ECONOMIC COMMENTARY

A look ahead: Q1 Market Update & Economic Outlook

The New Year has served up a heady mix of investing challenges and opportunities. Inflation, consumer activity and COVID-related issues are all on the radar and sending conflicting messages.

During our first market and economic outlook webinar of the year, Chief Investment Officer, Shannon Saccocia addressed these topics to help you navigate your investment options as 2022 unfolds.

Hear Shannon’s insights on:

  • Economic and market performance during 2021.
  • Current in focus topics such as monetary policy, inflation and China.
  • Our positioning as we progress into 2022.

Audio transcription

Shannon: Hello, everyone, and thank you for joining today. I'm Shannon Saccocia, chief investment officer at Boston Private, which is now part of Silicon Valley Bank. Today, we'll discuss our latest outlook on the economy and the markets, and what we expect to see going forward. I'm joining you from frigid Boston. And I hope wherever you are is a lot warmer than it is here today. I'm happy to take your questions today. If you'll notice on your screen, you should see the opportunity to add questions in the Q&A box. Go ahead and submit those during our discussion, and I'll answer them during the Q&A session at the end. Now, let's get started.

First slide, please. One look at this slide, and all I can think of to say is that past performance is not indicative of future results. Although we all often see this as a disclaimer in the financial services industry, and you're certainly going to see it as a disclaimer on any reports that you receive from me, this is an important concept in behavioral finance and one that bears worth mentioning. If we anchor to this past performance and attempt to project this as a predictor for what we see in the future, this never fails to disappoint. With that said, it does make sense to take just a quick glance in the rearview mirror, as 2021 was an extraordinary market for risk-taking. As equity returns were boosted by massive fiscal and monetary stimulus and any optimism that was available, it was used to quash the objections of those who thought that these ferocious moves were hardly justified.

If you look at the S&P 500, for instance, it returned almost 30%. And every single sector in that benchmark posted a double-digit return last year. Even utilities, which typically thrive in the worst of times, were up almost 20%, while energy stocks gained over 50% last year. REITs, financials, technology, those all did well. And while inflation was a constant concern, and one we'll talk about a lot today, earnings growth still carried the day. Under the surface, however, and something to note, as we look forward to 2022, there was plenty of pain. The high valuation stay-at-home work from home darlings of 2020 pulled back significantly, and have continued to do so as we move into 2022. Smaller cap growth companies also fared poorly last year. And again, this trend seems destined to continue, at least in the first couple of months of this year. Outside of the U.S., performance wasn't that great either. And that's certainly something else we're going to talk about.

If we look at the other side of this chart, bonds were the anchor, not necessarily all that surprising, but they weighed on the proverbial 60/40 return, much to the dismay of those who had benefited from that allocation for the last decade, where bonds had been additive to your overall return while helping with your mitigate risk in your portfolio. High-yield bonds dramatically outperformed high-quality bonds last year, and this reach for yield was evident in the strong return for preferred stocks as well. Taxes do continue to weigh on investors' minds, and the demand for tax-advantaged income through municipal bonds kept demand for these bonds fairly high throughout the year, something we expect to continue. Finally, the strong performance of commodities came as no surprise given the inflationary pressures we've discussed. And perhaps most surprising was the negative return for gold. Actually lost 4%. And historically, if you think about inflation, generally, gold does pretty well in those periods.

Next slide, please. With that discussion of 2021 behind us, I think it's important for us to shift to what we're focusing on for 2020. One constant over the last several years, especially for those of you who have seen this slide from us here at Boston Private, has been accommodative monetary policy. And for much of the last year, the Fed had remained locked in on providing the support the economy needed, pointing to higher inflation as transitory, rather than a source of concern. This is fairly consistent globally as well. High inflation and the risk of COVID-19 related and the economic dysfunction kept most central banks fairly accommodative. That has started to diverge, however. While the People's Bank of China, for instance, cut its reserve rate requirements recently, more of an accommodative move, we've seen tightening from the Bank of England, as well as the Fed, as well as the European Central Bank. And so while we anticipate continued tighter moves from most central banks, there is an opportunity over the course of the next several months to see this path diverge. The rationale behind this shifting stance is that inflation has turned out to be not so transitory, at least in the near to midterm.

The view that the rapid increase in consumer demand would create higher prices came with an acknowledgment that the short-term supply-demand mismatches would be rectified as global supply chains improved. Unfortunately, we haven't seen this improvement, or at least not quick enough. In fact, inflation is our number one concern coming into this year. And for those of you who have not had a chance, I would encourage you to read our 2022 outlook entitled, "The Inflation Infiltration," for a deeper dive on how this persistent inflation could impact the economy. The takeaway that we outlined in the piece is that inflation is here to stay, but one could argue it's far better than the alternative of deflation. Economic growth begets higher demand, and higher demand creates that need for this higher production of goods and expanded services. Companies need to work to meet that level of activity. And so that's going to continue to drive earnings, growth, and global GDP.

The final area of focus for us this year is China. Coming into last year, the Chinese economy appeared poised to re-accelerate quickly, both on the significant demand for the country's exports, as I've talked about, as it relates to this global GDP acceleration, but also on the strong and seemingly effective response of the Chinese government due to COVID-19. Consumer demand was expected to bounce back similar to what the U.S. had experienced. And there was even talk of additional fiscal stimulus coming out of the Chinese government. That has changed more recently, as the government has announced a move towards this ideal of common prosperity, which was a sharp move away from the prior government's more capitalistic approach, and one more in line with traditional socialist principles. This put the spotlight on corporations such as Alibaba and Tencent, which have grown into large, profitable enterprises, and are not as well controlled by the Chinese government.

In addition, this persistent over-investment in real estate in China, which we've been talking about for decades, remains a problem. And the government in Beijing seems hesitant to shore up developers in the same manner it has historically. So, while these are our three areas of focus, what you can see elsewhere on this slide is that our team reviews a wide swath of economic and market data in order to craft our views. And so now I'll spend a few minutes on our views for the U.S. economy, and then shift to our positioning for 2022.

Next slide, please. Like a spring, we've seen consumer demand bounce off the bottom in this particular recession. And the pace at which the bounce-back occurred last year created a scenario that stressed every part of the supply chain. Couple this with an already muted level of manufacturing coming into 2020, and one can see that the Fed was probably not wrong to consider that inflation was transitory. Our view going into this year is that we will begin to see inflation moderate as we move towards the back half of the year. Although interest rates will move higher on fed growth and tightening.

CPI could still end the year above 3%, but we believe that more of that increase will be driven by the pass-through of stickier costs, such as wages and health care, rather than the shipping costs import delays that are plaguing companies today. Volatility will increase along with the Fed's intentions. And then one thing to consider is something that we're seeing here is how inflation is measured. When the Fed talks about inflation, they talk about the PCE. When we think about inflation, we think about the CPI. And we can see the divergence of PCI and CPI pick up as we move through the year, given the high percentage of that housing represents as part of the CPI, which could end up being the most sticky of these costs.

Next slide, please. The other thing to consider, however, when we're thinking about investing, is how higher prices could impact margins. U.S. companies have become very vocal about the threat of higher costs for things like commodities, for labor, for shipping. While deflation was more of a general economic concern prior to COVID-19, inflation concerns coming out of Corporate America tend to be much more specific, and analysts are keen to understand how management teams are grappling with this new challenge. The importance of strong management teams, and at least some level of inelasticity and demand for a company's products and services, has become increasingly more important as a result.

Next slide, please. These concerns about inflation are not just coming through in earnings calls. Business sentiment surveys such as the ISM, which is what's shown here on this slide, are reflecting these concerns as well. PMI, services, and manufacturing surveys have historically been able to point to growth or contraction in the economy 12 to 18 months in advance. And just for reference, any reading over 50 indicates an economic expansion. The initial bouncing in manufacturing has cooled a bit, perhaps reflecting some of the continued supply chain issues and high commodity prices, while services sentiment left higher in the fourth quarter on improvement in activity and wider vaccination rates. While both readings have shown some deceleration to start 2022, we believe this is attributable primarily to the swift rise of the Omicron variant and is likely to bounce back in February and March.

Next slide, please. Well, input cost inflation is likely to moderate. The pressure on companies to pay higher wages could continue well into next year. With over 11 million job openings and the unemployment rate falling sharply, as of last Friday's non-farm payrolls released, this number was down now to 3.9%. Companies need to pay more competitively in order to fill their roles. The short-term staffing issues are being exacerbated by COVID absenteeism as well. While on the surface, it would appear that higher wages could help to offset the impact of higher prices for consumers, in reality, wage growth has been stagnant for a decade, and real hourly wages are actually negative against this torrid pace of inflation that we're grappling with. So, while we could see higher wages coming through for the consumer, it's going to mean higher costs for companies. And again, that goes back to how much of this price increase and cost increase is digestible by the end consumer.

Next slide, please. So, as I mentioned earlier, we talked about central bank policy and the importance of this accommodative monetary policy that's been the backbone of the economic growth that we've had over the last two years. In its December meeting, the Fed acted as expected, accelerating the taper in a move that is consistent with the view that the Fed is likely to raise rates by the middle of next year, with a growing probability that the first rate hike comes as soon as March of 2022. This view was confirmed recently following the release of the minutes from the meeting, and equity and bond markets reacted almost immediately to the perceived shift in the Fed's narrative. This has actually resulted in a lot of the weakness that we've seen thus far in the 2022 trading year, which has been short, but eventful. While it was telegraphed in the original release from the meeting, and in the press conference that the members of the FOMC had become increasingly concerned about inflation, the minutes added a ton of fuel to that fire, pointing to not only an earlier resumption of interest rate hikes and even faster taper than expected but perhaps most importantly, the notion that the Fed would consider a true reversal from quantitative easing, with a focus on shrinking the balance sheet.

The size of the Fed's balance sheet has been a topic of conversation since 2009. And many have thought that the likelihood is is that it would remain significantly higher than it has been historically for an extended period of time. So, with this divergence comes both risk, as well as opportunity, particularly in the currency markets. And while it is difficult to anticipate currency movements, given the number of factors that are...contribute to relative currency valuations, a more aggressive stance by say, the Bank of England, or the European Central Bank, or the Fed could create different appetites for assets domiciled there. But most importantly, again, the volatility that we talked about coming into this year is not only about what the Fed is going to do, but how quickly are they going to do it, and to what level rates will rise this year? It's something that is an evolving story.

Next slide, please. So, with that as the backdrop, how are we positioning portfolios coming into 2022? It's probably the number one question that I get from our clients. As I mentioned earlier, as much as it would be great to say that we could project the same returns for this year as last year and in the same markets, there are some reasons for both optimism and caution as it relates to the largest allocation in most U.S. investors' portfolios, which are U.S. large cap stocks. Valuations remain elevated from an historical perspective, if not quite as elevated as they may be looked, seven or eight months ago.

Earnings growth is likely to slow on a percentage basis, which isn't saying much because it was incredible in 2021. But that accelerating global economy that we talked about, should continue to support stronger earnings for companies across, you know, most sectors and industries. Perhaps more concerning is the rotation from growth stocks to cyclical stocks, as that could prove challenging in a number of areas. The S&P 500 is heavily concentrated not only in growth stocks but in a small number of growth stocks, which could be easily pressured over the next several quarters as casualties of this rotation.

So, again, there's a lot to think about both at the index level, as well as at the individual security level. But one potential catalyst for U.S. large caps broadly could be buybacks. Buybacks were a significant part of the market success prior to the pandemic, as low-interest rates allowed companies to assume cheap debt and buy back their stock at a meaningful clip. In this environment, earnings could actually fund those buybacks as well. And any sustained pressure on companies with solid earnings and free cash flow could result in an uptick of buybacks, which could give the S&P 500 the oomph it needs to get over this near-term hurdle.

Next slide, please. One of the areas of relative opportunity for investors, wishing to concentrate on the U.S. economy, are small-cap companies. Small caps are prone to greater volatility as measured by standard deviation, meaning that the range of outcomes for these companies' stock prices tend to be wider. However, small-cap companies tend to perform well in an accelerating economic environment, particularly in a post-recession period. In addition, small-cap companies tend to have earnings and revenues that are more U.S.-based. So, if there is an expectation of accelerating demand and economic activity continuing into 2022...Oh, excuse me, 2023, and 2024, these companies will be well-positioned. The caveat here is that smaller companies tend to have less cash on the balance sheet and often have debt-financed at higher rates. And so if you think about a period where we could see rates rising at a faster pace than expected, or to a higher equilibrium level than expected, these companies could be hamstrung to refinance their debt.

Next slide. So, one of the things that we've been thinking a lot about is international developed stocks. And there's one thing I'll tell you, we talked about anchoring to past performance. And then there is nothing more fundamental to investing than this concept of mean reversion. The biggest challenge for investors, for all of us as well who sit in this seat, is attempting to time the point at which point assets will revert to the mean. International developed stocks have underperformed U.S. stocks for much of the last decade, 8 of the last 10 years to be exact, and yet, U.S. institutional and individual investors have continued to allocate to that.

So, why have they underperformed? Excuse me, and how could they possibly outperform in the years ahead? Well, one of the reasons they've underperformed in the last 10 years, is that the makeup of the international developed universe, and emerging markets for that matter, is that there are higher concentrations of more cyclical sectors. And those are not the sectors that have outperformed over the last decade. In fact, it's been these growth stocks that we talked about earlier in the conversation. And so now that there's this renewed emphasis on cyclicals within the U.S. market, with many investors pivoting away from technology, and healthcare, and consumer discretionary, to energy, materials, and industrials, one can actually argue that an easier way to pivot, and perhaps provide greater diversification, would be to add exposure to international developed stocks.

This transition to a higher inflation, higher interest rate posture could be the inflection point for that mean reversion to occur. Couple that with this concentration we've talked about in the S&P 500 with growth stocks, and you don't have that in the MSCI EAFE, which is a common index. There isn't that top-heaviness as part of that index. And so one way to potentially add some diversification, especially if you have large positions in growth stocks with very low-cost basis, would be to add some international exposure.

Next slide, please. Putting aside that argument for REIT mean reversion, one of the most glaring examples of divergence that we saw in 2021 was the underperformance of Chinese stocks relative to the rest of the MSCI Emerging Market Index. China bulls, and there are many of them out there, would argue that this is an opportunity to reallocate to Chinese stocks ahead of what could be an excellent year for the global economy, and China, in general, which is likely to grow in excess of 5%. The issue with that is how we effectively underwrite the risks from this shifting political agenda that I mentioned while selecting areas of the economy, which can benefit from the rebound and deliver this promise of excess return.

Merely allocating to the largest companies could be a fool's errand if the idea of common prosperity results in egregious taxation on these largest, most profitable companies. But investing in those smaller enterprises offers less transparency. Our view is that a flexible approach to investing in China, and in turn, the emerging markets, should be the plan for 2022. Monitoring the shifting landscape appropriately and leveraging the insight of those closest to the companies in the region, as well as being comfortable pivoting is the best course of action.

Next slide, please. We haven't discussed yet fixed income. And it's not that we're shying away from it. We talked a little bit about how bonds had underperformed last year. And our expectation is that bonds relative to equities and other asset classes will likely continue to underperform in 2022. Persistently, low yields have created a demand for riskier assets, in both the fixed income market and outside of it. But rising rates, as I mentioned, as it relates to small-cap companies, could result in stress for over-leveraged or cash-poor companies. While this global reach for yield could keep a lid on how high U.S. interest rates can climb, low coupons may not be able to keep up with negative price pressures. And that's what we saw last year.

Low rates have given corporations the opportunity to solidify their balance sheets in historically, low credit spreads. But higher short-term yields and tighter liquidity will elevate volatility and force these very narrow spreads to widen. Lower quality assets will experience more volatility and a quicker pace of widening. And therefore investors should be careful to weigh the benefits and risks of reaching for yields. While there are going to continue to be opportunities, particularly in different types of structured bonds, or in the high yield and floating-rate space, the sizing of those positions should be appropriate, given the risk that they have over a more traditional high-quality bond portfolio.

Next slide, please. One of the areas that we have continued to focus on, over the last several years, is assets that can deliver a different risk-reward dynamic. And we've been adding those to portfolios in order to diversify and ideally to create better outcomes for our clients. Real assets fall into that category. As you can see here, this positive correlation to inflation, coupled with the opportunity to potentially create higher income within a portfolio, have made sense in this environment. But there is significant dispersion in the opportunity set. So, while we continue to focus on adding real assets, whether through real estate, infrastructure, farmland, commodities into portfolios, we believe a more nuanced approach to the selection of those assets is important in order not to get caught up in a potential sentiment trade, which does not reflect the fact that this basket, much as any other universe, has some differentiation within it.

Next slide, please. So, with that, what is our positioning for 2022? We prefer equity and alternatives over fixed income. We prefer U.S. small cap equity and international equity over U.S. large cap equity. From a relative perspective, we know that U.S. large-cap equity is going to continue to be the largest allocation within our portfolios, but where you can add additional allocations to small cap or international, we recommend it. We are currently overweight emerging market equities, but we may look to modify our implementation based on some of those concerns around China that I mentioned. We maintain an underweight high to quality, fixed income. And we have a modest overweight in high yield, again, as appropriate based on the client mandate, and something that should be taken into account when building a fixed income portfolio.

Finally, we are implementing additional opportunities within alternatives. So, real assets was just an example of some of the things that we're putting into portfolios to create differentiated risk-reward. We are going to continue to add to our platform, and many of you will be beneficiaries of that as we continue to grow that portion of the portfolio. But in short, one of the things that we've thought about is maintaining diversification in order to create the better outcomes that we're looking for. And looking at the questions, what I would like to elaborate on, just before we have to go is, you know, thinking about what will happen over the course of the next three or four weeks in terms of the growth rate. That is something that we continue to get questioned on. We've seen significant pressure in technology stocks. We have seen significant pressure, particularly after the release of the Federal Open Market Committee, the FOMCs minutes. And we anticipate that as the Fed moves towards a tighter posture, that there will be continued focus on high valuation stocks, not just in technology but also in areas like biotech.

And so when you think about the potential divergence within technology, for instance, there's two parts of that universe, high free cash flow, high earnings, significant profitability enterprises, and then there are high valuation stocks that may make little in terms of earnings or may actually be losing money from a profitability standpoint. We expect the ladder to be more negatively impacted by some of this trade, but it will feel a bit painful in this transition period even for the highest quality large-cap names, names like Apple, and Microsoft, and Amazon will suffer in this environment on sentiment.

With that, I'm just making sure we don't have any other questions, and I'm not seeing any in the chat. So, we've covered a lot during today's discussion. And I'd like to reiterate that events like this provide an opportunity for you to revisit your plan, consider your risk tolerance, and reevaluate adjustments based on your long-term goals. Our team is committed to providing you with all the guidance and support that you need. So, please reach out to your wealth advisor or relationship manager with any questions or changes that may impact your plan. You can also reach out to us with specific questions that you had from this webinar that we may not have answered. Thanks again for joining me today. I wish you and all your families very good health.

The views expressed in the article are those of the author and/or person interviewed and do not necessarily reflect the views of SVB Private or other members of Silicon Valley Bank and SVB Financial Group. The materials on this website are for informational purposes only, are subject to change and do not take into account your particular investment objective, financial situation or need. Since each client’s situation is unique, you should consult your financial advisor and/or tax planning professional before acting on any information provided herein