The big shift: New market forces and ways to prepare, part 2

The Perspectives Podcast

 

The big shift: New market forces and ways to prepare: Part 2

With:

Chris Hyzy

Chief Investment Officer,

Merrill and Bank of America Private Bank

Savita Subramanian

Head of U.S. Equity & Quantitative Strategy

And Head of ESG Research,

BofA Global Research

 

Alex Lin

Senior U.S Economist,

BofA Global Research

 

Joe Curtin

Head of CIO Portfolio Management, Chief Investment Office,

Merrill and Bank of America Private Bank

 

Marci McGregor

Senior Investment Strategist, Chief Investment Office,

Merrill and Bank of America Private Bank

 

 

 

Please see important information at the end of this program. Recorded on 3/21/2022.

 

 

 

 

 

CHRIS HYZY:

Inflation and rising interest rates; a big policy pivot by the Fed; shifting supply chains; a new CapEx cycle for U.S. businesses; an important turn for sustainable investing. 

 

These are just some of the big shifts we’re seeing today. And they have important implications for our financial lives, including how we invest. 

 

So how can investors navigate what could be a very different market environment ahead?

 

Hello and welcome to this edition of the Perspectives podcast.  I’m Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank.

 

This podcast is an audio version of a webcast I hosted called “The big shift: New market forces and ways to prepare.”  It’s all about the major changes we’re seeing in the economy and the markets and steps investors could take from here.

 

We’re bringing you the podcast in two parts:

 

Here in part two, we focus on the big shifts happening in the U.S. markets and economy and what they could mean for our financial lives.

 

First, I speak with two experts with BofA Global Research - Savita Subramanian, head of U.S. Equity and Quantitative Strategy and head of ESG Research; and Alex Lin, senior U.S. economist.  We discuss what’s driving the sharp rise in inflation; where Fed policy and interest rates could go next; and the ongoing rotation in U.S. equity and sector opportunities. 

 

Then, I’m joined by two of our top market strategists with the Chief Investment Office – Marci McGregor, senior investment strategist and Joe Curtin, head of CIO Portfolio Management.  Together, we offer portfolio insights and ideas you could consider now to prepare for the risks and opportunities ahead.

 

And be sure to listen to part one, where we take a deep dive into the forces driving change around the world and their significance for global financial markets. 

 

With that, let’s go to my conversation with Savita Subramanian and Alex Lin.  

 

CHRIS HYZY:

Alex, let's start with you first: What three or four big shifts do you see out there? Is it the energy situation? Is it supply chain, labor, inflation, nominal growth? You could pick so many.

 

ALEX LIN:

I would say one of the first things is really that since the pandemic began, that we have seen a big rotation towards goods spending, right? Just thinking about the consumption basket; it's shifted about four percentage points towards goods. And this has contributed to the other, the second big shift, which is inflation, right?

 

We're now seeing the strongest inflation that we've seen in many years.  Basically, think about headline CPI, it's at eight percent, year on year. In terms of core CPI, it's at six and a half percent, year on year. (Source: U.S. Bureau of Labor Statistics, 03/20/2022.)  And that's the strongest inflation prints since the early 1980s, which is the last time that the U.S. dealt with major inflation.

 

And this leads to essentially this next shift, which is we're now going to have to deal with a Fed that is probably going to hike rates the highest levels that we've seen in some time.  They're probably going to hike rates another six times this year, another four times next year. And so they're probably going to try to get policy into a restrictive setting.  And that's going to create a much more challenging environment for the economy and probably for markets.

 

CHRIS HYZY:

With all of this as a backdrop under that big pivot that Alex talked about, Savita, take us through your thoughts right now on the markets, given what you thought coming into the year.

 

SAVITA SUBRAMANIAN:

What we've seen so far has actually been relatively anticipated. What we've seen is inflation beneficiary sectors that benefit from inflation have outperformed and sectors that don't benefit from inflation have underperformed. So that's in line with Alex's expectations of moving into more of an inflationary environment.

 

We're also seeing areas of the market that could benefit from higher interest rates and higher cash yields outperform. So where we're seeing the strength in the U.S. equity market is really in the cash heavy, free cash flow, yielding areas of the S&P 500, of the Russell 2000 and that's what we really like going forward.  Because if the Fed is going to hike six more times this year and potentially a few more times next year, that basically creates an environment where cash yields grow pretty significantly and that's actually a good thing for U.S. stocks because right now they're relatively cash rich. So I think that it's not all bad for equities. 

 

But the volatility that we've seen this year is also something that I think could continue for the next couple of years.  And I think what we need to really tether expectations to is an environment that could look very different from the last 20 years where we had generally disinflationary pressures. We had a lot of disruption coming from tech. We had no upward pressure on interest rates and I think what we're in for is a very different environment, not necessarily anathema for stocks, but it's going to be different.

 

CHRIS HYZY:

Well, let's talk about differences because under the big shift theme, there's a lot of differences from what many people have seen, as you've said, Savita over the last few decades. 

 

So, as we look out over the next few years and we have a higher nominal growth backdrop, we have higher inflation, the need for commodities as a diversifier in a portfolio should rise. Talk to us, Alex, about the labor supply and demographics. What's your view on that? And how does that feed into the broader backdrop of growth under the big shift theme?

 

ALEX LIN:

Sure, it is still the case that in the U.S. that we are dealing with an aging population.  And a lot of the boomers, right, they're one of the largest demographic cohorts in the U.S., they are in retirement, or they're now approaching retirement age. A lot of those people are falling off and so it is the case that labor supply is actually probably still going to be very challenged going forward.

 

And it's actually been very challenged over the past year. Right? We saw a big move lower during the pandemic. Right? A lot of those people were early retirements and that's explaining our belief that the labor supply issue is probably going to persist going forward. And that's really one of the key elements for why we're expecting inflation to remain elevated. Because we know that there's a very significant hiring demand in the U.S. 

 

Just thinking about the kind of job vacancies to unemployed ratio as kind of a signal of labor imbalances.  That ratio has moved up to 1.7. So they're now 1.7 job vacancies per unemployed people.  (Source: U.S. Bureau of Labor Statistics, 03/09/2022.)  Again, just really highlighting this labor imbalance.  So that's motivating the Fed to want to tighten rates to hopefully ease some of those demand pressures and allow it to kind of rebalance towards where labor supply has been trending essentially.

 

CHRIS HYZY:

So does that portend higher productivity, reinvestment, CapEx in the corporate sector to deal with that issue?

 

ALEX LIN:

I think so, yeah. Another big shift, I guess, to your point that we've seen in this cycle compared to the last cycle is that the CapEx trajectory has been so much stronger. Essentially, if you looked at the last cycle, it kind of moves sideways. But since the pandemic it's really just soared higher and if you look across various expectations in business surveys and what have you, they're all still sending variable bullish signals.  And I think with these labor supply issues, to your point, there is a desire to invest in more CapEx, invest in more automation to account for the fact that you just can't find the same amount of skilled workers as you could before.

 

CHRIS HYZY:

Savita, that's a great point. You and I have talked about this for probably two to three years. You were early in this, talking about the coming CapEx cycle.  Take us through your thoughts on the shifts that are going and your sector thoughts and particularly what you see now in technology given the repricing that's going on.

 

SAVITA SUBRAMANIAN:

Yeah, absolutely. So I think that Alex's point about almost a necessity for companies to spend on automation is paramount right now. And when you look at the labor shortages, when you look at the actual wage inflation that we've experienced in the U.S., I mean, it's staggering, if you think about what companies are shouldering today, relative to the cost of labor that they were paying a couple of years ago.

 

On top of that, we have an environment where companies are shifting from global to kind of near-shoring or on-shoring their plants and part of this is for national security reasons, other reasons include just carbon emissions.  It's more intensive to move stuff around the world rather than grow it in your own backyard. So lots of different things are moving around and creating a scarcity of labor in the U.S.

 

And what we're seeing is that companies have actually started to pencil in a much higher spend on automation, so this could benefit industrials companies, it could also benefit technology like semiconductors, we think is an area where we're going to see massive unit sales growth. 

 

What I worry about is that we're in an environment where investors have grown used to the idea that high secular growth tech companies just lead the market every year for perpetuity and that might not be the case going forward.

 

So we might want to look for some of the cyclical areas that'll benefit from CapEx, from a little bit of inflation, some of the less labor intensive areas of the market that could take some of the CapEx spending. So I think those are the areas that look really interesting in this environment.

 

CHRIS HYZY:

Okay. Savita, let's talk about another wave. Another shift.  Talk to us about the next wave of environmental, social and governance investing.

 

SAVITA SUBRAMANIAN:

So, a lot of changes have taken place within ESG investing, but one thing remains the same, the momentum continues and we're continuing to see flows into environmental, social and governance types of strategies or sustainable investing. The next generation, “Gen Z,” cares about ESG, even if they don't call it ESG. They care about allocating capital based on their values.

 

But what I think is different is instead of looking for companies that are best in class, ESG investors are now looking for improvers. So for example, energy was considered an uninvestible sector and most ESG funds are quite underweight energy. But I think what's interesting is that energy companies are essentially reinventing themselves.

 

So energy companies got the memo, they have set carbon emissions reduction dates. They are paying their CEOs in line with meeting those targets. So they're really putting their money where their mouth is and saying, “We're going to get better. We are going to become a more investible concept” in this environment of the world scrambling to get to net zero.

 

So it's a really interesting time to be an ESG investor, but I think it's a lot more nuanced than it was maybe five or 10 years ago.

 

CHRIS HYZY:

And still evolving.

 

SAVITA SUBRAMANIAN:

And still evolving. Absolutely. Lots of work to be done.

 

CHRIS HYZY:

So, let's end on this one final question as it relates to the big pivots and shifts that are going on. Alex, take us through the big one that you see, is it monetary policy? Is it the supply chain disruption? What is it between now and, let's say, mid-part of 2023?

 

ALEX LIN:

I would really say it's the Fed. And the reason I say this is because I think recently there have been a lot of concerns about recession fears, especially with these commodity shocks.  And from our perspective, that's probably not going to be the main driver of a recession, actually. It's probably going to be the Fed hiking cycle.

 

The Fed ultimately wants to engineer a soft landing, but if you look at history, their track record is not that great. But we do actually think that the Fed needs to get to restrictive policy, because again, we are dealing with such an elevated inflation pressures and you really, you can't fight inflation without a little bit of pain. 

 

But getting that right level of restrictive policy is going to be a challenge and that's really the main thing that we're kind of concerned about as we get into 2023.

 

CHRIS HYZY:

From your perspective, Savita, what turns investor sentiment for the better between now and the same timeframe, mid-2023?  And knowing full well, all the work you've done longer-term thinking -- time in the market versus trying to time the market? Can you put that in perspective?

 

SAVITA SUBRAMANIAN:

Absolutely. So I think that what we're all learning to do is navigate volatility and we've seen that come back with a vengeance this year. Let's think about how to craft your portfolio in an environment of rampant volatility.  And one of the things that we've learned in our quantitative work is that there is a very strong relationship between the outperformance of high-quality stocks and periods of rising volatility.

 

So the name of the game is stick with quality, look for companies that are generating predictable free cash flow, where their earnings are not going to be eaten up by higher wage pressures or spending on CapEx, but companies that are taking CapEx and that are relatively labor light.  We would also look for companies that benefit from inflation, like energy and even select financials.

 

To the second half of your question is, really the idea that when it comes to equities, time is actually one of the best arbitrage opportunities that we have as investors. And the reason I say this is if you think about the S&P 500 making money on a one day basis, you have a little bit better of a chance than a coin flip it's about, you know, 53% that the market goes up in a day and a little less than 50% that it goes down.  But if you extend your time horizon to about 10 years, that probability of losing money drops almost to zero, it drops below 10%. So over a 10 year period, the S&P 500 has gained over 90% of the time. (Source: S&P, Bloomberg, BofA U.S. Equity & Quantitative Strategy, 1929-Feb. 2022.)

 

And I think that is one of the advantages that we have as individual investors is thinking about the long term; buying companies, sticking with them, maybe not looking at your portfolio every day, but maybe letting some of these stocks ride and thinking about this as more of the long game, rather than a short-term trading strategy.

 

CHRIS HYZY:

Well, shifts or no shifts. That's a great place to end. Savita, Alex, thanks for joining me today.

 

ALEX LIN:

Thanks for having us.

 

SAVITA SUBRAMANIAN:

Thanks.

 

CHRIS HYZY:

That makes the perfect segue for my discussion with Joe Curtin and Marci McGregor on portfolio insights and ideas you could consider now.  

 

Joe, Marci, thanks for joining me today.  We had a lot of great insights from our previous guests about this big shift, market forces. How does that take into account everything that's going on? Not just what we've been through with the pandemic, but the crisis in Ukraine. And then following on, all of the different interplay that's going on right now: rising commodity prices, higher inflation, higher nominal growth, interest rates, the dollar, everything.

 

So with that in the context, Joe, let's start with you. Do the core principles of investing change?

 

JOE CURTIN:

You know Chris, I don't think so.  I think it really just highlights the importance of those core principles. You should always know why you're investing.  What is the best asset allocation plan to meet those goals with the least amount of pain that you need to take on.  And then you should really use these moments where we have volatility and lots of rotations in the markets to think about rebalancing. 

 

So I would say at the end of the day, if someone hasn't thought about rebalancing, this is an area that they really should sit down with their financial advisors and have a deep conversation about it.

CHRIS HYZY:

Marci, you talk to a lot of investors, a lot of clients, a lot of advisors.  What are the big things on their mind right now, given everything that's going on? And in particular to the big shift in monetary policy, big shift through the pandemic, and then obviously the higher geopolitical risk we're all dealing with.

MARCI MCGREGOR:

Yeah, so what I'm hearing from investors is uncertainty, right?  We're coming off of a pandemic where we're moving, hopefully, from pandemic to endemic stage with the crisis. But now there's a geopolitical crisis going on and an inflationary regime that we haven't seen in nearly four decades, right? And inflationary regimes then themselves tend to be volatile and they tend to be uncertain. So I get it. That's the number one thing I'm hearing from clients.

 

And, you know, it takes me back to our core principles and the one that really shines for me, is staying disciplined. We put a lot of thought and energy into our long-term plans with our financial advisors. I think of it as a roadmap.  What does a roadmap do? It helps you when you feel lost. And that's what I think people are feeling right now. So discipline to that long-term plan actually increases the odds that you'll meet your long-term goals.

CHRIS HYZY :

So time in the market versus timing the market is the focus we would like, but that doesn't mean do nothing. What does that mean in your perspective in terms of time in the market? Joe talked on rebalancing - tactical adjustments, adding themes to a portfolio?

MARCI MCGREGOR:

Absolutely. So of course, lengthening your time horizon improves your experience in the markets historically.  But I think you should also position for where we are in the cycle, right? We're mid to maybe late cycle right now. So you have to position for what is a strong economy, an inflationary regime where maybe inflation will moderate, but it's significantly elevated. So you want to be exposed to cyclical areas of the market, to equities, even though they're volatile. 

 

And then you mentioned long-term themes. I always think about what are the areas that are maybe glacially moving in front of our eyes, but with the hindsight of a decade, or the decade, you're going to see that the health crisis, the geopolitical crisis acted as an accelerant.  Those themes are important to position through for where we are right now.

CHRIS HYZY:

And Joe, it's difficult to work through a cycle, stay disciplined, stay consistent. It's harder to do that even when it's more volatility. So take us through your thoughts on this new found volatility, supply shock, energy shortages, commodity shortages, being accelerated right before our eyes and potentially lasting longer.  How do you account for that in a portfolio - in the core, or do you add to it?

JOE CURTIN:

Yeah, I would say you add to the core, right? You don't abandon it. So, this would be a good time where you start thinking about rebalancing into those areas that do really well in equities, in an inflationary environment, until that subsides. And what is that, right? That's going to be the value side of the equation, the cyclical sectors. It might be certain commodity-oriented investments or natural resource stocks, energy stocks. Right, that’s on the equity side.

 

And as interest rates go up, you really want to start underweighting your bonds, and looking at those sectors that get maybe the most negative impact from rising interest rates, like Treasuries and agencies, and start really favoring credit and shortening up duration and underweighting fixed income. And then once the interest rates rise to the level of inflation or close to it, then you start thinking about taking back some of the equities and buying fixed income.  

 

So the key is really use this part of the cycle, right? When you have volatility, certain things did bad, certain things did really good. Rebalance and continue to rebalance because things will eventually normalize.

CHRIS HYZY :

So rebalancing in the core to areas that potentially are going to do better than what we've seen recently in a non-inflationary environment. But then adding an overlay to protect it further or benefit further from rising prices, particularly in the commodity arena.

 

So another question to you, Marci, in terms of underneath the indexes, we've talked about this before.  Some of the trends will likely be more interesting below the index versus at the top of the index, which many of us have enjoyed for the better part of a decade. Underneath the index, what do you see as rotating right now? Is there a big rotation going on, a big shift?

MARCI MCGREGOR:

Yeah, there's a significant rotation going on in this market. And I think it's the cyclical sectors like Joe mentioned that are going to lead the way. So if we think about, you know, areas that benefit from higher commodity prices, so like energy and materials, sectors that maybe benefit from rising interest rates, like financials.

 

But I also think, you know, corporate profits are strong, but we're no longer in an environment where a rising tide lifts all boats, there's going to be winners and losers in this market. So I also think about quality.  Companies that have lower earnings volatility or variability is another area I would focus on in this rotation. So its value, it’s cyclicals. Don't abandon growth, right, it's not a binary decision. It can be ‘and’ in a well-diversified portfolio. But I do think it's those inflation and rate beneficiaries that are going to lead this market.

CHRIS HYZY:

Now let's go back to portfolio construction in terms of life stages, Joe. Talk about the different stages of the investment cycle and how to take a picture of all that, given all of these shifts that are going on for those who are about to retire, those who are just starting out, those who are trying to grow wealth. Take us through that. 

JOE CURTIN:

Yeah, depending on where you are in your life, let's say somebody who just graduated, it's about accumulation, right?  Taking advantage of savings opportunities, investing for longer term growth and establishing that plan and that nest egg and let that work for a while.

 

And then as they formulate a family, as they have children, they might have segregated buckets of money for college education, but they really should start adding more to those assets, continue to build the base. And every now and then, life throws its speed bumps at us.  There might be a change in family circumstance, could be a divorce, really starting over again, reestablishing and then taking stock, “How do I get back on track?

 

And then those closer to retirement, I'd say, take a step back. What does your portfolio look like relative to your goals?  And with the great performance we've had in the markets, maybe this is time to reassess, “Am I taking on too much risk? Should I de-risk a little bit, prepare myself for those initial years in retirement?” 

 

And then those in retirement, it's ensuring that you don't de-risk too much because you may still have another 30, 40 years in retirement. So you’ve got to ensure that there's still growth to supplement the income. So the idea is, as you progress through life, you should really reevaluate your plans.

CHRIS HYZY :

See, that's a great point, reevaluation. Really hard to reevaluate something without advice and guidance, particularly higher volatility backdrops, late cycle moves, geopolitical risk. We've all talked about this. How important is advice and guidance in the framework of the big shifts?

MARCI MCGREGOR:

I think it's more important now than ever. You know, I mentioned this environment feels uncertain. That's the number one thing I'm hearing from clients. So that guidance is critical. I also say make your goals personal, right? Because I think it increases the odds that we're going to stick with it, right? If it's a very personal goal, not something off 40 years on the horizon, I'm going to be more likely to stay disciplined.  

 

So I think advice right now is more critical than ever, because times feel uncertain, a lot is going on in the world, and paying attention to that long-term plan, that roadmap, I think is the most important thing we can do as investors.

 

CHRIS HYZY:

That's a great way to end. Practical insights, great takeaways. Marci, Joe, thank you for your time. 

 

And thank you all for tuning into part two of this Merrill Perspectives podcast on “The big shift: New market forces and ways to prepare.” 

 

Be sure to listen to part one, where we discuss recent events around the world and their significance for global financial markets.

 

Thanks again for listening.

 

 

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This podcast was recorded on March 21, 2022.

 

Ian Bremmer and Eurasia Group and GZERO Media are not affiliated with Bank of America Corporation.

 

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