What got us here, won’t get us there…
The more recent elements that got us here (“here” being new record highs in market indices, record low interest rates, an expensive stock market led by tech sector concentration, unprecedented fiscal and monetary policy, and the gradual and imperfect climb out of the pandemic) are mostly unlikely to be sustained. Strategy requires considering who will be the winners as we move through more predictable changes ahead of us.
What we see as strategic success for investors: value-added results, alignment with better opportunities, effective risk management, meeting your individual, personal goals.
Why won’t it get us there?
2020 was a one-of-a-kind, probability defying, freakish type of year. For the only time ever, the economy went down while the market went up. (Worst GDP performance since 1946.) The economy’s performance in 2021 was worse than in the horrible markets of 1973-74, 2000-01, and 2008-09, the average market decline for these periods was -40%2.
What made 2021 such a notable exception? The combined contributions of the remarkable, unprecedented fiscal and monetary stimulation. Fiscal intervention of $2.7T in 2020, plus $900B in tax relief, another $2T in 2021, securities purchases of $2.7T in 2020 (73% Treasuries and 27% mortgage related) and another $1.4T for 20213. So, a $500B hit to the economy was offset by $5.6T of government spending and $3.7T of government asset purchases1. Then consider the various loan forbearance and other credit deferment programs. Our perspective is that intervention on this scale is unsustainable, getting off this juice is complicated, and there will likely be an economic intervention hangover that follows the intervention binge.
Remarkably, the market narrative largely seems unconcerned with any potential consequences of the stimulus. To which we respond that the market narrative is a trailing indicator and the fact that a fuse is burning is not an issue for the narrative unless and until the stick of dynamite explodes. Our approach is a bit different in that we think investors should observe there is a fuse burning.
Before this analogy gets taken too literally, please know that we are not forecasting impending doom or another recession. We anticipate:
▪ A shift from immodest Index returns (from 4/1/20 to 6/30/21, the S&P 500 Index rose 74%2) to more modest Index returns resembling something like the rate of earnings growth.
▪ Interest rates will rise in a regression to the mean when the Fed tapers asset purchases. This portends rising rates even when the Fed does not yet increase the discount rate.
▪ Stocks get repriced when interest rates rise. If your portfolio is populated with quality companies trading at reasonable prices, this is not much of a risk. If an Index is dominated by premium and super premium priced businesses, that is more of a risk.
▪ The bond market faces a rising interest rate headwind, probably over a period of years.
▪ The economy continues in expansion mode, creating ample opportunities, even in this changed environment.
The episode ahead will likely see more significant contributions from economically sensitive sectors like industrials and financials (per usual during an expansion), and while the tech sector will continue to thrive and be critically important to the economy, it is less likely to dominate the stock market. We have worked to position for these adjustments in our strategy and in our portfolios. We expect our discipline of investing in reasonably priced, quality companies with better growth will provide better results.
For fixed income investors, we take confidence from the positive results in our bond strategies in the first half of the year, concurrent with negative returns in many bond indices, and that our defensive approach in fixed income can pass the stress test of rising interest rates. In that we anticipate we are at the beginning of a several year cycle in which interest rates will increase, we think this is an important strategic difference.
Our perspective continues to be that “the light is green, and the road will be winding.” Selective investors can find reward, and the progression will be more like two steps forward then one step back. Be ready for new challenges amidst this changing environment.
1 Source: https://www.forbes.com/sites/mikepatton/2020/03/30/how-stocks-performed-during-the-past-6-recessions/?sh=347d2155339d
2 Source: FactSet , 6/30/21
3 Source: https://www.bloomberg.com/news/features/2021-06-01/stimulus-checks-2021-is-government-cash-as-economic-policy-here-to-stay