Is the financial impact of Covid over? We believe so. The Omicron spike appears to be high but short-lived. While this may create supply chain disruptions, we don’t expect markets to react to these in the near term.
Will inflation persist? Yes. Inflation is likely to be the most important factor driving financial markets in coming years. Structural factors that have kept inflation low for the past several decades are shifting. This will have a profound impact on asset class relative performance going forward.
Will the Great Resignation last? No. A September Harvard Business Review analysis found that resignations are highest among mid-career employees, suggesting this labor market dynamic is transitory. But the wage pressure effects are likely to linger.
Will tensions grow between China and the U.S.? Yes. There’s a diplomatic boycott of the Beijing Olympics, and Congress approved the Uyghur Forced Labor Prevention Act. How global leaders respond to China’s human rights violations will have financial implications. If China feels victimized, it could respond with sanctions or tariffs, which could jolt financial markets.
Will monetary policy tighten? Yes. The Fed outlined a plan to remove monetary accommodation and start hiking rates. The market is pricing in interest rate hikes in the coming quarters, but will the economy allow the Fed to raise short term rates beyond 1.75%? We think the Fed may need to acknowledge this pace is inadequate. The longer the Fed is wrong about inflation, the more credibility it loses. In 2022, we expect that the Fed will hike more than it has currently signaled.
Should we be worried about tech valuations? Yes. Weighted by market capitalization, tech shares currently trade at higher multiples than the rest of the market. The Nasdaq 100 is close to its all time high as are the five largest tech stocks. By contrast, the fastest growing unprofitable tech names saw their valuations cut by 20% in 2021 and are 37% below peak. Valuations remain rich and if discount rates move higher, stocks valued based on distant future earnings could fall further.
Other risks we’re concerned about. Geopolitical unrest: An escalation between Russia, the main provider of energy to Europe, and Ukraine could send energy prices significantly higher. If China becomes aggressive toward Taiwan it could impact semiconductor production, which is crucial to everything from smartphones to cars.
Leverage: Its high in private credit, crypto and non-profitable tech equities.
Fiscal cliff: The drop in Covid-related stimulus could drag down growth.
In summary, we expect economic reflation and are overweight real assets including TIPS, oil, and industrial metals. Higher sustained inflation would cause cash to lose value quickly, turning it into a risk-increasing rather than risk-reducing asset. With yields still low, we have turned to proprietary liquid alternative strategies to replace traditional fixed income and are avoiding most credit. As to equities, we don’t believe valuations are justified by low rates. The valuation premium will decline if rates move higher.