How Well Are Investors Prepared for Post-Covid Markets?

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  • 17 mins 46 secs
Widening gap between investor return expectations and what financial professionals think is realistic, taxes as the top financial fear, and volatility concerns are among key survey findings analyzed alongside today’s market dynamics.
Channel: Natixis Investment Managers

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Dave Goodsell: For two years, the pandemic has offered up a steady diet of shutdowns, lockdowns, and even a few meltdowns.  But even as the worst public health crisis in a hundred years put the world on edge, markets refused to give up.  The S&P posted gains of 18 percent in 2020, and another 17 percent so far this year.  It’s been a rewarding time, but it’s been far from the norm.  The big question for investment professionals, how do you prepare clients for what comes next?  Welcome to the Investor Insight Show, where we look at the attitudes, perceptions, and motivations behind investor behavior, and provide insights for managing client relationships.  I’m David Goodsell, Executive Director of the Natixis Center for Investor Insight, and I’m here with Jack Janasiewicz, Portfolio Manager at Natixis Investment Manager Solutions, where he manages a range of multi-asset strategies.  Jack, welcome.

Jack Janasiewicz: Thanks for the invitation, Dave.  I look forward to our conversation here.

Dave Goodsell: Oh, so do I.  Let’s jump right in.  One of the most surprising – not surprising – headlines from our [00:01:00] 2021 investor survey, the expectations gap has doubled.  And you think about this: every time we do a survey, when we talk to investors we ask them about their expectations for long-term returns, we talk to advisors, we ask them what’s realistic.  Every single time there’s a big gap.  And between 2019 and 2020, investors said they expected returns of 10.9 percent above inflation.  Advisors called 6.7 percent more realistic.  Let’s fast forward to 2020 to 2021, now investors say they expect returns of 17.5 percent above inflation.  And it doubles that expectations gap to 161 percent between what they expect, and what advisors say is realistic.  Jack, I’m going to assume this isn’t a very realistic expectation.  What are your thoughts?

Jack Janasiewicz: Yeah, Dave, and the math on this just simply doesn’t work out.  If we look at the market’s expectations for earnings for 2022, for example, the market’s discounting above a nine percent earnings growth.  So if we just simply do the math behind this earnings growth at nine percent, add on the dividends that you get paid for investing in equities, and then maybe we can layer in a little bit of multiple expansion in there, that still seems to come up a little bit short versus that 17.5 percent plus inflation number that some of these expectations are building in.  So either we could argue that earnings need to be significantly higher, and that’s something that maybe the market’s missing, but I find that one hard to believe.  So at the end of the day, listen, I’d love to see that 17.5 percent plus inflation happen, but I think those expectations need to come down.  [00:03:00]

Dave Goodsell: Seriously, and that might be a little bit high, perhaps.

Jack Janasiewicz: Just a bit.

Dave Goodsell: Just a bit.  (laughter) All right, so, you know, the other part that’s interesting is when we look at millennials in this, so the younger group of investors, the gap between millennial investors and millennial advisors is even bigger.  So investors say 19.8 percent above inflation.  Advisors in that age group say six percent.  That’s 230 percent gap.  What are your thoughts?

Jack Janasiewicz: Big number there as well, and I think a lot of the millennial backdrop there is based on their experience that they’ve witnessed so far.  If you look at the traditional definition for millennials, right, those are considered to be the people between the ages of 25 and 40, so let’s split the difference, let’s call the average millennial at 32 years old, and then let’s assume that they’ve been actively investing for five years or so, just given their respective lifecycles and probably where their income is and their ability to start putting some money aside regarding investing, you know, if I look at the last five years of the S&P average annual returns, [00:04:00] shockingly, 17.8 percent.  So you can kind of see where those expectations might be coming from.  If you look at the Nasdaq, so the Nasdaq 100, for example, almost 30 percent, just inside of 30 percent for an average annual return over the last five years.  And the reason why I throw that one out there is, you know, millennials have a habit of favoring tech, they are more in tune with disruptions and innovation, so they might probably be leaning more toward that side of the equation.  So I guess in the end here it’s not surprising that millennials might be a bit overly optimistic with their expectations, because quite frankly they haven’t seen anything else.

Dave Goodsell: I mean, that’s fascinating to think about that, you know, the past 10 years, what, there’ve been three down years, two down years?  One of them was, you know, only one year was up by less than double digits.  It’s incredible to think of that experience coming into it, and if you think a generation ahead that came in with the dotcom, the financial crisis, and really a different view on things altogether.

Jack Janasiewicz: Very different, and that’s that, we talk about this quite a bit, it’s that post-partum, [00:05:00] you know, the Post-Traumatic Stress Syndrome, so to speak, and I think that the older generation has witnessed significant drawdowns and those memories are still burned in the back of their heads, and so they actually are more cognizant of potential big downsides because they’ve gone through that.

Dave Goodsell: So you’re saying they’ve seen some stuff?

Jack Janasiewicz: Sure.

Dave Goodsell: Okay.

Jack Janasiewicz: Absolutely.

Dave Goodsell: All right.  So if expectations aren’t enough, having these big expectations, it seems like they expect that they’re going to take on very little risk to get there.  Our data shows that investors tend to overestimate their risk tolerance and underestimate their fears.  Here’s the numbers that get to me.  It’s like 60 percent of investors say they’re comfortable taking risks in order to get ahead.  75 percent say they recognize that market swings of 10 percent are a normal occurrence.  But when it comes down to it, 77 percent, more than three quarters, say they’ll take safety over investment performance.  High returns with no risk.  How do you square that off for investors?

Jack Janasiewicz: I wish it were that simple, once again here, [00:06:00] but, you know, the adage, “there’s no such thing as a free lunch,” and that, I think, is something we need to be cognizant of here.  I mean, listen, we’d all love to have those assets that throw off some handsome returns with low risk, but with high risk comes high returns, and just the opposite, too, the potential for high loss as well, and that’s the definition of risk premium.  That’s what the markets are all about here.  So, you know, this might be a definitional issue we’re talking about.  You know, as you just mentioned, normal market corrections are typical, five to 10 percent drawdowns three times a year, maybe we get one 10 percent drawdown every year, but there’s a risk and a volatility that people are willing to accept, and that’s the norm.  But mind you, this year, 2021, is certainly not a normal year.  As of the time of this recording, the biggest drawdown that we had seen was at the end of March, which was just over four percent.  So a little bit of a different backdrop I think than typical years, but this is where I think safety does start to take over.  Investors are ok with taking the normal market ebb and flows, those drawdowns of five and 10 percent, [00:07:00] but something more significant, closer to 20 percent, let’s say, that’s where you’re going to start to see them default back to that safety issue.

Dave Goodsell: Exactly.  And here’s the thing, what should investors really know about risk?  There hasn’t been a ton to deal with in a long time.  What do they need to know?

Jack Janasiewicz: Yeah, and I think that there’s, again, a definitional issue here.  It’s volatility, and I think volatility is often confused with risk.  And, you know, to me, what my definition of risk is, it’s permanent loss of capital.  And volatility to me is just simply how much an asset price is jumping around, and so there’s volatility when stocks are moving higher, and there’s volatility when stocks are moving lower.  But I would like to think that people are okay with volatility or risk if they’re getting paid to the upside.  That’s a big difference in here.

Most would basically be okay with upside volatility, that upside risk, because you’re making gains on that front.  But permanent loss of capital, that’s the problem, and that’s where I think most people least expect it, for obvious reasons, because if we knew something bad were about to happen and that would result in a loss of capital, we would probably take measures to adjust accordingly.  So it’s that unknown that we’re talking about, and that unknown can often lull us into a false sense of security.  So the point of all of this?  Portfolios should be designed to help absorb some of these risks, you know, you’re relying on the equity component to drive all your returns, and sometimes we forget those offsets, specifically today you’re talking bonds, you know, yields are so low it’s easy to ignore them because they’re not really contributing to the upside in your portfolio, but one thing that we want to just caution here is don’t lose sight of why you want bonds.  They’re there because they’re offering you a negative correlation to equities.  [00:09:00] It’s that equity-risk offset.  So back to your original question, what should investors know about risk, it’s always there but just don’t forget about it.

Dave Goodsell: Yeah, it’s very true.  You know, we also see a big difference between how professionals define risk and how investors define it.  You struck on this early on here, but for investors it’s about losing assets, that absolute sense of it, but it’s also exposure to volatility.  So it’s more of that visceral reaction to a tough time, let’s say.  Professional look at it and they say, risk is really about not meeting your goals.  To me that sounds like that ultimate long-term outlook on things.  How should investors really frame up their views on risk?

Jack Janasiewicz: And I think the definitions you walked through here, it’s probably both.  I think one thing leads to another on this one.  If you take permanent losses on assets, a permanent loss of capital, you may not be able to attain those goals you’re trying to reach.  So I think these definitions both go hand in hand.  And I think it’s important that you define this, right?  It’s important for investors to communicate these [00:10:00] goals with their professionals and vice versa, the professionals to communicate their goals back to the clients and make sure there’s a mutual understanding of the definition of risk here, and it’s not a one size fits all, either.  There’s very different backdrops here, there are many variables that go into the definitions of risk, and these vary from person to person.  So to me, communication is probably the bigger issue here.  It’s critical on this front, and both sides of the table need to understand and be clear about each other’s definition of risk.  Both work in this case.

Dave Goodsell: Simple solution to it.  Talk about it.  Put it on the table.  Listen, there’s another area that investors show really a great deal of concern, and that’s taxes.  You know, given all the talk about tax increases coming from Washington, it’s probably a good idea to be clear about this.  You know, taxes rank as the number one financial fear for investors.  They worry more about taxes than they worry (laughs) about the boiler blowing up in the middle of the night, or the roof coming off in a storm.  But we also find it’s the number two investment [00:11:00] concern, right behind volatility.  How should taxes figure into the investment discussions?  What do they need to worry about?

Jack Janasiewicz: You know, this is a very good question, it’s a timely question, especially given the backdrop where, you know, President Biden is looking to push through an infrastructure proposal, and in order to fund that infrastructure proposal, you’re going to have to have pay-fors, which are going to include tax increases in there, and so, you know, without pay-fors in that bill, it’s probably going to be dead on arrival.  So listen, these pay-fors are going to be leveraging those increases, and investors should be expecting some changes in that tax bill going forward.  So what do we expect?  Our base case scenarios?  I think you’d expect the statutory corporate rate to head up to close to 26-and-a-half percent, I think most people probably don’t even know the tax rate that their employer is paying, unless they own their own business, but I think this is a palatable solution that can basically be [sailed?] to the U.S. public.  But probably more important to our listeners on [00:12:00] this side is it’s the capital gains front, and what we’re hearing, you’d expect that cap gains to be pushed up closer to about 25-and-a-half percent.  But the catch here, and one of the things that we’re hearing, they actually might push this back to making this retroactive, meaning the tax laws would actually go into effect, and I’m hearing potentially for September.  So the ability for the market to actually take some action before the actual change may end up proving to be a moot point here.  So the other thing to point out, too, the top tax bracket we’re hearing potentially could get reset back up to 39.6, which would be the pre-Trump level.  [Salt?] deductions would potentially come back into play as well, but, you know, these three headline tax numbers, two of these probably have an immediate impact on you and I, and so from an investment perspective, an increase in corporate tax rates certainly is going to eat in the potential for the earnings backdrop, so that matters for the equity markets.  [00:13:00]

And we also estimate that the S&P earnings hit would probably be in the area of three to five percent in aggregates, so is that a significant offset?  I think the market can look past that, and you could also argue that the market’s really already priced this in, but listen, corporate America, tell the rules by which they need to play and they’re going to figure out how to make money.  That’s the beauty of our economy here.  But on the cap gains front, you know, just looking back, and let’s assume that there is no retro fitting for this, you know, we’ve got two instances in history where we’ve seen cap gains go up that we can point to to see how the market reacted.  And in both instances, you saw modest weakness in the quarter preceding the effective date of the tax increase, but the subsequent quarters after that, the markets recovered and basically continued on with that underlying trend.  So, you know, listen, I think the market’s really going to look past this, it’s maybe have a little bit of [00:14:00] tax-related selling in the runup to that, if the effective date is, let’s call it January 1st, but the point being here, the markets are going to continue to do what they do.  The longer-term trend is what matters most here.  And the other thing to point out on the higher tax brackets on the income side, they tend to be more savers rather than the lower income earners, which are probably more apt to spend.  Those people tend to be more savers if you will.  The impact to consumption there, I think at the margin’s going to be a rounding error.  So should we be worried about this from an economic perspective?  Probably not.  I just don’t see this as a big enough impact to derail the market overall, but there are some specific instances overall that’ll have impacts.  But I think by and large the market’ll look past this and not a huge headwind, I guess, if you will.

Dave Goodsell: That’s fantastic to get that kind of macro perspective on this.  Let’s take it down to the micro.  Market’s been up substantially in the past year and a half.  Investors have a ton of gains built into their portfolios.  What do they need to be thinking about now?

Jack Janasiewicz: Yeah, and this is another great question, and [00:15:00] there’s a couple of things that I think are worth highlighting here that may be applicable, not even to just a concern about the potential for taxes going up but just in general.  Listen, yeah, there are certainly some pretty healthy gains wrapped up in the markets right now, as you’ve mentioned, and if you’d have any sort of transactions, you’re probably going to have a nice tax bill associated with those transactions.  Taxes are certainly a consideration as a result.  We tend to focus a lot on pretax returns, rather than what really ends up in our wallets at the end of the day, the after-tax returns.  You know, if we look at the year-to-date numbers in the S&P 500 right now, I would say roughly five percent of the names are down for the year, and some of those names are down 20 percent.  If we expand that to something like small caps, for example, small caps, almost 20 percent of those names are down year to date.  It certainly seems like anything and everything you bought this year went up, but there are some names that didn’t, and why is this important?  Well, you can use portions of that segment of the market to help offset your tax bill.  So for those investors who are likely to have [00:16:00] core allocations to U.S. equities for the long term, and I assume that’s basically everybody, there’s some things you can do.  Like why not harvest a – or why not harness a tax-lost harvesting strategy?  This makes complete sense, and this is again, doesn’t have to be an investment process or investment strategy that you’re using because taxes are going up.  You can use that any time, basically.  And it’s a simple strategy, it’s one that adds incremental alpha to your portfolio with what I would call modest risk.  And what is that risk?  It’s really tracking here to the overall benchmark.

So if you’re expecting X, Y, Z return for the S&P, maybe you’re going to have a plus or minus several basis points off of that return, but, you know, at the end of the day, when you’re looking at the tax benefits of tax-lost harvesting that are built into your total return, your after-tax return, I think you’re more than compensated with that.  So this strategy I think is something that everybody should be considering.  It’s pretty straightforward, and it’s something I think that at the end of the day can make a significant difference in your long-term [00:17:00] accumulated wealth.

Dave Goodsell: You know, to me that’s such practical advice: to be able to look at things and understand how the tax code, how all the issues around taxes actually impact you, and to think about what you can do about it.

So we’ve covered a lot of ground today.  We started talking about this idea of getting investors ready for, let’s call it for the next normal, it’s not the new one, it’s next one we’re going to (laughs) see.  We talked about three big issues, right, and we talked about managing return expectations, because there’s a big of recency bias here, things have been up and it’s only going to keep going up.  Probably not the best idea to have for the long term.  Making risk concerns clear.  What do you mean by risk, and how are you going to manage it?  Making it an active dialogue, which I think is really important.  And then really that ultimate point, I love this idea that when you look at your investments, it’s not always the pretax number that matters the most.  I think I’ve heard it say, it’s not what you earn, it’s what you keep.

Jack Janasiewicz: Spot on with that.  It’s your wallet.  What ends up in your wallet, that’s what matters (laughs) the most.

Dave Goodsell: You can’t spend the other part.

Jack Janasiewicz: Exactly.

Dave Goodsell: Jack, anything last that you’d like to share with folks?

Jack Janasiewicz: I think the themes that we just spoke about are really not that complicated.  They’re pretty straightforward, they’re pretty simple, and, you know, I think these are some things that anybody can take home with them.  So that’s what I would highlight here: keep it simple, and this is what I think we just highlighted.

Dave Goodsell: Always the challenge, isn’t it?  Keeping it simple.  Thanks, Jack.  Glad you’re here today.

Jack Janasiewicz: My pleasure.  Appreciate it, and this was a lot of fun, Dave.  Thank you.

Dave Goodsell: Awesome.


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