“Every new beginning comes from some other beginning’s end.”
– Semisonic, “Closing Time”
The economy is growing a bit above trend. The labor market is a bit tight. Inflation is a bit high. Not perfect, but not the worst fate imaginable after a global pandemic and two wars. The Fed seems okay taking a backseat to the data, sitting patiently as investors struggle to understand why the economy is not buckling under the weight of higher rates.
It is easy to forget that austerity was politically popular following the debt-fueled real estate boom-bust cycle of 2005-08. [1] Between shortsighted policymaking on one hand and retrenching households and corporations on the other, no one was left to invest in the real economy. That was the old normal and rates were low as a result.
The pandemic was a different kind of recession and sparked a different kind of recovery. All three parts of the economy are playing offense in the new normal. Corporations are investing heavily into artificial intelligence all along the value chain from power generation to productivity-enhancing office tools. The government is upgrading infrastructure, helping reshore domestic manufacturing capacity, and accelerating the broader trend of electrification. Household consumption is rising, supported by a strong labor market and healthy balance sheets.
Productive investment is the seed corn of future growth. It means competition for resources today—labor and materials—and sparks efficiency and innovation. Investment is ultimately disinflationary as new capacity comes online. The new normal used to be the old normal so long ago, and markets have thrived in a variety of interest rate environments. In hindsight, we suspect it is the under-investment of the previous decade that will seem abnormal, along with the low rates it fostered.
QUARTERLY REVIEW
Equity markets rallied across the board in the quarter. Corporate earnings beat expectations and showed signs that profit margins have stopped falling, at least for large cap US companies. Beneath the surface, the market has been separating winners and losers. For instance, there has been large dispersion among formerly high growth companies that were investor darlings during the old normal. Those able to convert revenue into earnings (e.g. Uber) have been rewarded, while those that are unable (e.g. Peloton) have languished or gone out of business entirely.
Within fixed income markets, the 10-year US Treasury yield rose 0.32% to 4.20%, retracing nearly half of the rally from the prior quarter. Outside of long-term rates, most fixed income sectors produced at least modest gains. The riskiest segment of corporate bonds performed the best. Higher Treasury yields, positive equity returns, and tighter credit spreads—the connective tissue tying it all together is rising optimism about future growth.
MARKET OUTLOOK
The large technology companies concentrated in the US indexes touch nearly every part of the global economy, directly or indirectly. They have scalable business models built atop the internet that have grown quickly even at scale. They earn sizable profits that can be reinvested into AI development, the capabilities of which are improving daily. They are amazing companies.
An amazing company is not the same thing as an amazing investment. Investing is about the future, not trophies on the shelf. On nearly every pricing metric, the largest technology companies trade at a premium to other stocks in the S&P 500. The largest premia belong to those benefiting most from the AI boom, Microsoft and Nvidia.
We believe they deserve a premium, but we also know that trees do not grow to the sky. Fortunately, a diversified portfolio does not have to choose between all or nothing. We increased our exposure to these companies last year when we felt the market was not appreciating the scale of the opportunity in AI. At some point, the risk-reward may grow unattractive and justify leaning away from the heavily concentrated US indexes.
This exposure is balanced primarily with exposure to high quality large cap US companies. Earnings expectations are more reasonable, they have balance sheets that can withstand a downturn, and they are capturing gains from the reinvestment trends described above. It also stands to reason that as AI continues to advance, the productivity gains will be dispersed across the economy. Large cap companies are best positioned to make the investments required to capture this value.
Small and mid-cap companies remain broadly inexpensive, likely because of higher exposure to rising labor costs and floating-rate debt. We take a rifle shot approach within these markets, favoring firms trading at what we believe are low valuations with higher profitability ratios.
Within fixed income, the current level of elevated yields on cash and other short-term bonds remains attractive even though no one, including the Fed, knows how long it will last. Longer-term Treasury yields are higher than the start of the year, but we are not yet convinced they will provide the same level of protection in the new normal as they did in the old.
We have begun reducing our overweight to High Yield corporate bonds. The new normal is favorable for credit, but this reality is no longer our little secret. Bond prices have rallied, spreads are tighter. While there are still opportunities, the risk-return in publicly-traded credit is less favorably skewed in our favor. We prefer to take chips off the table.
What the new normal means for a diversified portfolio is a separate question from the economy itself. Valuations today are not extreme, but with optimism comes an even greater need for diversification and risk management. There are few investments that perform well in every environment, in the old normal and the new. Our goal is to be resilient to both, as well as whatever normal comes after that.
[1] Adjusted for inflation, the non-transfer portion of the US federal budget declined 9% from 2009 to 2013.
