New Year Cheer, End of Covid is Near?

2021 was supposed to bring an end to the pandemic. Will 2022 finally get us to a place where we can coexist with the virus? Unfortunately, the flip of the calendar won’t solve the pandemic and the world’s problems as we may have thought in 2020. Yet, there is fresh optimism that we will get to a stable place, with the Omicron variant moving at breakneck speeds through the world population, eventually rendering the virus “endemic”. The stock market has certainly continued to reflect this thesis.

As resilient and intransient as Covid has been, the same could be said for the US stock market and earnings growth. Nothing could stop domestic stocks in 2021 – Covid, supply chain issues, inflation, geopolitical risks, the partisan divide in Washington, the Fed’s more hawkish rhetoric, rising crime - the list goes on. The S&P 500 index finished 2021 up 27 percent after a 16 percent gain in 2020. Remarkably, the benchmark index notched 70 new record high closes this year, only surpassed by the market in 1995 when there were 77, according to S&P Dow Jones Indices. The best-case scenario for the US economy going forward is more than priced in.

What continues to drive investment to US equity markets despite apparent risks? It’s a reflection of many factors. Not to oversimplify it, but the excess cash and liquidity from over a decade’s worth of unprecedented loose monetary policy had to be applied somewhere. Higher inflation eats away at cash, ultra-low global interest rates do not compensate investors enough, and the rest of the world has been in a much different place than the United States, economically.

Digging deeper, what also made the US market so attractive was corporate earnings and growth that kept pace with inflation. Profits were unexpectedly strong by many measures and consumer spending remained robust in December and throughout the year, despite weakened confidence. If you prefer investment in a proven asset class as opposed to crypto or meme stock speculation, good old US equities was your best option.

What do we expect going forward, and where do we position ourselves now? We’re focusing on several things in the near term: Supply chains, inflation, Fed policy, tensions with Russia and China, and the global economic recovery from the pandemic. Margins have held strong as companies have been able to pass on higher prices. We do expect inflation and GDP growth to head lower as they normalize, and the monetary and fiscal stimulus runs dry. Fundamentals will start to matter even more and in turn, so will valuations.

If inflation remains high, it will affect consumer confidence and higher prices will eventually hurt profits with a consumer driven economy. The current account deficit has grown larger, and the US dollar has been intractably strong despite the flood of liquidity. Dollar strength could easily continue with higher interest rates. Years of exceptionally easy money policies may have distorted asset classes to a point where if the Fed does not act fast enough in tapering and raising interest rates, we may be in for some pain. At minimum, this should provoke volatility for the US stock market as the central bank tries to thread the needle with tightening policy.

The hope is that the rest of the broad market fills out post-covid, with small caps, mid-caps, and service-based industries having muted returns through the pandemic. This could soften the blow for any decrease in goods demand and growth stock valuations as rates rise. It is akin to the back and forth of the re-opening/reflation trade.

Growth vs value has been a big part of any asset allocation discussion throughout the pandemic; but with capital shifting back and forth between the two depending on Covid news, it makes sense to consider quality and not significantly over- or underweight either factor. I have written about holding quality factor names for some time now, as they tend to do well in slowing growth, high price, and rising rate environments. Strong balance sheets, pricing power, low leverage, and more consistent operating margins will be sought out in volatile times, hence the phrase “flight to quality,” as rates go up and liquidity goes down. We will reflect this factor in our portfolios.

What about the rest of the world? Boring bonds and commodities? As mentioned, the rest of the world is playing catch up to the US. Europe and other developed markets should emerge out of lockdowns with more pockets of value and emerging markets have much lower valuations in both equities and fixed income relative to the US. Countries such as China, India, and Brazil have had higher inflation, slowing growth, and a much tighter monetary policy than the US. This was reflected in 2021’s poor performance for EM indices. Hope is on the horizon though and investing in those markets as they recover will provide diversification and higher yields to pricey US markets.

As we’ve mentioned in the past, professional management overseas is especially important. Many countries, most notably in emerging markets, have vastly different reporting standards, government structures, and transparency. China’s opaque market is probably the best example of this. Having an ESG lens on your portfolio is especially helpful in this aspect as well, implementing a preference for companies with higher standards. Despite the potential for ongoing dollar strength, we expect continued commodity inflation, which strengthens the bull case for EM markets. We have healthy exposure internationally for dividend income, as well as commodity and value diversification.

As mundane as the US Treasury market may seem, things could get interesting at the coming auctions, once the Fed steps away and begins to reduce its massive balance sheet. We still expect the US Treasury yield curve to continue flattening and could eventually invert as growth slows, institutional money moves in, and the Fed tightens monetary policy. If inflation persists, this could be reflected in mid-term rates, assuming the economy hums along and is able to digest higher short-term rates.

Either way, we expect mid to long term rates to stay range bound, and we are positioned with longer dated treasuries for cushioning volatility and diversification against rising short term rates. Green bond floating rate notes will be utilized to reduce duration and interest rate risk. Obviously, yields are still very low across the developed world, so having EM debt exposure makes sense for income enhancement and spread tightening. High yield bonds will be tricky as interest rate volatility picks up and spreads are very tight relative to investment grade/risk free bonds.

Despite the many things out there to worry about these days, there is reason for optimism. With a keen eye, we will continue to monitor market developments and adjust tactically within a long-term framework. Having a well-disciplined and balanced investing approach can give you one less thing to worry about. Wishing you all the best for you, your loved ones, and your portfolio in 2022. Happy New Year!