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The Horizon – Q1 Update

Imperative Insights for Investors

Woman looking at the horizon

The Horizon is a quarterly report from our Chief Investment Office, exclusive to Merrill Private Wealth Management, intended to help high net-worth clients pursue their personal goals by addressing timely topics in areas such as macroeconomic trends, long-term investment themes, market dynamics, asset allocation and portfolio strategy as well as wealth structuring, planning and transfer.

“For the foreseeable future, the broader equity market likely will continue trying to come to grips with competing story lines and factors, creating a grind-it-out environment across asset classes. In this environment, it’s important to remember that volatility is considered normal, and pullbacks may create an opportunity for long-term investors to consider adding high-quality investments.”


— Neel Mukherjee,
Managing Director and Head of CIO Portfolio Strategy

The first quarter of 2022 was a tumultuous one as markets worked through a number of headwinds, including elevated volatility, a major geopolitical crisis, tightening financial conditions and the hottest inflation reading in 40 years. So far this year, we have written extensively about what this turmoil means for investors, reiterating the importance of staying committed to a disciplined investment approach in the face of uncertainty.

Our market thesis for 2022, as highlighted in The Meerkats and the Buffalo Market1, still includes higher volatility and larger pull-backs than occurred in 2021. We continue to believe that we are in the midst of a “buffalo market”—one that is still in the bull family but tends to roam more and get spooked easily, and is less attractive overall. For the foreseeable future, the broader equity market likely will continue trying to come to grips with competing story lines and factors, creating a grind-it-out environment across asset classes.

In this environment, it’s important to remember that volatility is considered normal, and pullbacks may create an opportunity for long-term investors to consider adding high-quality investments. In The Journey of Long-term Investing2, we indicated that shallow 5% pullbacks happen quite regularly―on average three times a year for the S&P 500 ―and that the market tends to bounce back quickly from these. Declines of 10% to 20% are also not that uncommon and occur about once every 2.5 years, with the markets recovering the selloff in roughly four months. Severe declines of 20% to 40% are usually associated with recessions and occur about once every 8.6 years, but even with those markets recover fairly quickly from the perspective of a long-term investor―14 months on average.3

 

“In our view, the global economy and the attendant financial markets are in a new and unique phase, with very different characteristics from the 2016–19 and the 2020–21 time frames. The current phase of the market cycle is characterized by higher inflation, lower central bank liquidity, and lower investment returns.”


— Emily Avioli,
Assistant Vice President and Investment Strategist

Market volatility is likely to remain elevated in the coming weeks, as the crisis in Ukraine remains a fluid situation. But investors should keep in mind that historical geopolitical shocks have been short-lived, with markets recovering and then some in the following months. In An Examination of Past Crises as a Guide to the Present4, we found that following major geopolitical events the S&P 500 has returned 8.8% in the subsequent 12 months, 6.8% in the subsequent 6 months, and 2.6% in the subsequent one month, on average.5 For investors, this underscores the importance of diversification and disciplined portfolio positioning.

It’s also imperative to understand that the macroeconomic backdrop is continuously shifting. In our view, the global economy and the attendant financial markets are in a new and unique phase, with very different characteristics from the 2016–19 and the 2020–21 time frames. In The Changing Forces Driving Asset Allocation6, we examine how the fundamental elements of asset allocation have evolved (Exhibit 1).

Exhibit 1: Key Forces Driving Asset Allocation by Era

  The Slow Expansion Era
(2016-2019)
The Pandemic Disruption Era
(2020-2021)
The Great New Dawn Era
(2022 – beyond)
Real Growth Remained anemic near 2% Historically high near 4%-6% Should glide lower to trend levels
Inflation Generally below Federal Reserve (Fed) target Rose to over 7% for CPI Persistently high
Money supply Normal 3%-7% expansion Exploded higher to 13%-25% Likely slows substantially
Fed funds rate Gradual increase to 2.50% At zero bound Multiple hikes expected
Fed balance sheet Increased to about $4.5T Increased to about $9T Quantitative tightening
Fiscal stimulus Tax cuts to improve U.S. corporate competitiveness Stimulus to support households, state & local governments, small businesses Fiscal drag given less likelihood of new spending
Company fundamentals U.S earnings outpaced international; shareholder returns favored over capex; companies maintained leverage over labor Profit margins rose; large companies fared better from pandemic disruptions; technology began to reshape business models; capex rose Cyclical earnings revival; dispersion based on pricing power and economic moat; accelerating creative disruption; labor gains leverage

Source: Chief Investment Office, Bloomberg. Data as of March 9, 2022.

The current phase of the market cycle is characterized by higher inflation, lower central bank liquidity, and lower investment returns. As outlined in The Journey of Long-term Investing7, we suggest that investors consider the following:

  • Investors should continue to remain anchored in their long-term asset allocation and ensure appropriate diversification across asset classes, regions and styles. Consider risk-appropriate tactical tilts and rebalance opportunistically to ensure optimal exposures.
  • Persistent inflation means that long-term investors should consider accessing and staying invested in assets that have a history of providing real returns, that is, returns above inflation. In our opinion, growth assets like public Equities and certain similar private assets make sense.
  • Seek total return opportunities. In our view, dividend growth strategies can provide potential income and benefit from rising prices in the economy which add to company cash flows.
  • Positioning may need to be more micro than macro as the effect of rising rates and inflation will be specific to sectors, industries and companies, leading to a higher dispersion in earnings. High quality, free cash flow, pricing power, operating leverage, sustainable yields, and relative earnings strength are features that are likely to be rewarded in the marketplace.
  • Having some allocation to Alternative Investments, for qualified investors, aimed at the purposes of capital appreciation, yield, inflation protection, and non-correlated exposure to traditional asset classes should be beneficial to portfolios from a risk/return perspective.