETF was yielding 1.99%.
Private Credit is an effective way to diversify and reduce overall volatility in your investment portfolio. Returns are reasonably predictable given that interest rate risk is, for the most part, eliminated. This is because borrower loan rates are floating rate, not fixed, and are reset at least quarterly. The major risk of this asset class is credit quality. This risk is mitigated by BCRED portfolio construction, diversification (by issuer and industry sector) and by the senior, secured loan composition of the BCRED loan portfolio. Historical loss rates in private credit over the period 2006-2021 averaged 1.4% (vs. historical yield of 8.8%). This compares favorably to High Yield Loans which have historical default rates and historical yields of 1.8% and 4.0%, respectively. Please contact us if you would like to discuss the fund in more detail and to determine if this asset class is appropriate for your portfolio: https://www.bcred.com/
Conclusion
While most market strategists predict returns in 2022 to be more aligned with the historical average in the 8.0% – 10% range, we should expect markets to remain choppy in the earlier part of the year given omicron, interest rate hikes, supply chain bottlenecks and mid-term election uncertainties.
As advisors we are always being asked what the best investment for a given year is going to be. For 2022 that investment just may be discipline. Discipline is one of the most important investing virtues one needs to have in order to achieve long-term success in the markets. When one drastically changes their long-term course based on a short-term event, they may be caught off guard and experience regret soon thereafter. Understanding where your risks are, and if are they appropriate to your long-term goals, will be more of a concern this year. Working closely with your Investment Advisor to achieve and understand that picture, and align your asset allocation and positions accordingly, will be key to a successful outcome.
As we begin 2022, you may have questions in terms of CPAs and/or estate planning. If so, please reach out to us. As Investment Advisors we should be involved in this process and working alongside these professionals is an important component to both tax and estate planning.
-Team Copper River