Despite a variety of autumn headwinds, a variety of which have been ongoing, there are positive takeaways for investors.
Growth. From both the standpoint of the economy and corporate earnings, numbers are growing. At the risk of oversimplifying, long-term equity market returns have largely tracked long-term corporate earnings growth. When this earnings growth slows or declines, typically coinciding with recessions, risk assets have performed poorly. However, if the numbers are simply expanding, the probability of positive outcomes is far higher. The term ‘TINA’ (There Is No Alternative) applies to the choice of stocks as the preferred current place to invest, with bond and cash yields so low from an after-inflation basis. This has no doubt driven valuations higher, in keeping with stronger fundamentals. Of course, stocks have risks, with bonds often still the place investors flock to in times of crisis, which makes them vital portfolio building blocks.
Strong consumer and business demand. Over the past year, demand has surged for a variety of goods and services; the hang-up, unfortunately, has been the difficulty in getting supplies and manufacturing enough to satisfy market demand. The supply difficulties have manifested as production slowdowns and transportation delays, leading to inflation in several CPI price categories. This is especially the case for goods needing semiconductors (which includes more household items than one might think, like washing machines, ranges, etc.). Why is this happening? Most simply, the factory shutdowns in the early part of the pandemic, ongoing factory disruptions abroad, and a difficulty in finding qualified and willing labor. Logistical issues have been highlighted by a lack of personnel to unload container ships (dozens of ships have been sitting off of Los Angeles harbor waiting to dock), as well as a shortage of U.S. truck drivers. The good news is that once the supply dynamics ease, demand for finished products has been exceptionally strong. This translates to higher corporate revenues and earnings, which is what the stock market relies on. (By contrast, waning demand is more indicative of late cycle dynamics moving into recession, which is certainly not the case today.)
Accommodative monetary policy. Aside from the recent ‘taper talk’, low interest rates are expected to remain low for several years, and allow for several positive conditions to occur. These include lower consumer and corporate borrowing rates, higher modeled valuations for equities and real estate, and a subtle pull of investor assets away from savings and into stocks. The latter is debatable over the last cycle, as trillions of dollars remain in savings and money market mutual fund assets yielding near zero; this implies the safety component is far more important currently than the negative real yields currently being earned. If and when rates begin to rise (which we started to see a dose of last week), the implication is that the economy is strong enough to handle it without Fed intervention again to push rates downward.
Pandemic duration and end. The Covid delta variant added another significant wave of cases, just when many (including experts) thought it was close to being over. Medically, spread was worse than the initial wave due to a higher infection r-value, but higher vaccination rates appear to have kept death rates contained in many areas. This is a unique event for the today’s world, but historically, pandemics haven’t lasted indefinitely. Typically after several waves, they’ve ‘burned out’, when the majority of the population becomes immune. An interesting aftermath of the 1918 flu pandemic (although complicated by the co-effect of World War I) was the beginning of the Roaring ‘20s—a period of strong economic expansion and significant societal change. It’s been speculated that the immense number of WWI deaths (of younger men, specifically) was an important catalyst for many of these changes, particularly with women’s rights, more progressive attitudes, as well as general optimism. Historically, pandemics have been catalysts for societal and economic shifts, so this isn’t totally surprising.
A key forward-looking factor will be how much the Covid pandemic effects future economic behavior, including comfort being in larger groups, shopping online vs. in-person, urban vs. suburban living, business travel, office vs. home work, etc. Some of these trends were already in place, but the pandemic accelerated these several-fold—particularly, with productivity technologies like teleconferencing. Market leadership in 2020 favored such companies, with valuations rising as well. Their investment value isn’t just about winning industries, it’s about the price being paid. Are investors too optimistic about digital? Conversely, are investors too pessimistic about the decline traditional/brick-and-mortar companies?
Benefits of Diversification. Many investors think of U.S. stocks as ‘the market’. However, 40% of the world’s stock market capitalization is domiciled abroad. These stocks have traded more cheaply than U.S. equities for some time, for a variety of reasons, including slower growth and less favorable (less tech-heavy) sector composition, but U.S. vs. foreign leadership has tended to vacillate over multi-year periods. With the U.S. having led for much of the last decade, and growth rates picking up abroad, a foreign stock comeback would reward a more globally diversified asset allocation portfolio. We have already seen the benefits of owning assets such as commodities, real estate, and floating rate bank loans during periods of rising inflationary pressures and interest rates. Even government bonds can become more attractive the higher rates rise, as multi-year bond total return is largely based on starting yields.