2021 Fall and Winter Outlook

October 6, 2021

In our most recent webinar, we went over what we are expecting going forward and how we are positioning ourselves. We have recently made some minor alterations to the portfolios, so I just wanted to reiterate some of the things we discussed for those that missed it. On the positive side, we are seeing COVID cases start to turn down, but on the negative side, we are seeing a variety of economic indicators we follow begin to turn down from elevated levels. Based on the data coming out now, we believe we have seen peak economic growth. That doesn’t mean we think the economy will begin to contract but that we think the rate of growth going forward will be lower than what it has been this year up to now. There is always a risk of contraction, but we wouldn’t expect that to happen unless we are faced with more severe circumstances such as a new, more infectious, and deadlier Covid variant, or an unforeseen geopolitical shock.

One indicator I like to follow that gives a pretty good overview of how everything in the economy is doing is the Citi Economic Surprise Index. The Surprise Index shows us the difference between what was forecasted by economists and what actually happened. If the economists are right on the money, the Surprise Index would give a reading of 0. If the Surprise Index is negative, it means that the economic results were worse than what was forecasted. If it is positive, it means the results were better than what was forecasted. Since economists rarely get their forecasts right, you can see that the Surprise Index bounces around frequently. The Surprise Index isn’t just useful for showing us how incompetent economists are. It’s also useful for gauging market expectations. There are two main reasons for this. The first reason is that a lot of the time market participants think in terms of improvement from a relative standpoint. If things are getting better and that’s expected to continue, that’s seen as positive for the market, even if the current state of things aren’t looking good in absolute terms. The Surprise Index is what gives us the reading for how things are doing in relative terms. The other reason is that the Surprise Index is a fairly good indicator of how sectors in the market will perform. When the surprise index is positive, cyclical sectors tend to outperform, and when it is negative, defensive sectors are typically the outperformers.

Looking at what the surprise index has been telling us over the last year and a half, we can see that 2020 had the biggest swings for the Surprise Index since it has been recorded. When Covid and the resulting lockdowns first hit, the economic results were far worse than what was forecasted. Economists then revised their forecasts lower, but then everything started to reopen, and the result was that everything ended up being much better than expected at that time. Until about a month ago, the surprise index has been positive, meaning that the economy has been better than expected until just recently. That brings us to our concerns going forward. We believe the Surprise Index is now telling us what we should expect for the rest of the year. The effects of stimulus money are starting to fizzle out, forbearance relief is ending, and we have seen credit impulses across most major economies turn negative over the past few months. This gives us the expectation of an economic slowdown for the remainder of the year.

All of this leads to our thinking that for the remainder of the year, we think the best way to survive (and hopefully thrive) in markets is to favor defensives over cyclicals, growth over value, non-US over US, and large caps over more economically sensitive small caps. In the emerging markets segment, we have made a change to reduce our China exposure as we are less optimistic about China going forward. Within fixed income, we think that now is a good time to start extending the duration a bit and we have made changes to reflect that. We are also favorable on alternatives that have performance that is less connected to the overall economy.

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