How to Navigate the New Pandemic Business Cycle

Nobody knows exactly what causes recessions, right? It’s one of the mantras we’re taught in Macro 101. Every few years, a complex collection of market inefficiencies will cause our ever-expanding economy to inevitably contract. And these market inefficiencies are so esoteric that even the most respected Nobel Prize-winning economists cannot predict a recession with any scientific certainty.

But the world we are living looks nothing like the one we were taught in Macro 101. Gone are the mythical, complex, financially induced reasons for a recession. Instead, they have been replaced with a much simpler explanation. In fact, it’s so simple that everyone from the chairman of the Federal Reserve to a child in elementary school could tell you exactly what caused the recession in 2020: COVID-19. And not only that, but this recession was also the shortest ever recorded—just two months long. For context, the average recession between 1945-2008 lasted around 11 months, according to the National Bureau of Economic Research (NBER).

The pandemic has shaken up the very foundation of macroeconomic theory—the business cycle. And that could have big consequences for investors. If we are in fact in a new expansion cycle, investors can rest easy knowing that it will likely continue for at least another few years. Some institutional investors, such as the Florida State Board of Administration (SBA), have taken this position.

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news. 

However, if this theory turns out to be incorrect, and the markets have still not corrected financial inefficiencies that have been brewing since June 2009, investors who aren’t hedging properly could face major consequences. Along those lines, Sean Bill, the chief investment officer at the Santa Clara Valley Transportation Authority (VTA), said his team is trying to prepare for a market slowdown.

“Now that the Fed is now talking about tapering and really being done with the taper by June or July, I do have to think it’s going to get a lot trickier,” he said.

Bill is particularly nervous about interest rates rising. “We are concerned that once the Fed and the ECB [European Central Bank], the Bank of Japan, and the People’s Bank of China take their foot of the accelerator, it would be a threat to the markets,” he said.

Santa Clara VTA has shifted its weight in certain asset classes to prepare for this new future. The fund has cut back its holdings in fixed income because the negative real yields have been a big drag on returns, according to Bill, and the team has shifted a lot of that money into hedge funds and private credit. Santa Clara VTA also maintains 10% in traditional hard assets such as real estate and 5% in diversified real assets such as farmland, timber, and minerals. The fund is also hopeful about the cryptocurrency space.

“Some of our hedge funds take a relatively substantial position in Bitcoin, which we do see also as another great hedge,” Bill said.

However, there is still some evidence to support the idea that we are in a new business cycle. Robert Barbera, an economist at Johns Hopkins University whose research focuses on the relationship between finance and macroeconomics, said this current economic expansion looks distinctively different from the expansion we saw before the pandemic.

“The expansion we were in from 2010 to 2019 was really disappointing economic growth,” he said. “The unemployment rate was low, but employment growth was so weak that nobody could get a job.”

In 2021, the situation has been much better for the labor market, with quitting rates reaching an all-time high in September. To Barbera, this is evidence of a healthy Main Street economy.

“I think that governmental authorities had a spectacular success in 2020,” he said referring to federal economic stimulus policies. Nevertheless, he cautions prudence when it comes to equity markets.

“The price we’re paying for that success is we have financial asset prices that are very hard to reconcile,” he said. “To me, it looks it looks like there is a valuation problem here. But the valuation problem is likely to be resolved once we see some stepwise interest rate increases.”

Exclusive: ‘Bull Market Is Going to Go for Another Few Years.’—Florida SBA Senior Investment Officer Talks Strategy.

After the Bull Market’s First Year, What Happens in the Second?

Tags: Bull Market, economics, Florida State Board of Administration, Robert Barbera, Santa Clara Valley Transportation Authority, Sean Bill, VTA

Higher interest rates and tech stocks don’t mix, as we saw with Tuesday’s market reaction to talk of imminent tightening from the Federal Reserve. The momentum tech-tilted Nasdaq 100 suffered a 1.1% fall yesterday, a quarter percentage point worse than the overall S&P 500’s dip.

So, if that’s where things are headed, where can stock investors go for decent returns? For Morgan Stanley’s chief US equity strategist, Mike Wilson, the answer is what he calls “large-cap quality defensive stocks.” That’s as opposed to large-cap quality growth stocks, mostly tech names—i.e., the ones that just got pounded. Prime example: Microsoft fell 3.3% Tuesday.

Quality is a Wall Street watchword lately, meaning solid businesses, strong balance sheets, and growing earnings and revenue. Those traits often are embodied in large-caps—those with market values of $10 billion and up—regardless of the sector they inhabit.

For more stories like this, sign up for the CIO Alert newsletter. 

Appearing on CNBC, Wilson lauded the defensive end of the large-cap quality spectrum as “bastions” and “safety nets.”

Overall, Wilson and his firm are bullish, with a year-end projection for the S&P 500 of 4,800; it closed yesterday at 4,634. That implies a 3.5% increase through the end of this month. He is more sanguine than he was in September, when he wondered whether trouble ahead would come from “fire” (inflation) or “ice” (a market correction). “Fire is happening now with inflation running hot,” he told the TV viewers.

But Wilson added that he expected an end to supply-chain disruptions and higher rates from the Federal Reserve to douse that problem. Meanwhile, regardless of whether a correction appears, he expressed wariness about risk-on strategies involving the tech leaders that have until recently been powering the market. The Nasdaq 100 is off 4% from a month ago.

“They’re falling by the wayside,” he remarked. Even worse off are small-caps, which now are in correction territory. Over the past month, the category’s benchmark, the Russell 2000, is down more than 10%.

And that’s where large-cap quality defensive plays come in. They are not necessarily cheap, sporting price-earnings (P/E) ratios well north of the market’s historical average of around 16. The point is, in Wilson’s estimation, that they can withstand headwinds better than can the tech behemoths, whose future returns would ebb as interest rates ascend.

While Wilson didn’t single out any particular stocks, let’s take a trio of large defensive stalwarts that meet his criteria. Their returns over the past month have hardly been stratospheric, yet they are a marked contrast to the tech titan’s downdraft. Becton Dickinson, the medical equipment supplier, has risen 1.2% over the past month. Clorox, the cleanser product company that briefly was all the rage at the pandemic’s outset, is ahead 1.8%. And soft-drink maker Coca-Cola has blipped up 2.2%.

Although noting that the S&P 500 in toto was “fairly resilient,” Wilson termed the large-cap tech outfits the losers in the current “mid-cycle transition.” A marker for the trend, he said, is the shrinking of valuations. Since the end of 2020, when stocks enjoyed a huge turnaround from the early-pandemic lows, the S&P 500’s P/E has slid to 25 from almost 40. In historical terms, the current level is still high, just nothing like before.

Up ahead, there could be an earnings slowdown and margin compression, he warned. Not for his bastions, though.