Inflation, Interest Rates and Volatility
2021 was another strong year in financial markets as domestic equities again delivered outsized returns and significant relative performance. With domestic equities positing three extraordinarily strong performances in a row, we feel strongly that a significant amount of future returns may have already been realized and that performance going forward may be muted as a result. Additionally, volatility throughout 2021 was well below historical norms which appears to be driving a sense of complacency that investors need to be cognizant of as it is likely to end abruptly and be replaced by a period of elevated volatility. We believe that the broad financial markets will need to navigate three major areas of concern during 2022 — elevated inflation, rising interest rates and an uneven global economic recovery as the COVID-19 pandemic transitions to endemic status. Investors need to be prepared as these hurdles point directly to higher volatility.
First, inflation is elevated at current and will likely remain so throughout the first half of the year with the potential for moderation in the back half of 2022 and into 2023. Numerous issues are to blame including: the extraordinary levels of stimulus by the US Government and accommodation by the Federal Reserve Bank to combat the economic impact of the pandemic; global supply chain issues impacting nearly everything from high-priced durable goods to lower-cost consumer staples; and labor shortages in nearly every industry as the US labor participation rate continues to disappoint as compared to pre-pandemic levels.
Second, the Federal Reserve has pivoted to a more hawkish stance over the past few months to combat inflation that proved to be persistent than originally thought. While the Federal Open Market Committee’s definition of transitory has evolved, we believe that the elevated level of inflation will last longer than most anticipated and that it is likely to stabilize at a modestly higher level than what people have become accustomed to over the past several years. As a result, monetary policy must adjust to this new paradigm and this portends the ongoing tapering of the Fed’s asset purchasing programs, increasing interest rates and eventually the reduction of the central bank’s massive $9 trillion balance sheet. To be sure, these are all necessary steps in the right direction as the over-stimulation of the economy for the last decade could not continue indefinitely, and it allows the Fed to reset in preparation for the future should economic conditions deteriorate.
Lastly, an uneven global economic recovery is likely to drive volatility throughout 2022 as regions of the world reopen at different times and with varying degrees of success as the pandemic transitions to endemic. As this transition occurs, demand will rise, supply chain issues will resolve, and a more even underlying business environment will take hold setting the table for mid-stage economic transition.
Our predisposition is neutral with respect to our allocation to equities and fixed income as we believe risk/reward is balanced over the next year. Within equities we see a modest transition towards value and away from growth stocks as a cyclical rebound across the broader economy takes hold. Energy, financials, industrials and materials should benefit most in this environment while long-term secular growth areas of the market are likely to continue to advance on a relative basis. Traditional fixed income (fixed coupon, fixed maturity) on the other hand appears expensive from a valuation standpoint. This is especially true in the Treasury complex which is highly responsive and inversely correlated to movements in interest rates; presenting significant price risk. Although sparse, opportunities exist the traditional fixed income space within high- quality mortgage backed and mispriced investment grade securities. Additional areas of opportunity within the fixed income complex include senior loan, yield curve sensitive (steepeners), high yield, and emerging markets categories.
“As we move into 2022, real output looks set to exceed its pre-pandemic growth path, indicating a full recovery. At that point, a shortage of workers and much less fiscal and monetary stimulus should slow economic growth to its long-term trend of roughly 2%. Inflation will moderate from its highs but remain above the Fed’s 2% target.”
- Dr. David Kelly, Chief Global Strategist, JP Morgan Asset Management.1
Domestic equities performed admirably again in 2021 rallying into year-end and providing outsized returns when viewed in a historical context. Strong earnings growth, an accommodative monetary and fiscal policy along with yield scarcity in the fixed income complex drove investor flows to equities. These investors were well-rewarded with returns better than 2:1 historical levels. Over the past two years domestic equities have averaged annual returns of approximately 20%; although equity valuations have come in slightly, they remain elevated in historical terms. As we head to 2022, we strongly believe expectations for equities should be moderated as earnings growth likely moderates throughout the year and begins to pressure valuation in a meaningful fashion.
Cyclicals and value stocks started 2021 strong, then drifted during Q2 and Q3 before rallying into year-end. We see strong potential for this to continue into 2022 driven by the broader macroeconomy as the COVID-19 pandemic transitions to endemic status. From a style perspective, growth outperformed value modestly among large cap stocks whereas in the mid and small cap equities, value outperformed growth significantly during 2021. Thus far in 2022 value has outperformed growth by a wide margin across all capitalization ranges. The best performing sectors during the past year included energy, financials and technology while lagging sectors were communication services, health care and utilities. Energy experienced a reversion from a weak 2020 benefiting from a broad recovery in pricing. Financials rebounded as the credit defaults expected from the pandemic did not materialize. Technology stocks proved resilient as revenue and earnings continued to hold up well and expand at many companies. Health Care, was the broad markets weakest performer while producing mid- teens percentage gains during 2021, setting these stocks up well going into 2022 given low expectations and favorable valuations for many areas within the sector.
Within international equities, developed markets increased outperformed emerging markets in 2021, benefiting from quicker reflation of asset prices as pandemic stretched on. While we see opportunity in emerging markets as the global economy edges closer to normalization, developed markets are likely to continue outperforming until the fits and starts of the ongoing pandemic meaningfully subside. Relative valuation and a weaker U.S. dollar present the meaningful catalysts for emerging market traction as a more favorable global economic landscape reveals itself. In the near-term we favor developed markets over emerging markets until the pandemic recedes.
As we look ahead to 2022, we believe a rolling global recovery continues to benefit equities but this needs to be tempered against elevated valuations. With domestic equities trading above historical levels and earnings growth likely moderating during 2022, stock selection will be of greater importance for disciplined investors in the face of increased volatility. From an allocation perspective, we believe equities are still slightly more favorable given the interest rate environment and rebounding global economy. Although equities are slightly more attractive, our view is cautious given the 10+ years of remarkable performance in combination with a Federal Reserve Bank that is retreating from easy monetary policy. Within that backdrop, opportunities exist in domestic cyclicals including energy, financials, materials and industrials as the combination of higher relative earnings growth and favorable valuation present a compelling risk/reward dynamic. In international equities, while relative valuation is encouraging, we continue to prefer developed market equities over emerging market equities until a more stable global landscape is presented.
Rising inflation and hawkish action by the Federal Reserve late in the year lead to varied performance across fixed income complex in 2021. While market observers spent most of the year debating whether heightened inflation levels were transitory or more persistent, monetary policy is set to turn less accommodative in 2022. The changing landscape likely leads to a steepening yield curve later in the year and a healthier fixed income complex generally with increased opportunities. Performance within the fixed income space was mixed, with high yield (both taxable and municipals) and inflation-protected performing best, followed by senior loan and floating rate. Conversely, lagging areas included medium/longer dated Treasuries and emerging market bond. The aggregate bond category ended the year in the red with total returns pressured by declining Treasuries and corporate investment grade.
Looking at the current condition of the fixed income market, credit spreads remain tight signaling little concern for a slowing economy by investors. Credit spreads are a key indicator as widening spreads, often foretell a slowing economy and trouble ahead. Currently there is little unease being telegraphed from this indicator. Additionally, while there has been concern with the volume of new corporate debt issuance versus historical levels, this needs to be viewed in relation to operating earnings and interest expense; when viewed in context, current levels are manageable.
With the Federal Reserve preparing to act in 2022, interest rate pressures are likely to keep a ceiling on the broad performance within the asset class. Less monetary policy accommodation and a strengthening global macroeconomic picture likely justifies modestly higher interest rates and establishes the conditions for a steepening yield curve as we progress throughout the year. While these measures are necessary, these factors may present temporary headwinds as markets reprice individual issues and asset classes. Our marginal predisposition is toward modestly higher exposure in the high yield and senior loan categories while maintaining exposure to emerging market fixed income as the global macroeconomic picture should improve markedly as the COVID-19 pandemic subsides. Conversely, we remain very cautious of exposure to U.S. Treasuries given the propensity for rising rates and the likelihood for price pressure.
KbC Equity and Allocation Strategy Model Portfolios
KbC’s Dividend strategies performed best during 2021 with significant alpha generation realized against the benchmark. Our strategy’s barbell approach is to hold constant dividend payers and outsized dividend growers aligned well with the domestic equity market’s performance over the past year. A mix of exposure in financial services, healthcare and technology led by Blackstone (BX), CVS Health (CVS) and Microsoft (MSFT) worked nicely in a year of fits and starts across the broader economy. Looking to 2022, we are confident this strategy is well positioned as the economy moves towards normalization benefiting cyclical sectors that had underperformed early in the pandemic and now have fundamental tailwinds.
KbC’s Market strategies had a solid year on an absolute basis while modestly trailing its benchmark, the Vanguard Total Stock Market ETF (VTI) as underweights in Technology and Real Estate sectors and an overweight in Utilities negatively impacted relative performance. While we rarely make outsized sector bets even being modestly underweight (technology and real estate) and our overweight to a core long-term utilities position, NextEra Energy led the strategy’s slight underperformance during 2021.
The Alpha Leaders strategy experienced similar performance in 2021 with solid absolute returns in the mid-20% while modestly trailing its benchmark, the SPDR S&P 500 ETF (SPY). Stock selection, generated alpha during the first half of the year but was hampered in the back half as the strategy’s positions in Biogen (BIIB), The Walt Disney Co. (DIS), Paypal Holdings (PYPL), and Workday (WDAY) negatively impacted performance. This modestly offset positive contribution from Applied Materials (AMAT), CVS Health (CVS), NVIDIA (NVDA) and Exxon Mobil (XOM).
KbC’s Alpha Tax/Qualified benefited early in the year from a strong value rotation which reversed mid-year before igniting again into the end of the year. We see a strong potential for this to continue into 2022 with the broader macroeconomy expanding as the COVID-19 pandemic transitions to endemic. Overall, the absolute performance of the strategy was in-line with its primary benchmark, the S&P 100 equal weight index while modestly trailing its secondary benchmark, the S&P 100 market capitalization index.
KbC’s Strategic Asset Allocation continued to outperform against its blended benchmark as a slight tactical tilt early year to the Vanguard Russell 1000 Value ETF (VONV) and exposure to the Real Estate Select Sector SPDR (XLRE) provided outsized returns. This coupled with strong performance across approximately half of the strategy’s fixed income exposure including allocation to high yield (Franklin Liberty High Yield Corp ETF (FLHY); SPDR Portfolio TIPS ETF (SPIP); and SPDR Blackstone Senior Loan ETF (SRLN)) aided in producing strong relative and absolute returns. As we move to 2022, we are highly cognizant of the strong performance realized in 2021 and over the past three years. As we transition to the next phase of our economic and investment cycle, rebalance frequency will likely become more frequent during times of volatility as we look to rotate into areas that have been unduly punished and defend gains from downdrafts.
1. https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/economic-and- market-update/
Exhibit 1, 2, 3: Data source Morningstar Office.
Exhibit 4: Morningstar Market Barometer provides a visualization of the performance of Morningstar Indexes. ©2021 Morningstar.
The information provided herein is the opinion of Knightbridge Capital and subject to change without notice. It is not to be construed as investment, legal or tax advice. This publication may contain forward looking statements which reflect our best judgment based on factors currently known but involves significant risks and uncertainties. Actual results will differ from those anticipated in forward looking statements as the result of changes in underlying assumptions including, but not limited to systemic, macro and company-specific risks.