Climbing the "Wall of Worry"

November 4, 2021
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September is often a weak month for the capital markets, and this year was no exception. Stock markets ended the third quarter slightly down as investors came to grips with the reality that above- average inflation and supply-chain bottlenecks may persist for longer than many had anticipated a few months ago. As we discussed in last quarter’s letter, the collateral damage from the extraordinary interventions in the global economy over the past 18 months is unlikely to disappear overnight.

News stories of clogged ports and soaring prices for shipping and energy abound. Transporting goods across the Pacific is now reported to take about 80 days, twice the pre-pandemic norm. After a very rapid recovery from the shortest and sharpest recession ever experienced, the economy now appears to be straining against its capacity to grow. Meanwhile, job openings are going unfilled while wages begin to rise.

The latest New York Fed Survey of Consumer Expectations shows the expected rate of inflation one year ahead at 5.2%, and 4.0% in three years. During the second quarter, inflation was mentioned on 45% of earnings calls, according to FactSet, well above the 28% five-year average. Amid mounting inflation concerns, long-term interest rates began to climb. While the Federal Reserve has not yet moved to raise short-term interest rates, it has made it clear that the time to remove its foot from the accelerator, by tapering its monthly bond purchases, is drawing near.

As companies adapt to doing business in this high-pressure economy, output-per-hour (productivity) gains are beginning to occur. Business processes are quickly evolving out of necessity, and firms are incorporating game-changing technologies such as automation, artificial intelligence and virtual communications.

Higher rates of productivity growth, conspicuously absent in the slow-growth decade of 2010 through 2019, allow the economy to grow faster for longer without creating additional inflationary pressure. They give the Federal Reserve an opportunity to try to orchestrate a slow, patient normalization of monetary policy without triggering a sudden, sharp increase in interest rates. The Fed is clearly determined to wait until it sees the whites of sustained inflation’s eyes, as it still views today’s rising prices as a temporary phenomenon.

Against this backdrop, Gross Domestic Product (GDP) growth has slowed. According to the Atlanta Fed’s GDPNow real-time estimate, the economy is set to expand around 1.8% this quarter, significantly slower than its breakneck 6% pace of just a few months ago. For the economy to resume above-trend growth, the Delta variant of COVID-19 must continue to subside, supply chain bottlenecks need to continue to clear, and more fiscal support has to be provided from Washington, D.C. While the contours of the next stimulus package have emerged, the final details of the legislation are in flux as Democrats seek compromises that will allow a bill to pass with a narrow majority.

Meanwhile, corporate profits continue to grow robustly, if a bit more slowly. The consensus estimate for S&P 500 earnings growth in 2022 is more than 9%, according to FactSet. Long-term interest rates have been rising slowly, which, in our view, has kept stocks from becoming extremely expensive relative to bonds; that’s good news because a big gap might prompt worry about an impending sustained bear market. Other market indicators appear to confirm that stresses in the economy are not yet seeping into capital markets: The yield curve remains positively sloped, for example, and credit spreads--the difference in yield between bonds of differing credit quality--remain tight.

We remain near the top end of our ranges in equities and near the bottom end of our ranges in fixed income, despite the “wall of worry” that the market continues to climb. As always, we maintain two years’ worth of cash needs net of portfolio yield, so that we do not have to sell assets at artificially depressed prices to meet spending needs during the inevitable corrections that will occur as this bull stock market ages.

Anchoring on Domestic Value stocks

One theme that has driven stock markets this year is the sharp tug-of-war between Value and Growth stocks. In many ways, it’s been a contest between the pandemic era, where economic growth and interest rates were low and technology and health care ruled the stock market, and the post-pandemic era, with its sustained higher growth and interest rates, where cyclicals, financials, and resource stocks have benefitted.

The COVID-19 pandemic and subsequent lockdown were the largest blow to the global economy since World War II. Investors shunned Value stocks in that environment, because these capital- and labor-intensive companies tend to have anemic growth and thin profit margins. Very legitimate bankruptcy fears caused Growth stocks to outperform, even more dramatically than during the “tech bubble” of 1999–2000. Today the market capitalization of the combined Energy sector is still smaller than the market cap of Apple! The COVID-19 pandemic accelerated a multi-year period of Growth outperformance, which benefited our strategies.

In September 2020, after a prolonged period of underperformance, Value began to experience a strong rebound, driven by anticipation of a sharp economic recovery. This Value rally was sustained through the spring of 2021, sufficient for our discipline to conclude that a multi-year period of Value outperformance was dawning. Yet just as we had reduced our long standing and highly successful emphasis on Growth over Value stocks, Value gave up much of its gains over Growth due to the emergence of the Delta variant of COVID -19 and ensuing concerns about renewed lockdowns and a potentially faltering economy.

Unlike 2020, when our strategies outperformed rising markets, this year our strategies have made solid absolute gains but have lagged in relative terms due to being late to the start of a new cycle of Value outperformance. At this point we are comfortable maintaining our Value bias for several reasons. Our discipline shows that the cycle of performance between Value and Growth typically lasts for several years, and that once a trend-change signal has occurred, a long period of outperformance should be expected, despite corrections along the way. By design, we are always late to the start of a new cycle, as we wait for several months of sustained outperformance from a new trend to confirm that a portfolio shift needs to occur.*

Value stocks also remain very attractively y valued relative to Growth stocks: Having hit an all-time low during the pandemic, they are still cheaper relative to Growth stocks than during the “Tech bubble” of the late 1990s (which preceded a multi-year period of strong Value outperformance in the early 2000s). That remains the case even after their partial rebound over the past year. Value stocks are therefore priced for better returns over the long term and also for a cushion in the next sustained bear market. Importantly, the rate of Growth’s outperformance over Value has decelerated sharply since June; September ended with Value outperforming. The catalyst for Value’s renewed outperformance has been the demonstrated effectiveness of COVID-19 vaccines, particularly in reducing the risks of hospitalization and mortality.

Finally, as elevated inflation remains sticky and long-term interest rates rise, future profitability from Growth stocks must be discounted back to the present at a higher rate when assessing their worth. This poses a stronger headwind to their valuations expanding further from today’s frothy levels. In the meantime, we are being rewarded for being patient, as Value stocks return a larger share of their total return in the form of dividends. This allows us to generate more income and hold less cash, net of portfolio yield, to meet spending needs.

Policy Change

Elsewhere, we did make one change to policy by reducing our emphasis of Emerging Market stocks. Emerging Markets’ outperformance late last year, which continued early into this year, looked durable, as it was propelled by improvements in fundamentals in local currency terms. However, by mid-summer, momentum had stalled dramatically, signaling that something else was afoot. Over the years, we have learned to be decisive when our discipline calls for us to reduce our exposure to this area. We pulled back as concerns about government intervention in China escalated, and before the collapse of Evergrande- a highly leveraged real estate company in that economy - signaled that debt levels could spell contagion risk for the broader Emerging Markets sector for the foreseeable future.

Private Markets: From “Nice to Have” to “Must Have if You Can”

If public market Growth stock valuations look elevated, some of the valuations in private markets look quite frothy. Outside of domestic Value stocks, today’s starting point for above-average returns from public bond and stock markets remains challenged due to low interest rates and high valuations. Private market exposure has moved from a “nice to have” to a “must have,” for those who can tolerate illiquidity, to help meet portfolios’ after-tax income and capital growth goals.

In this environment, discipline is key. Given the long-lived commitments we make in this area and the likelihood that another recession will occur within the next decade, we are focused on managers with track records of managing through prior downturns. We believe that smaller firms can provide a unique idiosyncratic competitive advantage, while larger firms may feel the pressure of having to deploy large amounts of capital quickly. And we are pursuing a broad private capital program that avoids direct deals and concentration in a small handful of managers and strategies.

We are currently pleased with the progress of all our managers. Monroe, our Senior Secured Loan Manager, is now 40% called. It has been able to be selective in this market due to its smaller fund size and focus on the lower middle market. This has allowed it to originate loans at higher-than-average rates with protections, or covenants, in the event the borrower begins to flounder. This contrasts with the broader loan market, where the trend is for lower rates and no protections on loans.

We were busy in the venture space in the third quarter, as we approved two venture funds for portfolios. The first is Panoramic V, which is a rebranding of the BIP Capital Venture team, whose fund IV has been a part of our stable. While it is early, fund IV continues to outpace our expectations as it concludes its investment period. Panoramic has grown its team and capabilities for fund V, and we remain confident in its ability to deliver results for portfolios.

The other Venture fund we approved is the Adams Street Innovation Fund. In this investment, Adams Street is leveraging their 40 years of venture investing to gain access to the top managers around the world. Top-tier venture is still very difficult to access, but our relationship with Adams Street has offered an access point at very favorable terms. We believe Panoramic and Adams Street are a good blend of focused Southeast exposure and diversified global access to venture capital.

We continue our work on infrastructure and real estate, as we believe these two asset classes represent meaningful hedges against elevated inflation in the coming years. Market pressures are also supportive in certain areas as the world struggles with the need to become more energy efficient and shuffle real estate square footage amid changing office, retail, residential, and industrial dynamics. We expect to have additional offerings in real assets in the coming months.

We remain pleased with the pace with which our managers have put money to work and the returns they have generated for your portfolios. We believe the need for this type of access is greater than ever, as the level of liquidity in the market can easily push pockets of the public markets to head-scratching extremes. The patience and discipline our private managers deploy allows them to remain focused on adding value through efficiency, expertise and growth, and not just financial leverage¹.


Last year was one in which our strategies delivered outsized absolute and relative gains as our discipline helped us lean against the excessive emotions of a traumatic year. By contrast, 2021 has been a year of continued, steady progress as we are comfortable forfeiting some of the upside relative to the broader market in exchange for positioning portfolios for elevated inflation and higher interest rates in a post-pandemic world. As for the capital markets as a whole, the wall of worry that investors have been climbing became more daunting as summer turned into fall this year, and that looks likely to persist in 2022.

We are very grateful for the trust and confidence you place in our team and process. Thank you. Please do not hesitate to call if we can answer any questions you may have.

*Past performance is not indicative of future results

¹Please ask your Relationship Manager for more details on a private capital "roadmap" that can be used to increase the probability of your strategy to meet the goals outlined in your financial plan.

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