As we embark on the final two weeks of a challenging and unpredictable year, it seems the next year will resemble its predecessor, but with some unique and important differences. In parsing the macro and the micro, we are reminded that we dress for the weather, but the climate has a longer-term influence that often gets disregarded.
As we heard this week, the economic climate finally began to shift the Federal Open Market Committees viewpoint and long gone is the transitory belief that inflation will subside, and we will return to normalcy. Now this begs the question, what is normal and how can that ever be a reasonable conclusion? Ultimately, I think most investors “normal” is a time where chaos subsides, and predictability becomes more reliable. If that is a correct assumption, then I believe the recency bias is influencing far greater than we may know.
The big story is inflation and the minimalization that investors gave it as far as a tectonic force. This is understandable as an elevated inflation level has not been seen for nearly three decades. We became accustomed to longer expansions relative to history and assumed that is the new normal. What history has shown from a behavioral finance perspective is that the more evolved we believe we are and are not vulnerable to emotional swings, the more we become susceptible to those. The blind spot from assuming we are no longer exposed to it often brings back the correction disregarding that contingency.
Inflation pure and simple slowly erodes economic and market expansions. The cumulative effect of elevated inflation begins to shift the top two metrics we look for when a longer-term correction takes place. History has shown that economic and market shocks have four L’s that need to be monitored and measured prior to a shock: Liquidity, Leverage, Lethargy and Leniency. The first two are a bit of a counterbalance where when liquidity is rising, leverage is often lower. Currently, liquidity is still high in nearly every facet of the economy and leverage is relatively low. This can change slowly at first and pick up a counter trend as inflation begins to erode both household and corporate liquidity. While we are not at a critical juncture yet, asset price vulnerability and elevated prices begin this process of draining excess liquidity. This is represented artistically from a consumer confidence number and the various political polling numbers showing dissatisfaction with the elevated strain from higher prices.
We expect GDP growth to be a solid 4% next year and corporate earnings to be in the 6-8% range on a year-over-year basis. While this is solid, the news of the Federal Reserve projecting three rate hikes next year, begins to see the higher percentage of these growth metrics occurring in the first half of the year. We do expect inflation to recede from these historic levels to a more 3.5% annually on a longer-term basis. So while it recedes from these levels, it is still elevated from the averages over the last 30 years and that amplifies the silent drain to liquidity.
Corresponding to these interest rates and a slow erosion of liquidity, we will begin to see a tick up in leverage. The interest rate sensitivity coupled with the Federal Reserve’s historic quantitative easing that began over a decade ago, will strain some of the metrics for various growth sectors and certain high duration equity and debt instruments. We see income being the crucial aspect to returns in a world where there appears to be marginal rates of price return.
We continue to like the value aspect of equities with continued focus on the energy, financials, materials and health care sectors. Internationally, after a strong start, the emerging markets struggled. While one of our choices for 2021, we continue to see the risk reward scenario for various emerging markets as still being very favorable. While there will be some tensions, we would focus on Asian emerging markets, Eastern European and select South American countries. In the developed world, the UK and Japan may provide better price returns. We would also be selective in the European markets with the larger export driven countries getting a neutral allocation. We believe stock selection and active management will be crucial to navigating the ebbs and flows of the equity tides next year.
For income investors, we would favor taxable and tax-exempt municipals with various bar bell strategies encompassing credit and coupon factors within the model. We would favor dividend-paying companies with an expected increase in dividends paying next year as well as look at alternative income from bank loans and floating rate structures.
We believe housing will begin to slow down from its torrid level, but still be positive returns with certain regions being much higher than others. Commodities continue to see elevated pricing pressure and we would expect to see a more consistent growth to this sector relative to the visceral spikes seen in the last 12 months.
It appears to us that the quantitative analysis for asset returns and the fundamental analysis are pointing to a more difficult asset return market for the next few years. While spikes in returns are possible and should be expected, ultimately the prices and the multiples they represent, may take a few years for them to justify and are priced for perfection. When markets are priced for perfection, then perfect execution only maintains prices.