Economic Recovery With Low Inflation
What we said: The pandemic created a deep recession that has set a low base from which to rebound. We now anticipate a resumption of dynamics that existed prior to the virus-driven shutdowns, with strong growth in GDP and corporate earnings, higher but modest initial inflation and accommodative Federal Reserve policy. While unemployment should continue to decline next year, higher inflation is unlikely until 2022 or beyond, even as the Fed continues along its dovish path.
What we’ve seen: The economic recovery has been exceptionally robust as reopening has gathered steam on the back of successful vaccine efforts and extraordinary stimulus. Various data are “running hot,” including industrial and service activity. Consumer inflation rose 5.4% in June, while a disconnect emerged between unemployment and available positions, and companies struggled with supply chain bottlenecks. Amid debate as to whether pricing pressures are transitory or something more permanent, we fall solidly into the “transitory” camp: As the pivot to reopening progresses we expect to see pricing pressures ease, although perhaps to somewhat higher levels than we once anticipated.
Populism Is Here to Stay… Tax Efficiency and Planning Take Center Stage
What we said: The election of 2020 does not mark the end of political populism or its causes, in our view. That probably means continued political volatility and additional fiscal stimulus beyond the immediate crisis. This suggests an upward bias in taxation over time, regardless of who is in political control. We believe a key structural “hinge” to moving through the doorway to the 2020s is tax-efficient investing—as well as effective tax planning. Though a divided government may make near-term changes to tax laws less likely, we believe individuals should focus on long-term tax-efficient portfolio strategies, as well as capitalize on currently available planning techniques.
What we’ve seen: The Biden administration has introduced massive stimulus proposals seeking to transform the economy and levy new taxes on the wealthy. But with Democrats’ narrow legislative majorities and hesitancy on the part of key moderates, chances of passing the entire agenda appear remote. Still, the possibility of change has renewed attention on tax efficiency across investment portfolios and estate planning strategies. Given likely budgetary pressures moving forward, we anticipate that regardless of the fate of current proposals, taxes will remain at center stage for some time. Maintaining taxes as a key element of the planning process could be essential in the years ahead.
Accelerated Digital Transformation Puts Down Roots
What we said: During the coronavirus crisis, consumers and businesses have embraced working, shopping and accessing services from home, making the business case for digitalization and automation in factories, warehouses, offices and homes stronger than ever. Some unwinding may take place once the pandemic eases, but in our view the world of 5G connectivity, the Internet of Things and cloud computing is here to stay.
What we’ve seen: The digital transformation of the economy shows little sign of slowing. According to Gartner, spending on cloud services is seeing double-digit growth, while desktop services could increase 70% this year.1 Meanwhile, the global stock of robots used in smart factories could swell from 2.4 million in 2018 to 4 million in 2022,2 as automation and artificial intelligence gain traction. Views on “work-from-home,” however, appear mixed: Although many employers (and employees) anticipate maintaining hybrid arrangements, they recognize the social, training and collaborative benefits of being in the office.3 Altogether, we anticipate that digitalization will continue to spread across the economy, changing how we live and do business. In our view, investors should consider seeking exposure to these trends to capitalize on the opportunities they present.
Sustainable Investing Gains Momentum
What we said: The pandemic has helped expose glaring inequalities in society, in terms of health care, incomes and employment. As the world emerges from the crisis, we believe that governments, businesses and investors will increasingly seek to mitigate such issues, while redoubling efforts on climate change and corporate governance. More than ever, viewing investments through an Environmental, Social and Governance (ESG) lens will help identify material risks and opportunities, while providing a vehicle, where desired, to effectuate change.
What we’ve seen: Momentum around ESG issues continues to accelerate. The U.S. has reengaged on climate, rejoining the Paris Agreement and setting aggressive goals on carbon. Other countries, including China, have introduced long-term emissions targets. At the corporate level, business leaders have released science-based timelines to achieving net-zero emissions, and enhanced reporting on an array of issues. Racial equity has seen heightened focus, as companies have sought to enhance diversity at all levels. Finally, shareholder engagement has reached critical mass, as reflected in a very active proxy season. Morningstar reports that U.S. sustainable funds attracted nearly $21.5 billion in net inflows in the first quarter, or more than double the figure from a year earlier. We continue to believe that integrating material ESG factors into investment research can help drive performance over the long term.
Global Trade Wars to Ease, but Tensions Remain With China
What we said: Geopolitical uncertainty, economic nationalist populism and simple wage and cost convergence illustrate the pros and cons of our key trading relationships tied to China. As the U.S. shifts gears politically and economically in 2021, we expect one outcome to be the increased diversification and efficiency of supply chains; a variety of our trading partners (including China) stand to benefit. The ongoing transformation of supply chains will reduce companies’ and industries’ exposure to disruption risk, but at some cost to investors and consumers.
What we’ve seen: The U.S. has reengaged with the global community, rejoining a number of multilateral agreements and institutions. At the G7 meeting, President Biden emphasized cooperation with allies on climate and defense, and recently ended a long trade dispute over airplane manufacture. In contrast, elevated tensions with China remain on display, as the U.S. has sought to counter China’s efforts to expand its political, military and technological influence; recent U.S. legislation dedicated funds to competition with China and banned exports to certain Chinese companies. Meanwhile, companies continued to reorient supply chains in light of geopolitical issues and vulnerability to crises, including future pandemics. In our view, the ability to address these challenges could be fundamental to value creation as we move forward.
The Hunt for Yield Continues
What we said: As with every recession, the 2020 coronavirus downturn caused the difference in yields between U.S. Treasuries and other fixed income securities to widen. Rapid and substantial central bank intervention made this an exceptionally short-lived phenomenon, however, leaving investors with a complex mix of growth dynamics, and default and valuation risks. We think this demands a flexible, “go-anywhere” approach to fixed income investing, backed up by the ability to make relative value assessments across sectors, as well as broad expertise and nimble decision-making.
What we’ve seen: The economic acceleration and resurgence of inflation helped drive a sharp rise in U.S. Treasury yields in the first four months of 2021, but non-Treasuries came away relatively unscathed as the difference in their yields versus government bonds narrowed sharply on strong credit conditions. Given upside inflation risks, we continue to believe that seeking yield with limited duration (or exposure to changes in interest rates) may make sense for many investors. Moreover, recent trends have reinforced the value of flexibility in seeking yield across the fixed income marketplace, where security selection appears likely to become even more important in the coming months.
Spending and Tax Trends Point to Municipals
What we said: Already large government deficits and debt loads have grown substantially, as authorities have sought to insulate industries and workers from economic dislocation. With a consensus favoring more stimulus, and pressure to spend more on health care, climate and the social safety net, we think it’s only a matter of time before tax rates go up to pay for it all—reinforcing the role that creditworthy municipal bonds already play in generating after-tax yield and income.
What we’ve seen: With high spending proposals and income tax increases anticipated for wealthier Americans, municipal bonds have seen strong demand this year despite rate pressures. Federal rescue dollars have helped municipalities, even as their financial picture has been surprisingly strong. Given current fiscal support and economic recovery, the credit environment for municipals has improved significantly. In terms of technical factors, mutual fund inflows are on a record pace even as the supply of tax-exempt bonds has remained manageable. That said, municipals have rallied dramatically this year, leading to relatively full valuations, and reinforcing the importance of security selection in looking for returns.
Growth Vs. Value: a Possible Rotation on the Horizon
What we said: As the economy works through the impact of COVID-19, we believe that there will be a cyclical recovery and markets will likely experience a rotation back toward cyclical stocks similar to what we have seen sporadically this quarter on days where there has been particularly good news around vaccines. To date, this trend has not been sustained given the uncertainties associated with the ongoing spread of COVID-19 and the timing of vaccines, but likely will become more meaningful sometime in the coming year. That said, we ultimately believe the outlook for the U.S. economy will be characterized by low interest rates, low growth and low expected returns, which will be supportive of growth stocks. This calls for diversification and a balanced approach to equity style investing.
What we’ve seen: In the early months of the year, many cyclical and value stocks experienced an impressive rally over growth and defensive names. This was a function not only of explosive economic growth, but also sharply higher interest rates, which tend to dampen the market performance of companies whose earnings are anticipated far in the future. More recently, growth has surged in light of easing yields and shifting growth expectations. Although we aren’t calling the end of the value “reopening trade,” we believe these patterns reinforce the value of a diversified, balanced approach to portfolios as we look toward the middle innings of recovery.
Secular Growth and Thematic Opportunities for the Long Term
What we said: In a low-growth world, secular growth stocks are likely to command a premium. We think a thematic approach can help to uncover lesser known and more attractively valued “hidden gems.” Investors should recognize that themes such as the digital transformation of the economy transcend regions and also may support growth deep into value chains. Having analysts with specific regional and technical knowledge can help unlock this significant opportunity.
What we’ve seen: As part of the recent rotation toward value this year, stocks within tech-driven thematic trends have tended to underperform. However, with less stark economic “base effects” and the gradual reduction of accommodative monetary and fiscal policies, we anticipate that the economy could slow in 2022 and enter a period of more stagnant expansion. In that environment, we believe that looking to select avenues of secular thematic growth, such as the 5G transition, automation, fintech and next-generation health care could be useful to supporting equity return expectations. That said, we believe that thematic investing is about employing research to find quality companies exposed to secular growth themes, particularly at a time when many growth stocks are trading at relatively high valuations.
Uncertainty Paves the Way for Opportunistic, Idiosyncratic Strategies
What we said: Next year is likely to present an unusual mix of economic dynamics, with hints of cyclical acceleration against a backdrop of longer-term economy maturity, and ongoing pandemic and policy uncertainty. We believe any resulting volatility should provide a role for opportunistic strategies (for capital appreciation) and idiosyncratic, uncorrelated strategies (to lend stability to portfolios). Meanwhile, private investing opportunities will likely be found in sectors and regions where businesses have resilient growth prospects and executable business plans that add value amid uncertainty.
What we’ve seen: Recent market trends including Treasury, dollar volatility, and equity style rotation have created a rich environment for trading strategies and other liquid alternatives this year, with many of the benchmark HFRI hedge fund indices in strongly positive territory through the end of June. Private equity deals have continued to focus on companies with fundamentally strong businesses to ride out ongoing volatility, as well as the ability to generate strategic and operationally driven growth. In our opinion, recent market volatility has served as a reminder of the need to seek out new sources of diversification as the world emerges from the pandemic.
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