2021 was another strong year for stock market returns, with the S&P 500 gaining 29% after a rise of 18% in 2020. But the composition of returns across each year could not have been more different. 2020 was marked by a dramatic drop in corporate earnings and stock prices in the first quarter (when the pandemic started), and then a very strong rebound, largely concentrated in industries and companies that stood to gain from Covid-induced changes. This included e-commerce platforms and companies benefitting from the shift to work from home. Conversely, companies hurt by Covid, such as restaurants, hotels, and air travel got crushed.
Last year, by contrast, was more varied. For example, energy and financials rebounded strongly after a terrible 2020, while many tech companies that saw strong Covid-related gains in 2020 continued to surge in 2021. Investors were whipsawed by the re-opening of the economy one week and the spread of the Delta variant or the Omicron variant the next, in addition to news about vaccines and boosters. Underneath all this activity, a number of stocks fell noticeably below their highs, while an increasingly small number of richly valued tech names surged to new heights. In fact, only five such stocks accounted for some 30% of the S&P 500’s gains last year. Such concentration of performance is often viewed negatively by professional investors, but time will tell.
Now with 62% of Americans fully vaccinated and Omicron apparently highly transmissible, but not particularly lethal, we believe the economy will continue to recover. Consumers have lots of money and are growing tired of Covid restrictions. They are going out and spending and increasingly resuming normal activities. This should continue unless, of course, some new and more virulent Covid variant sends us all scurrying back into the safety of our homes.
As we survey the economic landscape, we think it only prudent to assess the impact of Covid and to sort out the temporary effects from the intermediate and permanent ones. We certainly would put the reduction of normal leisure and entertainment activities and product/commodity shortages in the temporary camp.
In the intermediate camp, we would note an acceleration in the move from brick and mortar retail to e-commerce, a shift from office to home for many workers, and an accelerated migration of the U.S. population to suburban areas, particularly to the sunbelt states. While not entirely new, these trends did gain considerable momentum as a result of Covid restrictions.
In the permanent camp, the most profound effect has been in the labor markets and supply chains. The pandemic has caused many older workers to accelerate their retirements, while it has caused many younger workers to stay home either to avoid catching Covid or to supervise children kept out of school. Many workers have also transitioned from one industry to another (e.g., from working in health care to working in warehouses), and workers have demanded higher wages, with labor strikes a common occurrence. As a result, labor participation rates have declined, and labor disruptions have become widespread. Couple this with the desire of companies to shorten supply lines – often by shifting away from offshore suppliers – and the result is a very tight labor market with upward pressure on wages as employers compete for scarce workers.
All this is a sharp reversal of the last 20-30 years of globalization in which manufacturers were able to tap into an almost limitless supply of cheap labor in China and other emerging economies. As manufacturing jobs were shipped overseas, domestic wages stagnated, and inflation hovered at or below 2% annually. American companies also shifted supply chains overseas and dramatically reduced excess inventory in search of just-in-time efficiencies. The twin forces of globalization and technology wielded a potent downward pressure on prices. Aside from its usual role in making business processes more efficient, technology enables remote work and facilitates the related migration to low-cost living areas, both of which help keep inflation in check. But globalization has lost its bite. As a result, we expect inflation to rise above its long-term trend of the past two to three decades.
Today inflation has spiked to over 6%, the highest in 39 years. Part of this simply represents the impact of Covid-related bottlenecks – which we fully expect to dissipate over time – but, as explained above, part of this appears to be more permanent as globalization wanes, U.S. labor participation rates stagnate, and domestic wages rise.
As a result of higher secular inflation and the Fed’s shift from an ultra-easy money policy to a more hawkish stance (to combat inflation), it appears rates are poised to rise. In November, Chairman Powell testified that some inflationary pressures do not appear transitory, and the Fed announced policy actions that, in our view, increase the likelihood of rate increases. Specifically, the Fed accelerated plans to taper its bond buying program and indicated its intent to hike rates more aggressively than previously suggested starting in 2022.
Typically, stocks tend to do well in the early stages of a rising interest rate cycle (though volatility may also increase), as higher yields generally correspond to an expanding economy and rising corporate profits. It is not until the late stage of the cycle – when the Fed raises rates more aggressively, pushing the economy into recession – that stocks are hurt by higher interest rates. We believe we are far from that point, perhaps several years away, but this is something we will monitor closely. However, we should also point out that higher interest rates are likely to put some downward pressure on equity valuations, particularly the very elevated valuations of certain high-tech companies, suggesting a shift from growth to value. Going forward, the market will likely see-saw between valuation compression on the one hand and rising earnings on the other.
With interest rates still near 30-year lows – real interest rates are actually negative – stocks appear to be relatively attractive, especially those with steadily rising dividends. Given the likelihood of higher inflation going forward, we think it is especially important to focus on companies with pricing power, which will enable them to maintain or improve profit margins in an inflationary environment, and to avoid companies unable to do so. The key to stock selection over the next few years will be investing in competitively advantaged companies operating in growing industries where profits, free cash flows, and dividends are all rising. Often, this means owning industry-leading companies. Such companies have the ability to raise prices, can invest to reduce costs, and often enjoy secular tailwinds that support growth. If we can find companies with these characteristics and attractive valuations, we think our portfolios will prove particularly resilient over the long term.
In closing, we want to wish all our clients a most healthy, happy, and prosperous New Year. We genuinely appreciate the trust you have placed in us, and we look forward to serving you for many years to come.
Sincerely,
John Osterweis and Larry Cordisco
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