2022 CAPITAL MARKETS FORECAST
Beyond the Horizon
Dedication This year’s Capital Markets Forecast is dedicated to our longtime colleague, Robert E. “Bob” Reiser, Jr., who retired from our firm last year after more than two decades of service. A lifelong learner, Bob honed his quantitative skills while earning his Master’s Degree in Business Administration from the University of Chicago. He began his career in the Treasurer’s Office of the Standard Oil Company of New Jersey and later worked at Connecticut Robert E. Reiser, Jr. General Life as a securities analyst, where he discovered his love for the investment business. In 1971, Bob joined the investment counseling firm of Montag & Caldwell in Atlanta, earning his Chartered Financial Analyst® (see here: https://www.cfainstitute.org/en/programs/ cfa) designation the following year. In 1982, he founded his own investment management and consulting firm, Reiser-Builder, and in 1998, merged his firm with Balentine & Company. As Partner and Chief Investment Officer, he created a unique model-driven, repeatable investment process which became the foundation for the firm’s investment management capabilities. After Balentine & Company was acquired by Wilmington Trust in 2002, Bob served as the company’s Chief Investment Officer. When Balentine LLC was formed in 2009, Bob joined the firm as Senior Investment Advisor, a role he held until his retirement in 2020. As a leader, mentor, and friend, his selfless contributions to our industry and community exemplify servant leadership. Bob has left an indelible impact on Balentine, and we honor him with this year’s CMF edition.
Contents Executive Summary
1
Inflation, Interest Rates, and Secular Cycles
2
Time to Reevaluate Multi-asset Investing
12
Beyond the Horizon: Themes for Intergenerational Clients
16
Considerations for Allocating to Private Capital
18
Appendix 24 In Closing and Disclosures
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WELCOME TO OUR
2022 Capital Markets Forecast The CMF draws from our research to identify realistic market expectations over the next year and align them with opportunities we foresee to achieve portfolio goals. In 2020, we experienced the genesis of the global COVID-19 pandemic, which spurred a market bottom on March 23, 2020. Much of the easy money to be made off the bottom was made in 2020 and early 2021. In 2021, the pandemic continued, and the markets performed in line with the historical template for a second year coming off a major bottom. While the overall market rose another 15% throughout the rest of 2021, that money was anything but easy, as different areas of the market ebbed and flowed during the year.
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We see tough sledding on the horizon for 2022. History has been generally unkind to midterm election-year markets, and the confluence of the election cycle with what is a generally weak third year off a major bottom likely makes for a tough grind in 2022. Additionally, as we get later into this bull market, which is about to complete its 13th year, active management becomes a much more important tool in driving investors toward goals. As the cycle matures, beta alone does not cut it; rather, alpha becomes an even more crucial lever for the portfolio. While this is generally always the case in the private markets, it becomes increasingly more so in the public markets the later into the cycle we get, hence the need for an active approach such as that taken by Balentine. With all that said, all signs from our end continue to point to any challenges this year as a healthy pause that refreshes the bull.
1
Inflation, Interest Rates, and Secular Cycles The month of March will mark the 13th anniversary of the secular bull market that began in March 2009.1 Secular bull markets include interludes that refresh the journey higher, so multiple market and economic cycles can transpire over their duration. The challenge for investors is twofold:
1. when a bear cycle commences, assessing whether it is the start of a new secular bear market or merely a bear cycle that will rejuvenate the ongoing secular bull, and
2. if the latter, determining how much of a refresh the cyclical bear provided (i.e., where we are in the secular bull). In our 2019 Capital Markets Forecast,2 we wrote about the nature of the economic cycle and the characteristics of each phase. This structure remains generally intact as it relates to both the economic cycle and the resulting market cycle. But we would be remiss if we did not explore the possibility that increased central bank intervention over the past 12-plus years has distorted the cycle template. For example, was it a coincidence that the bull cycle that ended in February 2020 was the second-longest in the post-depression era? And for good measure, add in the ongoing, and unprecedented, multi-trillion-dollar fiscal stimulus: How does that impact the economic cycle and the secular bull market?
At this point, several important questions pose themselves:
1. How will the sudden, sharp inflation we’re now experiencing play into the remainder of the cycle? 2. What is the future of interest rates, both in the short term and the longer term? 3. As it relates to our asset-return projections, what do questions 1 and 2 mean for valuations over the next seven years?
Recall the distinction between secular markets and cyclical markets, about which we recently wrote here: https://balentine.com/insights/publications/market-update-may-04-2021/
1
https://balentine.com/insights/publications/2019-capital-markets-forecast/
2
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Inflation Inflation has reared its ugly head for the first time in a while, and to little surprise, the financial media is all over the story. However, the real story is a little more complicated than the headlines suggest. Firstly let’s dig into what is being reported. The financial media have reported year-over-year price increases that are greater than any in the past 30 years. And while the facts presented may be technically accurate, we don’t believe they tell the whole truth. It is important to remember that
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not much more than a year ago, the coronavirus commenced, and a deflationary vortex on par with the one seen during the Global Financial Crisis was feared. Within that context, it makes sense to look at price increases over a two-year period and remove the denominator effect of the low Consumer Price Index levels of 2020. When viewed from this angle, the level of inflation we are experiencing was last seen all the way back in … 2008! (Figure 1)
3
Figure 1. Although year-over-year inflation is running at its highest level in 30 years, accounting for the deflationary effects of the coronavirus paints a modestly different picture. 1-Year Inflation Rate 15% 10% 5% 0%
1/1998
1/2001
1/2004
1/2007
1/2010
1/2013
1/2016
1/2019
1/2022
1/1998
1/2001
1/2004
1/2007
1/2010
1/2013
1/2016
1/2019
1/2022
1/1995
1/1992
1/1989
1/1986
1/1983
1/1980
1/1977
1/1974
1/1971
1/1968
1/1965
1/1962
1/1959
1/1956
1/1953
1/1950
(5%)
2-Year Inflation Rate 15% 10% 5% 0%
1/1995
1/1992
1/1989
1/1986
1/1983
1/1980
1/1977
1/1974
1/1971
1/1968
1/1965
1/1962
1/1959
1/1956
1/1953
1/1950
(5%)
Source: St. Louis Federal Reserve and Balentine
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Secondly it is important to distinguish between supply-driven inflation (i.e., price increases driven by reduced supply) and demand-driven inflation (i.e., price increases driven by increased demand). The former is more of a temporary phenomenon that eventually resolves itself, whereas the latter generally necessitates action by either the monetary authority (reducing the money supply) or the fiscal authority (reducing the velocity of money via tax increases and/or fiscal contraction). This is an important distinction because as supply-driven inflation resolves itself, it does not necessarily choke off an economic cycle, whereas the resolution of demand-driven inflation typically does.
Inflation’s Relationship to Capital Markets Before we get into which is the more likely situation at present, let’s discuss why inflation is significant in relation to economic cycles and capital markets. We recently explored inflation’s impact on the economic cycle, so we would like to focus here on why it’s of concern to investors. This may seem obvious, but as we have mentioned in the past, the economic cycle and capital markets are not always tethered at the hip over the short term or the medium term. To determine how inflation affects market returns, we analyzed annual data going back to 1928; we went farther back than 1950 in order to include the highly inflationary periods pre-Great Depression and post-World War II as well as the highly deflationary period during the Great Depression. We found, unsurprisingly, that stocks, bonds, and
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cash react differently to varying levels of inflation. In the analysis, we looked at both nominal and real returns. The nominal data, in Figure 2, suggest the perfect spot for inflation has been 0% to 2%, which happens to be where we spent almost the entirety of the 2009–2020 cyclical bull. Importantly as it relates to today’s concerns, stocks have struggled in highly inflationary environments, which occurred mostly during the 1970s but also in the first few years after WWII. The most lucrative nominal period for bonds and cash was during the 4%–6% inflation regimes. Of course, that is somewhat misleading, since purchasing power was eroding quickly during said regimes. Thus it is crucial to look at real returns, which we show in Figure 3.
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Figure 2. Nominal returns of stocks, bonds and cash under varying inflation scenarios suggest different optimal scenarios for each asset class. But this can be misleading …
Figure 3. … which is why we need to focus less on nominal returns and more on real returns.
Nominal Returns
Real Returns
Inflation
% of Years
Stocks
Bonds
Cash
Inflation
% of Years
Stocks
Bonds
Cash
<0%
11%
7.7%
1.3%
1.5%
<0%
11%
11%
4.7%
4.9%
0%–2%
24%
12.4%
5%
2.1%
0%–2%
24%
11.2%
3.8%
0.9%
2%–4%
34%
9.6%
5.6%
3.3%
2%–4%
34%
6.6%
2.6%
0.3%
4%–6%
13%
9.3%
8.8%
5.9%
4%–6%
13%
4.5%
3.9%
1.1%
>6%
17%
7.4%
3.7%
5.4%
>6%
17%
(1.8%)
(5.5%)
(3.7%)
Source: Aswath Damodaran
Source: Aswath Damodaran
Not surprisingly, real returns are far worse during the periods of higher inflation, and in the highestinflation environments, the returns go negative. On the other hand, the real returns during periods with negative inflation (i.e., deflation) are better than they appear at first glance because deflation improves upon real returns. To summarize, some inflation (often dubbed “disinflation”) is good for financial assets, but excessive inflation is not. Additionally, while positive real returns can occur during periods of somewhat high inflation, it is clear that rising inflation does have a corrosive effect as the erosion of purchasing power outweighs inflation-related gains such as rising corporate revenues.
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Determining the Cause of Inflation So, back to the question at hand: Is the current inflation problem supply- driven (i.e., more than likely transitory) or demand- driven (i.e., more than likely non-transitory)? Current inflation readings are somewhat unique in that they include components of both reduced supply and increased demand. There are good reasons why inflation may be either transitory or non-transitory:
Reasons inflation may be non-transitory: 1. Unprecedented amounts of fiscal and monetary stimulus, including direct payments to employers (via the Paycheck Protection Program) and citizens. Consumer balance sheets are robust, owing to money saved during the pandemic. While they have begun to spend, consumers have as yet barely whittled down their cash balances.
2. A potential structural change in the labor market, with a structural deficit of labor.
Reasons inflation may be transitory: 1. Supply chain disruptions and shortages are
3. Unemployment benefits have been reduced, which should help lower the potential for the sort of structural change in the labor market referenced above.
4. As powerful as the economic rebound has been, we would expect the economic growth to revert to the mean. This would likely head off some of the inflationary pressures.
5. The structural technology gains made during the pandemic should continue to bring about deflationary pressures. The Federal Reserve has championed the view that inflation is transitory, but of late it has ratcheted back that rhetoric. This is vitally important because transitory inflation would likely not lead to upward pressure on interest rates, whereas a more permanent inflation likely would. Although there is compelling reason to suggest that the inflation will abate, properly gauging the inflation’s permanence will dictate the proper interest rate policy moving forward, which is of vital significance. Alongside inflation, interest rates are an important determinant of both short-term and long-term equity valuation and price action.
likely to be ephemeral, albeit not as ephemeral as we all would want. That said, it is not reasonable to expect the global supply chains to simultaneously begin to function efficiently, so there would be fits and starts.
2. While consumers still have a lot of cash on their balance sheets, we would expect that the explosion we saw in consumer spending as the world has reopened over the past year is larger than the spending we will see going forward.
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Interest Rates Why do interest rates matter to businesses? Most notably, higher interest rates increase companies’ cost of capital and discount rates. Thus, future cash flows are discounted back more heavily, leading to a lower present value of those cash flows. This affects asset classes differently, based most notably on the duration of cash flows: Shorter-duration assets are affected less than longer-duration assets. While this sounds a little bit like one of those theoretical business school concepts, the reality is that the excess return on capital over the cost of capital for a company (or for an individual project) matters tremendously when it comes to long-term valuations. Asset prices are very sensitive to disruptions in the cost of capital. And the cost of capital, in turn, is highly sensitive to perturbations in capital supply and demand. In fact, prices are often more sensitive to these factors than to changes in fundamentals. This is a crucial point: Fundamentals often determine which specific asset is superior within an asset class (e.g., do I buy Apple, or do I buy Bank of America?). However, discount rates and the cost of capital are more important in determining the superiority of the overall asset class (e.g., do I buy more stocks, or do I buy more bonds?).
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Comparing Current and Historical Interest Rates So if we assume that at least some of today’s inflation is demand-driven, what are the implications for interest rates, and what is the corresponding impact on asset prices? As economies cycle through periods of inflation, disinflation and deflation, interest rates have historically adapted to the changing conditions. Conventional economics suggests that in the face of inflation, interest rates will rise, and this has generally been the case. Look no further than the period from the late 1960s into the early 1980s as inflation ramped up quickly (Figure 4). Of course, no two periods are the same, and as a result, the trajectories of interest rates will vary. Case in point: during and in the aftermath of WWII, from 1941 to 1952 (Figure 5), inflation was arguably more rampant than during the period from 1968 to 1982, yet interest rates in the earlier period essentially did not rise.
8
Figure 4. Interest rates rose during the strong inflation of the late 1960s to the early 1980s Inflation vs. Interest Rates: 1968–1982 20%
15%
10%
5%
0% 1/68
1/69
1/70
1/71
1/72
1/73
1-Year Inflation Rate
1/74
1/75
1/76
1/77
2-Year Inflation Rate
1/78
1/79
1/80
1/81
1/82
10-Year Treasury Rate
Source: FactSet and Balentine
Figure 5. … yet rates did not rise throughout the even stronger inflation that occurred during and after World War II. Inflation vs. Interest Rates: 1941–1952 20% 15% 10% 5% 0% (5%) 1/41
1/42
1/43
1/44
1-Year Inflation Rate
1/45
1/46
1/47
2-Year Inflation Rate
1/48
1/49
1/50
1/51
1/52
10-Year Treasury Rate
Source: FactSet and Balentine
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We think the WWII period is a logical parallel for today, given that fighting the pandemic is in a sense a war. So what happened back then? Prior to the current period, the highest debt-to-GDP on record in the U.S. occurred around 1946, on the heels of robust spending for WWII — we recently surpassed that high, with a debt-to-GDP ratio currently over 120% (Figure 6). During that era, there were three independent episodes of inflation, and not one of them drove interest rates higher. Quite simply, the economy grew into the extra debt, which led the debt-to-GDP ratio to fall precipitously over the subsequent years — which in turn, allowed borrowing costs to remain low. That scenario certainly could recur this time around, given the pent-up demand for the economy to get going after all its fits and starts relating to the coronavirus. So, even if inflation does rear its ugly head in a less transitory fashion, it is by no means a given that rates will rise.
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Conclusion So, in summary, what does this all mean?
1. Inflation and the level of interest rates will factor heavily into how the secular bull market progresses from here.
2. Inflation does not preclude interest rates from remaining low.
3. Against the backdrop of low interest rates, asset values can continue to rise as the cost of capital and discount rates remain relatively low, providing reasonably low hurdle rates for corporations.
4. When the secular bull inevitably ends and the secular bear begins (again, the timing of this is uncertain; it could be any number of years away), the bear will likely be either longer or deeper than previous ones. But importantly, it does not mean that the underlying bull will meet its demise more quickly. Markets can defy longer-term trends for far longer than any investor can imagine, even if it means harsher consequences down the road when the bull ends.
10
Figure 6. After WWII spending drove the debt-to-GDP ratio to ~120%, a level breached only recently, strong economic growth brought the ratio down quickly. Debt-to-GDP Ratio 140% 120% 100% 80% 60% 40% 20% 2021
2017
2013
2009
2005
2001
1997
1993
1989
1985
1981
1977
1973
1969
1965
1961
1957
1953
1949
1945
1941
1937
1933
1929
0%
Source: FactSet and Balentine
Figure 7. A change in direction for interest rates can take far longer than expected. 10-Year Treasury Rates 16% Rates take another 7 years to sustainably break 4%
14% 12% 10%
Rates take 15 years to sustainably break 3%
8% 6%
Rates bottom at 1.95%
4% 2%
1/1/21 1/1/23 1/1/25 1/1/27 1/1/29 1/1/31 1/1/33 1/1/35 1/1/37 1/1/39 1/1/41 1/1/43 1/1/45 1/1/47 1/1/49 1/1/51 1/1/53 1/1/55 1/1/57 1/1/59 1/1/61 1/1/63 1/1/65 1/1/67 1/1/69 1/1/71 1/1/73 1/1/75 1/1/77 1/1/79 1/1/81 1/1/83 1/1/85 1/1/87 1/1/89 1/1/91 1/1/93 1/1/95 1/1/97 1/1/99 1/1/01 1/1/03 1/1/05 1/1/07 1/1/09 1/1/11 1/1/13 1/1/15 1/1/17 1/1/19 1/1/21
0%
Source: FactSet and Balentine
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Time to Reevaluate Multi-asset Investing The reputation of multi-asset investing, also known as global asset allocation (GAA) or global tactical asset allocation (GTAA) investing, has diminished undeservedly over the last several years. Some see it as a strategy that cannot deliver attractive returns. But that opinion rests on the misperceptions that: first, the performance of the average multi-asset manager is representative of the performance of all multi-asset managers; and second, weak performance by the overall universe of multi-asset managers will persist.
Investors should not concede this strategy for three primary reasons.
1. A small group of multi-asset managers with a truly tactical approach has generated benchmark-beating returns over periods as long as 10 years. Accordingly, investors who have been disappointed by a strategy’s results should consider adding a second multi-asset strategy that takes a different approach from their original multi-asset manager. They may also need to reconsider the role that the strategy plays in their asset allocation.
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2. Tactical multi-asset managers can play a role different from multi-asset managers’ traditional role of providing exposure to asset classes that plans could not access easily. Instead, they can potentially add value by emphasizing areas of the portfolio’s strategic asset allocation that are likely to do well over the short to intermediate-term. Plans and their consultants cannot move as quickly as a tactical manager. Thus, they should consider using a multi-asset manager for tactical reasons, rather than strategic reasons.
3. The recent increase in asset class return dispersion—a broader range of outcomes between asset classes—will likely favor these tactical multi-asset managers. The time is right for multi-asset investing skeptics to give this strategy a chance.
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Some Multi-asset Managers are Different The dominance of the multi-asset category by value-oriented and equity-oriented managers (managers who also tend to take a more strategic than tactical approach to investing) has overshadowed the emergence of managers who are lumped into the same category but who perform differently. Some investment plans mistakenly assume that all multi-asset managers perform similarly. Even investment professionals fall victim to “narrow range of experience” bias, which happens when a person considers too narrow a range of experience when making an estimate or judgment. As a result, they overlook managers who could potentially help their overall portfolio performance. Multi-asset investing is an investment strategy for which manager selection matters more than for other strategies. This is evident from the low percentage of outperformers: Of the 162 firms in eVestment’s GTAA category, only 9.9% have consistently delivered top-quartile performance over three-, five-, and seven-year periods ending September 30, 2021. That’s only 16 out of 162 firms, suggesting that plans’ issues with multi-asset managers are a matter of picking the right manager, rather than a problem with the strategy itself.
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Some managers in this strategy have outperformed by making bold allocations to investment styles with sustainable momentum, taking a more tactical approach than many of the firms in the same category. It’s almost as if they don’t belong in the same category as the other firms in the GTAA category. One might call them multi-asset managers with a truly tactical bias. But there’s a limit to how finely the databases can break down categories. So, discerning consultants and investment plans must uncover the differences on their own. The 10-year record of relative performance by tactical versus strategic GAA managers favors this tactical approach. Almost 70% (69.2%) of tactical GAA managers versus only 43.3% of strategic GAA managers beat their benchmark over similar time periods, according to Morningstar.
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A Different Role for Tactical Multi-asset Managers What clients need from multi-asset or GAA managers has changed over time. In the early years of this strategy, clients needed these managers to provide diversification and exposure to asset classes they couldn’t access easily or directly. Since then, plans have diversified significantly with the expert help of their consultants and the advent of investment products. In a sense, the consultants have now filled the role formerly filled by a strategic multi-asset or GAA manager.
portfolio’s strategic asset allocation that are likely to do well over the short to intermediate-term. While plans and their consultants may recognize these same opportunities, they’re not set up to move as quickly as a tactical manager. Most plans don’t allocate only to one large-cap or one small-cap strategy. Such diversification is even more true of their hedge fund allocations, which may include five or more funds. Similarly, they should consider broadening their exposure to multi-asset managers to go beyond a strategic to a tactical multi-asset manager and to further diversify investment style and manager selection risk.
Institutional portfolios can benefit by adding a tactical complement to their strategic asset allocation. Tactical multi-asset managers can potentially add value by emphasizing areas of the
Significant Shift Appears Likely Historically, multi-asset investing strategies have performed best in environments with significantly dispersed asset class returns. However, the financial crisis of 2008 to 2009 started a period of low dispersion. During this period, U.S. growth equities have performed best. As a result, the many multi-asset managers with a value bias and higher allocations to fixed income have performed poorly relative to an equity-centric portfolio.
An Unprecedented Bull Market S&P 500 Price: January 2000 – December 2021
4,800
alue al er V nation v o r h t e t w Gro over In c i t es Dom
2,400
|
Bear Market
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Covid-19
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
Bull Market
Source: FactSet
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2002
2000
600
2001
1,200
S&P 500 14
High Dispersion
1/21
1/20
1/19
1/18
1/17
1/16
1/15
1/14
1/13
1/12
1/11
1/10
1/09
1/08
1/07
1/06
1/05
1/04
1/03
1/02
1/01
1/00
Since April 2020, dispersion in asset class returns appears to be increasing, creating what look like more favorable conditions for multi-asset investing (see graph).1 If there is a correlation between dispersion and multi-asset strategy returns, this should lead to better relative performance, especially by tactical multi-asset managers.
Low Dispersion
Source: FactSet and Balentine
Summary The history of investing suggests that, over time, strategies will cycle in and out of favor. Multi-asset investing’s time will return. It’s impossible to predict when exactly that will occur, so we feel it’s important to position portfolios now. Investors who don’t reposition until a shift is evident may miss some of the biggest potential gains.
The bottom line: First, add a multi-asset manager if your investment fund lacks one. This is important as the dispersion of asset class returns increases, so you position your portfolio before it’s too late to reap the full benefits of an allocation in
this strategy. A multi-asset manager’s ability to quickly make tactical changes could potentially protect investors when they need to de-risk in a protracted bear market. Second, if you already have one multi-asset manager, consider adding another multi-asset manager who takes a tactical approach to this strategy. The difference in the two managers’ performance could serve you well. In either case, it makes sense to consider a manager who has consistently beat the benchmark.
We define dispersion by looking at the average monthly excess return of each submodel and then quartiling the data. Months in the top two quartiles are considered months with high dispersion; months in the bottom two quartiles are considered months with low dispersion.
1
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Beyond the Horizon:
Themes for Multidecade Clients Multidecade themes identify long-term trends that will impact markets and livelihoods over the next few decades. These themes affect how we invest and how we work with clients. They are particularly crucial to our intergenerational clients and our private capital program, where long-term patient capital can outperform more liquid investment options. While our capital markets forecast looks at the medium term (three to seven years), our multidecade themes look beyond that, offering areas of interest and focus 15 years or more.
Generational Themes Decarbonization as an intergenerational investment opportunity
achine Learning and Artificial M Intelligence as a potential Third Industrial Revolution
A Biotech Revolution moving from potential to kinetic energy
Explosive Growth continuing in the Sun Belt
Decarbonization Decarbonization is the process of taking traditional carbon-based processes and either replacing them with non-carbon-based processes or capturing and mitigating the carbon in existing processes. When it comes to decarbonization, several sub-themes exist with potential to disrupt and impact companies: reimagined mobility; renewable and clean energy; clean hydrogen and new fuels; and nuclear fusion. Though decarbonization has been a politically sensitive area of investing, the opportunity for investment in decarbonization over the next few decades is in the trillions, perhaps even tens of trillions, irrespective of politics.
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Machine Learning and Artificial Intelligence Machine learning and artificial intelligence are two related concepts that often merge. Machine learning is the ability for machines to learn from available data. With the advent of big data, machines that can improve their information analyses have led to some rapid economic advances. Artificial intelligence is a broader category, generally defined as the pursuit of machines developing the qualities of the human mind. Some of these qualities include language and pattern recognition and solving complex problems. Together, machine learning and artificial intelligence have the potential to harken a third industrial revolution that will transform our economy over the next generation.
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A Biotech Revolution The third wave of a long-standing biotech/medical revolution began a few decades ago as efforts from the human genome project, advances in computing (see Machine Learning), and scientific breakthroughs combined to create what some have called the dawning of a new Golden Age of Medicine. This Golden Age of Medicine may offer a revolution in healthcare, pharmaceuticals, and biotech. Pundits have pointed to several trends to support this theory, such as the so-called “Moore’s Law for Medicine,” where the speed of discovery builds on itself and quickens, or “the biological century,” where innovations in medicine shift from a trial and error method in the past to an engineering science with predictable/scalable outcomes in the present and future. We saw this play out on a global scale in 2020, when, thanks to computing technology, the mRNA vaccines for COVID-19 were miraculous in their delivery mechanism, development speed, and emergency approvals. As the pandemic has shown, new diseases can emerge and spread rapidly, increasing the stakes and the potential role for government funding and public-private partnerships to speed drug discovery and delivery. Diseases such as cancer and Alzheimer’s are coming into the target range for solutions to transform the developed world’s life expectancy and quality of life.
Explosive Growth in the Sun Belt In the largest economy in the world, people are moving to the Sun Belt in droves, bringing their spending, businesses, education, and ideas. For example, three dozen people, net, move to Atlanta every day, double that in Nashville and nearly three times that to Jacksonville. Phoenix has about 200 net new residents per day. A mind-boggling
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average of 8,300 people per day, net, have moved into Texas over the last decade, attracted primarily to the large urban areas. This trend shows little to no sign of abating; with in-migration, high taxes in coastal capitals, and expanding transportation and cultural options in the Sun Belt, we believe it will continue to expand at or above the rate of growth over the last decade.
Conclusion Though multidecade themes do not change our core approach in private capital, where we look to allocate across vintages and managers to large areas that can absorb meaningful capital, they do play out in several ways in our current and evolving investment platform. They represent areas we are watching with particular attention as we craft portfolios to clients’ specific needs. These themes are not exhaustive, and though some will fade, and others will emerge, we are particularly interested in overweighting these areas as we look for private investment opportunities. Balentine has proven its ability to balance strong investment performance in the long-term with client asset protection in the near term. We rely on science first and foremost to allow for unemotional decision-making in liquid markets. We are also able to move tactically when unexpected opportunities, such as the coronavirus pandemic, present themselves. Finally, we take an multidecade view of macro themes that slowly but forever change the world in which we live. By blending these tested approaches together, we enable our clients to meet their goals with consistency through time.
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Considerations for Allocating to Private Capital 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. At Balentine, we look to spend our active management budget primarily in private capital.
Why Private Capital? In Private Capital, meaningful excess returns are more persistent than in the public markets, and true active management beyond the point of purchase takes place. In our view, this persistence is due to the high growth nature of private companies and the control managers have over the outcome.
High growth: Companies in the private markets can double or triple earnings year-over-year as they expand from ideas to country-wide products. Once a company has reached the public markets, the growth can continue but typically at a much slower pace.
Control: Private capital managers can also add value through the control they take of the company. Managers can take a long-term view on replacing management, starting or stopping a product line, or expanding into new markets all without the worry of missing a quarterly earnings number.
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Selecting A Private Capital Manager To capture the excess return that comes from high growth and control, investors must be willing to accept illiquidity, or not having access to their money for an extended period of time. This illiquidity is necessary as it gives private capital managers the resources to let their theses play out without selling assets crucial to their operations. The illiquid nature and dependency on the general partner for success drives our due diligence process to be robust and repeatable. We evaluate private capital managers with the following criteria:
People Teams have a history of working together General Partners have seen multiple economic cycles Have proven ability in managing a fund — we typically stay away from first-time funds
Philosophy P hilosophy aligns with current market opportunity R eturn comes from the improvement of the underlying company or asset and not from leverage
Have a clear succession plan in place
Process Investment process is clear and repeatable Manager has an apparent edge in deal sourcing Changes in the process over time have led to better results
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Performance T he People, Philosophy, and Process categories manifest themselves in consistent first and second quartile performance U nderperformance is explainable and lessons learned have led to process improvements
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Where to Invest When assessing where to invest in the private markets, we look to asset classes that have an established history of excess return and that can absorb billions if not trillions of dollars and maintain that level of excess return. These asset classes are private equity, private real assets, and private debt. We then seek managers that align with our due diligence criteria in the following sub-asset classes:
Private Equity
Private Real Assets
Venture capital is an investment in early-stage, emerging companies with high growth potential. Venture capitalists typically take a minority stake in the company and use their talents to assemble the right leadership team, create repeatable processes across the company, and leverage their network to grow the business.
V alue-add real estate investing is the purchasing, repositioning, and selling of real estate — typically involving older buildings in economically strong areas diversified across residential, commercial, industrial, and retail properties. The focus of value-add real estate investing is driving improvement, which is opposed to core real estate’s “buy and hold” process geared toward collecting rents.
Growth equity is an investment in a more mature company which typically has a proven product and is looking to expand or restructure the company. Growth equity managers typically take a minority stake but can have a controlling stake. Buyout equity, or leveraged buyout (LBO), is when a private investor borrows money to purchase a controlling stake in a company with the goal of creating efficiencies, increasing margins, and then either selling it to another private investor or taking it public.
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I nfrastructure and natural resource investing is the purchase and operation of key infrastructure, such as sea ports, airports, or energy generation and distribution. Similar to value-add real estate investing, the manager will typically reposition the asset to garner a higher exit price while collecting cash flow from operations.
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Private Debt
Opportunistic investments
Secured Lending is lending to small and mid-size companies which cannot access the public debt markets. These loans are high in the capital structure and typically have strong covenants. Loss rates tend to be low, and yield tends to increase as EBITDA of the borrowing company decreases.
T he ebb and flow of markets bring myriad dislocations and therefore investment opportunities. Balentine is constantly on the lookout for these opportunities that can be accessed in the public or private markets.
Non-secured Lending is junior to senior debt and therefore earns a higher yield. This debt is typically used for leveraged buyouts or when companies already have senior debt in place. Loss rates will tend to be higher than senior secured but can be offset from a return perspective by managers taking a small equity position in the company.
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Constructing Your Portfolio An investor’s private capital portfolio should be sized based on the need for return and balanced by the level of spending. The higher return an investor needs, the more private capital to which they should allocate. This needs to be balanced, however, on the level of spending from the portfolio. We complete strict scenario analyses to ensure we size the illiquid portion of a client’s portfolio under the level which would inhibit the same level of spending. Below is a chart that depicts this relationship: 7%
Yearly Spend Rate
6% 5% 4% 3% 2% 1% 0% 0%
10%
20%
30%
40%
50%
60%
Source: Balentine
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The size of the private capital portfolio determines the final allocation. The more assets that are allocated to private capital, the more funds can be used. Balentine utilizes a core – moon – satellite approach that goes from broad based, diversified funds to more focused, sometimes thematic investments. This is depicted in the following chart:
$5,000,000+ in private capital $2,500,000 in private Private capital Real $1,000,000 Assets in private capital 3c-1 options
Private Debt
Public Markets
Private Equity
Opportunistic
Conclusion We believe the next market cycle will be a defining one from a return perspective. Portfolios that can handle the complexity and illiquidity of private capital should distinguish themselves from portfolios that cannot. Balentine has invested material resources to ensure we can build the private capital portfolio that our clients are going to need for the next cycle.
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Appendix Each year, we update our forecast of capital market returns for the next market cycle, as measured by the succeeding seven-year period, because future market returns, specifically, projected income and projected adjustments to valuation, are a function of the starting point. As a result, the goal for our strategic forecast is to update our outlook to account for year-over-year changes to the starting point of the new seven-year cycle. We update our strategic forecast for asset classes on an annual basis, but that does not mean these are tactical, one-year allocations. Instead, our updated returns contemplate the market’s actions during the preceding year and rely on mean reversion. Over the long term, markets show a strong tendency to mean-revert to historical averages adjusted for underlying trends. This happens because high profits and momentum attract investors and drive down future returns in highly-valued asset classes. A classic example is the bifurcation we see at this point in U.S. Large Cap Growth vs. Value. These forecasts offer little insight into the tactical outlook over the next year or so, but over the next seven years, Value stocks are in a much stronger position to deliver superior returns owing mostly to superior starting valuation and dividend yield. The valuations in U.S. Large Cap Growth contemplate earnings growth that, if history is any guide, is likely to overstate what actually comes to pass.
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Our update includes answers to the following questions:
What public market returns are realistic during the market cycle? What risks may have to be assumed to capture those returns? What opportunities do investments in private markets have to offer? Based on our updated projections, we restructure our strategic asset allocation targets in key areas to maximize the efficiency of our strategies and, therefore, better meet our clients’ objectives over the next market cycle. Our forecast provides the quantitative blueprint for the steps we are taking designed to both manage risk and maximize opportunities in 2022 and beyond.
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Fixed Income YTM
Duration
Bloomberg Barclays US Aggregate
1.8%
6.7
Bloomberg Barclays US Treasury
1.2%
7.1
Bloomberg Barclays US (7Y-10Y)
1.4%
8.2
Bloomberg Barclays Municipal Bond
1.3%
5.0
Bloomberg Barclays US Aggregate Credit - Corporate - Investment Grade
2.4%
8.6
Bloomberg Barclays US Aggregate Credit - Corporate - High Yield
4.8%
3.8
Bloomberg Barclays US Treasury Inflation Protected Notes (TIPS)
1.4%
4.5
Bloomberg Barclays Global Aggregate
1.3%
7.5
JP Morgan EMBI Global Diversified
5.3%
6.7
Return
Risk
MSCI All Country World (Global equities)
2.4%-5.0%
16.5%
Russell 1000 (U.S. Large Cap)
1.2%-3.4%
14.5%
Russell 1000 Growth (U.S. Large Cap Growth)
0.1%-2.3%
16.0%
Russell 1000 Value (U.S. Large Cap Value)
2.3%-4.5%
13.0%
Russell 2000 (U.S. Small Cap)
2.6%-4.8%
19.2%
MSCI EAFE (International Developed)
3.8%-6.0%
17.0%
MSCI EAFE Small Cap (International Developed Small Cap)
4.4%-6.6%
19.7%
MSCI Europe
2.6%-4.8%
17.0%
MSCI Japan
5.6%-7.8%
21.0%
MSCI Emerging Markets
7.3%-9.5%
23.5%
Return
Risk
2.7%-3.7%
6.0%
Return
Risk
7.4%-10.0%
9.5%
Market Risk
Alternatives HFRI Fund of Funds Composite
Private Capital Cambridge PE Source: Balentine
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In Closing We hope you find this year’s Capital Markets Forecast informative in understanding what is realistic to expect in the market in 2022 and what possibilities exist to achieve portfolio goals. As portfolios ride the market cycles in periods of high inflation, low inflation, and even negative inflation, it is important to ensure they are set up to achieve goals in an environment with low interest rates and potential growth challenges. This is especially the case looking forward given the possibility of changes in both cost of living and tax rates, though recent developments in Washington D.C. suggest the latter may be less likely to occur. Nevertheless, accounting for all possibilities to inflation and tax rates will allow us to effectively balance portfolio risk and spending needs to build better portfolios for both today and decades in the future. Though none of us can predict the future, time-tested research methods and innovative thinking provide pathways to move forward.
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Disclosures The opinions expressed are those of Balentine. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward looking statements cannot be guaranteed. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Balentine or any non-investment related services, will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Balentine is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Balentine’s investment advisory services can be found in its Form ADV Part 2, which is available upon request. Chartered Financial Analyst® (CFA®) are licensed by the CFA® Institute to use the CFA® mark. CFA® certification requirements: Hold a bachelor’s degree from an accredited institution or have equivalent education or work experience, successful completion of all three exam levels of the CFA® Program, have 48 months of acceptable professional work experience in the investment decision-making process, fulfill society requirements, which vary by society. Unless you are upgrading from affiliate membership, all societies require two sponsor statements as part of each application; these are submitted online by your sponsors. For more important disclosures visit www.balentine.com/disclosures
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