Five Year Economic and Market Outlook

Changes at KWM are occurring during period of global economic and market changes, which we describe as a means of assessing our future investment posture and actions. It is appropriate to share these considerations with clients, to avoid conflating economic and KWM firm considerations.

Ecological Realities

The global human population appears to be at an inflection point. Centuries of progress in science, engineering, and innovation distributed to national and global mass markets solidified expectations of rising productivity, vibrant economic growth projections, higher average standard of living, longer life expectancies, higher educational attainment, and economic stability. The last two centuries witnessed a global population boom of 6 billion people (300%) born into this favorable human environment. Now global constraints are limiting this global population boom, maybe even reversing it. The above economic and demographic miracle we accept as our birthright is premised on a stable physical environment. The combined vast natural resources of land, minerals, atmosphere, and water are no longer deemed limitless. We live in a world beset by water, land, air, and heat pollution. Such wastes must be avoided even as we depend on the useable aspects of resource reservoirs for our survival. As we currently generate more waste than we recycle, biological life increasingly must adapt to survive. Our environment is experiencing higher temperatures, extreme weather, species extinctions, water shortages, and desertification. Global temperatures are projected to rise above pre-industrial averages by 1.5 degrees C in 2027. Humanity is experiencing lower fertility, shorter life expectancies, population migrations and psychological issues, and is more vulnerable to evolving and dangerous pathogens. These trends, emerging as the world population growth declines, have accelerated over the past twenty years. This reality is sobering but also motivating. We at KWM do not proscribe personal, social, political, or family values to our clients or the wider community, nor should we. Our charge is to navigate economic and market trends as we manage assets. However, environmental trends eventually result in economic effects, after long and variable lags. The looming ecological inflection point implies an eventual economic effect of either slower growth, volatility, uncertainty, or inflation. Thus, we project and share with clients what we anticipate in terms of future economic trends for the purpose of setting expectations and assisting with their planning. Because of the very high uncertainty of projecting at or around inflection points, we here limit our time frame to five years. These projections are based on the most recent data from the economy and markets. Uncertainty often results in higher asset volatility, and frequently is associated with lower valuation multiples such as PE ratios, or abnormal interest rate spreads as investors are disinclined to tie up wealth by investing in longer term equity or bond positions.

Projections of U.S. Economic Fundamentals

Annualized % Ave 2020-2023 Ave 2010-2020 Ave 2000-2010 Ave 1950-2000

Growth, GDP 2) 2.0 3.30 3.15 3.75

Unemployment 3) 5.5 6.5 5.5 6.0

Inflation 4) 4.0 2.0 3.0 4.0

Productivity .9 1.0 2.0 1.0

Judging from the above averages, a gradual slowing of economic behavior has occurred. Productivity has been slowing, the workforce has not been growing sufficiently, global trade growth is slowing, and much higher policy interest rates are now needed to reign in inflationary market pricing. Short-term, a contraction is probable due to the presence of certain aberrations in policy and the economy. Interest rates in the short-term debt market have substantially repriced closer to the average because of Fed policy. This net repricing is an asset correction which led to the regional banking crisis. Since the U.S. economy is becoming more diverse but also more stratified, one can envision the national economy as a collection of economic segments, each with different characteristics, values, expectations, assets, and liabilities. These different segments experience rising interest rates and reduced liquidity in differing time frames. A rolling recession across segments of the economy over time is likely occurring, a response preferable to a broad simultaneous downturn. Though recessions can be long or short, deep, or shallow, we sense this rolling recession is due to directional economic restructuring. Historically such restructuring results in more profound and longer recession, but this effect is being mitigated by the widespread recessionary anticipation and reactions from businesses, institutions, and individuals. Longer-term, we expect several trends: Diminishing growth on a scale of .5% per decade; lower than average unemployment as the proportion of retirees grows relative to working population; persistent inflationary pressures which are capped at higher levels around 5% by Fed actions; diminishing productivity by .5% per decade. We suspect that U.S. and global economic growth peaked around the decade 2000-2010, though innovative growth, such as artificial intelligence, is very difficult to predict. The cross currents described above lead to higher uncertainty, increasing risks generally. In a counterintuitive statement, we advocate clients expect the unexpected, or at least not be surprised when the unexpected happens.

Comparisons of Selected Markets Averages and 10 year returns

Market Metric/10 Yr Return Current 01/03/Return 01/83/Return 01/63/Return Historic Ave SP500 Dividend % 5) 2.34 1.8/88.38 6.2/167.8 3.7/105.5 1.85 SP500 PE Ratio 6) 7) 24 29/88.38 11.5/167.8 17.8/105.5 16

10yr Treasury Yld % 8) 4.0 4.0/100 10.3/66 3.9/-41 4.25

The above chart details some fundamentals of stock valuations, specific to the S&P 500 index, and the ten-year US Treasury bond. Note that yield is more important to Treasury performance than dividends are to stock performance. For stocks, average SP500 price to earnings ratio is more important. When PE ratios are below the average of 16, the ten-year return is higher than when PE is over 16. The ten-year return in 2003 for stocks was 88% while the 10 yr T-bond was 100%. In 1983, however, the ten-year return was 168% for equities while the 10 yr T-bond was 66%. This exemplifies the inverse relationship between stock and bonds historically. Typically, as stocks become more attractive, bonds become less attractive, and vice versa. However, this past decade, markets have deviated from this inverse pattern. In our current situation, growing evidence suggests a return to the historic inverse bond and stock attractiveness relationship. Stocks have been the preferred asset class over the past decade, but bonds are now gaining advantage. We see that a 4% ten-year T-bond is less risky than stocks on average at a 24 times equity PE ratio. Thus, we are anticipating a stock market correction, and hope to rebalance back into equities when the PE ratio reverts to a mean or average value of 16. This valuation correction is not assured, but it is premised on historical patterns that have happened numerous times. We anticipate this correction, but as we have often noted, there is no assurance of the timing, duration or magnitude which will occur. The safety of 4% bond interest does offer a safe harbor as we wait for equities to reprice. Note that our KWM Standard Growth portfolio now targets 60% equity exposure. We position long-term investors to continue to participate in market gains but to a lesser extent due to increasing risks. Exemplified by bond yields since 2000, rational market corrections often occur unpredictably in time and magnitude. Eventually mean reversions are expected for stock and bond markets.

1) https://www.un.org/en/climatechange/science/key-findings#physical-science

2) https://www.macrotrends.net/countries/USA/united-states/gdp-gross-domestic-product.

3) https://www.thebalancemoney.com/unemployment-rate-by-year-3305506.

4) https://data.bls.gov/timeseries/CUUR0000SA0L1E?output_view=pct_12mths

5) https://www.investopedia.com/articles/markets/071616/history-sp-500-dividend-yield.asp.

6) https://www.multpl.com/s-p-500-pe-ratio/table/by-year

7) https://www.slickcharts.com/sp500/returns

8) https://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-char