by Nick Schommer, CFA – Portfolio Manager
Key takeaways
- The dynamics that drove equity markets over the last decade are changing and investors must likewise be willing to adjust their approach.
- This year has been painful as investors react to a more hawkish US Federal Reserve (Fed), but it has also created opportunity.
- While some stocks may now appear more reasonably valued, we believe it will be essential for investors to have the utmost confidence in the earnings of the companies they own.
The dynamics that drove equity markets over the last decade are changing. Following the Global Financial Crisis (GFC), equities were supported by a benign market backdrop through a period where easy monetary policy substantially supported appreciation in risk assets. Historically low nominal interest rates – and, at times, negative real rates – made equities attractive relative to other asset classes, driving investment and resulting in a long-running bull market. During this time, investors were rewarded for owning the market, as equities generally appreciated.
At the same time, the post-GFC market became more and more concentrated in a handful of companies that performed well and heavily influenced index performance. While this investment strategy proved effective in recent years, we don’t necessarily believe that will be the case going forward. Inflation has forced the Federal Reserve (Fed) to change its stance from easing to tightening, which is now shifting equity valuations and economic growth forecasts.
Given these changed dynamics, we think investors would be wise to re-evaluate their approach in the new environment.
A painful adjustment
So far this year, we have seen heightened volatility as the market adjusts to an increasingly hawkish Fed. While investors may view recent market performance as extreme, this feeling is perhaps reflective of the long-running bull market environment that we have enjoyed over many years. That is not to say that the pain has not been swift and meaningful, but we do view it as a natural and expected reaction to a changed environment where the cost of capital is higher.
Structural changes in the market, especially over the last several years, have also added to recent volatility. Systematic traders and retail investors that are less fundamentally focused and have shorter time horizons now make up a large percentage of the market, contributing to significant short-term market swings. Thus, we view some of the recent selling as not fundamentally based and believe investors may be able to take advantage of the disconnect when the market normalizes. So, while recent volatility has been painful, we currently see more opportunity than we have in a long time.
As an example, the health care sector is generally trading at low historical valuations. At the same time, industries like pharmaceuticals are generally less impacted by inflation due to their ability to adjust prices to keep up with rises in the Consumer Price Index (CPI). In general, companies with high gross margins and an ability to control operating expenses can generate high profit margins even in an elevated inflation environment.
What expectations are priced in now?
While this year has been volatile, we believe the market is forward-looking and has now factored in significant interest rate hikes. This has led to asset declines but is also beginning to present opportunities. The U.S. dollar has strengthened meaningfully, driving the price of imports down. And if we should see a resolution to the war in Ukraine and/or an end to the zero-COVID policy in China, both developments would be positive catalysts as the Fed battles inflation.
On the economic front, consumers are in a stronger position now than in previous rate-hiking cycles thanks to a thriving real estate market and government stimulus, which boosted individual savings rates to record levels. While savings numbers have since come down, the U.S. consumer is generally on solid footing. And so we are faced with a tug-of-war between a robust U.S. consumer and a Fed that is behind the curve in fighting inflation. It remains to be seen whether the central bank can navigate a soft landing and avoid a significant slowdown in growth. As the cost of capital rises, the probability of recession certainly increases, but we still think consumer strength can likely support economic growth through the rest of this year. Therefore, if the economy does enter a recession, we believe it is more likely to occur in 2023 than in 2022.
Focus on earnings
In stark contrast to the past decade of broad market strength, there has been nowhere to hide this year. Equities have seen significant valuation changes thus far due to multiple compression. While some stocks may now appear more reasonably valued, as earnings adjust in coming quarters, we believe it will be essential for investors to have the utmost confidence in the earnings of the companies they own.
With the cost of liquidity higher, some stocks that grew rapidly without producing earnings now look like they may never earn anything and simply go away. On the other hand, misunderstood business models where management execution drives performance can provide stability and ballast to a portfolio. During volatile times, we think investors should lean into these opportunities when they present themselves.
