In the nearly two years since the start of the COVID-19 pandemic, the pace of change in both the global economy and daily life has been remarkable. North American stock indexes notched double-digit gains in 2021, fueled by loose monetary policy and abundant fiscal stimulus; vaccines have slowed but not nearly stopped the spread of the disease; and the combination of a revving economy and pandemic-related factors have led to soaring inflation and the prospect of the end of three decades of easy money.
On financial markets, 2022 will be defined by interest rate hikes at most major central banks. This should ultimately reset the risk premium in both equities and fixed-income investments, but not without a period of volatility and the potential risk of policy error.
We are still positive on North American equities but not on market froth, as the normalization of rates could trigger a rerating among companies that lack the cash flow to justify their lofty valuations. A shift from high growth to value stocks should pick up pace in 2022, benefiting financials and energy, as well as international markets, which are more value-focused than the U.S.
In fixed income, the volatility of 2021 should only increase as we move into the tightening cycle. We would avoid duration early in the year, as the prospect of higher rates should initially trigger outflows and a flatter yield curve. Following this adjustment, however, we see fixed income as an attractive space, with higher yields and potential for a tightening of credit spreads.
In the current context, the potentially higher returns available in private equity and private credit investments should be appealing for high-net-worth, accredited investors who are comfortable with the unique risks involved with those asset classes.
Less market-related but no less significant are the behavioural changes brought about by the pandemic that will have both short and long-term impacts on consumers and businesses. Some of these are already evident, such as the continued embrace of online shopping, and flexible work-from-home arrangements that could have longer-term implications for commercial real estate and retailers. Other impacts are developing more gradually, such as a possible rethinking of just-in-time inventory practices in the face of supply shocks, and the potential re-shoring of some manufacturing capabilities.
Central bank tightening and risk of policy error
The aggressive interest rate cuts and other liquidity measures enacted by central banks from March 2020 onward have factored heavily in the economic and market rebound to date. However, these actions also set the table for an eventual policy reversal, ideally a gradual one to ease the economy back into a more normalized policy of higher rates. But the emergence of surprisingly persistent inflation means central banks have been forced to adopt a more accelerated pace than initially expected, and a contrast from the methodical and gradual tightening path that followed the 2008 financial crisis.
Both the U.S. Federal Reserve (Fed) and the Bank of Canada (BoC) are dealing with inflation at its highest level in three decades, as well as strong economic growth and employment indicators that reflect very strong consumer demand. This is unfamiliar territory for central banks, which have had to deal as much with the risk of deflation as inflation over the past decade. It is also unfamiliar for the many in the investment community who have not dealt with inflation during their professional careers.
Complicating the matter is that the current price pressure is not purely borne out of healthy growth but also potentially transitory factors, most notably supply chain issues brought about by pandemic-related factors. There is also significant labour migration that has led to staffing shortages across certain industries and forced many firms to raise wages.
We see considerable risk of policy error if inflationary pressures force the Fed to hike rates too aggressively. This puts a focus on central bank communication, and we expect the coming tightening cycle to be conducted more transparently than past campaigns.
Another element to this equation is the massive fiscal stimulus that has entered the economy since March 2020 and has, along with ultra-easy central bank policy, provided a vital economic cushion. This is also new territory for central bankers, as there has not been a comparable fiscal outlay in the period since the 2008 crisis. Our concern is the potential for a renewed and prolonged spike in COVID-19 infections to lead to a situation where the U.S. or Canadian governments feel another round of fiscal stimulus is needed. This fiscal infusion could dilute the impact of central bank tightening efforts and provide a new trigger for inflation.
That scenario notwithstanding, the central bank policy shift as currently envisioned should make for a year of volatility for fixed-income markets. We expect yields to rise across all maturities, though more significantly in the rate-sensitive short end. This should lead to a ‘bear flattening’ of the yield curve due to inflation fears and pessimism about the economic outlook. We would expect significant outflows from assets further out on the risk curve, at least initially.
Looking past the short-term volatility; however, the picture becomes more constructive for credit, as the higher move in yields will make for an appealing entry point for investors. In the U.S., Fed rate hikes were positive for both investment grade and high yield spreads during tightening cycles in 2004 and 2015 due in part to higher Treasury yields. For corporates who can demonstrate revenue and earnings growth in a higher inflation environment, there will be a considerable opportunity for spread compression as central banks continue to tighten through 2023.
High valuations + high correlations
The inevitable disruption associated with monetary tightening comes as markets are dealing with the combination of extremely high equity valuations across several sectors and an unusually high rate of correlation across asset classes and geographies. The gap in price-to-earnings multiples between U.S. growth and value sectors is currently near multi-decade highs, as investors continue to show a willingness to pay higher premiums for additional growth, backed by the stability of long-term interest rates.
However, the idea of mitigating risk—often accomplished through diversification—is made difficult by the high rate of correlation across several markets, particularly between stock and bond prices. While high correlation is often present in markets coming out of recession or recovering from an economic shock, the current behaviour of the market suggests a much broader correlation. This gives investors little shelter from the potential disruption of rate hikes or pandemic-related news.
A key question then is what level interest rates can get to before the impact is felt in growth stocks, other asset classes and consumer spending? Our view is in the short term, rate moves are unlikely to have a significant impact on the consumer, who has benefited from wage growth, falling non-mortgage debt levels, and who has an appetite to spend post-pandemic. However, we are cautious on growth companies with stretched valuations, such as ‘unprofitable tech’ that has already begun to come off its recent highs as the market has begun pricing in rate normalization. In Canada and the U.S., we see the opportunity to rotate into value names that have the free cash flows to justify their valuations. Overall, Canadian valuations remain quite attractive, particularly compared to U.S. valuations.
European stocks look increasingly appealing in this context as they have a smaller proportion of growth names and as a group are trading at sub-15x earnings. European banks, for instance, have yet to re-rate and are trading at compressed multiples, providing an appealing entry point with the possibility of multiple expansion in a rising rate environment.
The commencement of interest rate hikes may cause volatility among some cyclical stocks. Ultimately, however, Canadian and U.S. equities tend to perform well when rates rise from low levels as there is an implicit suggestion of growth behind the tighter policy. In the current inflationary environment, we also prefer companies that have pricing power and can ‘pass through’ higher input costs to customers. Many names which have been doing this successfully should avoid the lower re-rate that could befall companies unable to do so.
There should also be opportunities camouflaged within each investment universe that have attractive risk/reward skews. We see this as a market that is favourable for active management and believe being selective will be key for strategies that can outperform the broader indices and with downside risk.
A key question is how long supply chain disruptions will remain and how companies decide to deal with them. A potential complication could arise from companies that ‘double order’ inventory to ensure they can meet customer demand. While this approach may work in the immediate term, it raises the risk of excessive inventory on the books if supply bottlenecks resolve themselves, potentially leading to an economic slowdown. Indeed, we see excessive inventory build as a risk in 2022.
Public vs. private markets
The private market segment showed double-digit annual percentage growth over the 10 years prior to 2020, according to investment data company Preqin. There have been a number of factors behind this growth. In private credit, the shrinking of loan books at large banks has forced many smaller companies to seek funding outside public markets. On the private equity side, liquidity has benefited from growth companies increasingly conducting additional private funding rounds before making the decision to go public.
For investors, the appeal is the expectation of higher returns, as private equity returns have, on average, outperformed public markets, according to Preqin. Private equity and debt also have the advantage of being largely immune to the fluctuations of publicly traded assets, which are marked-to-market. This is a particularly differentiating factor during times of irrational volatility, when publicly traded investments can see wide swings that have little connection to the quality of the underlying assets.
We believe private market assets have considerable value either as a stand-alone strategy or as part of a broader portfolio allocation alongside public investments. The space has increasingly been embraced by hedge funds, and recent regulatory changes have brought the space within reach of retail investors. However, it’s important investors understand the considerable differences between private and public investments, and the separate set of risks a qualified or accredited private market investor assumes.
Unlike public markets, where assets can be usually bought or sold any time a market is open, private investments are often illiquid in nature. This allows private funds to take in an illiquidity premium which increases the return, but it also means they are locked into the asset for an investment horizon that can stretch to several years. As such, fund managers have limited ability to course-correct. This puts a premium on careful research of equity and credit opportunities, and ultimately, on choosing the right manager.
Private investments also have looser disclosure requirements, and it can be difficult to accurately analyze their business from the outside. This makes assessing a private investment challenging for an individual investor, but it means investment firms with experience in particular industries can gain an information advantage that can help them pick strong targets for funding.
We expect to see a continuation of the considerable flows into private markets, although a by-product of the segment’s growth is that an ever-larger chunk of the economy is becoming more opaque in terms of financial reporting and disclosure. This raises the risk of regulators stepping in at some point with new disclosure requirements, and it also reinforces the importance of working with investment managers that know the space and have partnerships with private market players that can provide a key information advantage.
It has become increasingly evident with uneven global vaccine distribution, vaccine skepticism, and the potential for breakthrough variants, a quick end to the pandemic is wishful thinking. We will continue to be vulnerable to disease-related shocks, though likely with a short-term impact on markets. However, we see value in examining the long-term changes to consumer and business behaviour that should become increasingly evident as we move through 2022 and beyond.
Flexible work arrangements had been a slowly developing trend before the pandemic. Once the initial wave of infections hit, they quickly became a necessity for nearly everyone working in sectors that do not require constant in-person attendance. While offices have largely reopened over the past year, flexible work arrangements look to be a permanent fixture. This will inevitably lead to a downsizing in commercial real estate, though we expect this to be a slow drip rather than a torrent. This is due in part to the timing of lease expirations, but we also expect many companies may decide to keep their offices intact and instead attempt to wring cost savings from reductions in work travel and office amenities.
Interestingly, the continuation of work-from-home could mean the pandemic shift to online retail at the expense of brick and mortar will only partially reverse, as a reduction in commuting means less lunch-hour shopping or store visits on the way home from work. This should also contribute to demand for warehousing and other logistics real estate, which has been a huge area of strength over the past year.
We should continue to see an unwinding of the shift to durable goods spending by consumers who spent heavily on items like furniture and home renovation during the lockdowns. Variant scares notwithstanding, people will continue to return to spending on services, such as restaurants, sporting events and ultimately long-distance travel. Indeed, we see the consumer in a very strong place, with wage growth in many sectors augmenting high savings and an appetite for a return to normalcy.
For businesses, a major factor will be inventory management, as the just-in-time model of strict inventory that has been the model since the 1980s led to companies running out of stock when supply-chain issues took hold. Businesses will face the task of adjusting to the fragility of the global supply chain, and we expect to see an inventory rebuild in 2022 that should be positive for economic growth and lead to upward earnings revisions for certain sectors. The risk, of course, is that higher inventories don’t ultimately translate into demand growth, leading to a supply glut that stops growth in its tracks.
The supply chain drama should also prompt many companies to re-examine their overreliance on overseas manufacturing centers, with the potential of some reshoring of capacity or other diversification of supply. Over the longer term, however, we think that as companies become more comfortable with the reliability of global supply they will revert to a smaller and more margin-friendly inventory model.
We see this as a dynamic environment that should yield many winners and losers as pandemic-related changes in behaviour move through different parts of the global economy. From an investment perspective, we emphasize smart active management, and put a premium on owning companies with pricing power.
The past year has provided much stronger returns on financial markets than could have reasonably been expected at the end of 2020. This has been fueled by optimism over the economic reopening and consumers’ eagerness to spend; made possible by the cheap money flowing through the ultra-easy monetary policy of central banks in North America and abroad.
With that ultra-easy policy now transitioning into a tightening cycle, the one-way path of markets is almost certainly about to pause. Over the coming months, volatility will be the watchword, and we expect money to exit companies with extreme valuations and find its way to value plays with manageable debt and substantial free cash flow. We see the potential for international markets to outperform, as their valuations are more favourable than in the U.S.
There will likely be outflows from fixed income as rates normalize, though this will set the table for higher yields that should present appealing entry points, perhaps as early as the fourth quarter.
The higher level of volatility in public markets will likely further increase the appeal of private equity and credit investments, which are not vulnerable to short-term market swings. However, investors need to carefully weigh the illiquidity-for-yield trade-off inherent in the segment and ensure they engage a manager able to choose stable companies. At Gluskin Sheff, we build portfolios to suit the individual client’s risk tolerance and desired return level, both in public markets, and in private markets through our partnership with Onex.
The potential for pandemic aftershocks adds to the overall risk level of markets, which is why we maintain a cautious approach, with somewhat higher cash holdings than we would normally maintain. However, we believe we are past the point of widespread lockdowns that would threaten what is a compelling path for economic growth going forward.