Q4 Quarterly Commentary
As we reflect back on the past year, we realize how fortunate we are relative to many others around the world. In the US, we are on Covid vaccine shots 3 and 4 and many people in developing countries still haven’t received shot #1. From an investment perspective the good news is that it appears that Omnicron is running its course quickly (e.g. South Africa and Britain), primarily because of its ease of transmission. This seems to be a continuing trend of the ongoing variants, meaning as more of the population has been infected and/or vaccinated, the time of the waves and the severity of the illness has been lessening. We believe this phenomenon is a positive for the stock market in general, as well as specifically for a resumption of economic and social normalcy. That said, investor sentiment has turned negative into year end as investors are focusing their attention on inflation. The economy had a strong year, albeit off a low base in 2020, but there are still service and travel industry sectors being impacted by Covid and that should lessen over time. It will be interesting to see how workforce and consumer behaviors evolve and how that impacts these sectors. During the year companies with pristine balance sheets, solid market share, and pricing power, continued to generate significant profits. Increasing profits and an extremely accommodating Federal Reserve led to another year of strong US stock market returns, hitting multiple new all-time highs throughout the year.
However, we now find ourselves at a crossroads: the Federal Reserve has signaled their intention to wind down monetary stimulus and is currently forecasting 3 interest rate hikes in 2022; inflation continues to rise, furthering the divide between the haves and the have nots; and economic growth, while currently very robust, will likely slow as the Fed tightens and the second half of 2022 may have a more challenging year over year earnings comparisons. The balancing act between economic growth and inflation may likely be one of the major stories of 2022 as the Fed’s resolve to apply the brakes will be tested.
At the same time, the new Covid variant Omicron continues to surge throughout the US and the rest of the world causing widespread disruptions to staffing, store closures, supply chains, and potentially creating a new healthcare crisis. On a more positive note, wages are rising, unemployment is back to pre-pandemic levels (although more people are leaving the workforce at a record pace, a phenomenon being dubbed “The Great Resignation”1 and current vaccines seem to be mitigating the severity of Omicron. As the government subsidies have ended and Fed stimulus is supposedly subsiding, we will have to wait and see how this “tug of war” plays out.
Our focus on your family’s financial well-being has been a respite from this day-to-day dystopia, and we are especially honored during this time for the trust and faith you continue to place in us.
The re-opening of global economies and a return to a more normalized lifestyle in much of the developed world has led to a significant increase in economic activity. This backdrop, coupled with continued historically low interest rates has proven to be a productive environment for stocks during the final quarter and full year of 2021 as US Stocks (as measured by the S&P 500 TR Index) were up 11.03%2 in the fourth quarter and 28.71% for the year, and Developed International Stocks (as measured by the MSCI All Country World ex-US TR Index) were up 1.49% in the quarter and 7.48% for the full year2. However, US Bonds (as measured by the Barclays Intermediate Aggregate Bond TR Index) finished -3.48%2 on the year as the Federal Reserve indicated a tightening of monetary policy and interest rates rose from 0.91% on the 10-year Treasury to 1.80% by the end of the year2. As a refresher, generally bond prices and interest rates move in an inverse relationship so as rates rise, bond prices decline.
This outcome was driven primarily by successful vaccine rollouts and unprecedented amounts of global stimulus. As we have mentioned in the past, we agree that the monetary and quantitative easing was necessary to address the economic disruptions caused by the pandemic and to maintain stability in the markets. That said, there is a feeling that we are now in an endless cycle where central banks will permanently backstop the financial markets. This does change the complexion of the risk characteristics of assets which is something we need to be mindful of.
However, there is an old saying in the financial markets “Don’t fight the Fed.” This means when the Federal Reserve is flooding the economy with money and buying financial assets, it’s a good idea for investors to follow their lead. This time has been no different. Moving forward, as the Fed signals it will begin to reverse their accommodative position, we will have to wait and see how this all plays out. We believe the highest probability is that one of the following scenarios will ultimately occur: either the Fed will raise interest rates and push the economy into a recession which will in turn lead to a reversal and a lowering of rates, or the Fed is so behind the curve and inflation is worse than expected that they will have to continue to raise interest rates more than the market anticipated.
At some point it’s fair to believe the economy will stabilize (it always has in the past). However, with the enormous amounts of stimulus injected into the economy, unsustainable US debt levels, and an evolving construct in workforce and consumer behaviors – what that “new normal” will be is still very much evolving. There is, and always will be, something to analyze and dissect on a day-to-day basis when it comes to markets and investing, but we will not be distracted.
Inflation has become the major discussion point for the markets as the year came to an end as CPI and PPI have been increasing at a 7-9.7% annual rate, the highest levels in 30-40 years. As this has proved to be more than transitory as the Federal Reserve had been declaring, it has also caused the Fed to reverse course and announce that it will speed up the pace of unwinding its monetary stimulus and interest rate increases in 2022. This unwinding comes in the face of a labor market that, from an unemployment rate, is back to pre-pandemic levels, where weekly jobless claims are at near all-time lows, and where corporate profitability continues to surge. At the same time, fiscal stimulus measures have ended, inevitably creating a furthering gap between the fortunate and less fortunate, and individuals are leaving the workforce at the greatest pace we have seen in years. As fiscal stimulus dies off, perhaps that will encourage this trend to stabilize and reverse since many businesses are suffering from staff shortages and empty shelves, thereby impacting their bottom lines. How this all plays out for the markets, for the economy, and for corporate profits remains a significant wild card that we are watching closely and following our rules-based investment discipline so as not to let emotions take hold of us.
This type of backdrop is exactly why we don’t try to predict what the markets will do in the short-term as it is a fool’s game in our professional option. Instead, we will continue to focus on long-term macro trends in our asset allocation and portfolio strategies, knowing that we are prepared to implement our proprietary risk management approach to seek to navigate whatever direction the market takes. Until then, we will continue to be grateful for the market’s resiliency and seek to attempt to actively position client portfolios to capture what we believe will continue to be their fair share of risk-adjusted future returns.
What Have We Done
From an asset allocation standpoint, the biggest changes in our Managed Volatility Growth and Balanced portfolios YTD has been a reduction in exposure to Emerging Markets. Those markets have faced significant challenges from foreign governments (in 2020 China was the primary culprit), choosing to impose their will on corporate activity It has also resulted in the delistings in the US of companies like Didi (Uber of China), and created investment challenges in avoiding “who’s next.”
From an equity standpoint, our US and International strategies have not shifted dramatically during the quarter and continue to focus predominantly on the long-term macro trends we believe will be paramount moving forward such as: decarbonization and green energy (wind, solar, rebuilding the electrical grid, and electric vehicles), technology and science innovation, digital transformation in consumer and business behaviors, infrastructure, and the reopening trade. More specifically, many of the companies in the sectors hardest hit by the pandemic, like hospitality, financial services, and consumer discretionary, are re-emerging, however, not all of them have fully reopened or recovered to pre-pandemic business activity. The past quarter, a more hawkish Federal Reserve and rising interest rates produced a noticeable headwind to many of the high growth company stocks we own as valuations are most adversely affected by this. It has also caused increased trading activity in the portfolios as individual securities have triggered our sell discipline. We have been deploying capital selectively when we see opportunities based on our long-term macro trend thesis and in some of the companies where we believe post-pandemic realities are not currently reflected in their stock prices.
It is also worth re-addressing the underperformance this year of the international markets in general and our Managed Volatility International Large Cap strategy as a whole, compared to its underlying benchmark (which is a sleeve within some of your portfolios). While we continue to believe that the international markets are an important component of a prudently diversified portfolio and the current valuations are more reasonable in general than many parts of the US equity market, they have been challenging. The regulatory crackdowns by the Chinese government on several of their largest US listed companies has caused confusion and significant declines in many of these stocks. We have been reducing our exposure to China during the first three quarters of the year but maintained it, at reduced levels, during the fourth quarter. Nonetheless, the international markets and our strategy were impacted. In addition, with the uneven rollout of Covid-19 vaccinations, varying degrees of impact from the Delta variant, and multiple economic and political agendas among the developed European countries, there has been a divergence in performance within those countries and the stocks we own.
Despite this, we are not altering our overall weighting to the asset class, and instead have been active in taking advantage of the opportunity to reallocate into quality companies that are in line with the long-term macro trends we believe will continue to materialize moving forward.
Additionally, an area of the portfolios that we addressed last quarter was the introduction of digital assets in our investment portfolios. While there was heightened volatility in the asset class in the fourth quarter due to a reduction of risk across all markets in general, we maintain our conviction in the long-term benefits and transformational aspects of this asset class in general and bitcoin in particular. We maintained our exposure throughout the quarter and will tactically look for opportunities to rebalance the weightings back to their original allocation. We believe we are still early in the use case adoption phase, and as bitcoin specifically begins to gain institutional and retail investor portfolio adoption, we believe we will see significant long-term appreciation in the asset. However, the volatility, in our opinion, will continue to be significant both up and down; it is the cost we pay for the long-term opportunity. This volatility is also something we are working to address and will be rolling out new investment solutions soon that will incorporate various risk management approaches that seek to minimize the drawdowns and enhance risk adjusted returns.
Bonds remain the final hurdle for investors to digest in a higher inflation and interest rate environment. Traditionally, bonds are used to diversify away risk and to act as a ballast to investor’s portfolios, and that works well in a stable or declining interest rate environment. However, as rates rise, bonds become more of a liability in investor portfolios and we have systematically reduced our exposure to bonds across the entire rate curve to seek to protect client capital. Since the early 1980’s interest rates have declined from the mid teens to near zero today. As a result, bond prices which tend to move in an inverse relation to yields, are at historic highs. With the unwinding of fiscal and monetary stimulus, rates should move higher; how much is yet to be determined. Regardless of how the Fed proceeds, we acknowledge that we are in for an abnormal bout of volatility as the market adjusts to a new normal. The fact of the matter is that trying to make money based on guessing what the Fed is going to do is a losing strategy as the Fed can change direction quickly to respond to financial conditions, and has often done so in the past. Maybe this time is different, and inflation will finally force some degree of responsibility back into monetary policy, or maybe it won’t. The conundrum facing the Fed this time around is that they will be challenged to normalize rates (~6.5% on the 10 year Treasury historically), due to a combination of debt, demographics and the wealth effect. With 130% debt to GDP and the US and world relying on the dollar as its reserve currency, even if we perform some sort of operation twist, we will have a hard time seeing rates normalizing above inflation. Ultimately, this plays into our thesis that the Fed will have no choice but to continue to debase the dollar keeping the US in a negative real rate environment. Historically, this has been a bullish backdrop for asset prices. We believe stocks, commodities, real estate and digital assets should all do well as bond holders either suffer losses or own an asset that is producing a negative real return. We will continue to actively monitor the situation, but the risk-reward characteristics of bonds, in our opinion, are not currently attractive.
What Comes Next?
After a number of constructive years for the equity markets, it would not surprise us if 2022 was a more challenging year with increased volatility, especially in the first half. Historically, the markets experience at least one 10 to 15% drawdown during the course of most years, yet we didn’t have one last year and 2020’s Covid crash was fierce but short lived. We also have mid-term elections this year which may have a significant impact on Government policy and spending. However, once we have greater clarity around Fed policy and the election, we believe the markets should settle down which could lead to further gains into year end.
Despite this backdrop, the long-term structural characteristics of our investment themes remain intact and continue, in our opinion, to gain steam. We believe the market will return to a focus on fundamentals and that stock selection will be more important than in prior years. It seems unwise to try to guess what the Fed will do in 2022, but one thing seems pretty certain – the great liquidity spigot that overwhelmed fundamentals and propelled meme stocks and others up significantly in 2021, will almost certainly not be flowing this year. While this will likely present a challenge in the first half of 2022, it doesn’t necessarily mean that equity markets need to go through a serious decline. That liquidity is still sloshing around in the economy, and eventually it will need to find a home. What seems more likely is that assets get re-rated as investors preferences shift from a world dominated by narratives to a world in which fundamentals suddenly matter again. In fact, we are already seeing signs of this as many of the frothy tech names and posterchildren of COVID-era liquidity (Zoom, DocuSign, and Peloton as examples), are being re-rated in real time. Companies with pristine balance sheets, dominant market share, and pricing power appear to be more stable.
As a reminder of our core investment principles, we don’t try to predict the future, we prepare for it. In other words, we use our Dynamic Cash Allocation® to adjust our risk exposure between cash and investment assets. This systematic rules-based approach eliminates emotion from our investment process, allowing us to focus our attention on asset allocation, long-term thematic trends, and individual investments. With the enormous amount of government stimulus over the past two years, and pent-up demand as a result of Covid, economic growth remains robust and operating leverage in our portfolio holdings is high. This combination usually results in productive equity markets.
We remain confident heading into the new year that our conservative, rules-based approach will help us continue to navigate the impending uncertainty. As we have mentioned before, we believe that many financial firms will not be properly positioned for what lies ahead. In our opinion, traditional forms of risk management, such as portfolios that rely heavily on bonds, or equity strategies that take a buy and hold approach, may not provide the risk-return characteristics investors have come to rely on.
Please feel free to share this market commentary with those you believe would benefit from it and know we will do our best to be available to assist anyone you refer to us. As always, we know and respect the enormous amount of trust and faith you have placed in us, and I assure you we are more than up to the task. Please feel free to reach out at any time – we are all here for you and eager to assist however we can.
& Chief Investment Officer
1) Source: https://www.linkedin.com/pulse/what-great-resignation-william-meller/
2) Source: Ycharts
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