Quarterly Update for the Quarter Ending
December 31, 2021
Running into the Wind
Marathon runners much prefer to run with a tailwind rather than a headwind. A tailwind, or wind at your back, allows for less effort and stress on the body, and better results. Conversely, studies show that running into the wind increases oxygen consumption, which inevitably decreases performance. But, adjustments can be made with clothing, pace, technique, and attitude to cope with more challenging conditions. Runners cannot control the weather, but unfavorable wind conditions can be overcome when focused on the big picture and long-term results.
The winds have shifted suddenly in financial markets. Since the pandemic began in early 2020, an enormous amount of fiscal (government) and monetary (Federal Reserve) stimulus has been poured into the economy and financial markets. It is estimated that the money supply has increased an astonishing 41% over the past two years. This is more than double the money supply expansion following the 2008-2009 financial crisis and substantially greater than the money printing of the 1970’s. Easy policy conditions have aided in pushing risk assets higher. Stocks, bonds, real estate, commodities, and even meme stocks and cryptocurrencies have benefited. More importantly, unless a more severe variant of the virus emerges, it appears we are at the back end of the pandemic and entering the endemic stage soon. There is no doubt that a change in economic policies is warranted given the strength of economic growth and corporate earnings coupled with rising inflation. Investors must proactively adjust after a period of substantial gains and reposition for what lies ahead. Tighter policy conditions can be overcome when focused on the big picture and long-term results.
Strong Finish for US Equities
2021’s final quarter proved to be one of the best quarters on record for large U.S. equities. The S&P 500 outpaced most indices, increasing 11.0% during the quarter and 28.7% for the year. As has been the case in recent years, gains were mostly centered in a select group of companies that make up the bulk of the index. Small domestic equities stalled after a massive run-up late in 2020 and earlier in 2021. The Russell 2000 Small Cap Index increased 2.1% during the quarter and 14.8% for the year. International equities, as measured by the MSCI EAFE Index, increased 2.7% for the quarter and 11.3% for the year. The MSCI Emerging Markets Index declined 1.3% for the quarter and declined 2.5% for the year. A stronger dollar and geopolitical risks in China kept a lid on equity performance overseas.
Traditional fixed income finished in the red for only the third time in the last 40 years. The Bloomberg U.S. Aggregate Bond Index was flat for the quarter and declined 1.5% during the year. Of course, the last four decades have seen mostly declining interest rates, which is a tailwind for bonds. The years 1994, 2013, and 2021 were years in which interest rates increased and bonds values decreased, and we could see more of the same moving forward given the current low interest rate environment coupled with the growth and inflation data we are experiencing.
The Fed’s Pivot
During the pandemic, Chair of the Federal Reserve, Jerome Powell, continually commented about how inflation was “transitory”, and that the Fed was “not even thinking about thinking about” raising interest rates until 2023. However, the Fed’s gameplan shifted dramatically in November and December policy meetings, including at a Congressional testimony that was ironically a day after his confirmation to a new 4-year term. The current plan is to end the stimulative bond buying program at a faster pace and raise interest rates 3-4 times this year.
After allowing inflation to run hotter than normal, it seems like inflation finally has the Fed’s attention after trending over 5% annually for the last 6 months. We still contend that inflation could cool slightly later in the year, as the “base case” comparisons from one year ago with the economy mostly shut down will make it more difficult to post such dramatically high readings. Some supply chain issues are improving, and greater global immunity from the virus and fewer economic lock-downs should help alleviate rising prices later this year. Nevertheless, inflation should remain elevated in the coming months due to the massive growth in the money supply coupled with the surge in economic growth during the economic reopening. To counter this trend, the Fed has pivoted and should begin tightening monetary policy. Risk assets can perform quite well in the beginning stages of tightening conditions, but volatility is often greater, and we expect more chop eventually.
Corporate Earnings Growth
Equity valuation is above median historical levels, but reasonable due to exceptionally strong earnings growth. While equities have risen considerably since bottoming out in March 2020, valuations have declined from 24x forward (expected) earnings in September 2020 to almost 20x forward earnings in January 2022. This is because the pace of earnings growth has been significantly better than expected in every quarter of 2021. Corporate earnings are expected to grow by nearly 22% in the fourth quarter and 45% for all of 2021.
Earnings growth should continue to be strong in 2022, but the pace of year-over-year growth is expected to normalize to high single-digits in year two of the economic reopening. This is partially due to what will be a more difficult comparison to 2021 when the economy was closer to open. Overall, there will be less margin for error, as profit margins are already at all-time high levels, inflation is running hot, and interest rates are on the rise. Earnings may in fact stay strong, but the concern is that earnings may peak at some point now that the recovery is largely underway, and fiscal and monetary policies will be a headwind.
Global Asset Allocation Strategy
The strategy has been “risk-on” since March 2020, allowing equities to remain overweight during the economic recovery due to unprecedented stimulus combined with historically low bond yields. However, at year-end, the strategy reduced risk by rebalancing to target equity allocations. Although we remain optimistic about the year ahead and further upside from equities, the recovery is maturing and the Fed is pivoting, which could get messy. Reducing risk to neutral is more appropriate at this point in the cycle.
Going into 2022, the strategy reduced equities and a significant portion of bond exposure to four bond alternatives that we feel can protect capital while outperforming bonds in this ultra-low interest rate environment. Each new investment strategy is unique, with almost no correlation to bonds and changes in interest rates. Strategies focus on arbitrage (risk-less transactions), hedging, mergers and acquisitions, and other catalysts and events, and market neutral strategies. Each of the four strategies has experienced volatility that is commensurate with traditional bonds. The focus was identifying alternatives to bonds with a repeatable, systematic process that does not make top-down macroeconomic bets.
Bonds remaining in the portfolio are predominantly higher quality and lower duration and positioned for rising interest rates. Cash levels are slightly elevated. The reduction in equities and repositioning to bond alternatives further positions the portfolio to be more defensive in a rising interest rate environment. This should enable us to be even more nimble and take advantage of any volatility since risk was already adjusted while the S&P 500 and the Dow Jones Industrial Average were at all-time highs.
Focused Equity Strategy
The S&P 500 finished the year strong. Growth outshined value, making up for its early deficit in the year. The S&P 500 Growth index was up 13% for the quarter while the S&P 500 Value index was 8%. However, in December and early January, value regained leadership. The indices were heavily driven in the quarter by some of the largest companies: for the quarter Apple was up 17%, Microsoft was up 20%, and Tesla was up 36%. What was remarkable was the lack of breadth of the advance, as smaller companies and international companies lagged meaningfully.
Even more interesting was the bloodshed in parts of the market that had previously seen spectacular advances, such as pandemic-related growth, meme stocks, and cryptocurrency. Underneath the surface, a correction has already been underway, but the indices have held steady due to the largest growth names and value leadership.
We can’t be sure if the change in leadership we’ve seen in recent weeks is permanent. However, the divergence and reversals in performance of former high-flying stocks is normal when looking at stock market history. We’ve seen this story before, and will probably see it again. That’s why managing risk is just as important as seeking returns – one can never avoid losses in the stock market, but the probability of loss can be mitigated if managed carefully.
There were no significant changes in the portfolio during the quarter. The strategy has a strong value bias, though we are certainly willing to buy growing companies that we think are reasonably priced. We are still positioned heavily in cyclicals and high-quality e-commerce plays while hedging with more defensive names in health care. For the year, financials and energy did well while lagging a bit in the quarter. Technology did well in the quarter and year, but performance was mixed. The small amount of exposure to China was a detractor from performance, but we are anticipating that those names have stabilized and that recent strength can continue.
Looking forward, we are as always focused on companies that we think can do well in many different economic environments and will be able to create value over time. We are heavily focused on risk, historically keeping a portfolio “beta” (or portfolio sensitivity to the market changes) below average. We carefully evaluate the portfolio in light of macro changes in inflation, interest rates, and economic conditions, while seeking to buy companies that are trading below intrinsic value.
Preparing for the Road Ahead
We have been in a very favorable environment for risk assets, with unprecedented stimulus and low interest rates. Inflation has been low for decades. We envision that this stage of the economic reopening and recovery could be a bit bumpier, as the Fed looks to raise interest rates and exit the stimulative bond buying program very soon. This should be seen as a completely normal and expected occurrence for this point in the economic cycle. Anyone thinking that the Fed can continue to pump stimulus into the economy and keep interest rates low indefinitely has their head in the sand.
As we transition to slightly higher interest rates, we do foresee greater volatility – and this is normal. There is the potential for missteps by the Federal Reserve and other central banks. We believe inflation may level off and be less of an issue later this year due to continued trends such as aging demographics, technology, debt levels, and globalization that are deflationary and simply not going away anytime soon. Supply chain issues will vary by industry, but they should slowly improve over the short-to-intermediate term.
Just as marathon runners are not always in ideal wind and weather conditions, investors do not always find themselves in ideal market conditions. It is important to grind through these times and focus on the big picture and long-term results. Having a financial plan to fall back on will be especially important if we do experience market volatility.
As always, please do not hesitate to contact us with any questions. We are always more than happy to discuss any of the above in greater detail at any time!
 Up & Down Wall Street Column; Randall W. Forsyth; Barron’s; January 10, 2022.