— Auguste Rodin; 1840-1917
In response to the stock market’s 25% drop on October 19, 1987, Italian artist Arturo Di Modica sculpted the bronze Bull of Wall Street and dropped it, sans permission, right in front of the New York Stock Exchange. The artist and the bull seemed equally resolute. Today, Rodin’s Thinker might be more fitting. How will the casting of COVID-19, inflation, rising interest rates, and a not-so-cheap stock market play out?
Although portfolio management requires substantial application of science, stock pickers generally have access to the same data. (1) Final decisions are often premised on experience and judgement and fall more into the “art” category. Unlike Leonardo de Vinci, Michelangelo favored sculpture, despite his ability to produce some of the world’s most famous frescos. Like Rodin, he had an affinity for subtractive sculpture that entails freeing an image through elimination.
Subtraction is exactly the art form that we successfully applied to your portfolio in 2021. When designing WCF’’s bond strategy, we started with the entire bond universe and chiseled away the longest maturity (10 years and beyond) and worst quality (high yield) bonds. Your bonds continue to have relatively low interest rate risk and extremely low default risk. We largely eliminated hyper growth stocks that propelled the market in 2020. Stay at home darlings such as Roku, Teladoc, and Zoom dropped by more than 30% in the year. We avoided small cap stocks that failed to produce earnings, requiring a rational valuation more than a “story.” Although foreign equity markets lagged the S&P 500 for the year, they were still up by more than 10%. Emerging Market stocks, an area we have purposely avoided, were negative for the year.
The economy sprang out of the short but deep contraction in the spring of 2020. Although the spike experienced toward the end of 2020 could not be sustained, growth persisted throughout 2021, as seen below. (2)
Pent-up demand after sheltering at home, along with government stimulus efforts, created a voracious appetite for both goods and services. Unfortunately, disarray in the labor market, low inventories, and broken supply chains impeded the ability to satisfy that demand, resulting in higher prices. The consumer price index, thought by many to understate inflation, rose 6.8% for the 12 months ending in November - the highest figure in 40 years. (3)
The data, on both economic growth and rising costs, drowned out the Fed’s well-orchestrated and consistent messaging about the “transitory nature” of inflation. Finally, in December, Fed chair Jerome Powell announced, “The economy no longer needs increasing amounts of policy support.” (4) The new Fed game plan calls for a winding down of bond purchases and three interest rate hikes in 2022.
How did the bond market respond to more inflation and the specter of higher interest rates? Let’s preface our response by noting that the bond market, like the art world, is not monolithic. Both are complex. The bond market varies in quality (U.S. government down to junk), duration (30 days to 30 years), and features (interest only to zero coupon).
However, the U.S. Treasury market sets the tone for most U.S. dollar denominated debt. The 10-Year Treasury Note started the year at less than 1.0% but finished higher at 1.55% as seen below. (5)
Who wants bonds issued at the beginning of the year with yields of less than 1.0% when you can go buy new ones with much better yields? A seller must provide a discount to the price paid to induce a buyer, thus, the loss of value in such bonds – formally recognized as interest rate risk. Treasuries with a maturity of 7-10 years lost 3.3% in 2021 and those with a maturity of 20 years lost 4.6%. (6) WCF has intentionally kept maturities of your bonds extremely short to mitigate interest rate risk. We continue to hold bonds because they produce cash flow and provide a hedge against equities. In addition, we have recently added foreign bonds and mortgage-backed securities to diversify risk and increase yield.
Higher interest rates increase the cost of capital and make bonds more competitive relative to stocks. However, a combination of rising inflation, a complex and challenging labor market, social unrest, and a rapidly evolving epidemic, all molded together with higher interest rates, failed to restrain the upward trending stock market in 2021. The S&P 500 delivered double digit returns for the fifth time in the past six years, defying the pundits and nearly doubling the return of small cap (Russell 2000) and foreign stocks (EAFE). (7)
Why? In a world filled with uncertainty, capital tends to flow into the U.S. financial markets and especially larger, more stable companies. In addition, the big stocks performed, delivering earnings growth approximately equal to price appreciation.
Overall, WCF was able to deliver some of the best returns (relative to benchmark) ever. We were able to accomplish this not by swinging for the fences and hitting home runs, but through a deliberate focus on avoiding the strike out.
2022 will mark the fourth calendar year of co-existing with COVID-19. The optimism sparked by vaccines, boosters, and effective treatments gave way in November to the discovery of the Omicron variant. As famously stated in the movie Jaws, “Just when you thought it was safe…” (8) Though the research needs to be completed, early signals suggest a vastly more contagious mutation, capable of evading vaccines, but perhaps not as lethal. We shall see. The economic impact will certainly be challenging. Between Christmas Eve and New Year’s Day, airlines cancelled 13,700 flights, partially attributable to COVID-19 related illness hampering the ability to put flight crews together. (9) Three major lines of the N.Y. City subway have been shut down due to a lack of operators. (10) In addition to labor problems, it would be reasonable to assume that some consumers will curtail the social interaction associated with restaurants, travel, and entertainment. The epidemic has already demonstrated an ability to both slow the economy and raise costs, not an ideal combination.
COVID-19 arrived on US shores in the spring of 2020, bringing forth the question of whether massive fiscal and monetary stimulus could compensate for an economy grinding to a halt. Today the opposite holds true. Will diminished stimulus slow the streaking economy? Can the inflation genie be put back into the bottle? Can earnings grow enough to justify the rich price to earnings ratio of 22 times?
The early news is encouraging:
The Wall Street Bull represents unbridled determination. Today we can relate to The Thinker, an image that portrays deep thought and philosophy. The financial markets have no mold, no prior experience with this unique combination of powerful variables. Yet, we do have a philosophy that leans toward a quality selection bias in your stocks and your bonds. We have a disciplined allocation to cash, despite the low current yield, so we can exploit any future weakness in the markets. After all, The Thinker’s powerful body serves as a reminder of the great capacity for action.