Remember when 2021 was supposed to be a return to normality? Instead, it has been a transition year featuring high inflation and the ongoing coronavirus pandemic continuing to disrupt regions across the world, especially as new variants emerge such as Delta and Omicron. These disruptions have impacted global supply chains as higher costs and delays in product deliveries have emerged. There have also been domestic labor shortages in transportation and logistics that have only added to the supply chain headwinds. While we believe these headwinds will gradually improve, the current supply chain constraints have driven costs – and subsequently inflation – higher. This is evidenced by the fact that annual year-over-year inflation, as measured by the Consumer Price Index (CPI), hit 6.2% in October. To combat inflationary pressures, the Federal Reserve (the “Fed”) may consider raising the federal funds rate above zero sooner than anticipated.
Despite the backdrop of inflation and ongoing pandemic, investors continue to seek risk assets. In fixed income, the spreads of non-investment grade bonds to Treasury bonds are in their top decile of tightness relative to the past 20 years. And, total yields of these high risk bonds seem to be ignoring historical default records.
Another risk measure is the Schiller Price to Earnings (P/E) ratio. The graph below shows a historically expensive P/E at 38.3x, a level only exceeded by the dotcom bubble in 1999-2000. The high multiple has been driven in large part by expansionary fiscal and monetary policy for well over a year. Another commonality with the dotcom bubble is the number of unprofitable companies. We believe this highly speculative market carries significant risk. If/when the market shifts from rewarding high risk, we could see significant contraction risk. One way to prepare for a potential downturn while still participating in the up market is to consider a more conservative equity strategy that invests in higher quality securities.
Source: http://www.econ.yale.edu/~shiller/data.htm
