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After the dramatic and sudden collapse of the global economy last year, The U.S. has spent most of 2021 in recovery mode. Although corporate earnings and revenue growth have reached new highs alongside a rallying market, the post-pandemic boom has been far from smooth. Supply chains remain constrained, many companies are struggling to hire workers, and supply/demand imbalances have thrown off the prices of everything from autos, to housing, to a range of global commodities. The latest surge in Covid-19 cases is also weighing on consumer sentiment and delaying many office reopening plans. So far, the market has ignored these stresses, making continual new highs this year. While we enjoy the growth in portfolios, there are several risks we are watching going forward:
Risk 1: Earnings Disappoint in the Near Term
Investors are expecting another tremendous quarter of earnings growth to be reported starting in just a week or so. With the resurgence of COVID-19 outbreaks this summer, it is unclear if that growth will meet expectations. Recent economic reports have been mixed, giving little insight into what corporate results will show. The latest retail sales report showed an increase of 0.7% in August after falling 1.1% in July, and existing home sales cooled a bit, down 2.0%. These mixed results may reflect an economy that continued to recover over the summer or an economy that remains under stress. Investors may be expecting just too much for the rest of the year. While we don’t see the market as significantly over-valued, we think there is a risk of a 10-20% equity correction if earnings fail to meet lofty expectations.
Risk 2: Global COVID Outbreaks Delay the Recovery
The most recent data suggests that the U.S. may be starting to move past the peak of its COVID-19 delta variant surge, but many parts of the rest of the world are still struggling with deadly and uncontrollable outbreaks. Some countries still can’t acquire enough vaccines to meet their needs and manage the pandemic. The unique storage needs of our Moderna and Pfizer vaccines render them nearly useless in many countries, so the U.S. is constrained in its ability to help. Over the summer, after one case of COVID, China closed a terminal for one week at the world’s third busiest port, causing shipping delays and backups across the globe. Increased restrictions and strict lockdowns like this around the globe may delay our recovery even as U.S. consumers are ready for a reopening. In the longer term, the U.S. can only grow to the extent the global economy grows. To manage this potential risk, we continue to invest portfolios with a mix of domestic-focused investments as well as global ones.
Risk 3: Inflation is More Persistent Than Expected
We believe that the current inflation spike is transitory, caused by short-term supply chain issues that should be resolved within 6-12 months. If we are too optimistic and inflation seems more persistent, interest rates are likely to rise. Even if the Federal Reserve does not increase its benchmark rate, bond investors that worry about inflation will push interest rates of all maturities higher in the markets. This is a particular risk to high-growth stocks that enjoy full valuations when interest rates are low. Increasing interest rates tend to lead to lower price multipliers for these stocks even if they continue to report strong earnings. Our portfolios have benefited from a number of these high-growth investments. To manage this inflation risk, we have been regularly taking profits in positions that have grown oversized.
So far this year, the S&P 500 has made over 50 new highs. Our portfolios have been well-positioned since the lows of last spring and participated in this performance. We still see an attractive recovery and expansion ahead for the economy in which equities should continue to do very well. However, we think it is always prudent to be prepared for a correction at any time and identify risks that might be mitigated and monitored.