Looking back at 2021, markets have performed as a textbook case study of an economic recovery. Equities performed strongly as valuations improved with strong earnings. Fixed income assets performed poorly as yields rose from very depressed levels. But there was nothing textbook-like about last year’s recession, the recovery, nor the ensuing cocktail of monetary and fiscal policies.
Investors continue to face the challenge of forming expectations at a time when disruptions to economic activity are unprecedented for peace time. Supply chain disruptions are impacting production as well as prices around the world. Labour shortages are evident in some sectors, as labour participation rates have shifted. Consumption patterns have also shifted because of consumer caution, as well as excess savings built-up during lockdowns. Covid-19 is evolving with new variants that are impossible to predict. None of these factors are likely to be resolved following patterns of past economic recoveries.
While it is difficult to have a high degree of conviction regarding the trajectory of real economic activity, one can have a higher degree of conviction regarding the trajectory of policies. Fiscal policy in almost all countries will turn contractionary next year. In part, this is because the exceptional stimulus measures will come to an end in many countries. But this is also because governments in most advanced economies are contemplating, or enacting, revenue raising measures. This could be to better manage debt levels, upgrade infrastructure, or to achieve politically expedient income redistribution objectives.
Monetary policy will also move away from being stimulative, though it may not necessarily turn as contractionary as fiscal policy. Whether Fed policy turns contractionary or simply neutral is a complex question for two reasons. First, the strength of the underlying inflationary dynamics is not clear. Second, because so many economic variables are unusual, currently, it is difficult to estimate the “neutral” rate of interest. Indeed, we note that the Fed has not been updating its estimates of the neutral interest rate for more than a year. This implies that Fed policy is operating within an environment in which errors are likely.
Where do we think inflation is heading? The Fed has clearly moved away from suggesting that the current bout of inflation is purely transitory. The Fed is right to be concerned. The dispersion of inflation across different sectors is low, suggesting that price increases are impacting a wide range of goods. Additionally, there is evidence that inflation is changing consumer behaviour and wage negotiations. This will imply that an underlying inflation momentum is building.
Structural changes support inflationary pressures. Businesses are prioritising resiliency over cost minimisation. Recent disruptions have heightened the desire to reduce reliance on global supply chains. Labour force participation has fallen from pre-Covid levels, tightening the labour market and heightening the possibility of wage pressures.
The Fed needs to act to prevent inflationary expectations from getting out of hand. But given the difficulty in estimating the neutral stance of monetary policy at this time, there is a high risk that the Fed will act either too late, or too fast.
Where does all this leave investors at the start of the year? A combination of net negative stimulus, declining profit margins and high starting valuations provide an unstable footing for risk assets going in to 2022. Decelerating GDP growth and inflation is an environment that would typically warrant defensive positioning, with larger fixed income allocations. But low starting yields and fixed income valuations that are distorted by central bank policy makes recommending the asset class challenging.
Allocating to equity markets is not without its challenges either. Equity valuations are high because fixed income valuations are astronomic. Concentration risks have also increased as some companies have grown. The five largest companies in the S&P 500 are now close to 24% of the index, double the share of just 5 years ago. The problem with this level of concentration is that developments in a few companies can have an outsized market impact. The last time the market was as concentrated was in the 1970s, hardly an era associated with strong market performance.
This implies that the best strategy for equity investors is to significantly increase diversification, across regions and sectors. Historically, equity sectors such as health care, consumer staples and utilities have fared well during periods of slowing growth and inflation. But it would be imprudent to shy away from certain technology stocks, particularly as some of those have become cash-rich, predictable revenue generators.
Looking across regions, valuations in Europe and Japan continue to look attractive on a relative basis. In emerging markets, however, policy challenges are likely to linger. In particular, China’s policy pivot is far from complete. Heavily indebted economies in Latin America and Africa are likely to underperform in an environment of rising rates.
All of this implies that while we continue to be heavily invested in equities, we find it difficult to be comfortable without looking for other alternatives. We continue to increase allocation to hedge funds and private equity. Among the strategies to which we are increasing allocations, are high quality income replacement strategies across private markets, such as leasing or royalty funds.