Shifting Fundamentals Still Point to Higher Rates

There is an old and much-quoted saying by the Greek philosopher Heraclitus:? “A man never steps in the same river twice” – because it is not the same river and it is not the same man.? A very similar observation could be made about investors considering their portfolios as the pandemic, hopefully, begins to wane.? Covid-19, and the policy choices it triggered, changed the economic and financial landscape in a significant manner.? However, it also changed investors, leaving them, for the most part, with larger portfolios but also with portfolios that are more seriously out of balance.

The last two months have seen some further significant changes in assumptions about the pandemic, politics and policy.? However, for investors, the broad implications remain the same.? Earnings growth will slow and long-term interest rates look set to move higher, suggesting limited returns on traditional U.S. equity/fixed income portfolios.? However, there are opportunities in areas of U.S. equity markets, overseas equities, thematic investing and alternatives and a need for investors to reassess their goals and positioning after three years of extraordinary capital market gains which have left them with much bigger but less balanced portfolios.

On the Pandemic, the Omicron surge continues with a record 4.7 million confirmed cases over the past week.? However, there are signs that the growth in cases is slowing, suggesting a peak and decline in cases over the next few weeks.? Importantly, the Omicron variant appears to be crowding out the more deadly Delta variant and hospitalizations, while near record levels, are only 30% of what might have been expected from previous Covid waves.?

Omicron is clearly disrupting economic activity at the start of 2022, with both airline traffic and restaurant bookings dipping in recent days.? We expect a continued drag for the rest of January but improvement in February and, if we are lucky, a very significant fading of pandemic effects in March.??

On Fiscal Policy, negotiations between the White House and Senator Manchin appear to have stalled.? The enhancements to the child tax credit, earning income tax credit and dependent care tax credit have all expired and, even if they are renewed, it is likely to be in a very watered-down form.? The Administration would very much like to pass some version of the Build Back Better bill and there continues to be a possibility of higher taxes on corporations and very wealthy individuals.? However, major fiscal stimulus has ended.

With the Omicron drag and a sudden cutoff of fiscal stimulus, we expect real economic growth to slow from roughly 7% in the fourth quarter to just 2% in the first before rebounding to average about 3% over the rest of the year.? Growth should be helped by a similar post-Covid recovery in the rest of the world, as well as pent-up demand for consumer good and strong capital spending.?

Inflation Pressures continue to be very strong.? Despite a weaker-than-expected payroll job gain, the unemployment rate fell to 3.9% in December, lower than has been achieved 96% of the time over the past 50 years.? Last week’s jobs numbers also showed a record 4.2 million gap between the number of job openings at the end of November and the number of unemployed people in the second week in December.? In addition, the data revealed record low layoffs and record high quits, underscoring the strong bargaining position of workers.?

Wage growth remained very strong with a 5.8% year-over-year increase in the wages of production and non-supervisory workers.? Crucially, with still low immigration and a continued flood of Baby Boomer retirements, we believe that the labor market will continue to be tight throughout the year ahead, maintaining upward pressure on wages.

Other areas of inflation pressure should moderate.? Oil prices remain high with West Texas Intermediate Crude still selling at close to $80 a barrel.? This is partly because many OPEC+ producers are actually finding it hard to produce at the levels set by their rising quotas.? However, at these prices, we expect to see a pickup in U.S. and global supplies in the months ahead, cutting WTI prices to the mid $60s by the end of this year.

Similarly, there are some early signs of improvement in supply chain issues and we expect further improvement in supplies of imports and autos in the months ahead in response to very strong prices.?

Overall, we believe Wednesday’s CPI report will show headline inflation of 7.0% year-over-year, the strongest reading since June 1982.? The first quarter should see an inflation peak with lower energy prices and a decline in food and auto inflation allow for a slower increase in prices for the rest of the year.? However, crucially we expect core PCE inflation only to fall from 4.7% today to about 3.0% by early 2023 and to stay at close to that level for as long as the current expansion continues.

On Monetary Policy, last week’s Fed Minutes underscored the reality that the Fed has now taken a more hawkish turn.? For a long time, they have stated that they would begin to raise policy rates when inflation had reached 2% and was on track to exceed 2% for some time and when they had reached maximum employment.? As they made clear in their December FOMC statement, they now regard the inflation condition as having been satisfied.? Moreover, with the unemployment rate now falling below 4% and wages rising sharply, they must surely also now think that the employment condition has essentially been met.?

Because of this, the fed funds futures market has now priced in a first rate hike in March followed by three more in June, September and December.? In addition, the Fed is actively discussing how it will reduce its balance sheet once it begins to raise rates.? Crucially, the minutes revealed that at least some members wanted to avoid flattening the yield curve and consequently were in favor of a more aggressive policy towards reducing their balance sheet.?

This gets to the single most important issue for investors.? If the Fed wants to tighten monetary policy to ward off inflation, it can only achieve its goal by achieving higher long-term interest rates.? If it wants to raise long-term interest rates, it surely has the tools to do so with a hoard of $5.7 trillion in Treasuries and $2.6 trillion in mortgage-backed securities.? It is, perhaps, this realization which caused 10-year Treasury yield to back up by 24 basis points last week and 10-year TIP yields to rise by 32 basis points.

In addition, both the Eurozone and the U.K. are seeing headline inflation of roughly 5%.? While the ECB is unlikely to raise rates in the year ahead they are phasing out their emergency bond buying program while the BOE has ended QE and has already begun to raise short-term rates.? All of this suggests that last week’s selloff in the Treasury market has room to run.

On earnings, this week marks the start of the 4Q2021 earnings season with six S&P500 firms set to report.? For the first time in six quarters, negative preannouncements exceed positive preannouncements, suggesting less room for upside surprises.? In addition, as we move into 2022, corporate profits should be squeezed by higher wage costs, interest rates and, potentially, taxes, along with a moderation in nominal economic growth.? We expect earnings growth to slow to the high single digits in the year ahead and the low single digits, at best, in 2023.

For investors, these more tricky fundamentals coincide with significant valuation issues.? On the fixed income side, low Treasury yields and tight credit spreads limit income opportunities and add risk to portfolios.? On the equity side, the forward P/E ratio on the S&P500 is 20.6 times, more than one standard deviation above its long-term average.? Combined, this suggests a long-run return on a traditional plain vanilla 60/40 U.S. stock/bond portfolio of less than 4%.

So what can investors do?

First, get active both in asset allocation and security selection.? Value stocks are at some of their cheapest valuations relative to growth stocks seen since the tech bubble.? International equities are selling at a more than 30% discount in forward P/E’s compared to U.S. stocks.? And, within the U.S. equity market, there is plenty of evidence of mispricing, with the spread between the 80% percentile and the 20% percentile in P/E valuations running at almost twice average levels.

Second, look for diversified sources of growth and income.? ESG technologies and a wide-swath of labor-saving technologies are likely to boom in the years ahead as the world grapples with climate change and a shortage of skilled workers.? In addition, international equities and alternatives can both offer better income streams than most developed economy fixed income markets, and,

Third, reassess portfolios.? If an investor had established a reasonably balanced portfolio at the end of 2018, with the weights we show on page 61 of our Guide to the Markets, and gone to sleep, they would now have seen a more than 52% return.? This could radically change their need for income, for growth and for portfolio protection going forward.? However, if they had not rebalanced the portfolio, it would now be significantly overweight U.S. large-cap equities at a time when they promise significantly more risk and less potential return than three years ago.? That is why, for many investors, the most important resolution in the New Year is not just to see how the world has changed but to see how they have changed in their goals, in their wealth and in the balance of their portfolios and to take action to develop a new financial plan for a post-pandemic world.

Disclosure

Any performance quoted is past performance and is not a guarantee of future results.

Diversification does not guarantee investment returns and does not eliminate the risk of loss.

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.