Economic Recovery Is Upon Us and a Return to a ‘New Normal’ Awaits
Global stock markets have been anticipating economic recovery and re-opening since the announcement of vaccinations hit the news last November, and the second quarter showed continued progress. Strong employment data, shortages of goods and services, low inventories, lengthening lead times, and firming prices underpin what has been the strongest economic recovery since the early 80s.
As detailed in last quarter’s Capital Markets Review, these conditions have been largely underwritten by the combined efforts of the Federal Reserve and the supernormal fiscal response from the U.S. Congress. Now, the need to sustain these enormous levels of government-provided stimulus is fading, and growth from continuing fiscal and monetary support may already be past its peak. Early evidence of this can be seen in the scaled-back size of the proposed infrastructure bill and the offsetting impact that proposed tax increases would have on its stimulative effects.
While we’re currently enjoying the best of the early-cycle, stimulus-driven recovery, beginning in the third quarter, consensus GDP forecasts decelerate and ultimately narrow to less than 2% on an annual basis (as Chart 1 shows). While many economists expect this deceleration process to be orderly, that’s likely to depend on inflation, which plays a key role in dictating the long-term interest rate outlook. A rising-rate environment stemming from persistently higher inflation data could potentially threaten this outlook and result in much greater volatility in global financial markets. We incorporate each of these scenarios into our risk modelling and portfolio construction process.
Earnings Look Great Now, but Fundamental Support is Fading
While the economic backdrop has provided tremendous support for the short-term earnings outlook, the consequences of government action and the prospect of waning support have yet to be fully discounted by the financial markets. Corporate earnings are likely to follow a similar trajectory as economic projections. The level of earnings growth continues to look quite healthy through the end of the year, and current headlines will trumpet this strength. However, a pronounced slow-down in this rate of growth is widely expected in 2022 and 2023 (as shown in Chart 2) as government stimulus subsides.
Without large amounts of new economic stimulus, earnings are likely to struggle to grow at historical norms over the intermediate to long term. This combined with expensive valuations for most global asset classes has industry observers expecting a low-return environment for the coming decade. Chart 3 is illustrative of these expected returns (net of inflation).
Source: Research Affiliates, 1/31/21
This low-return environment is likely to be very challenging and look nothing like the previous decade. Investors who pursue a strategy that establishes a diversified portfolio of assets with fixed weightings are likely to be disappointed. Based on expected returns, there are simply no assets that one can blindly hold through the next decade and achieve success. In fact, U.S. large-company stocks and intermediate-term bonds, typically the largest holdings in many portfolios, are widely projected to have flat-to-negative returns after inflation. Also, with valuations for most assets at very expensive levels, there could be bouts of great volatility as prices move to more normal levels.
A Dynamic Process is a Must
To succeed, investors will need to have clear objectives and manage to those objectives. To us, this means achieving high-quality, absolute returns with lower volatility and protecting portfolios from large losses from which it can take many years to recover. Also, understanding what constitutes a quality investment is paramount. Since investing is essentially about owning the future cash flows of an asset, in our view, one wants to buy them at a market price that will yield an acceptable return with a high level of certainty.
Since not all assets will be attractive all the time, a dynamic and discerning management process will be essential in our view – one that captures pockets of opportunity and avoids pockets of unwanted risk. Making these judgments will require a deep understanding of an asset’s future cash flows and how tomorrow’s economy might impact them. Further, having a valuation level clearly in mind where an asset is no longer attractive and it’s time to move on needs to be clearly established.
In our view, executing this process with excellence demands the full attention of a sophisticated investment office. A team with depth and breadth of global asset experience, executing an investment discipline rooted in exhaustive research and deep continuing analysis. One that chases down every possibility while exercising true collaboration and a willingness to challenge one another to get to the best outcome. That’s what our Portfolio Management Group does every day.
Current Portfolio Holdings
We continue to search for value among global assets. In the equity markets, our emphasis remains on large, economically sensitive value stocks. These companies have experienced strong profit recoveries since last November and, through the end of the second quarter, have been among the best-performing stocks year to date. Further, these companies are among the best business franchises in the world, and even with the prospect of slowing economic growth, we feel their valuations are attractive. We will look to add to our positions as earnings progress or if there is a meaningful pullback in price.
In the bond market, we expect continued firmness from trend inflation to lead to higher interest rates and lower prices for intermediate to long-term bonds. Therefore, we continue to favor safer, short-term maturities as inflation pressures persist.
Thank you for the continued privilege of managing your portfolio. We always welcome your questions and observations. Please feel free to reach out to us at any time. We are here to serve.
Framing Valuations Through the Eyes of a Baseball GM
Or How to Avoid Paying Too Much for the Past
Making quality investment decisions relies heavily on the starting valuation. Determining the appropriate P/E for a stock, sector or asset class may seem like a mathematical or scientific endeavor, but there’s an important element of human behavior that swings between skepticism and confidence over long periods of time. As a result, investors can unknowingly express their greatest confidence at times when they should not, leaving them vulnerable to disappointment.
A Major League Baseball general manager (GM) is frequently confronted with a similar challenge when considering contracts for free-agent players. The GM has two primary tasks: 1) to develop a set of expectations for a player’s future and 2) to determine an appropriate price to pay for that anticipated performance. It’s a real-world example that illustrates how a disciplined valuation process can apply just as easily to portfolio management as it does to other endeavors.
Albert Pujols’ free agency signing just prior to the 2012 season serves as a terrific analog. In the first 11 years of Pujols’ sure-fire Hall of Fame career as a St. Louis Cardinal, he was a 3-time MVP and finished in the top 10 in MVP voting every year. As his contract came up for renewal, he became a free agent and the Anaheim Angels agreed to pay him $30 million per year for the next 10 years. This was an exorbitant sum at the time, and it was predicated on a continuation of his exceptional performance. The Cardinals could have matched the Angels’ offer, but they elected to pass.
Mr. Pujols never finished in the top 10 in MVP voting again and obviously didn’t deliver commensurate results for the Angels, who never managed to win a playoff game during his tenure with the team. They continue to pay his salary today while he finishes this season playing for the league minimum as a Los Angeles Dodger. This is a clear example of paying too much for past performance and just how detrimental it can be.
At its heart, this is an issue of ‘behavioral awareness’ that can easily be translated into the portfolio-construction and risk-management processes. Many of today’s leading growth stocks are well-known technology companies that have provided historically strong returns over the past decade. Current valuation multiples are now 2-3 times higher (and, in some cases, 4-5 times higher) than they were a decade ago. Even if they’re able to continue delivering great results, returns will be far less based on starting valuation; but the sustainability of those trends looks increasingly more difficult.
Many investors today are betting more heavily on growth stocks than they realize through the continued purchase of index funds. We believe that paying high P/Es for previous performance could well be akin to betting on Albert Pujols halfway through his career. Our quality compass is aligned with the management style of the St. Louis Cardinals, as we’re willing to pass on what we view to be overpriced equities and focus our efforts on high-quality cash-flow opportunities that will enable us and our clients to meet objectives.
Charlie Munger of Berkshire Hathaway fame once said, “I didn’t get rich by buying stocks at a high price-earnings multiple in the midst of crazy speculative booms, and I’m not going to change.” Whether you’re a baseball club or an individual investor, that kind of discipline is necessary in certain market environments, and it’s particularly essential to keep top of mind with all the government-induced liquidity pressuring valuations higher today.