Article November 30, 2021

Monthly macro update – November 2021


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Snapshot of views

US equity markets bounced back from a weak September to reach all-time highs despite ongoing concerns about inflation. Our primary concern is to what extent inflation causes policymakers to withdraw monetary support prematurely, which could negatively impact equities. Recent assurances from the US Federal Reserve, as well as other central banks, are supportive of our ongoing preference for equities. We expect equities to be supported by above-trend economic growth and low real borrowing costs. Equities should outperform other return-seeking asset classes over the next 12-18 months (albeit more muted than the last 12-18 months in absolute terms). As policymakers withdraw stimulus, we expect bouts of volatility to be sharper, which warrants greater consideration of downside protection strategies. We continue to prefer equity over credit.

Equities reach new highs

US equity markets bounced back from a weak September to reach all-time highs, driven by strong corporate earnings and central banks maintaining accommodative policy. We have long said that corporate earnings would be the primary driver of equity returns in 2021. Companies are benefitting from strong demand and many have the ability to pass on increased costs to consumers. However, we are aware of the risk higher inflation presents, specifically if it causes central banks to raise interest rates much more quickly than is currently expected by markets. The US Federal Reserve’s current commitment to a slow withdrawal of bond purchases, followed by gradual interest rate increases, even if inflation remains higher than it has averaged in the past, supports our preference for equities.

As shown below, US GDP growth continues to surpass pre-pandemic levels, bringing total US real GDP back to where it arguably would have been absent the pandemic. Negative real interest rates (interest rates adjusted for inflation) and low nominal corporate borrowing costs continue to support capital expenditures and other investment.  This should help to support the corporate sector and keep GDP growth at or above long-term trend.

US GDP has recovered back to trend

Source: Bloomberg, November 10, 2021

Fading stimulus warrants downside protection

While our base case is that equity returns will be positive over the next 12-18 months, we expect more muted returns than over the last year. Monetary and fiscal stimulus has been effective in providing a backstop to equity markets throughout the pandemic and limiting market corrections. But as policymakers withdraw stimulus, albeit gradually, we expect bouts of volatility to be sharper. Historic analysis illustrates this pattern, with 5 of the last 7 equity drawdowns over 10% coinciding with the bottom quartile stimulus (shown in the table below). We expect our measure of central bank stimulus to enter the 3rd or 4th quartile in 2022.  This calls for the greater use of risk management tools such as structured equity. Structured equity provides defined exposure to equity markets, usually with explicit downside protection. Given we expect more modest equity returns over the next year, sacrificing high gains (which are less likely to materialize) in favor of downside protection, can be prudent, risk-managed way of maintaining a meaningful equity allocation. Not that we think equities will fall, rather, it is an acknowledgement that equities may not rise as uniformly or rapidly as in the past 18 months and investors who have defined needs may find it is more efficient to utilize protection strategies.

Source: R&M, Bloomberg, Index is S&P500, November 10, 2021. Market Drawdown is the percentage change in market index price from peak to trough.

Lower quality bond yields move negative

As credit spreads (compensation for a risky bond above a risk-free bond) progressively tightened over the past 18 months, we took steps to reduce our exposure to credit. Due to higher inflation and low corporate bond yields, lower-quality bond yields have now taken the unprecedented step in moving negative in real terms. This means that if inflation were to remain at these levels, a broad index approach would lead to investors receiving a return below inflation for lending to higher-risk companies. While monetary and fiscal policies have been effective in minimizing economic scarring from the pandemic, it is realistic to think defaults may rise as policymakers withdraw support. This justifies the use of opportunistic credit mandates which can select more attractive individual credits and can rotate away from segments of the market which look increasingly overvalued or susceptible to default.

Source: Bloomberg, November 10, 2021
Investment advisory services are provided by River and Mercantile LLC, an investment advisor registered with the US Securities and Exchange Commission.  It is a subsidiary of River and Mercantile Group PLC, a U.K. corporation.
The information and opinions contained in this document do not constitute investment advice and is provided for background purposes only. References to specific securities are provided solely as illustrative examples of the River and Mercantile LLC analytical methods, and are not a recommendation to buy or sell such securities. This information is subject to updating and verification. Portions of this presentation are based on data provided by third parties whom River and Mercantile LLC deems to be reliable; however, River and Mercantile LLC cannot guarantee the accuracy and completeness of the information.

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