Is the Pandemic Over?
Activity in the bond and stock markets shows that the worst effects of the pandemic, at least from an economic perspective, may be behind us as we start the new year. It has become apparent that though the Omicron variant of the virus is more infectious than previous strains, it is less deadly, especially for the vaccinated, suggesting that the coronavirus is becoming more endemic. Therefore, the need for future widespread economic lockdowns to contain its spread is much less likely.
The Shift from Growth to Value
As a result, long-term interest rates jumped from 1.4% to over 1.8%, and cheap Value stocks in the resources, financials, and cyclical sectors sharply outperformed the Growth sectors of technology and consumer discretionary in the early weeks of January. In our view, Value stocks stand to benefit from continued strong economic growth and are less sensitive to persistently higher-than-average inflation and rising interest rates as the services economy resumes activity at a more normal level.
As we discussed in our last quarterly letter, for over nine months, our discipline has been calling for us to anchor portfolios on Value stocks for precisely this outcome: a long, sustained period of outperformance. This shift looked premature as the Delta variant in summer 2021 and then the initial reaction to the Omicron variant during the 2021 holiday season led investors to seek safety in “stay-at-home”¹ Growth stocks again. Though our strategies generated good absolute returns in 2021, they did not keep pace with the returns delivered by the broader stock market indices. Now it looks like the cycle may finally have turned decisively in Value’s favor for months to come, with January’s outperformance continuing what started in December last year.
How the Fed May Address Inflation
The key question now is how quickly the emergency fiscal and monetary stimulus that the Treasury and Federal Reserve (Fed) implemented needs to be removed. The economy looks like it is ready to stand on its own two feet again without such extraordinary measures. Support for the administration’s “Build Back Better” fiscal stimulus package has already dwindled rapidly, and the consensus seems to be that we should not expect anything to be passed before this year’s mid-term elections.
So, all eyes have turned to the Fed. With the economy continuing to grow rapidly and inflation readings persistently registering 30-year highs, many are worried that it is doing too little, too late to normalize monetary policy. Job openings continue to exceed the number of available workers, particularly at the lower end of the wage spectrum 2, leading many to conclude that the unemployment rate cannot go much lower than it already is at 3.9%. The bond market is now expecting the Fed to raise short-term interest rates in the bond market as many as four times to 1% in 2022 3 and to end its commitment to buying bonds to provide liquidity to markets.
For decades, the Fed committed to “to take away the punch bowl just as the party gets going”4 to fulfill its twin mandate from Congress of stable prices and full employment. Now, by allowing the economy to “run hotter” than it used to in past economic cycles before raising interest rates, it is clearly betting on two factors:
- As the global economy opens up more consistently, many supply chain bottlenecks contributing to today’s cost-push inflation will ease quickly.
- More significantly, the current high-pressure economy has forced companies to innovate and become more efficient; they have adopted technology that changes the game and allows them to achieve more with fewer inputs. In other words, the economy will regain its mojo by attaining the high rates of productivity growth that characterized past robust and sustained periods of economic growth like the 1950s, 1960s, and 1990s. This productivity growth will prevent a more pernicious inflationary psychology from taking hold, as it did in the 1970s, allowing the Fed wider latitude to normalize monetary policy in a way that markets conclude it is doing so neither too early nor too late.
Public Market Policy Changes
Despite interest rates rising to start the year, the corporate profits boom continues to surprise to the upside, preventing stock market valuations from being extremely expensive on our criteria5. At this stage, any correction over the next few months should be seen as an attractive opportunity to put to work “dry powder” (cash in excess of two years’ worth of spending needs net of portfolio yield)6. We remain near the top end of our ranges in equity exposure and the low end of our ranges in fixed income, an asset class that will likely continue to be challenged by high inflation and rising interest rates.
We made one change to our exposure within equities during the fourth quarter; we added a dedicated allocation to the domestic energy sector for the second time in a year. Earlier in 2021, our allocation outperformed the broader stock market, and we were happy to take profits ahead of the typical one-year time frame we hold sector positions. After underperforming in the spring and summer months due to concerns about the Delta variant, the energy sector began to show strength again in the fall. This renewed strength in tandem with strong third-quarter earnings7, which drove down valuations to extremely cheap levels, catalyzed our move into the sector again.
These tactical opportunities in the energy sector have emerged within the context of a broader theme: the trend of moving away from a reliance on fossil fuels towards a “greener” future powered by decarbonization and electrification. This economic transformation is likely to occur over several years, not overnight, as suggested by the excess pessimism investors continue to show towards energy stocks. During this transition capital expenditures into the fossil fuel space will continue to decline, as they have over the last seven years. Capital expenditures are already half of what they were the last time the oil price was this high, a chronic underinvestment that will continue to lead to fewer wells and impairment of the oil supply in the future. So, ironically, as companies continue to transition a greater part of their capital expenditure budgets toward a “greener future,” we are likely to experience oil price inflation from a reduced supply that will likely exceed the structural decline in demand in the very near term.
Private Capital Updates
Over the medium and longer-term, we anticipate sustained flows into alternative energy infrastructure. We are positioning a portion of our illiquid strategies to capitalize on this longer-term trend in Private Capital as a key multigenerational investment theme8. This is not a political statement by our investment team. Rather, we think the commercial opportunity to invest in the repositioning of our energy stack is likely to stretch over more than a decade and offers a compelling opportunity to generate excess returns over public markets9. Regardless of the environmental impact elevated carbon dioxide is having on the planet, the fact that we are using fossil fuels faster than they are being generated puts a shot clock on the adoption of non-fossil fuel energy sources.
We believe the size of this opportunity requires a multi-faceted approach, using large-scale funds that are sized appropriately for the opportunity, as well as small, niche funds that can be nimble. We also believe this opportunity spans across multiple asset classes, requiring proven technologies to be implemented, as well as new technologies to be discovered.
This belief leads us to recommend the Brookfield Global Transition Fund and Kendall Sustainable Infrastructure III as the first two commitments we wish to make in this area10. Brookfield is looking to purchase real assets that need to be transitioned away from high carbon dioxide sources of energy to lower sources and purchase or construct renewable energy sources. Kendall is focused mainly on constructing small solar fields in the U.S. and connecting to the power grid close to where the power will be consumed. We will likely also commit to two additional growth managers focused on cleantech and industry disruption in the future.
All these managers are difficult to access directly by individuals because scale is required to qualify. Therefore, Balentine has constructed a pooled access vehicle, “Decarbonization 2022,” as an accommodation to our clients to blend these investments appropriately given the large minimum ticket sizes into each and to provide exposure in a simplified way11.
Elsewhere in Private Capital, there was a flurry of activity on the fund side in the fourth quarter as our private debt manager, Monroe, and one of our venture managers, Adams Street, held final closings in their funds. These two funds bookend the risk spectrum we look to achieve in Private Capital well, with Monroe investing in senior secured loans to established lower middle-market companies and Adams Street allocating to a diverse group of the top venture capital managers in the world and their co-investments. We expect both funds to be back in the market at the end of 2022 for clients requiring allocations.
Our managers have also been hard at work investing capital in the fourth quarter. J.F. Lehman, our leveraged buyout manager, made its sixth and seventh investments during the quarter. The sixth investment was in a provider of diversified infrastructure and environmental services and the seventh was a market leader in the design, engineering, and manufacturing of custom radiofrequency. J.F. Lehman V has deployed its capital slightly ahead of schedule and should also be back in the market in 2022 with fund VI.
Our real assets managers have been busy as well with Pantheon, our infrastructure manager, investing in seven assets in the second half of the year, bringing Pantheon to a fully committed level. These investments range from a freight car and tanker lessor in Europe to a portfolio of data centers in the Asia-Pacific region. Harbert, our real estate manager continues to find compelling deals in a post-COVID world, including a medical office repositioning opportunity in Phoenix, AZ.
We published our annual Capital Market Forecast in early January. The 2022 edition12 looks ahead over the next market cycle and examines:
- the longer-run outlook on inflation and interest rates;
- different pathways clients can take to achieve their financial goals given today’s starting point, including the many ways we go to minimize the tax drag of investing for taxable clients;
- opportunities to invest in trends beyond innovation and decarbonization that will impact markets for generations to come; and
- important considerations when allocating to private capital. With the amount of money that has been raised by large private capital firms looking to be deployed, driving multiples up to ever-increasing levels, we may be at an inflection point for private capital where there’s “too much money chasing too few good deals.”
Despite the economic fits and starts that have ensued from the coronavirus pandemic, public markets have offered above-average returns over the last three years. As the virus becomes more endemic, we continue to shy away from fixed income and have shifted our emphasis towards Value and energy sector stocks in public markets. We have coupled that stance with a disciplined approach to capturing multigenerational themes in private markets. This will offer investors the highest odds of hitting their financial goals as interest rates rise to reflect a more normal economic environment. Midterm election years like 2022 normally provoke market volatility and a correction along the way should not come as a surprise at all. At this stage, any correction should be considered an opportunity to invest excess cash.
We are very grateful for the trust and confidence you place in our team and process. Thank you.
Please do not hesitate to call if we can answer any questions you may have.
1 – “Stay-at-home stocks” refers to securities that perform well when people stay at home due to restrictions.
2 – As a result, real (i.e., after inflation) wage growth for lower-paid workers has exceeded that of more skilled workers, reversing a multi-decade trend of an ever-widening gap between “the haves” and “the have nots,” which many have argued is responsible for the populist, polarizing streak in politics on both sides of the aisle. The labor market today is being swept by many cross-currents as it responds to: the general surge in demand for labor from a strong economy; at the lower end of the wage spectrum, automation reducing the demand for jobs and lower immigration reducing the supply of jobs; and, at the upper end of the spectrum, the “Great Resignation” reducing the supply of jobs in the aftermath of the pandemic at the upper end of the spectrum, accelerating the effects of the aging of our workforce and retiring “baby-boomers.” This makes it especially difficult for the Fed to judge what the post-pandemic “full employment” rate should be.
3 – This will increase the cost of borrowing “on margin” against portfolios, which is priced off the short-term Fed funds rate. It may be an opportunity to fix borrowing priced off long-term Treasury bonds, such as mortgages, for as long as needed.
4 – As famously stated by William McChesney Martin Jr., 9th Chair of the Federal Reserve
5 – While fourth-quarter earnings for 2021 are still to be finalized, the estimate for growth for the whole year is now 45%, stronger than the 40% rise in 2010 after the global financial crisis. Companies’ earnings are set to surpass not just their 2020 levels, but their 2019 levels too. According to FactSet, analysts expect earnings for the S&P 500 to continue to grow by just over 9% in 2022.
6 – Our cash policy is a hallmark of our process and is the best way to balance the need to take enough risk to achieve clients’ goals against the risk of permanent impairment of capital as it prevents emotional reactions to inevitable market volatility.
7 – Recent earnings releases in the sector confirmed an improvement in operating earnings when compared with the last time oil was at this level. Analysis of industry financial statements indicates an improvement in net margins for two reasons. First, as companies in the sector have struggled with the low oil price over recent years, they have improved their technology to allow them to lower the cost of bringing a barrel of oil out from the ground, which is now shining through in the companies’ gross margins. Second, the companies rightsized their expense structures to leverage their assets more effectively and improve return on invested capital.
8 – We established our first multigenerational theme, establishing exposure to the technological innovation that has been accelerated by the pandemic, late last year, when we allocated to the Adams Street Global Innovation Fund.
9 – The reason behind this is the idea of “additionality.” “Additionality” refers to the concept that because this money is being invested, change (in this case, carbon reduction) is taking place. Without this money going to work, this change would not occur. Contrast this against environmentally-conscious investing in the public markets. An Environmental, Social, and Governance (ESG) -aware manager is most likely going to run a carbon screen and not buy Exxon, Chevron, or Halliburton. While that may reflect an investor’s desire not to own oil companies, it does not do much to take carbon out of the system. Compare not buying Exxon to building a solar farm. In the latter case, because money went to work to build the solar farm, carbon is being pulled out of the system.
10 – Brookfield launched the Brookfield Global Transition fund to invest in the commercial opportunity of decarbonizing the world. The Fund will have a dual objective: to achieve attractive investment returns for investors, and to generate measurable environmental change. Kendall Sustainable Infrastructure III will invest in sustainable infrastructure projects with the goal of building and owning assets that create meaningful return and current cash flow for investors. The core strategy is to partner with developers of renewable energy assets that need expertise and capital to bring their projects from the development stage to completion and operation, offering significant tax advantages along the way.
11 – Balentine does not benefit financially by collecting any form of revenue in this access vehicle.
12 – This year’s edition is dedicated to our colleague Bob Reiser, who recently retired from our firm. Bob’s unique model-driven, repeatable insights remains the foundation for our investment process. Bob’s tenure with Balentine spanned over two decades.
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