Warning: Use of undefined constant add_shortcode - assumed 'add_shortcode' (this will throw an Error in a future version of PHP) in /home/customer/www/equitas-capital.com/public_html/wp-content/plugins/stray-quotes/stray_quotes.php on line 615
2021: A COVID ODYSSEY

Research

2021: A COVID ODYSSEY

Similar to Stanley Kubrick’s 2001: A Space Odyssey, the stock market in 2021 was a COVID odyssey. After a constructive October, US equities surged in November with the S&P 500 reaching, at the time, all-time highs. However, the emergence of the Omicron COVID-19 variant and concerns about the efficacy of existing vaccines sent stock prices and bond yields tumbling post-Thanksgiving. Investors were further unnerved by a more hawkish tone from Fed Chair Powell the following week, who said it was no longer appropriate to call inflation “transitory” and cited the strength of the US economy when saying that a faster tapering of asset purchases was under consideration. The S&P 500 finished November down slightly, posting a loss of -0.83%, but turned around to reach fresh all-time highs by the end of December.

The Federal Reserve addressed inflation in their December commentary: “Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation. Overall financial conditions remain accommodative.” The below chart illustrates two ways to look at inflation, Producer Price Index (PPI) and Consumer Price Index (CPI). PPI measures the average change over time in selling prices received by domestic producers of goods and services while CPI does this same analysis from the purchaser’s viewpoint.  When producers must pay more to produce their goods (an increase in PPI) they must make a choice. They may absorb the additional costs, thereby reducing profits; or they may pass these higher costs on to consumers. Since corporate profits are the lifeblood of stock prices, the more likely course is to pass these additional costs along to the consumer, thus pushing inflation (CPI) higher. In order to fight the resulting price inflation, the Fed customarily raises interest rates.

One way to slowly raise rates is by decreasing net monthly asset purchases by the Federal Open Market Committee (FOMC).  On a daily basis, the FOMC purchases and sells bonds in the marketplace to move rates in the direction it is targeting.  At a high level, net bond purchases by the FOMC result in higher bond prices and lower rates. Net bond sales would result in lower bond prices and higher rates.  As the chart below indicates, the FOMC has slowly changed their inflation and interest rate expectations over the last year.  In December of 2020, they expected no need to raise rates through 2023.  Come June 2021, the expectation was that rates would need to go up by 0.5% over the same period.  Lastly, by December of 2021, that expectation grew considerably to reflect a need to raise rates by up to 1.5%! Around March of 2022, net asset purchases should be in balance, allowing flexibility for Fed Funds Rate increases to start occurring. While we do not attempt to predict events here at Equitas, markets seem to be expecting three or four rate increases in 2022 and a similar number the following year.

What does this mean for investments? In general, rising rates tends to be a headwind for many areas of the fixed income markets.  As newly issued bonds pay higher coupons, older bonds issued with lower rates become less attractive to investors.  They are thus sold off by investors looking to invest at “current” coupons. The prices on these bonds drop until they reach parity whereby one is indifferent owning the older (lower coupon) bond at a newfound discount versus the newly issued bond at market price.  As for equity investments, rising rates can be a mixed bag.  For the most part, if companies are viewed as slowing their growth or becoming less profitable, the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company’s stock.  However, some sectors stand to benefit from interest rate hikes. For example, banks, brokerages, mortgage companies, and insurance companies can often increase earnings because they can charge more for lending than they were able to at lower interest rates.

In summary, while the relationship between interest rates and equity markets is more indirect than that of the bond market, the correlation between the two is actually somewhat vague. This is largely because the Federal Reserve only raises rates when the economy is already running hot.  However, there is no guarantee as to exactly how the market will react to any given interest rate change. As shown in the chart below, markets can, and often do, continue to rise even after the Fed begins to raise rates.  According to Blackrock’s Russ Koesterich, CFA, JD, “It is true that there have been historical periods, notably the ’70s and early ’80s, when higher rates coincided with lower valuations and poor returns. That said, the relationship between rates and stocks changes when rates are very low. At current levels the relationship between interest rates and valuations has been more ambiguous. At least historically, stock valuations have been more likely to rise than fall when rates are rising from low levels, as is the case today.”

2021 illustrated the benefit of diversification in investment portfolios.  In particular, there was a wide disparity in performance across sectors of the domestic economy as well as global financial markets, as shown in the chart on the next page. Developed markets across the world predominantly performed well, with almost all indexes generating positive double-digit returns.  The story was dramatically different when one looks at emerging markets where returns were slightly negative on the year.  Fixed income had an especially tough year as investors adjusted their portfolios in expectation of the pending rate increases.  Almost all fixed income indexes posted negative returns for 2021.

The combination of elevated equity multiples, uncertainty of the timing of rate hikes, and rampant inflation has left many people wondering where to invest their dollars. As Warren Buffett once said, “Interest rates basically are to the value of assets what gravity is to matter.”  In other words, higher rates mean that companies who earn money today will be more attractive relative to companies that hope to earn more in the future.  In these days of changing monetary policy, geopolitical strife, and supply chain difficulties, maintaining a strong investment discipline is paramount.  Proper asset allocation and rebalancing when opportunities present themselves become even more important during times of uncertainty.  Active management can be particularly important as these changes occur.  At this time, we are focused on active equity managers who invest in sectors that benefit from rising rates as well as companies able to pass through their higher costs to consumers. In the fixed income arena, we prefer managers that are nimble in their ability to manage not only credit risk, but are also active in managing the duration of their portfolios.  Please contact us to learn more about what we are doing and how we can be of service.

In 2002 Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high net worth family offices.

Disclosures and Disclaimers:

Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.

Equitas Capital Advisors, LLC is registered as an investment advisor with the U.S. Securities and Exchange Commission (SEC”) and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.

Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. This publication does not involve the rendering of personalized investment advice.

Charts and references to returns do not represent the performance achieved by Equitas Capital Advisors, LLC, or any of its clients.

Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.

All investment strategies have the potential for profit or loss. There can be no assurances that an investors portfolio will match or outperform any particular benchmark. Past performance does not guarantee future investment success.