Oct 13, 2021
Seven consecutive months of positive returns came to an abrupt end in September, erasing gains for the quarter for most broad-based equity indices. This turn of fortune was accompanied by a mix of new and old developments that for now have turned investors more cautious. Previous pullbacks of this scale have been short-lived over the past 18 months, quickly followed by new highs. That may again be the case as we move through year-end, but there are also some distinct differences this time that may mark an inflection point in this bull market’s 18 month run.
We comment below on some of these differences and conclude that investment fundamentals in general will remain positive, but with reduced return expectations and amidst elevated risks.
Key Investment Issues
For most of the last 18 months, investors have had a relative free pass in terms of understanding Fed policy. The Fed’s mandate has been to use the full suite of their powers to support employment and economic growth, without the normal constraint of inflation concerns. As this has now run its course, they have been careful in their commentary to prepare the markets for longer-term policy changes.
With policy change comes the risk of a policy mistake. Concerns range from pulling back on liquidity too quickly and undermining the economy’s recovery to not moving quickly enough and allowing inflation to gain a foothold, requiring more drastic tightening later. Neither of these outcomes is likely to get resolved anytime soon, but what’s changed for investors is the uncertainty around Fed policy where there was none before. Three years ago, markets dropped almost 20% in Q4 when the Fed tightened liquidity and raised interest rates as the economy was already showing signs of slowing down. Some believe the current window to make these tightening adjustments may again be passing, raising the risk that they will be seen as coming too late.
We also note the possibility that Fed Chair Jerome Powell may be replaced when his term soon expires. While he has received good marks for his response to the pandemic, there are other issues that seem to be driving this decision. While a leadership change can be disruptive, the odds are that his successor will follow similar accommodative policies.
The full impact of the Delta variant was not in the cards six months ago. With the broadening distribution of the vaccines, the reopening play was moving strongly ahead. While this recovery has encountered other obstacles along the way, the surge in COVID infection rates sapped the momentum that was building in the economy, not to mention delivering a blow to our collective psyches.
We can assume that Delta will not be the last variant that emerges from this Coronavirus, but each subsequent variant of the current strain should be incrementally less disruptive to our lives. Spreading vaccinations, superior therapeutics, more awareness of transmission risk, and adjusting to living with the virus all make us better prepared for the next wave. That said, the experience of the past 18 months tells us that the overhang of COVID risk over the investment environment is ever-present.
The striking new rhetoric and restrictive policy activity from China has escalated to a new level, with potential repercussions to global markets. What started as company specific attacks on business practices and growing powerbases of business owners has more recently rolled through entire industries with sweeping changes in operating parameters and corporate missions.
The recent news that Beijing was going to allow property behemoth, Evergrande, to default on their debt triggered fears of contagion and pressured global stocks. These concerns subsided over subsequent days, but the surprise of this development served notice to investors that there was more going on than China backing off its commitment to real estate. At the same time, China’s new focus on limiting carbon emissions is an additional threat to supply chains. Government controlled power usage is shutting down factories and raising the price of input costs.
Beyond regulatory actions and breaking the dominance of many of China’s largest companies, President Xi has signaled a retreat from Western-style capitalism to a more government-steered economy. This shift would likely discourage Chinese entrepreneurial efforts, reduce the flow of foreign capital, undermine further the integrity of financial information, and reduce the growth prospects of the country. Gaining a full understanding of the many implications of this are beyond the scope of this brief summary, but given China’s role as a lynchpin in the global economic growth story, this will undoubtedly impact the growth prospects of other economies around the world.
We add valuation to the list of investor considerations not because we are moving from growth to a value-driven market. We think these swings will remain in play as the economy gains and loses momentum in the current cycle. Rather, it is how investors think about valuation as inflationary expectations push longer-term interest rates higher. No surprise that the recent jump in bond yields pressured highly valued companies and fast-growing tech companies where profitability is projected far out in the future. Valuation metrics will become more relevant if interest rates continue to drift higher.
- Asset Mix: We maintain long-term targeted equity weightings and consider paring back to targets where exposure is extended. The limited fixed income return outlook is unchanged – maintain shorter maturities with a bias to corporates over Treasuries. Consider taxable yields over munis for new purchases.
- Valuation: The recovery in value stocks in the first half of the year reversed in the third quarter, leaving value stocks priced attractively again. The jump in bond yields at quarter-end also exposed the risk of very high multiple growth stocks.
- Economy: A slowdown in year-over-year growth rates was expected, but COVID and bottleneck issues proved more significant than earlier thought. Despite the supply-side constraints and more moderate economic activity, end-user demand remains. A more elongated reopening should still provide good economic growth, along with productivity improvements and the eventual normalizing of the workforce.
- Equity Style: We think there is a good opportunity for value outperformance heading into next year. Confidence should improve as the Delta wave runs its course, congressional tax and spending matters get resolved, and seasonal spending picks up. Growth styles should fare better if the Fed moves more aggressively to control inflation. Longer-term, we expect economic growth to moderate, favoring a growth style tilt and less cyclicality.
- Stocks: Quantitative data shows valuation spreads as attractive, especially in smaller-cap opportunities. Likewise, the Quality factor and high free cash-flow should continue to be positioned well, though much depends of the trajectory of the recovery and inflation. The latest update to Meritage modeling adds a machine learning component that emphasizes the most effective factors.
It is logical to expect more volatility as the environment transitions from an ideal combination of monetary, fiscal, and corporate fundamentals to something less. In fact, the odds of an investment backdrop coming together again like we’ve seen the past 18 months are extremely remote.
We are in the early stages of this transition and from any other perspective, conditions should stay hospitable for long-term equity returns. Despite tapering, the Fed will be adding an enormous amount of liquidity over the next year, interest rates will remain low, Q3 earnings are expected to grow 25%, and economic activity should pick-up as Delta trends level off.
As transitions go, markets will be weighing these attractive absolute levels against the negative change from recent peak levels. At the margin, it is often the rate-of-change perspective that drives the markets. While base investment conditions should remain attractive, stock prices will be discounting the expected change in these conditions over the next year.
It is natural for return opportunities to moderate given the extraordinary period we are emerging from. We also expect market swings will test investors’ conviction during this transition. Strategies to time these swings will be about as successful as they usually are. In this backdrop of increased uncertainty, we believe there will be attractive long-term growth and valuation opportunities at the individual company level and companies will continue to distinguish themselves from their competition. Our processes remain focused on selecting these companies in a portfolio context to add long-term value over and above the investment environment we get.