In January, growth stocks (most in the technology sector) continued rebounding from mid-October lows. While the rebound was impressive and seemed to break the price downtrend, the S&P technology sector had lost close to one-third of its value before bottoming. While some might breathe a sigh of relief, we think this is just a reprieve, and the stock market (as well as the economy) is beginning a profound shift we have not witnessed for at least 50 years.
In response to COVID, central banks worldwide flooded the market with liquidity, or more colloquially, lots of cash with little cost to borrow (i.e. low interest rates). In addition, governments significantly increased spending in real terms and the percentage of GDP. Government deficits as a percent of GDP are at historic levels in most countries (the spending part). Government debt as a percentage of GDP is historic in many countries (the balance sheet). Inflation has also risen around the world. Despite Federal Reserve interest rate increases, the inflation picture seems more intractable than hoped, and rates will end up higher than anticipated. And the U.S. government will likely decrease spending. Taxes will need to rise to support Social Security and close the budget deficit.
It all sounds so depressing, but then we need to keep in mind three significant facts as they relate to financial markets:
- The stock market is a market of stocks. The S&P 500 can perform very poorly, but there are likely to be sectors that perform reasonably well, like the energy sector did in 2022.
- The fixed-income market (bonds) may be very attractive as stimulus wanes and longer-term yields rise above inflation.
- The global stock market may outperform the U.S. market for extended periods, particularly in times of US dollar weakness.
Which Stocks May Do Well?
Value stocks tend to outperform growth stocks in a rising interest rate and inflationary environments. They also tend to have higher dividends, which tend to increase over time, providing additional inflation protection. Often, these companies are necessary and have some degree of pricing power. These sectors could include banks, insurance, and health care. In addition, global conflicts require continued defense spending to replace and upgrade equipment. Finally, commodity cycles tend to be very long, and we may now be entering into a long cycle of inflationary commodity prices. Therefore, energy, mining and metals, including gold, could be attractive.
In 2023, we expect dividend income to increase significantly with larger allocations to higher-yielding stocks.
Exchange Rates and the Global Markets
The value of the dollar relative to other currencies is a significant factor in international investment returns. For example, all other things being equal, a 10% fall in the value of the dollar relative to the Euro increases the return on European stocks by 10%. A weaker dollar also correlates with higher emerging market performance and gold prices. The dollar strengthened relative to other currencies over the past few months, but we expect it to revert to weakening.
While we are well aware of geopolitical tensions related to China, China’s reopening likely presents an investment opportunity. We are not China’s only trading partner, and given the size of China’s economy, increased growth should also support the commodity cycle and emerging market stocks. Emerging markets present a very attractive opportunity for capital gains when they trend positive, although not so much as a long-term hold.
After the Barclays Aggregate Bond Index lost over 13% in 2022 with the rapid increase in rates by the Federal Reserve, bonds have become very attractive. There was a slight setback in returns so far this year as inflation is likely to be higher than expected. But this asset class is set up to provide attractive returns over the next few years, likely outpacing inflation. What you can see from the chart is the dramatic increase in the percent return of the two-year treasury, which may hit 5%. There are two other key points:
- The 30-year rate is most highly tied to future, longer-term expectations for inflation. The recent upward move in this rate signals that inflation may not be under control. This rate can and will drop, even if short-term rates move up, if investors believe the Federal Reserve has inflation under control.
- The broad stock market eventually performs poorly when short-term rates exceed long-term rates. While the timing is unpredictable, the ultimate outcome tells us stocks will ultimately sell off, usually with higher growth stocks leading the way.
The U.S. economy has not experienced economic conditions similar to today for some time. Although we are sure we will not be able to time the transition perfectly, we want to be positioned to invest in taking advantage of higher yields and concentrating on those sectors likely to outperform (or perform less poorly than) others. The current economic conditions are still relatively strong, and we want to maintain a relatively normal allocation to stocks, but the mix is much more toward value investments.
All price only charts from Optuma.com