We are nearly two years into the pandemic and evolving variants continue to challenge us. Confirmed cases are setting new records daily and medical facilities are once again strained, but that is where the bad news begins to fade. Fatalities remain well below peak levels and families and businesses are learning to live with and manage the risk of exposure. Although the virus seems to be everywhere right now, we see light at the end of the proverbial COVID tunnel.
The charts below vividly illustrate these points. The left hand chart shows the seven-day moving average of new confirmed cases (blue line) and fatalities (black line). We’ve updated the charts through January 12, 2022 given the large surge since year end. Further, the CDC estimates that only 1 in 4.2 cases are reported, so the actual number of cases over the last week is probably closer to three million.
It seems like everyone knows someone who tested positive over the holidays. As of year-end it was estimated that over 90% of Americans have some level of immunity through the vaccine, infection, or both. Further, the upper right hand chart shows that Omicron is overtaking Delta as the dominant strain. Given our country’s growing immunity and reportedly milder symptoms with Omicron, we expect COVID will eventually become categorically similar to influenza. The virus will still be dangerous to some, but manageable for the vast majority.
Despite the challenges related to COVID, economic growth in the US was strong in 2021. The recent above trend growth rate is expected to continue during the first part of 2022 as reopening resumes, supply chains improve and businesses rebuild inventories. As reflected in the next chart, the economy (as measured by Gross Domestic Product) has recovered all of its losses from 2020 and is approaching its long term pre-pandemic growth trend. Economic growth forecasts for 2022 suggest we could achieve trend line growth by year-end, which would be a remarkable accomplishment, considering it took nearly ten years to achieve the same feat following the 2008 global financial crisis.
The economic recovery and high inflation have prompted the Federal Reserve to take a more hawkish stance on monetary policy. Absent an unexpected economic setback, the Fed will cease buying bonds and begin raising short-term interest rates by mid-year. Since the dawn of the pandemic, $5.3 trillion of fiscal stimulus and accommodative monetary policy have created strong tailwinds for our economy and kept interest rates low.
As noted in the graph below, the yield on the 10 year U.S. Treasury Bond was 1.51% at year-end, far below the 4.96% core CPI inflation rate.
Traditional fixed income investing has become less appealing due to low yields, high inflation and the prospect of rising interest rates. Forward expected returns for fixed income are relatively unattractive, with a high probability of negative real returns (returns net inflation) over the next few years. That said, fixed income can still serve a purpose in portfolios for investors with a low tolerance for the inherent volatility in equity markets.
And we do expect equity volatility in 2022 and beyond.
If you remained invested through the pandemic, the domestic stock market rewarded you with double digit returns for three consecutive years. Despite the 34% pullback in 2020, cumulative returns for the S&P 500 over the past three years exceed 100%.
In 2021 alone, the S&P 500 produced a total return of 11% during the 4th quarter and 28.7% for the calendar year. The index achieved 70 record closes, the second-highest annual tally in history. It’s clear that the domestic stock market has created a significant amount of wealth for investors over a relatively short period of time.
Going forward we should temper our expectations for US equities, broadly speaking. Valuations remain elevated and as stimulus is withdrawn and monetary policy becomes less accommodative, the recent tailwinds for economic growth may become headwinds.
When you look closer at performance attribution, two-thirds of the S&P 500’s 2021 price return (which excludes dividend payments) was from the index’s top 10 holdings, with the remaining third sourced from the other 495 holdings (the S&P 500 index actually tracks 505 companies). This trend has persisted during the pandemic, separating the winners and losers by a wide margin. Growth stocks trading at high valuations have benefitted from low long-term rates for almost ten years, while the more cyclical, value-oriented parts of the market have underperformed.
So, where do we see opportunities?
While the S&P 500 valuation remains elevated, the value sector is historically cheap relative to growth. Common characteristics of value stocks include modest valuation metrics (e.g. Price-to-Earnings ratio, Price-to-Book ratio), high dividend yields and often cyclical earnings. Further, value tends to outperform growth when the economy is strong and interest rates are rising.
As shown in the chart below, the last time value stocks were this cheap was at the end of the dot.com bubble in 2000. We believe future returns will rely more on profit margins, and much less on the expansion of valuation multiples.
We have tilted our domestic equity allocations towards value oriented companies, which we expect to perform relatively well as the economic cycle moves into the next phase.
Looking abroad, there remains a compelling case for global diversification. The table below shows the broad market indices we use to track domestic stocks (S&P 500), developed international stocks (MSCI EAFE) and emerging market stocks (MSCI Emerging Markets). We’ve also included an index that encompasses the entire investable world (MSCI All Country World) for further context.
Over the last ten years, domestic stocks have outperformed foreign by a substantial amount. The annualized return is double developed international equities and more than triple emerging markets. However, during the decade ending in 2011 and the most recent 20 year period, emerging market stocks were the best performing region globally.
Drilling down further, the calendar year performance provided in the table above shows how lopsided performance was for the last two decades. Emerging markets outperformed the US in 8 of the 10 calendar years from 2002-2011, while the opposite occurred from 2012-2021.
So, what will the next ten years have in store?
The case for international equities is a common theme in our market commentaries. Emerging market and developed international stocks are currently selling at their cheapest levels relative to US stocks in 20 years. Valuations have historically been a good indicator of future expected returns, but in order for the trend of outperformance to shift abroad, it often takes an unexpected catalyst to change market momentum. Regardless, it’s hard to ignore the potential.
International equities are more cyclical than US stocks. Cyclical sectors (such as financials, materials & industrials, etc.) tend to outperform in inflationary environments and represent 54% of international markets compared to only 32% in the US. As we mentioned earlier in this publication, the US economy has already surpassed pre-pandemic levels of output. Europe and Japan remain 0.4% and 2.2% behind their respective pre-pandemic levels, leaving more room for growth opportunities as the rest of the world catches up with the US.
Another common theme in these letters is the benefits of diversification. We know with certainty that the index representing global equities, the MSCI All Country World Index, will never be the best or worst performer. That’s the beauty of diversification. Global equity diversification has a smoothing effect on returns and mitigates the risk associated with a portfolio concentrated in one particular country or region.
For most clients, portfolios remain thoughtfully diversified both domestically and internationally. It would be a mistake to allow performance recency bias to rationalize abandonment of global diversification. We have also added hedged domestic equity securities to reduce portfolio volatility while US stocks are at high valuations and fixed income yields are near all time lows.
We are grateful for your trust and confidence. If you would like to review your financial plan or investment portfolio please do not hesitate to reach out to us. We welcome your questions and will be responsive.
The JRM Investment Counsel Team
Jack, Phil and Lauren