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Equities: Into the unknown

SCOTT KEFER, CFA 12-Jun-2021


Not to be overly dramatic, but we really are entering the realm of the unknown, at least as economics are concerned. The potent tag team of the pandemic and policy-makers is conspiring to set up a collision of epic proportions. This may have significant ramifications for all those popular passive strategies that have been the default approach for building a core equities portfolio. We think it might be time to reallocate. 


Our unprecedented monetary and fiscal stimuli are colliding with the reopening of the global economy. Most investors understand that the Federal Reserve (and other global central bankers) have pledged to keep rates low for longer to allow the economy to regain its footing and lost employment. Congress also stepped up with massive fiscal stimulus for the very same reason. But what’s difficult to grasp is the sheer magnitude of these actions and the fact that they are happening in concert.

Any graph of the Federal Reserve’s balance sheet (or European Central Bank’s, for that matter) will illustrate the dramatic expansion since the pandemic. Money supply, which typically grows at a moderate pace, also has surged higher by several hundred percent since the pandemic. Not to be outdone, the U.S. government kicked in with a $1.9-trillion stimulus in March, and the next wave is no doubt coming soon. These are other worldly numbers, and we have never unleashed this type of “support” on the economy before, let alone at the same time.

Meanwhile, an estimated 45% of the U.S population had been vaccinated as of mid-May, according to the US Centers for Disease Control and Prevention. That’s great news, and the economy is clearly re-opening quickly. Robust demand and expanding consumer net worth (thanks to stock portfolios and home prices) are proving to be potent medicine for the economy. At this point it looks certain that prices, inflation, and higher interest rates are on the way. When and how much are the only real questions. 

What does all this mean for investors? The three massive forces that are colliding—an accelerating vaccine rollout, extreme levels of monetary and fiscal stimulus, and pent-up demand—are together thrusting us into a new expansionary and pro-cyclical phase of the economic cycle. Thus, we believe we are in the midst of a true regime change that has significant ramifications for equity portfolios. In this new phase, we see value-oriented strategies and companies with cyclical exposure poised to outperform on a relative basis. In fact, such new market leadership may turn out to be worrisome for investors who rely on market cap-weighted passive approaches for their core equities exposure.

Remember, in recent years domestic market leadership has been dominated by just a handful of mega-cap stocks. As of the end of the first quarter, the top 10 stocks in the S&P 500® Index represented 27.4% of the Index. That type of overweight position was fine when the proverbial FAANG + M stocks—Facebook, Apple, Amazon, Netflix, Google (i.e. Alphabet) and Microsoft—were providing a nice tailwind and powering returns in the S&P 500. For years, it didn’t really matter much what the rest of the companies in the index (including those value-type companies with cyclical exposure) were doing. We think it’s about to matter once again. 

In response, investors may want to look for strategies that offer exposure to large-cap U.S. stocks without subjecting themselves to the inherent limitations of traditional market-cap weighting. For example, a volatility-weighting methodology allocates to stocks based on volatility, so each stock in the portfolio has an equal contribution to overall risk. Not only is that a more diversified approach, but it could insulate investors against the possible underperformance of mega-cap stocks versus the broad market, while also providing greater exposure to cyclical stocks and sectors. 

It's a new world out there. Simply buying funds that track the cap-weighted S&P 500 may be popular and easy, but it may not be the best way to build a core equities portfolio. The tailwinds of high market concentration that once helped may now be headwinds. We believe there are other systematic approaches that are better for the pending collision of fiscal and monetary stimulus with the global economic reopening.