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Not the Same, But Better

by Leah Jane Barnwell, CRPC®

It has been a truly extraordinary couple of years. In the world, in this country, and right here at home in North Carolina. As Americans, we are deeply rooted in the belief that we should always be moving forward – toward progress, toward “more,” toward better.

Two years ago, largely without warning, a global pandemic stopped the world in its tracks, confined whole populations of cities to their homes, and forced us all to sit still for a while. We stayed away from friends and family, masked up, and wondered if life as we knew it would ever be the same.

The idea of going “forward” was now a question of how and when, when it had always seemed to be such a sure thing. Many suffered hardship and loss, some found silver linings; no matter your experience, it’s safe to say we’re all emerging from this time changed.

During a particularly challenging time early in my career, I called a college friend who had recently moved to New York to pursue her dreams in the fashion industry. She listened as I shared all the troubles of my day and expressed doubts about the path I had chosen, and at the end of it all, she offered advice that has stuck with me for many years since that conversation. “Adversity is good for you,” she said, “It forces you to grow in ways you might not have, if there wasn’t something in your way.”

Those words are as true today as they were then. As a firm and like so many other businesses, Trust Company has experienced many challenges in the last two years, and out of that experience, we’ve realized we had the capacity to grow even while others stood still.

We grew as players on a team, seamlessly picking up the slack when a teammate needed to take time for family or experienced illness. We grew as professionals, quickly adopting remote work technologies and developing new communication protocols to keep the matters of daily business on track. We grew as a community, finding creative ways to maintain meaningful communication with our colleagues and clients from afar.

When faced with adversity, we confirmed that we can and will rise to the occasion for clients who depend on us, even if it means getting through one day at a time and wearing as many hats as it takes to “get it done.”

Thanks to the tireless efforts of leadership and our HR department, we came to know and appreciate our coworkers in new ways. Through one of many initiatives (dubbed “TCTS Cribs”, a reboot of the MTV classic), we got a tour of the favorite features of their homes and met their pets, through another we learned about the charitable causes close to their hearts, and we found ways to work better together by understanding the personality types that make each of us tick. A most unexpected silver lining, indeed — our firm culture deepened during our time at home and apart.

As we put the worst of the Covid-19 pandemic behind us, we find new ways to move forward together.

We learned that while there’s no substitute for face-to-face interaction, we can come pretty close to that experience with a great webcam – shortening the distance between us and our clients, between staff from different offices, and giving us the ability to work with vendors across the country as if we are sitting on two sides of the same table.

Out of necessity and under pressure, our successful adoption of innovative technologies allowed us to streamline many of our day-to-day procedures and reduce our dependence on manual and paper-based processes. We’ll use this newfound tech momentum to onboard and adopt two significant new platforms this year – both of which will further enhance our client experience. Pre-pandemic, we may have split these initiatives across multiple years to avoid over-taxing staff – we now understand that our team is ready and willing to tackle whatever comes.

We’ve enjoyed substantial growth in our relationships, welcoming new employees and new clients, and expanding into new spaces in Greensboro, Raleigh and Charlotte. In 2022, Trust Company will celebrate 30 years of exemplary wealth management and fiduciary service to our clients and communities in the southeast and beyond. We go into this next chapter not the same as we were, but better – more nimble, more appreciative, more committed to our shared mission than ever before.

As Trust Company’s Project Manager, Leah Jane works across the firm to support strategic goals through the implementation of marketing, technology and process development initiatives.

On The Eve of the Apocalypse

by M. Burke Koonce, III

It was inevitable, I suppose, the same way good dogs get old, Polaroids fade and rock drummers spontaneously combust. For decades, it looked like the ultimate clash of civilizations might never actually occur. The basketball gods seemed to have deigned that the world was just not ready; that the earth’s crust might crack, freeing some kind of noxious gas or that the atmosphere would be blown away into space. The world was just not ready, and would likely never be ready, for a Final Four matchup between Duke University and the University of North Carolina at Chapel Hill.

But sometime prior to last weekend, the gods changed their minds, or at least the NCAA selection committee and the good people in the advertising department at CBS. For years, the committee was careful never to place Duke and Carolina where they might play each other before the final game. This year, with the Twelve Month Parade of Coach K’s Farewell Tour coming to a close, I assume somebody did the math and determined that manipulating the brackets so that the two schools could face each other in the semi-finals was a maneuver worth taking. It would raise the odds of the apocalypse from extraordinarily low to just plain low. And like they say, a butterfly flaps its wings in Indianapolis and soon enough Roy Williams spits in the Mississippi River.

Of course, Roy Williams is no longer the coach at North Carolina. Neither is Matt Doherty, Bill Guthridge, or the legendary Dean Smith. It’s first-year coach Hubert Davis, a former UNC player and assistant coach (and, full disclosure, my classmate at Carolina). Duke’s coach, as has been the case since March 18, 1980, is Mike Krzyzewski, now the winningest men’s basketball coach of all time, as much as it pains me to say. For perspective, Dean would coach almost exactly half his 36-year career at UNC against Krzyzewski, who has now gone on to coach Duke for another 25 years since Smith retired in 1997.

I suppose over the course of 41 years, during which time Duke vs. Carolina became one of the greatest, if not the greatest rivalry in sports, this could have been expected to happen. And now, on the eve of K’s retirement, which will either be tomorrow night, inshallah, or Monday night at the latest, it has come to pass.

By midnight tomorrow night, as many have written, one side will have eternal bragging rights, and the other will be forced to walk the earth like Jacob Marley’s ghost.

It’s a wager that few of us here on Tobacco Road would ever make; it’s a bit like Russian Roulette. The risk/reward payoff is highly asymmetric and skews sharply negative. For those of us who grew up or attended school between the Haw River to the west and the Neuse River to the east, this is the basketball equivalent of the Ghostbusters crossing the beams, or putting Mentos in Coca-Cola, or making an alopecia joke in front of Will Smith.

But as renowned social psychologist and North Carolina product Ric Flair used to say, “whether you like it or not, learn to love it.” We must summon the wisdom of the ages to come to terms with this.

But how?

This rivalry covers more ground than the taproot of a Carolina pine and is woven into the fabric of my own family’s history like perhaps no other strand. My mother went to Duke and was a passionate basketball fan and my father went to UNC and played football there. So we had the incredible good fortune to have season basketball tickets in both Cameron Indoor Stadium and Carmichael Auditorium, and, later, the Dean Dome. I was on hand with my mom and dad, sitting in Section 16 in Cameron, when Coach K won for the first time against the Tar Heels. He has since won 49 more against Carolina.

As a Carolina graduate and fan, I suppose I should feel pretty good that despite Duke’s (and Coach K’s) wild success that the Blue Devils have only averaged 1.2 wins per year against the Heels in the four decades since, but then again each one felt like someone kicked my dog, some more than others. There was the Austin Rivers shot, the Duhon layup, a half dozen doses of J.J. Reddick, and then of course, Laettner. Duke finally reached the apex of the sport when they knocked off UNLV in the national semi-final in Indianapolis in 1991, the last time Duke and Carolina were both in the Final Four. Duke went on to beat Roy Williams’ Kansas team to win its first national championship. I even pulled for Duke—I was there in Indianapolis sitting next to my mom, of course, but that was the last time. As soon as Duke won, the “Go To Hell Carolina” cheer went up, and I abandoned my dual citizenship on the spot. After all, I was a UNC student at the time.

Fortunately for me, the gods would soon again look favorably on Chapel Hill. Duke would win it again in 1992, but Carolina would win it again for Dean Smith in 1993, in New Orleans, where Michael had given Dean his first championship in 1982, and would go to the Final Four five times in the 1990s. I mean, the Stackhouse/Wallace/Jamison/Carter era was an embarrassment of riches.

Since the famous Jordan shot in 1982, Carolina has won five national championships, and so has Duke. Twice, the two programs have won the title in succession, which exemplifies what has made this rivalry so great—it’s obvious the two programs have made each other better. When K arrived, Dean Smith ran the ACC. It was up to Coach K and the late great Jim Valvano to challenge him. Then the crown went to K. Even though Carolina was neck and neck with Duke, the game was changing in Duke’s favor.

Dean Smith famously lobbied for Krzyzewski to take the reins of USA Basketball, and K did a masterful job with the Olympic team. Unfortunately for the Tar Heels, this, and an academic scandal in Chapel Hill, led to a slight but definite recruiting edge that made Duke perhaps the top collegiate launching pad for future NBA superstars. Ironically, Carolina’s inability to attract the “diaper dandies” helped Roy Williams build veteran teams that could make deep tournament runs for years, but K’s talent edge was persistent.

Unfortunately for Duke and for college basketball in general, the Duke teams, among others, became something of a revolving door for NBA talent, and soon enough, the only Blue Devil I could identify well enough to scream at was Coach K himself.
Which brings us back to the apocalypse. After his year-long farewell tour, K will be exorcised one way or another within about 72 hours. There is another young coach in the league, on the trail of the undisputed king. Will the old lion roar once more, or will the young lion have his own day?

In a sense, this is a game we have seen before. No matter who wins, we are witnessing the changing of the guard in a tradition that has forged the finest that college basketball has had to offer for four decades. And whether you’re a Duke fan or a Carolina fan or just a college basketball fan, your life has been enriched by it. Think of the countless hours of joy and anguish and passion we’ve all felt over the years, and then consider how many hours of practice and preparation the coaches and players put into it. It’s astonishing and humbling.

I hope like hell that Hubert Davis, my old geology lab partner, leads the Heels to victory tomorrow. But no matter what, I am grateful to have been able to watch this extraordinary geyser of human achievement and competition-fueled passion that has erupted virtually every year since I was a child. I thank Mike Krzyzewski for continuing to make both Duke and Carolina better.

For making my life better.

Now, please, Hubert, make him go away! And Go Heels!

A Long March

by M. Burke Koonce, III

True to the proverb, March came in like a lion. As oil prices, interest rates, and geopolitical tensions each climbed higher, market volatility soared and asset prices fell. Fear was so ascendant that it caused the Fed to back away from plans to raise interest rates by 50 basis points and instead settle for just a quarter percentage point. And so, here we are at March’s end, and while the lions can still be heard roaring in the distance, there are some lambs stumbling around.

Amid all the tumult, major U.S. market indices finished the month higher. The S&P 500 finished March up 3.7 percent, while the Dow Jones finished up 2.5 percent and the tech-heavy NASDAQ closed up 3.5 percent (each on a total return basis). This rebound, in the face of perhaps the scariest geopolitical backdrop in more than a decade, is remarkable. After some indices flirted with bear market levels in February, defined by a decline of more than 20 percent, equity asset prices have rebounded strongly off the lows. While the first quarter of 2022 will go down as the first quarter of negative returns since the pandemic bear market, it felt a lot worse a few weeks ago than when it finished.

Curious Cross Currents

While the human tragedy in Ukraine is unspeakable, markets react to geopolitical events in curious ways. On February 24, news reports emerged that Russian forces had begun a “special military operation” in Eastern Ukraine. Immediately, global asset prices first fell, but then rallied hard by the close of that first day. After two additional weeks of market declines on frightening news and chilling forecasts about what had become an all-out war in Ukraine, and with oil having approached $124 per barrel, markets began to behave as if this conflict would have a more nuanced impact on the global economy, and accordingly, asset prices. There is an emerging view that some degree of higher energy costs will help prevent the economy from overheating and could convince central banks not to raise interest rates too rapidly. The yield on the 10-year Treasury, which had widened out to almost 2.5 percent (up almost 100 basis points YTD) has come back in slightly. After all, the cure for high prices is… high prices. The more bearish view is that high energy prices will further fuel inflationary forces even while the economy cools, bringing about a bout of stagflation, for which there is no easy monetary policy cure.

Speaking of monetary policy, it was just two months ago when Fed Chairman Jay Powell indicated that the Fed might be forced to raise rates more quickly to ensure inflation did not begin to impede employment. Fast forward to Powell’s remarks after the most recent Fed decision, and the tune has changed; the employment market is so hot that wage increases are increasingly seen as a bigger threat to price stability than higher prices stemming from supply chain issues. That’s another reason why baseline inflation expectations for the year have continued to creep higher. Just a month ago, the consensus forecast for U.S. CPI increase was about 5 percent—today it is above 6 percent, and the 5-year breakeven inflation rate has jumped from 2.8 percent to 3.4 percent. Yes, inflation is still widely expected to subside, but due to higher wages and higher energy costs, inflation seems likely to fall more gradually than was previously expected.

The trouble with easing inflation is that it feels like monetary tightening. Real interest rates are now at negative 4.0 percent (10-year treasury yields of 2.4% less core inflation of 6.4%). As inflation eventually subsides, the effect on real interest rates will be similar to what happens when the Fed raises rates. The market has been reacting to this tightening with volatility, especially among riskier, long-duration assets. Volatility peaked in early March, with growth stocks suffering significant losses. However, after the Fed slightly softened its stance in response to Ukraine, rates still moved higher but more gradually, and growth stocks staged a bit of a comeback. This is why we tend to view volatility spikes, all else equal, as bullish.

What’s Next?

While we have been keeping a close eye on events in Ukraine and on the broader markets in general, we have not made wholesale changes to portfolios. We believe that should the trend toward higher interest rates and higher inflation continue, value-tilted will be positioned well to outperform. That’s because portfolios with a value-tilt tend to perform relatively well in this kind of environment. Sectors such as financials and energy, which tend to be well-represented in value-oriented portfolios, benefit from these trends. Also, when earnings growth becomes more abundant, investors are less likely to chase pricey growth stocks in favor of value stocks that are also experiencing solid growth. Finally, higher rates tend to have an outsized impact on long-duration assets such as long-dated bonds and expensive growth stocks, because those future cash flows must be discounted back to the present at those higher interest rates.

Even though growth (Russell 2000 Growth Index) rallied in the latter half of March, bouncing more than 7 percent off its lows, value (Russell 2000 Value Index) did even better for the month and has outperformed growth by more than 1000 basis points so far this year.

While geopolitical turmoil is unsettling, it is a risk that has already been incorporated in our allocation models. While these specific risks are unpredictable, we know these events happen from time to time in the aggregate and accordingly they are already baked into longer-term expectations regarding overall risk and return.

While we will continue to monitor events in Ukraine and beyond, we do not anticipate much “trading” around the situation. We will maintain an eye toward rebalancing should circumstances warrant.

As always, we will continue to vigilantly monitor inflation, interest rates, geopolitical events and other market factors, and we thank you for your trust.

Burke is Trust Company’s Investment Strategist. Based in the Raleigh office, Burke works closely with the firm’s Chief Investment Officer helping develop investment strategy and communicating with clients.

When the Ride Gets Bumpy

by M. Burke Koonce, III

Last spring, my wife and I took our daughter to Disney World. We had been recently vaccinated and we were feeling empowered and brave. It helped that Disney was operating at 50 percent capacity—it was a luxury I will require for future visits. Anyway, as my daughter and I were exiting Space Mountain, my Apple watch started to vibrate and I saw I had a call coming in from 911. Startled, and a little out of breath, I answered, not really knowing what to expect. Turned out that our technological overlords had determined that based on the violent maneuvers and abrupt stopping, I might have been in a car accident, and they were calling to ask if I required assistance. I thanked them and told them I was just a middle-aged guy on a roller coaster and we all had a chuckle.

After January’s ride, I half expected my watch to start buzzing again today.

While the history books will show that the major market averages were lower for the month based on month-end pricing, they will not capture the mileage. Yes, January concluded with the Dow down 3.3 percent and S&P 500 down 5.3 percent, but those figures obscure the intra-month declines that landed the other major US index, the tech-heavy NASDAQ, well into correction territory, even though a furious rally these last two days enabled it to post just a 9 percent decline for the month.

For the majority of the overall market’s near two-year trip out of the COVID-19 crash of March 2020, the experience has been more akin to the Seven Dwarfs Mine Train than anything that would require a height minimum. That has changed. It was only three days ago that the Russell 2000 Growth Index had fallen 19 percent since year-end, a single percentage point from a bear market.

Almost right out of the gate, the markets had begun to behave differently than they had in months. Ironically, as COVID-19 finally appeared to be losing its grip on the U.S. economy, markets began to focus not on the virus, but on the side effects of the cure—not the vaccine, but the enormous fiscal and monetary stimulus intended to keep the economy afloat during the dark days of 2020 and early 2021.

Those treatments, coupled with persistent supply chain problems and an extraordinarily tight labor market, have resulted in price inflation not seen in this country since 1982. The Federal Reserve, having successfully achieved its stated goal of strengthening the job market, and then some, will now turn its focus to dampening inflation through a combination of reducing its ownership of financial assets and raising interest rates. Accordingly, the yield on the ten-year Treasury has jumped from 1.51 percent on New Year’s Eve to about 1.77 percent as of the end of January.

While markets had been expecting two rate increases in 2022, the markets are now anticipating five rate hikes before the end of the year. That’s a big difference, especially given how low rates have been, and markets quickly began to reprice assets based on that big difference.
Now, as a general rule, markets do not really like rising interest rates, especially markets for expensive assets such as “growth” stocks—you know, the kind of stocks that have been doing well for years. Investors pay more for “growth” stocks because of the promise of earnings growth that will yield big future profits for those companies. The trouble is, in an environment where we have rising interest rates (because of rising inflation) those future profits aren’t going to be worth as much. As a result, other less expensive stocks, of companies that already have strong earnings even if they’re not promising future trips to Mars, look that much more attractive. Intuitively, this makes sense, right? In an economy such as ours that’s chugging along quite nicely in which lots of companies are generating strong earnings, who wants to pay nosebleed multiples for discounted future earnings when we’re swimming in strong earnings today?

What happened in January was a giant rotation out of “growth” stocks and into “value” stocks. At one point, the Russell 2000 Value Index was outperforming the Russell 2000 Growth Index by more than 1000 basis points, or ten full percentage points in just 19 trading days.
Growth made up considerable ground during the last two trading days of the month to trail by slightly less than 8 percentage points, but that’s still a huge move.

Of course, while we as investors have had the luxury of enjoying a relatively smooth ride recently, it is actually perfectly normal for there to be a 10 percent drawdown; in fact, there’s one just about every year.

But what if this really is something more serious? What if this is an extended drawdown? That would be rare indeed—we’ve only had 12 drawdowns of more than 20 percent since 1946. They usually accompany recessions and yet American corporate balance sheets have perhaps never been stronger, but let’s just say for argument’s sake that this might be serious. What might it look like? Well, if monetary conditions tighten significantly, that’s almost certainly going to be harder on the more speculative areas of the market than the less speculative. The reality is that the Fed is going to beat down inflation, sooner or later. The trouble is, falling inflation feels a lot like rising interest rates, whether nominal rates rise or not. With the 10-year where it is and core CPI at 5.5 percent, that translates into a current real interest rate of negative 3.7 percent. As inflation subsides, it’s just hard to see how we even get back to a real interest rate of zero without some price volatility, particularly for long duration, pricier assets.

All that said, we are not in the market-predicting business. We are in the optimal long-term allocation business, with a tilt toward value (and small caps, and international, and profitable companies). Naturally, this positioning is unlikely to outperform markets when speculation and accommodative monetary policy is ascendant. However, the existence of markets such as this one, characterized by heightened volatility, is incorporated into our long-term view, and, so far anyway, the value-tilt is performing as one might expect.

One of my favorite Warren Buffett observations is that in the near-term the market is a voting machine, but in the long-term it is a weighing machine. Sooner or later, all companies must demonstrate the ability to generate earnings, not just promise it.

Because when the ride gets so bumpy that your watch starts to buzz, it will be the weight of the portfolio that counts, not the number of “likes” it has.

Burke is Trust Company’s Investment Strategist. Based in the Raleigh office, Burke works closely with the firm’s Chief Investment Officer helping develop investment strategy and communicating with clients.

October Surprise

by M. Burke Koonce, III

October. The name of the month conjures particularly vivid imagery. Autumn leaves whispering in the trees and crunching underfoot. Clear, cool nights with spectacular sunsets. Playoff baseball. And of course, fears not just of goblins but of financial market mischief.

More than any other month, investors associate October with spectacular market sell-offs, as evidenced in the wave of concerned emails and phone calls financial advisors begin receiving shortly after Labor Day. Of course, this is not without reason. Some of the biggest drawdowns in history have occurred beneath the Hunter’s Moon. In 2008, the market fell 17 percent. In 1987, it swooned 22 percent. The market declined 20 percent in 1929. But as my colleague Dan Tolomay pointed out last month, October is actually not a particularly scary month in terms of historical returns. Going back to 1928, October has delivered positive returns more often than not. While October does have a higher-than-average standard deviation, it is not the highest (August!). In terms of range of returns, October doesn’t even crack the top half. Finally, of all the “black swan” market returns that have occurred since 1928, October brings just slightly more than random chance would predict.

Now, markets are made up of human beings, and human beings experience fear, so the market isn’t always going to be a fun place. But last month was a perfect example of why trying to time the market is more difficult than bobbing for apples, and perhaps an even less profitable exercise. Markets soared in October. The S&P 500 was up almost 7 percent. The Dow Jones climbed almost 6 percent, and the NASDAQ rose slightly more than 7 percent. Those numbers are closer to historical annual average returns than monthly returns. If you had gotten spooked out of the market last month, you would have missed the best monthly return since last November, when the world was reacting to news of COVID-19 vaccines and the beginning of the end of the pandemic.

This is not to say there aren’t real problems with the U.S. and global economies. Inflation is beginning to look persistently high, fed by labor shortages and supply chain problems. The delta variant of COVID-19 continues to circulate, and wealth inequities are fostering growing social unrest around the world. But fear is the fuel that drives markets higher, not lower. After all, if there were no fear in the marketplace, there would be nowhere to go but down.

Over time, liquid markets are brutally efficient, and fear gets priced in quickly; the result is that market returns tend to run away from consensus not towards consensus—after all, that’s what makes returns possible. As Dan said last month, ‘rather than panic or prepare for an autumn decline, enjoy the beautiful weather.” I would only offer that while the weather outside won’t always be beautiful, and returns will rarely be as pleasing as they were last month, the key is to not get distracted by your emotions or short-term thinking and let the magic of compounding continue to work in your favor. No witch’s spell is more powerful than that.

A Super Genius Weighs In On Inflation

by M. Burke Koonce, III

I have a friend, a hedge fund manager of course, who was filling out a job application years ago at a major Wall Street asset manager. In the section asking about special skills and abilities, he wrote “Super Genius.” I can’t remember if he got this particular job—it’s possible that he did—but I have often giggled about the look on the human resource manager’s face upon reading his application.
Now, this fellow is extremely smart, and he is also clearly not lacking in the chutzpah department. I’m not sure I would categorize him as Super Genius though. Seems a bit inflated, which brings us to a topic on the minds of not just many investors but also business owners and grocery shoppers. Inflation. Is. Here.

I’m old enough, just barely, to remember the inflation of the 1970s and the terrible impact it had on this country. Rooted at least in part in America’s departure from the gold standard and exacerbated by energy crises, inflation reached 14.5 percent by 1980, helped chase a U.S. president out of office and came to symbolize a general sense of economic malaise and even societal decay that persisted until the Volcker Fed brought it under control with higher interest rates and slower reserve growth.

According to the Labor Department, consumer prices rose 5 percent last month, the largest increase since August 2008. The 3.8 percent increase in the core number, which excludes the volatile categories of food and energy, was the largest increase since June 1992. That’s when I graduated from college. For perspective, I have a child who graduated from high school last month.

There’s no disputing these are historic increases. But before we race to the gas station and get in line, let’s take a deep breath. One reason these increases are so large is that last year prices were so depressed. Governments around the world were doing everything they could to keep prices from collapsing. So the denominator (pandemic-pressured prices last year) is juicing these price increases.

Even so, it seems fairly obvious that the economy is far, far healthier than anyone could have believed just a few months ago. Pent-up demand is meeting supply that has been constrained by supply chain problems and labor shortages, so it’s only natural that prices are rising, and it is possible, depending on what happens with consumer expectations, that some inflation continues. As Nobel laureate Gene Fama recently pointed out, the longer inflation or deflation persists, the more likely it is to persist.

Still, there is a component to these price increases that seems decidedly short-term. Generous unemployment benefits are keeping some service workers on the sidelines, but those benefits will run out by the end of the summer and in many states well before, and this ought to ease the labor crunch in the service sector. The microchip shortages that have created a frenzy in the used car market, driving prices up more than 7 percent last month and accounting for about a third of the entire increase in overall prices, will eventually be met with new supply. Globalization has been a crushing weight on inflation for decades, and the base case is that this will continue to suppress price increases.

That’s the company line at the Federal Reserve anyhow, and it’s important to remember that this is actually what Fed Chairman Jay Powell explicitly predicted last September. At that point, the central bank was still so concerned about falling prices that it indicated it would allow the economy to run a little hot instead of pre-emptively raising interest rates. Of course, at that point, there was no such thing as a COVID-19 vaccine. Fast forward to today and we have a $1.9 trillion stimulus package coursing through our veins, potentially another $2 trillion in infrastructure spending on the way, and COVID-19 is on the run. (I actually went to a party last weekend! With people!) Also, I think it’s worth noting that the globalization bandwagon has gotten a little less crowded in recent years as populist and trade protectionist forces have gathered momentum. Combined with an aging population in rich countries and in China, the relative strength of deflationary forces is strong, but not as strong as it was just a few years ago.

So far, the financial markets have taken the whiff of inflation in stride. The threat of higher rates has taken some steam out of the more speculative sectors of the market such as growth stocks and long-dated fixed income, but other areas, such as financials, commodities, and value stocks, have done extraordinarily well. Inflation is a serious threat, but it is only one factor of many that the markets are always in the process of discounting. That’s why good old-fashioned diversification is so important.

My friend might think he is a super genius, but for the rest of us mere mortals, diversification and commitment to a plan still seem to work well. How long will inflation last? No one knows for certain, and there are reasons to be watchful, but diversification and a tilt toward value has historically served investors well over time. The real genius is in mastering one’s emotions, not mastering the market.

Burke Koonce recently joined Trust Company as the firm’s Investment Strategist, working out of our Raleigh office. 

2020 Year-End Tax Planning

by Chris Sutherland, CPA

Year-end tax planning often comes with a bit of art sprinkled in with the science. Thanks in part to the January Senate runoffs in Georgia, this year presents even more challenges. It is not unusual to see material tax legislation in years in which the presidential party changes. We are likely to see that continue in 2021. How impactful those changes will be hinges on the two Senate races in Georgia. Democrats need to win both seats to effectively win the Senate and thus control Congress and the presidency.

Much of what has been said and written about President-elect Biden’s tax plan highlights the impact on high earners –  those making $400,000 or more. We will focus on those provisions of his plan.

  • Ordinary Tax Brackets – The top ordinary tax bracket reverts to 39.6% from the current rate of 37% and applies to those making over $400,000.
  • Capital Gains and Qualified Dividends – For those with income above $1 million, long-term capital gains and qualified dividends would be taxed at 39.6%. Combined with the 3.8% Net Investment Income Tax, the total capital gains tax would be over 43%, nearly double the current rate of 23.8% for high-income taxpayers.
  • Step-up Basis – Also of note regarding future capital gains taxes, Biden has proposed eliminating the step-up in cost basis that allows for basis to be adjusted to fair market value at the time of death. Under current basis step-up rules, heirs can effectively sell inherited assets tax-free.
  • Social Security Tax – A 12.4% Social Security payroll tax would be imposed on earned income over $400,000. Like the current Social Security tax, this would be split between employees and employers. The new tax would create a “donut hole” in which earned income between $142,800 (2021 wage base) and $400,000 is not taxed.
  • Itemized Deductions – Biden has two proposals impacting itemized deductions:
    • His plan reinstates the Pease limitation for those making over $400,000. This is a reduction of total itemized deductions by 3% for every dollar of income over $400,000.
    • The Biden plan also caps the benefit of itemized deductions at 28%. This provision has the potential to impact more taxpayers, but Biden has pledged to prevent the limitation on those making less than $400,000
  •  Qualified Business Income (QBI) Deduction – The QBI deduction would phase out for taxpayers with taxable income above $400,000. Currently, certain businesses can claim a deduction of 20% of qualified business income.
  • Corporate Tax – One of the major provisions of the 2017 Tax Cuts and Jobs Act was a reduction in the corporate tax rate from 35% to 21%. Biden’s plan would split the difference and raise the corporate rate to 28%. He has also proposed a corporate alternative minimum tax that would impose a 15% tax on book profit should ordinary corporate taxes not reach that level.

The greatest impact of President-elect Biden’s plan falls on the top 1% of taxpayers. According to the Tax Foundation, the top 1% will see a reduction of after-tax income in excess of 11% in 2021. So what can you do now to lower your tax bill?

Conventional wisdom in times like these, with expected higher tax rates on the way, is to accelerate income and defer deductions. Unfortunately, it’s not that simple. For example, with the proposed limitations on itemized deductions, you might be better off taking deductions in 2020. Another consideration for those making over $400,000 is a Roth Conversion.  Converting funds from a traditional IRA to a Roth IRA is an easy way to accelerate income that also comes with the benefit of future tax-free growth. Finally, while some tax reform is likely next year, the ability to pass all the provisions listed above comes down to control of both chambers of Congress. And that will not be decided until January.

Tax planning is never a “one-size-fits-all” approach, so contact your tax professional to better understand what actions you can take before the end of the year.

Chris Sutherland is a Principal and Wealth Advisor in Trust Company’s Charlotte office, where he works directly with clients to provide integrated wealth management solutions.

FAQ Round Up with Dan

by Dan Tolomay, CFA

Over the last few months, the financial sector has experienced prosperity, decline and only one thing has been constant — that nothing seems to be constant. We all experience the anxiety that comes with not knowing what comes next. Our clients have been asking great questions lately, running the gamut in topics from the current geo-political climate to economic conditions to investing fundamentals. Trust Company’s CIO, Dan Tolomay, has compiled some of our most frequently asked questions and responses for you below. 

The COVID-19 cases keep rising. What does this mean for the economy and the markets?

Different states took different approaches to shutting down and re-opening. Those that rushed to re-open learned the hard way that they should have listened to the medical experts. Increasingly, the policy response has fallen on state and local leaders. Hopefully, they will learn from areas that have had success containing the virus.

There is a risk of more shutdowns, which would be effective at slowing the virus but would harm the economy. It is interesting to see capitalism at work. In a relatively short-time frame, we’ve learned to conduct virtual business and education, shop at (without entering) brick-and-mortar stores, and interact when necessary with the help of masks, shields, and sanitizer. The transition isn’t easy; but, over time, companies innovate and adapt, and conditions improve. The incentive to provide solutions and make profits drives these companies. These same reasons drive the continued search for a vaccine.

Many have been confounded by the rise in the markets at a time of increased Coronavirus cases. There are two things to remember with markets: (1) they are efficient at processing new information and adjusting prices accordingly and (2) they are forward looking. The news seems bad, yes. But, if it’s not as bad as macro expectations, that’s a positive. Also, the focus is not on the economic damage done or cases reported but future prospects and containment. The markets were blindsided with COVID but now deal with a known enemy. Each day we learn more and are closer to its exhaustion.

What’s the latest on value vs. growth stocks? Has TCTS made any changes?

A component of our investment philosophy is that we expect stocks trading at lower relative prices to have higher returns than names where valuations are higher. This is not a guarantee, though. We have been in a period of growth out-performance. While we believe in value long-term, we also have tactical reasons to be optimistic.

At the end of 2019, growth stocks were trading at 8.17x book value (vs. 5.10x average) while value traded at 2.14x book value (vs. 2.06x average). As there is a tight relationship between valuations and subsequent return, value had the better outlook.
The market sold off from 2/19/20 to 3/23/20. At the end of March, growth had fallen to 7.12x while value dropped to 1.60x. After the selloff, growth was cheaper but still expensive. Value became even more attractive. Fast forward to June 30th and growth and value were at 10.98x and 2.05x, respectively. The continued value lag has been frustrating, but we are more ardent than before.

With the headlines reminding us of value’s under-performance, it helps to put a value tilt in perspective. For example, for the 12 months ended June 30, 2020, the Russell 3000 Growth Index returned 22% while the Russell 3000 Value index delivered -9%, a variance of 31%. This gap is eye-opening but was not likely realized by many.

The market is roughly split between value and growth, so the return would have been 6.5%. An all value portfolio would have lagged by -15.5%. Not good, but not as bad as -31%. Compare that to a value tilt of say, 60% value and 40% growth. The return on that portfolio would be 3.4% and lagged the market by only 3.1%.

Why should I hold international stocks?

International stocks, represented by the MSCI All Country World Index (ACWI) ex US, have underperformed U.S. stocks in 8 of the last 10 years. But, how many of those years was the United States the top performer? Zero. Its best showing was 2013 when it placed 3rd (behind Finland and Ireland). Better returns will likely come from a country outside the U.S., but we don’t know which one(s).

So, what do we do? Own them all. As Jack Bogle, the founder of Vanguard said, “rather than look for the needle in the haystack, buy the haystack”. If we can’t identify the winners in advance, owning all the options gives us at least some exposure to the winners. Unfortunately, we also get some exposure to the losers. But research can help us optimize.
About half of the global investable stock market is international, which is a big opportunity set. Historically, investors have reduced their volatility the most by holding 30-35% of their equities abroad. Doing so ensures exposure to the best performer and should make an all domestic stock portfolio’s ride less bumpy.

Over the past 21 years, the US has won 11 times and foreign shares have been on top 10 times. At the beginning of 2008, when international triumphed six years in a row, one might have asked “why own US stocks?”. While it’s not known when the tide will turn, we know it will at some point. As valuations are more attractive beyond our shores, it’s a good time to buy low and sell high.

What moves should I be making ahead of the election?

As is the case with every election, anxiety rises. And, whether the worry is four more years or a change in control, the answer is the same – accept it is out of your control. There are reasons to feel reassured: checks and balances and mid-term elections.

In our current situation, one party controls the White House and Senate while another party controls the House. This can lead to frustrating gridlock, but it also prevents major policy changes. Should one party gain control of all three chambers, there are still items that prevent upheaval. One is the presence of the other party and moderates. The fringe elements garner the headlines, but there has to be consensus buy-in to implement changes. Lastly, even if one party begins radical changes, mid-term elections are only two years away.

It is not recommended that portfolio changes be made in anticipation of the election. First, what seems certain may not materialize (ex. 2016 presidential election, Brexit, etc.). Second, markets efficiently process new situations such that trying to outsmart global investors’ collective wisdom is futile. Lastly, much like the COVID situation, companies adapt to profit. In the face of tax changes, regulation revamps, tariffs, etc., firms modify their actions for survival and success.

If the government’s actions cause the dollar to weaken, what does that mean for my portfolio?

If government spending and monetary stimulus from the Federal Reserve increases inflation and the Fed holds down interest rates, there could be downward pressure on the U.S. dollar. There are multiple ways that this could impact one’s investments.

U.S. multinationals would benefit as American goods would become less expensive overseas. Also, when foreign sales are repatriated back to the States, there would be a benefit as the foreign currency would buy more dollars. International stocks would face the reverse situation. But, a U.S. investor would benefit as shares of foreign companies, which are denominated in other currency, could appreciate as the dollar declines.

A weak dollar is inflationary to Americans. Foreign goods become more expensive as the dollar falls. Higher inflation expectations tend to push up interest rates as bondholders seek to earn a positive return after inflation. Higher yields would push down bond prices. Inflation would force the Fed to take a more restrictive posture, which would likely mean higher short-term rates and better yields on money market vehicles.

How can the U.S. remain stable if it keeps running deficits?

The government spending more than it takes in is nothing new. However, a renewed focus has been placed on its finances in the wake of the COVID-19 response. Tax revenues are down and spending is up due to stimulus (and potentially more to come). What’s more, many states and cities are also experiencing financial strain, which has been exacerbated by the pandemic.

States are not able to routinely issue debt; so, they cannot finance ongoing deficits. If the books need to be balanced, revenues must rise and/or expenditures must fall. Such moves would be restrictive, not stimulative, at a time when economies are shaky. As such, the Federal government may have to step in.

Additional spending would need to be financed. Thankfully, rates are currently very low, which will ease the burden. Also in the government’s favor is the fact that American rates are higher than many other nations. As a result, finding buyers of our debt should be easier.

Eventually, the bill will come due. Taxes will need to rise and/or spending will need to fall. If steps are not taken, we’d expect to see buyers of Treasury debt perceive the U.S. as less creditworthy. This would take the form of a higher required return. So far, we have not seen that dynamic play out.

Why would I want to hold bonds at today’s low interest rates?

There is a great visual from Vanguard  that shows the close relationship between the current 10-year U.S. Treasury yield and the subsequent decade’s return for high quality fixed income. That number is below 0.75% today. Does it make sense to hold bonds?

The two main roles that bonds play are to generate income and dampen equity volatility. There’s not much income to speak of today. Rather than chase yield in lower quality or longer maturity bonds, more equity might be the answer. The dividend yield on stocks is close to 2% today. So, an investor could collect the higher yield, have exposure to potentially rising dividends, and have the possibility of capital appreciation as well.

This move is not without risk, though. Dividends can be cut and share prices can fall. So, increasing equity exposure should not exceed one’s ability or willingness to bear risk. If volatility reduction is sought, equities and riskier bonds are not the answer. High quality bonds provide stability and a better yield than cash (0.08% currently). Further, the Fed has been clear that short-term rates (which drive money market yields) are to remain low for some time.

Being smart about a bond allocation can improve results. For example, risk should be sought when compensation for bearing that risk is offered. For example, if bonds, which have greater risk, yielded the same as cash, why would you own bonds? Alternatively, if a lower quality bond doesn’t pay more than a high quality issue, why take the risk? Diversifying across maturities and geographies can lower volatility and improve returns by expanding the opportunity set.

We’ve had quite a run from 2009, aren’t we due for a downturn? Should I reduce risk?

Making investment decisions based on past performance or hunches is not wise. Rather, the questions to ask pertain primarily to: required return, risk tolerance, and time horizon. If your portfolio has performed better than hoped, you may be able to de-risk as you don’t need to target the same level of return. Similarly, if your personal situation has changed that you are not willing or able to tolerate as much risk, a change may be in order. Last, as the time until your goal nears, it can make sense to lower your risk and return profile as there’s less time to recover from a market dip.

If no changes are necessary, stick to the controllable and fundamental: diversify, target areas of the market where valuations are more attractive and risk is being compensated, and minimize costs.

As Chief Investment Officer, Dan is responsible for developing Trust Company’s investment strategy and managing client portfolios. 

How We Help: Putting our Family Office Services Model to Work for You

by Jay D. Eich, CFP®, CPA

The original vision of our founders was to make a positive impact in the lives of our clients and their families by continually working towards holistic financial well-being. Through our team of multi-disciplinary professionals, we’re able to develop and employ complex strategies across all areas of our client’s financial life. This “family office” approach sets us apart in our industry and allows us to add value for our clients in unique ways.

Recently, most conversations with our clients have been focused on the impact of geopolitical events on investment portfolios in the short term as well as the long run.

We’ve reassured them that while the coronavirus is an unprecedented event and market performance in the immediate is uncertain, based on the results of similar past events ( like the 1987 market crash, 2008 financial crisis, and the 2000 “dot com” crash), their performance, three, five and ten years after a market crisis will likely be very strong.

We’ve also reminded our clients that adversity often brings opportunity. In response to the recent downturn, we’ve harvested tax losses to offset future capital gains, we’ve rebalanced from bonds to stocks, and we’ve put excess cash to work at lower market prices.

While investment themes are often top of our client’s minds and are certainly very important, we’d like to highlight other examples of how our family office model has helped our clients in recent months.

Estate Planning
A depressed stock market is a great time to consider wealth transfer strategies. One such technique is a Grantor Retained Annuity Trust (called a “GRAT”) – a tax-advantaged way to transfer assets to the next generation. In addition to depressed market values, interest rates are also low, making this strategy an appealing way to transfer assets to the next generation with little, if any, gift or estate tax consequences.

A GRAT originates when a grantor contributes an asset to an irrevocable trust. The grantor retains the right to receive an annuity stream over the term of the trust. At the end of the term, the remaining assets transfer to a beneficiary, usually the grantor’s children. Depending on the terms of the trust, there may be gift tax consequences. However, by using a zeroed-out GRAT, a taxable gift can likely be avoided. Here is an example of how a zeroed-out GRAT works:

Sarah has one child, Amy. She would like to make a gift to Amy and feels the market will rise over the next few years. She contributes $1,000,000 of her diversified stock portfolio to a three year zeroed-out GRAT for Amy. In order to minimize the gift tax consequences, the trust must generally return the principal ($1,000,000 or $333,333 each year) plus an IRS prescribed rate (currently 0.60%) to Sarah. If the growth and income of the trust is greater than the IRS rate (again 0.60%), there will be remaining assets to pass to Amy. If we assume 10% growth and 2% income each year over the next three years, Sarah will have transferred approximately $270,000 to Amy with almost no use of her estate exemption.

Business Planning
Like so many Americans, many of our client’s livelihoods have been impacted by COVID-19. Our tax team has helped our clients navigate the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in order to determine the best way to access government programs, both as small business owners and as employees. While details of the programs are constantly changing, maintaining familiarity with the Paycheck Protection Program, The Economic Injury Disaster Loan Program, and state unemployment programs has allowed us to advise our clients on which program to apply to and why.

Tax Planning
The late 2019 release of the Setting Every Community Up for Retirement Enhancement Act (SECURE Act), and the recently released CARES Act have significantly impacted our clients. For 2020, July 15th is the new April 15th! In addition to the new filing deadline, first and second 2020 quarter payments (normally due in April and June of 2020) are also due on July 15th.

IRA, Roth IRA, and HSA contributions can also still be made by July 15th, while SEP contributions can still be made at the time you file your 2019 return (which can be as late as October of 2020).

New IRA distribution and contribution rules are also impactful for many of our clients. The SECURE Act allows IRA owners to make contributions beyond 70 ½ and required minimum distributions (RMDs) will now begin at age 72. While the CARES Act allows IRA owners to skip their 2020 RMD, in some cases it may still make sense to take one.

Financial Planning
The SECURE Act now requires adult children and non-spouse beneficiaries to deplete an IRA or Roth IRA within 10 years of the original owner’s death. Prior to the Act’s passing, adult children could take distributions over the course of their lifetimes. Lower stock market values combined with the SECURE act make this a great time to consider a Roth IRA conversion.

Let’s assume Bob, age 60, has a $1M IRA and a net worth of $15M. Bob does not anticipate a need for IRA funds during his lifetime. He has one child, Eric, who is 25 years old. Bob converts the IRA to a Roth IRA. This results in $1M of income to him and additional tax liability. After the conversion, Bob would not have to take distributions during his lifetime. If Bob lived until 90, there would be 40 years of tax free growth in the ROTH IRA, 30 years during Bob’s life plus an additional 10 that Eric could defer distribution. If the funds earned an average rate of return of 6%, it would more than overcome paying the tax upfront.

This technique does not just apply to the wealthy. For those who are young or in lower tax brackets this could also be a valuable technique. A Roth conversion is especially valuable when market values are down as you are converting at a much lower value, reducing tax and increasing expected future return.

Charitable Planning
As a result of the SECURE Act, the amount a taxpayer can deduct for cash contributions is limited to 60% of adjusted gross income (AGI). Cash donations over that amount can be carried over for up to five years and deducted on future tax returns. The CARES Act lifts the 60% of AGI limit to 100% for 2020 only before reverting back to the 60% limit in 2021.

The preparation of an income tax projection is critical in order to determine how best to make charitable contributions. In addition to the new 100% cash contribution limit, a few other issues to consider when making a charitable contribution include:

• Cash vs. Stock gifts: While a gift of appreciated stock is usually the best asset for a high net worth individual to give to charity, for those with portfolios who invested over the last few years, you may want to consider making a cash gift to take advantage of the increased AGI limits in 2020.

• The Medicare Surcharge: If your income exceeds certain thresholds you may pay significantly more for Medicare.

• Qualified Charitable Distributions (QCD): Distributions from an IRA are typically treated as taxable income. For those who are at least age 70 1/2, taking a QCD allows IRA owners to gift $100,000 per year from the IRA to a qualified charity. The QCD is not considered income nor do you report a deduction since the two cancel each other out.”

Risk Management Planning
At Trust Company of the South, we do not sell insurance policies. We help our clients identify areas of risk and then partner with firms who specialize in each individual area. Like most industries, the insurance industry has been impacted by COVID-19. Interest rates can have an impact on premiums and some providers have increased their premiums. If you have not recently done so, now is a great time to look at your life, medical, disability, property and casualty, and long term care coverage.

Please contact us if you have interest in discussing any of the above.

 

 

Weathering the Storm: Opportunities in Adversity

by Trust Company of the South

A philosophy can be defined as “an attitude held by an individual or organization that defines its behavior.” This, in essence, is how we view our investment philosophy at Trust Company of the South. It is not a theoretical concept. Rather, it is a concrete belief that drives our daily behavior as advisors. Consistency of investor behavior ultimately determines one’s investment success. Our philosophy has four core tenets. These foundational statements underpin our response to the current crisis:

Current Events

The most commonly used word we are hearing these days is “unprecedented”. Certainly what is happening today is unprecedented. There is no doubt. Without minimizing that fact, most crises are unprecedented.

September 11th is a relevant example. We had never had an attack on US soil (Hawaii was a territory during the attack on Pearl Harbor). We did not know what normal life would look like or how we would ever get back to it. The 2008-2009 Global Financial Crisis offers another comparison. For the first time ever, the “safest” asset on any household’s balance sheet, their home, began losing value. People were underwater in a matter of weeks as the number of foreclosures grew exponentially. The economic toll weighed on the economy for years.

Every crisis has a unique story, and each story in most people’s eyes is unprecedented. But if you listen closely, each story rhymes. First, an unprecedented event occurs, then markets enter a free fall. When the last drops of hope are gone, markets begin rising, and disciplined investors reap the reward.

Markets are efficient.

Beyond the research and data that support this statement, consider the conundrum of believing that markets are inefficient. The problem with this view is that you must now guess what the market has and has not priced in yet. How much worse will things become? What will be the ultimate economic cost? When will stocks fully recover? What will perform best going forward? These are questions no one can answer.

In our view, markets are extremely efficient. The recent volatility in prices proves this point. Early in this crisis, the market traded wildly up or down each day. The financial media likes to add a narrative to each trading day, but ultimately, each day prices are being moved to fair value based on any new information. We are receiving a lot of new information every day – every hour in fact. The market is excellent at processing new information. It leaves no opportunity to benefit from new information.

So why are prices falling so much and so quickly? Investors are recognizing that uncertainty (i.e. risk) has increased, and they are rightly demanding higher returns in the future in order to buy stocks today. It really is that simple.

What are we doing?

At this point, you may be wondering if our sage advice, honed over almost three decades, is to do nothing. Absolutely not!

Market downturns, painful as they may be, present a plethora of prudent planning opportunities. Every day our team is actively engaging with clients to improve their financial lives and advance the financial well-being of their children and future generations. Some of these opportunities include:

Investment Opportunities:

  • Harvest tax losses to offset future gains
  • Rebalance stock to bond allocations
  • Sell risky concentrated stock positions with lower tax burdens
  • Put excess cash to work in the market at lower prices

Financial Planning Strategy

  • Refinance home mortgage to take advantage of low rates
  • Convert a traditional IRA to a Roth IRA while account values are down and in light of SECURE Act changes

Estate Planning Suggestions

  • Low AFR rates present planning opportunities
    • Enter into or refinance an intra-family loan
    • Enter into a sale of assets at depressed values with intentionally defective grantor trust for a note with a low interest rate
    • Charitable lead trusts and GRATs work best in a low interest rate environment
  • Front load up to five years of annual exclusion gifts into a 529 plan to potentially capitalize on a market rebound
  • For taxable estates, use historically high exemptions before they are taken away (by sunset or a new administration) to make gifts at depressed values
    • Gift to a spousal lifetime access trust (“SLAT”) preserves access to the gifted assets via the spouse

History is on our side. 

Trust Company is no stranger to market downturns. We have walked alongside our clients through the savings and loan crisis of the early 1990s, the 1997 Asian financial crisis, the Tech Wreck of the early 2000s, September 11th, the Great Financial Crisis of 2008-2009, the 2011 European debt crisis, and countless other impactful events. Every market downturn is unique or unprecedented in cause yet similar in resolution. Stocks rise again. The economy resumes. Disciplined investors are made whole and continue growing their wealth. In fact, those who stick to plan and remain steadfast do not just endure – they stand to benefit.

All this to say: our seasoned team stands ready to serve you in good times and bad.