Volatility rising – what investors need to know

While inflation remains top of mind for investors worldwide, confidence in the vaccination drive and global recovery, combined with the expectation of relaxed monetary policy, have helped offset inflation concerns. In the US, the economic recovery has strengthened, and a record number of companies have issued positive guidance for the second quarter.

The market had slipped back when inflation jumped and the Federal Reserve brought forward interest rate hike planning, but stabilized as Chair Jerome Powell pledged to take a measured approach to tightening. Because interest rates are still low, equity markets keep pushing higher. Despite inflation fears and the prospect for tighter incremental monetary policy, the markets are clearly still settling back on an expectation of an environment that is going to involve persistently low interest rates for a long period of time.

Clearly, the markets believe meaningful tighter monetary policy is in the too distant future. Gains can continue as long as earnings growth continues. Multiple expansion of stocks is much more behind us than in front of us, so the level of earnings growth going forward will play a more predominant role in the level of stock returns.

From a political standpoint, the Biden administration has generally delivered on issues as forecasted. Vaccination programs, transfer payments to consumers, the ongoing move towards infrastructure, the US’s geopolitical stance on global relationships, and heightened regulatory scrutiny in certain areas have minimized uncertainty in the markets.

As we progress through 2021 and enter 2022, we expect to see a rise in volatility. The political landscape will naturally become more contentious as the important mid-term election serves as a barometer of the public’s satisfaction with the Biden administration.

We expect rising inflation will continue to be an issue in the second half of this year. While some price increases are slowing for goods like lumber and used cars, others remain high. Inflation should ease further into 2022 after unemployment benefits expire and wage pressures normalize.

While investors fear rising inflation, it generally indicates a healthier economic environment. Investors should keep an eye on the upcoming Jackson Hole Economic Symposium and whether Powell will give any guidance on scaling back massive bond purchases, which could have an immediate effect on sentiment and spending

Hedging inflation with quality

Companies with the right business models can withstand inflationary pressures. For example, certain strong consumer goods companies such as Nike have powerful brands that can command high prices, and have high margins. Good pricing power can outpace growth in the markets in an inflationary environment. Pricing power also comes through in business models focused on maintenance, services and subscriptions that are less economically sensitive, or where there is recurring demand for products that consumers’ need, desire or have a regulatory requirement to consume.

Investors tend to flock to commodities, such as energy companies, as a hedge against inflation. While energy companies may benefit in the short term as the price of oil rises to keep up with inflation, energy is a capital-intensive industry. Eventually, companies will have to re-invest in the business, at least to maintain production, depreciation will increase, and margins will normalize.

We should expect some continued equity market volatility this year as economic data fluctuates from quarter to quarter. But given interest rate policy should remain fairly accommodative over the next 18 months and the threat of Covid-19 is dissipating, we believe the landscape is positive for active stock pickers to find good investment opportunities. In life and the markets alike, there are too many unknowable variables to successfully time a cycle.

A common misstep in investing is the idea that you need to forecast these shocks to the market, like the pandemic or the last financial / housing crisis. Instead, investors should focus on getting attractive investments right, i.e., the business and the business economics, and ideally those businesses that are cycle resistant or agnostic. 

Resisting the siren song

It is as important as ever to focus on quality in today’s markets. By looking for companies with consistent and sustainable earnings growth, investors can maintain conviction that these companies should emerge strongly from inevitable ongoing market volatility. The rampant rise of thematic investing can cause distraction for some investors. In general, following a thematic approach can end up bringing you to stocks that are already well appreciated by others (because it’s unlikely that you had the thematic idea first or that it’s something very unforeseeable to most people).

By following themes, you run the risk of being in a good area and perhaps in a good company, but in a bad investment because of the valuation or euphoric optimism being priced into the future growth of the business. We believe investors should always start with a great company with strong economics and with an attractive predictable future, trading at an attractive valuation—whether or not it fits into some broader attractive story or narrative. Sometimes these bottom-up investments do end up in what seem like broader thematic areas, but we think it’s best to approach them from the other direction.