Overwhelmed with differing market views and economic outlooks? Us too. Headline noise aside, here are some items worth noting with respect to our view of the markets.
Current Valuation Themes
- Over-Valued: US Housing, Cryptocurrency, Lumber, Growth Stocks
- Under-Valued: Value Stocks, Small Cap Stocks, Emerging Markets
Economic Outlook
A little over 12 months removed from the market lows of 2020, we expect a solid global recovery over the coming years. Pent-up consumer demand, low interest rates, and unprecedented fiscal stimulus from governments worldwide will support the recovery. Whether one agrees with monetary policy or the stimulus measures taken is beside the point. As investors, we must embrace the current economic environment and mold our financial plans and investments accordingly.
Monetary Policy
The only word we have for this right now is patience. It appears the Fed isn’t going to hike rates anytime soon. This will continue to put pressure on short-term rates and justify increased equity valuations as investors flock to the stock market instead of low-yield savings accounts. As a result, we’ll stay on the shorter end of the yield curve for principal protection and will increase risk in the fixed income space for yield.
Inflation
We’re currently in 1) a low inflationary environment with 2) expectations of inflation rising. This combination is promising for international developed and emerging markets exposure given their performance in similar inflationary periods. While we’ve been receiving client questions about TIPS, we don’t believe that’s a good strategy. With TIPS, the current price already incorporates expected inflation. This means you will only win if inflation is higher than expected, and we do not believe there is a risk of runaway inflation.
Unemployment
We foresee the unemployment rate returning to pre-pandemic levels by the end of 2022. Unfortunately, current unemployment underestimates the level of economic distress caused by COVID-19. Among those not included in this metric: almost 4 million people have dropped out of the labor force since the pandemic. The pandemic aside, economic growth in decades to come may be slower than in the past due to the volume of the workforce entering retirement, slowing immigration, and increased automation.
Equities
Equity valuations are at all-time highs without earnings that existed pre-pandemic, which will likely lead to compression in high forward P/E ratios. We’ll need to see more stability in the market to be confident about the impact of the Fed’s short-term metrics (stimulus checks) producing longer-term growth. Remember, the weight of the top 10 stocks in the S&P is not aligned with their corresponding earnings contribution, which is an excellent argument to maintain some active management in this space.
Given this outlook, we believe value and small-cap stocks, given their cyclical nature, will outperform growth stocks as the economy accelerates. Maintaining exposure overseas will also remain prudent: international markets have a higher representation of cyclical sectors than the US, which tilts towards defensive and technology sectors.
Fixed Income
The recent recession and easy monetary policy equate to challenges in the fixed income space with low yields and tight spreads. As rates increase, the value of a bond temporarily decreases in value. Given this outlook, fixed income may not provide the same degree of protection as it has historically.
However, there is still a place for fixed income in portfolios given the need for diversification (low or negative correlation to equities). We’re wary of an increased allocation to high yield and long duration bonds as it’s uncertain if we’ll be compensated for the additional risk. Because of this, we are 100% active management in this space. If we look under the hood in our active fixed income products, our models have increased exposure to preferred stock and convertibles to combat the low interest rate environment.
Let’s not forgot that in addition to providing income, fixed income offers stability in the event of equity market turmoil. While it may be tempting to “reach” for yield by reducing the credit quality, high yield bonds tend to follow the performance of equities, which is detrimental when equity markets pull back, as we saw in March 2020.
ESG
For those who believe global warming is a hoax, that’s a tough thesis to support given this data: 2020 was the second hottest year on record behind 2016. With a new President in Washington, we believe there will be increased investment spending, R&D, and regulation on the horizon, impacting this investment approach. In a global context, the investment in storage, electrification, and carbon capture have grown significantly over the past 5 years compared to the 20 years prior, and we expect this to continue.
Cryptocurrency
We’d be remiss if we didn’t mention something on cryptocurrency. It’s been interesting to watch how a single person, or a group of retail investors, seems to have more influence over a decentralized currency than the Fed has with the dollar. However, it’s clear that the crypto market exists because of the Fed’s influence on the dollar and likely the actions leading up to and responding to the Global Financial Crisis. We encourage you to read this article, BofA Global Research: 10 Surprising Faces About Bitcoin.
Conclusion
In our line of work, it’s essential to understand the markets on a real-time basis. However, it’s even more important to distinguish between what’s market “noise” vs. a market “trend” when assessing the strategic outlook of our portfolios. Despite the current disparity in market views, we believe that markets are largely efficient over the long term. Broad-based exposure to multiple regions and sectors of the market is prudent! As investors, we have the choice of optimism or pessimism. If we choose pessimism, staying invested for the long-term will be challenging. We employ cautious optimism and maintain an unwavering belief that the world and the businesses within it will continue to drive growth in the economy over the long term.
Reach out to us today to assess the positioning of your portfolio given our view of the markets.