With the right tools, financial advisors can keep their clients on-track through the most challenging economic and market environments.
The recent rise of inflation has certainly created new challenges for investors, said Scott Ladner, CEO of Horizon Investments, on The Weighing Machine, a podcast from Rusty Vanneman, Chief Investment Strategist for Orion Advisor Solutions.
“We’ve lost five years of real wage gains due to inflation over the past 18 months,” said Ladner, who argued that goals-based investment strategies may be the right tool to help many clients through these difficult times.
Why Is There Inflation
The current spout of inflation is not a monetary problem caused by the expansion of the Fed’s balance sheet and low interest rates, said Ladner.
“Inflation, like many concepts in economics, is primarily a supply and demand issue, and we’ve had weird dynamics going on in supply and demand,” he said. “This is going to be a slow, lurching healing process. For the rest of the year, we’re going to be fighting a battle between generally falling goods prices and generally rising food, energy and services prices.”
Retailers have too much inventory and have been marking down their prices, said Ladner, but prices are still rising in areas like airline tickets and hotels—and higher prices are likely to stick around in some of these areas.
Interest Rates, Fixed Income and Equities
Ladner believes volatility in interest rates is beginning to subside, and that Treasury will become range-bound around 2.5% to 3.5% for the 10-year, with global fixed income dynamics creating a ceiling for how high rates can rise, and inflation creating a floor.
“The Fed has told us they want tighter financial conditions, that’s the hammer for the inflation nail they see,” said Ladner. “That means wider spreads and lower stock markets… it really means the only thing they can do to fight the inflation problem they see right now is demand destruction, and that is bad for asset prices.”
On the other hand, Ladner doesn’t believe equity valuations are currently a problem—persistently low interest rates, by historical standards, justify higher valuations.
The direction of the U.S. economy will depend, to a large extent, on earnings and consumer spending, said Ladner.
“Today, (recession) is not our base case,” he said. “I’m not going to tell you it’s off the table, it’s probably a 40%-60% call, 40% we fall into a recession, 60% we miss it. For us it comes down to the behavior of the U.S. consumer—and the consumer is objectively in great shape from an employment standpoint, from a savings standpoint, a net-worth standpoint and a debt standpoint.”
People have the ability to spend, said Ladner, but the problem is that they feel awful—many measures of consumer sentiment have found the public in a poor mood and financially pessimistic.
If consumers shake off the funk and go on their summer vacations and spend, the economy will absorb what is likely to be an earnings slowdown, and financial markets have probably at the very least reached within 5% to 8% of their bottoms.
“On the other side, if they don’t spend, if they say ‘we’re going to go on strike, we’ve had enough and we’re scared,’ and they hunker down, if they do that an earnings recession is certain and a U.S. recession is the base case,” said Ladner. “Then we’re talking about another 20% or so that the markets go down before we’re able to find a bottom.”
Ladner doesn’t see the emergence of “stagflation,” as consumers aren’t hoarding goods like they would if they expected a perpetual spiral of higher inflation.
Goals-based investing is focused on the needs and characteristics of individuals, said Ladner, while most widely recognized investing techniques and much of the language of investing have grown from institutional roots.
“In other words, goals-based investing is geared towards my mom, not geared towards my mom’s pension plan,” said Ladner. “My mom, at some point, will pass, but the pension plan will not. There’s time and a more finite nature to goals-based investing.”
When time is incorporated into the investment process from a mathematical and philosophical standpoint, Ladner said that it becomes clear that a portfolio needs to do something different for early-career 25 year olds versus retired 75 year olds. In goals-based investing, the solutions to basic investment problems, like how to allocate assets to maximize return over risk, change over time.
While financial planners build a plan using predictions for cash-flow needs and returns assumptions, goals-based asset managers like Horizon try to create investment strategies that act as a bridge between the plan and the portfolio.
“We invest with three tranches in mind, we call them gain, protect and spend,” said Ladner. In “gain,” the primary goal is to make money by generating returns. “Protect” represents a middle stage and a condensed time horizon around the time that money is actually needed, most commonly retirement. Within one to five years of the target date, a portfolio is most acutely exposed to sequence risk—the risk that even a temporary drop in value will lead to a shortfall in the future. The final stage, spend, describes the client in retirement or after their target date, when withdrawals of some kind need to be made to meet cash flow needs.
Ladner said that individuals’ perception of risk changes over time as well.
“When we talk about a gain strategy, where the primary goal is to make money, the primary risk is volatility and you’re trying to maximize return over volatility,” he said. “At the protect stage… the definition of risk is absolute loss—did my portfolio go down, and how much? If mom needs money in three years and she’s down 40%, I don’t care if the market is down 50%, because what matters is the measure of absolute loss or maximum drawdown.”
In the spend phase, the primary risk is longevity risk—the possibility of out-living a portfolio when it is being relied on for income.
Ladner said that, ideally, goals-based portfolios meet the needs of investors through all market conditions by ensuring that these different risks are addressed.