The last few months have brought about some important changes for the global economy and financial markets. Global economic growth slowed a tad, and the Federal Reserve is moving towards a tighter monetary policy – sending interest rates climbing higher. Inflation data continues to be significant, most recently in the prices of oil and gas, while China’s policy toward publicly traded entities has taken a turn for the worse. Given all of these potential headwinds, we are surprised that equity markets haven’t fared worse than the (so far) mild 6% correction in equity markets. However, we believe that each of these changes will lead to an essential transition for macroeconomic markets that all investors should carefully consider.
As we have learned from history, if not recent years, all markets are discount mechanisms for future movements in economies, stock, and bonds. As the theory holds, investors collectively buy or sell securities in anticipation of future changes – hence the term "markets are never wrong." Within this context, one must take the significant changes in central bank policy and inflation data and determine where the global economy is headed next. In anticipation of these changes, we must position portfolios and our expectations accordingly.
As you know, our team marks the COVID recession as the end of the last business cycle and the ongoing recovery as the start of a new cycle and bull market – and all the data points support that view. As in prior boom-bust cycles, central banks and the US treasury poured an excessive amount of liquidity into the system, which, in turn, prevented the economy from falling into the abyss and caused a melt-up in stock prices as investors anticipated better days ahead. The past 15 months share a lot in common with the 2009 recovery and the ensuing new business cycle that started in that year. Particularly the significant rise of equity prices during the ‘09-10 period and that of the past 15 months – mostly driven by tons of liquidity and investor’s rampant "fear of missing out (FOMO)." So what’s next?
Our research regarding economic cycles and markets shows a global economy that has reached cruising speed. There is little left to stimulate an acceleration of current, already above-normal economic growth. However, consistent economic growth - uninterrupted by another "black swan" event should be welcome to all investors! This is the stuff that allows business cycles and bull markets to have sustainability. This particular cycle may have a higher long-term cruising speed than the previous cycle – which would be welcome after the sub-par growth of the past decade. So what does it mean for the stock market?
Global Equity Markets
Global equity markets have provided a "unicorn" style gift of massive returns coupled with very little volatility over the past 15 months. In our view, global stocks will continue to outperform other asset classes but at a slower pace than the trajectory of the recent past. Probably much more in line with historical annual returns of 8-12% – still the best game in town! This makes sense, given that most folks who were underinvested are now fully invested. Moreover, future corporate profit growth is past its recovery stride and has also reached "cruising speed." From here, the "easy money" has most likely been made, but our team is up to the task of this transition. Lastly, in terms of future equity returns, we think investors should prepare for a bumpier ride. The mild market corrections (3-4%) of the past 15 months have been followed by market recoveries – now that the recovery phase has passed, prepare for the 10-15% market swings that occur in regular bull markets. We know many investors have been lulled into this fabulous, low volatility market recovery, but such smooth sailing is not normal, and it is unlikely to continue – so buckle up and enjoy what we look forward to as a continuation of this bull market.
In terms of sectors and stock selection, this phase of the economic cycle should be gentler to a broader mix of industries. For instance, consumer staples and healthcare have been neglected during the recovery phase. We think we will see a rotation to these sectors, as well as, a market that is generally more inclusive. Our research also says higher rates ahead. This can benefit banks and punish sectors such as utilities, so investors would be wise to do their homework regarding sector exposure and stock selection in this changing market landscape.
Global Fixed Income Markets
Change was in the air at the Federal Open Market Committee’s (FOMC) September meeting, and there is a growing consensus among Federal Reserve (Fed) officials that the economy has strengthened enough for them to consider veering from their current policy course. The Fed has taken broad, accommodative monetary actions in response to the COVID pandemic. Most notably was their swift action to cut their lending rate to near zero and reengaging their large-scale asset purchase program, often referred to as Quantitative Easing (QE). As we have discussed, this "easy" monetary policy has helped provide stabilization and stimulate the economy.
Lately, the strong employment and economic data are starting to align with the Fed’s framework and goals of providing maximum full employment and a 2% average inflation rate. While more substantial progress is needed for the Fed to raise rates, don’t be surprised if they start by reducing the scale of their bond purchases sooner rather than later. This reduction is known as "tapering." The Federal Reserve has been very transparent about its potential moves, so we do not envision market turmoil as we witnessed in 2013 when we were in a similar transition phase.
Overall, our research suggests that consistent economic growth with inflation pressures will lead the Fed to raise rates in anticipation of this healthy business cycle. For individual bond buyers like our team, this is wonderful news! Since we primarily invest in individual bonds with maturity dates, we don’t have to worry about the effects of rates moving higher since we get a return of capital at maturity. Moreover, a higher rate environment will allow us to lock in higher, more attractive rates in the future!
The Danger of Bond Funds
The risk for investors is in bond funds and long-maturity bonds. It has been decades since investors have seen a meaningful increase in interest rates. Long-dated bonds and bond funds can decline precipitously during these rate cycles, so as we like to say, "Don’t let your friends and family own a significant amount of bond funds or long-maturity bonds!"
Active Risk Management
We are optimistic about the intermediate future of financial markets – though with an understandably more muted tone than the past 15 months. Nonetheless, suppose our view becomes interrupted by a resurgence of a virus variant or other unexpected event that might reduce global growth. In that case, our Active Risk Management process will "kick in" to mitigate your portfolio from a catastrophic decline. As you know, this process includes our flexibility of reducing your stock exposure, management of your sector exposure, and the use of carefully placed stop-loss orders.
We hope you find this quarterly update helpful, and if you have experienced any significant changes in your finances or have any questions feel free to let us know.
From all of us on the team, we thank you for your vote of confidence in our work!
If you know of friends or family that can benefit from a no-cost portfolio review, please do not hesitate to reach out.