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 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, 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-home¹ 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 spectrum², 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.
For decades, the Fed committed to “to take away the punch bowl just as the party gets going”³ 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 b too early nor too late.
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 criteria4. We therefore 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 earnings5, 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.
We published our annual Capital Markets Forecast in early January. The 2022 edition looks ahead over the next market cycle and helps us frame our asset class ranges and strategy expected returns and risks.
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. Midterm election years like 2022 normally provoke market volatility and a correction along the way should not come as a surprise at all. We look at valuations of stocks relative to bonds as an indicator that a sustained bear market is ahead. At this stage, stock markets do not look extremely overpriced relative to bonds, and we are likely to maintain our overweight position to them.
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 those for more skilled workers, reversing a multi-decade trend of an ever-widening gap between “the haves” and “the have nots”, which many have argued as being 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: automation reducing the demand for jobs and lower immigration reducing the supply of jobs at the lower end of the wage spectrum; and 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 As famously stated by William McChesney Martin Jr., 9th Chair of the Federal Reserve
4 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.
5 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.
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