As we reflect on 2021, we can’t help but think that it was one heck of a year. While we had much to worry about, we also had much to be thankful for. Most importantly, despite two major Covid variants, Delta and Omicron (that latter of which is still very much with us), we’ve mostly managed to return to our pre-pandemic lives. In addition, the economy bounced back in 2021, delivering strong corporate earnings despite the continued snarl in global supply chains and rising inflation. On the other hand, companies still cannot hire enough workers to meet demand, though we are seeing some improvement there. And, of course, the Fed finally acknowledged that this inflationary bout may not be transitory after all.
Given that one can only invest looking forward, it is important that we understand the magnitude of the potential headwinds we face versus the tailwinds and their possible impact on the markets we invest in. Our headwinds remain continued inflation, rising interest rates, further lockdowns, and a less accommodating Fed. Our tailwinds are healthy corporate profit growth, strong consumer demand, and continued improvements in the labor market. Given these crosscurrents, we think it is critical to find the right balance between offense and defense. Sometimes it is better to play defense by finding calmer ports to wait out the storm than it is to make a prediction and bet on the outcome.
Corporate profits were very strong in 2021. The FactSet consensus estimate for 2021 S&P 500 earnings growth is 45.1%, which is extraordinary given the myriad challenges the economy faced. The 2022 consensus earnings growth estimate is considerably lower, currently standing at 9.2% − still a very healthy number but a marked slowdown from last year. (Note that this estimate is likely to be revised many times throughout the year.) The real question is whether equities can continue their winning ways. The S&P 500 returned 29% in 2021, following an 18% rise in 2020, and a 31% increase in 2019. While we like many of the current economic underpinnings of the market, we feel stock selection will likely be critical to success in the new year, as investors will be confronted with the potential for rising interest rates combined with the headwinds of slower, albeit positive, growth, the possibility of P/E contraction, and the prospect of continued supply chain disruptions due to the pandemic.
The Fed will remove references to inflation being “temporal and transitory” in future communications. We think this more realistic approach was overdue and, as a result, accommodation in the form of quantitative easing will be tapered starting in 2022 and could end as early as March. This paves the way for the start of a fed funds rate hiking cycle. So far, the consensus is for three rate hikes in 2022 and three in 2023. If that turns out to be the case, then by the end of 2023, the fed funds rate would be where it was at the start of Covid. We believe that this measured pace would allow markets to adjust and should not result in material revaluations. Whether it is enough to stave off increases in inflation remains to be seen; however, we feel that a normalization of rates is a healthy development that could dampen the enthusiasm for unbridled speculation in some corners of the market such as Crypto and non-fungible tokens (NFTs). 2
Inflation remains a concern, but we still feel it is under control. Some sectors, such as used cars, shipping, and some consumer goods are seeing very large price increases, but we have not seen persistent inflation following the price spikes in some commodities. In fact, as production began to ramp up, some prices have stabilized, albeit at higher levels than pre-Covid. While a book could be written about inflation, let it suffice that as long as we have decent economic growth, a fuller reopening, and continued wage gains, it is likely to remain above trend for some time. That will probably mean that interest rates will move off the zero bound and stay there, barring any exogenous events that could derail the economy.
Despite fears about the holiday shopping season, consumer spending was robust, rising 8.5% above last year. Savings have been bolstered during the pandemic and consumer sentiment remains very high. Record job openings may also give the consumer more confidence for the future. The latest year-over-year hourly wage growth reading was 4.8%, a very healthy number. We surmise that the latest Omicron spike and concurrent self-policing has only created more pent-up demand − the consumer should not be an issue in 2022.
When we survey the landscape, we continue to feel that non-investment grade (non-IG) debt offers very favorable forward-looking risk-reward characteristics. When compared to the investment grade (IG) universe, in aggregate, the credit quality has improved over the past five years and the interest rate risk has declined. The opposite is true for IG corporate bonds.
Since 2016, the lowest credit risk component of the non-IG ICE BofA U.S. High Yield index, BB debt, has increased from 49.30% to 54.46%, while the highest credit risk component, CCC debt, has declined from 13.84% to 10.07%. Conversely, in the investment grade ICE BofA U.S. Corporate index, the weighting of the highest credit risk segment, BBB debt, has increased by 3.03%, while the weightings of the two lowest credit risk segments, AAA and AA, both declined. (AAAs make up only a sliver of the index so the decline was small, but AAs fell materially – from 11.46% to 8.22%.)
Additionally, the overall duration of the ICE BofA U.S. Corporate index has risen from 6.98 to 8.34, while the duration of the ICE BofA U.S. High Yield index has fallen slightly from 4.25 to 4.04. This means that for a 100-basis point move in interest rates (presumably upwards in 2022/3), the price of an IG bond would decline by 8.34 points, vs. 4.04 points in non-IG. Given that the yield-toworst is 2.36% and the coupon is 3.70% for IG corporates, it’s clear that there is little room for policy error here. This compares to a yield-to-worst of 4.32% and coupon of 5.68% for the non-investment grade universe.
All of this does not mean there are not attractive defensive sectors within the IG universe, but since non-IG bonds tend to be positively correlated to improving economic performance, unless there is a recession on the horizon, they should hold up fairly well and also deliver better yields. In absolute terms, neither market is what we would call cheap at this point, but neither are they at extremely rich valuations. However, we still believe that having a shorter maturity profile is warranted.
Let us hope that we are nearer to the end of the pandemic and are saying goodbye to Fed-induced distortions to interest rates, the economy, and markets. Here’s to 2022 and beyond being healthy and prosperous. We thank you for your continued faith in us.
Carl Kaufman, Bradley Kane, Craig Manchuck
The Osterweis Funds are available by prospectus only. The Funds’ investment objectives, risks, charges and expenses must be considered carefully before investing. The summary and statutory prospectuses contain this and other important information about the Funds. You may obtain a summary or statutory prospectus by calling toll free at (866) 236-0050, or by visiting www.osterweis.com/statpro. Please read the prospectus carefully before investing to ensure the Fund is appropriate for your goals and risk tolerance. Mutual fund investing involves risk. Principal loss is possible. The Osterweis Strategic Income Fund may invest in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. The Fund may invest in foreign and emerging market securities, which involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Small- and mid-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies. Higher turnover rates may result in increased transaction costs, which could impact performance. From time to time, the Fund may have concentrated positions in one or more sectors subjecting the Fund to sector emphasis risk. The Fund may invest in municipal securities which are subject to the risk of default. Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. It is not possible to invest directly in an index. No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management. The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance. Price-to-Earnings (P/E) multiple is Price-to-Earnings (P/E) ratio is the ratio of the stock price to the trailing 12 months diluted EPS. The Federal Funds Rate is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis. Cryptocurrencies are digital or virtual currencies underpinned by cryptographic systems. They enable secure online payments without the use of third-party intermediaries. "Crypto" refers to the various encryption algorithms and cryptographic techniques that safeguard these entries, such as elliptical curve encryption, public-private key pairs, and hashing functions. Non-fungible tokens or NFTs are cryptographic assets on a blockchain with unique identification codes and metadata that distinguish them from each other. Unlike cryptocurrencies, they cannot be traded or exchanged at equivalency. Investment grade includes bonds with high and medium credit quality assigned by a rating agency. Carl Kaufman Bradley Kane Craig Manchuck 4 ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. ICE BofA U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market. A basis point (bp) is a unit that is equal to 1/100th of 1%. Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist. Duration measures the sensitivity of a bond’s price (or the aggregate market value of a portfolio of bonds) to changes in interest rates. Bonds with longer durations generally have more volatile prices than bonds of comparable quality with shorter durations. Effective Duration is a duration calculation for bonds with embedded options and takes into account that expected cash flows will fluctuate as interest rates change. Effective duration is calculated only on the Fund’s fixed income holdings and cash. The yield to worst (YTW) is the lowest potential yield that can be received on a bond, assuming there is no default. The Weighted Average Coupon is computed by weighting each security’s coupon rate by its market value in the portfolio. A security's coupon rate is its annual coupon payments relative to the security’s face or par value. Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [ OSTEOSTE-20220104-0408]
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