Sometimes, an investor is simply out of step with markets and that’s the way it has been of late for the team at Forge First. Aside from our ongoing constructive stance on Energy, given our concerns about stagflation, each of our two funds has maintained their exceedingly cautious net exposures. Obviously, given the strong countertrend rally in equity markets, this positioning hurt the funds during July. After reviewing the numbers, this note will discuss why we remain cautious towards stocks, including a fact check on the outlook for inflation.
While we all knew the party was going to end at some point, few expected such a reckoning to begin during the first half of 2022. In our year-ahead commentary, published in early January, we cautioned investors that 2022 could be a down year for markets based on the impact of sticky supply chains and weakening economic growth. However, we saw market weakness in H2, not H1. The principal reason for the earlier-than-expected shellacking of all things financial was clearly the Fed. The central bank of the U.S. waited far too long to admit inflation wasn’t ‘transitory’ and then shocked the market with a 180-degree turn during the 2nd week of January. Yet, talk is cheap (except for the negative wealth effect on investors) because, as you can see from the white line on the 15-year graph below, as of June 30th, the Fed has yet to begin to shrink the size of its balance sheet. But let’s not get ahead of ourselves, and prior to reviewing the second half outlook for markets, let’s recap H1 and discuss why June was so ugly.
One of the well-known quips about investing is that there are fewer things more humbling than markets. In last month’s commentary, we mused that by Labour Day markets would sense a pending shift by the Fed, be it dovish or hawkish. Then, lo and behold, near the end of April, in light of weakening Chinese data and plummeting U.S. housing data, market psychology assertively pivoted towards growth fears from concerns about inflation. The impact of this shift dominated market action during May, especially after Target Corp. (TGT.US) and Walmart Inc. (WMT.US) tabled sizable overhangs in their inventory positions and the latter joined Amazon.com Inc. (AMZN.US) in announcing a hiring freeze; two companies that employ three million people. As a result, markets exited May amidst a “perfect storm” of P/E multiple compression, profit margins that are rolling over and the rising prospect that revenue growth will roll over thanks to supply issues and the growing prospect of an economic slowdown.
Long-only investors endured a rough April as stocks unwound 100% of their H2 March rip higher, while bonds remained in the proverbial woodshed. NASDAQ suffered its steepest one-month decline (-13.24%) since October 2008, with April ensuring the S&P 500 is off to its 3rd worst year to date (-12.92%), with only the auspicious years of 1932 and 1939 having been worse. Here at home, the total return loss of -4.96% pushed the TSX into the red for 2022. For investors, the timing could not have been worse given equities as a percent of U.S. household assets stood at an all-time high of 41.9% at year-end 2021. The combination of rich valuations and fears towards inflation and growth, catalyzed this rout.
Driven largely by an influx of systematic capital flows during the back half of the month and a belief the Omicron-related Q1 economic dip was transitory, equities had a strong March. Markets appeared to be unfazed by higher interest rates and inflation, with limited impact from the Ukrainian situation. Despite the continuing conservative positioning held by each of our two funds, the table below highlights that each fund generated a positive net return. While we can identify catalysts that could cause equities to move higher, the combination of rising rates and slowing economic growth causes our bias to remain towards protection. The Energy sector continues to offer the best opportunity for offence.
In our 2022 Outlook Commentary, we suggested policy accommodation had peaked last Fall such that markets would ultimately turn on investors as this year progressed, but in the short term, ample liquidity would enable stocks to be okay. We also wrote that our constructive outlook on energy commodities and the value versus growth factor style of investing would enable Canadian stocks to outperform U.S. equities. Then by mid-January, the Fed turned hawkish and ever since, most financial assets, especially U.S. growth stocks, have had a volatile and rough time.
Last Fall, we suggested policy accommodation had peaked and this inflection would catalyze a prolonged unwind of the multi-year outperformance of growth stocks versus value-based equities. This gradual process continued during the month of January. Then in last month’s commentary, we suggested inflation would be the key variable driving the outlook for the price of assets during 2022; an item that definitely remains the case today. Before delving into these stories and revisiting our outlook for 2022, let’s recap the tumultuous month of January.
December 2021 was a volatile month in financial markets, as the newly named Omicron variant entered our lexicon and FOMC Chair Powell turned hawkish, though, in the end, equities appeared non-plussed by either situation. The S&P 500 enjoyed its best December since 2010, while Canada’s TSX generated a total return of 3.06%. For the full year 2021, stocks had a banner year driven by the impact of fiscal and monetary stimulus on asset prices and a strong recovery in corporate profits. In reviewing the performance of the S&P 500, 434 issues gained for the year, 96 of which climbed more than 50%, seven declined more than 25% and all 11 sectors posted double-digit gains (up from seven in 2020, five of which posted double-digit gains). The top five performers accounted for 32.6% of the total return for the S&P 500, including Microsoft Corp (MSFT.US) at 9.7%, Apple Inc. (AAPL.US) at 8.1% and Alphabet Inc. (GOOG.US) at 7.4%. The one-year graph below highlights the negative correlation between the relative outperformance of growth to value (white line) stocks against 10-year bond yields (red line; note the inversion). This correlation remained strong until Q4 when the flow of funds, words from the Fed, and Omicron combined to disrupt this relationship.
Usually it’s March, but this year, thanks to Fed Chair Powell and Omicron, it was November that came in like a lamb and went out like a lion. Powell’s ‘broken record’ denial that inflation could become problematic, combined with the Fed’s ongoing printing of money, U.S. M2, up +37% since February 2020, a further +13% year-over-year in October, kept investors dancing into the 3rd week of November. As shown by the one-year indexed graph below, the big winners during this latest leg of the rally were the ‘macro cap’ tech stocks (white line). In fact, at the November peak in the S&P 500, the six stocks highlighted below accounted for 26.4% of the SPX and 50.7% of the NASDAQ-100.
Equities roared back during October 2021 as markets were comforted by temporary stop-gap bills on America’s debt ceiling problem, respectable U.S. economic data, improving COVID-19 trends and a generally better-than-expected start to the Q3 earnings season. While the month closed with investors enjoying the 59th all-time high for the S&P 500 year to date, two stories that dominated headlines were the stunning climb in yields on two-year government bonds and the relentless rise in the price of oil. We’ll discuss oil later in this note but for now, please review the far right of the graph below, highlighting rise in yields on two-year bonds during October. German bunds (yellow line) are on the left axis, other sovereigns are on the right axis. Clearly, markets are pressing Central Banks to hike interest rates.
Last month’s commentary stated that “we now view markets as being expensive, with an increasingly asymmetrical risk/reward outlook when peering out over the next 12 months”. The S&P 500 had been trading comfortably north of 20X forward EPS amidst signs that monetary accommodation had peaked and a material retrenchment in fiscal stimulus was forthcoming. Our investment team proceeded to tactically reduce the net exposure of each of our two funds, resulting in solid net gains for the month of September.
While the deck of cards that market participants base their investment decisions upon has remained constant since COVID-19 changed the global dynamic 18 months ago, continued reshuffling of that deck has catalyzed significant month-to-month volatility across asset classes, equity sectors and factors. Unprecedented levels of liquidity remains the dominant variable pushing equity indices higher, yet larger-than-expected rates of deceleration in the American and Chinese economies (please see graph below), combined with fears surrounding the Delta variant, caused the growth style of investing to continue to outperform value during August.
Led by macro cap technology stocks and long-term government bonds, financial markets added to their year-to-date gains during July 2021 amidst growing concerns that, not only has the rate of acceleration in economic growth peaked, but it is transitioning to markedly slower levels. This note will table some thoughts germane to that discussion, but first let’s recap last month. As can be seen from the 18-month graph below, the strong correlation between falling yields and the outperformance of the tech-dominant NASDAQ has continued of late.
When we published our 2021 Market Lookahead commentary (December Commentary) in early January, it was an easy call to be bullish on stocks. The pitch was simple and the majority of buy and sell-siders shared similar outlooks. Unprecedented stimulus, albeit higher but still low interest rates and an expected flow of funds into stocks partially supported by declining volatility. With the S&P 500 having closed last week at 4,352 the outlook call gets tougher for long-only managers and especially sell-side equity strategists who have a propensity to be bullish. Interest rates remain surprisingly low and, as can be seen from the right side of the first graph, declining volatility (yellow line) continues to boost the capital allocation to stocks (white line) for traders targeting portfolio volatility of 10%.
With America shifting to a ‘getting back to normal’, no mask stance, investors began May 2021 exhibiting a ‘risk on’ attitude, enabling stocks to advance strongly out of the gate. As can be seen from the 1st graph below, the general trend of the past seven months (since Pfizer’s vaccine news of Nov. 9th) favouring value, cyclical and ‘re-opening’ stocks, continued during early May. By mid-May, the combination of a weak U.S. jobs report and hotter-than-expected pricing data south of our border, triggered a rethink among investors, catalyzing the 2nd factor reversal year to date. Judging by the lack of reaction in bond yields shown in the 2nd graph below, it’s apparent that, for now, investors chalked the miss on jobs to timing and have given the Fed a free pass on its ‘transient’ attitude towards inflation. Most equities recovered, though value bettered growth, yet lingering investor uncertainty made a sustainable rise through 4,200; a tough nut to crack for the S&P 500 through the time of writing of this note.
April 2021 featured a continuation of the year-to-date grind higher in stocks, enabling most North American equity indices to reach all-time highs. The catalyst for this strength remained ongoing policy stimulus and the re-opening of the U.S. economy. Meanwhile, this rally has masked significant factor volatility, which in turn has driven rising dispersion between the returns generated by different investment styles. Fortunately, given that security selection at Forge First is driven by a company’s ability to generate free cash flow, our funds are largely agnostic towards factor rotation and have been able to maintain net returns in the middle of the proverbial fairway.
It’s not surprising that Q1 of 2021 was good for equities, the question is whether the optimal conditions that drove stocks higher will move from the front windshield to the rear-view mirror during the remainder of this year. Before we assess that probability, let’s review the quarter that marked the anniversary of COVID-19.
Another action-packed month in markets saw bond yields spike, oil soar and all North American indices deliver solid returns despite the sea of red during the last week of February. Once again, the funds at Forge First profitably navigated these stormy waters.
Last month’s 2021 Market Lookahead commentary (December Commentary) included the text, ‘we continue to be of the view that the near-term setup for stocks remains good given the ‘market nirvana’ combination of open-ended stimulus and the pending recovery in earnings. While we expect cyclical and value-oriented stocks to outperform ‘high growth, momentum’ stocks during the next several months, neither do we foresee interest rates climbing enough to cause a stampede away from these heavily weighted securities.’ Our message today remains the same.
Happy, or should we say Hopeful, New Year has rarely seemed such an apt phrase. Obviously 2020 was a horrendous year for the majority of people, hence it’s good to have the last 10 months in the rear-view mirror. Entering 2021, hope that both society and the economy will evolve towards normalization in as timely a fashion as possible is a widespread theme. Ironically, it was a record year for financial assets, as Wall Street feasted while the rest of the world suffered. Governments everywhere tabled previously inconceivable amounts of fiscal stimulus, while monetary authorities definitely delivered on Draghi’s maxim of “doing whatever it takes”. Almost instantaneously this combination of adrenalin, estimated by Cornerstone Macro to equal 32.9% of global GDP, transformed the outlook for financial markets. In our minds, it was monetary action that mattered most for stocks.