First Eagle 4Q21 Market Overview: Even an End Has a Start

KEY TAKEAWAYS

• Developed stock markets pressed forward in the fourth quarter despite the emergence of the Omicron variant and a hawkish turn from the Federal Reserve. Elevated equity valuations, especially in the US, suggest little room for error as policymakers seek to tame decades-high inflation without waylaying economic growth.
• One major consequence of the easy-money environment of recent years has been signifi-cant concentrations of certain stocks, sectors and markets within indexes—and correspond-ingly high risks to portfolios benchmarked to them.

• Current distortions in relative performance— between US and non-US stocks and between growth and value names—may represent greater potential to benefit from normalization trends, especially if the underlying drivers of US outperformance begin to fade, as it seems they may.
• First Eagle seeks to invest in companies that combine sound business positions—or, even better, an engine to improve their current positions—with modest market expectations as reflected by valuation multiples, ultimately striving to construct vibrant, all-weather portfolios that position our clients for the long term.

Though robust fourth quarter gains capped off what was another banner year for developed equities, markets grew a bit choppy into year-end as monetary policy normalization loomed.

Strength during the quarter continued to be led by the US; the MSCI World Index gained 7.8% on the back of an 11.0% climb in US stocks (as repre-sented by the S&P 500) while the MSCI EAFE Index’s 2.7% gain lagged. Emerging markets had a more difficult time, as persistent weakness in China continued to weigh on the MSCI Emerging Markets Index, which fell 1.3%.1

The fourth quarter’s success came despite the arrival of new risk factors to cloud the investment horizon. This included the emergence of the Omicron variant of Covid-19, whose November appearance suggested the coronavirus had no intention of receding into the background despite global vaccination campaigns and other measures to halt its spread. Though financial markets reacted negatively to initial reports of the Omicron outbreak, fears eased as early indications suggested that this new variant, while highly transmissible, may be less virulent than the ones that preceded it.

Covid-19 and its mutations remain among the potential wildcards for economic activity going forward, but an increasingly hawkish Federal Reserve suggests that the most pressing concern entering 2022 may be the reaction of markets and consumers to waning fiscal and monetary stimulus.

Factors Supporting US Dominance May Be Waning

The massive fiscal spending that buoyed economies worldwide through the worst of the pandemic’s disruptions is slowly fading from view. In the US, for example, government spending at all levels flipped from tailwind to headwind in second quarter 2021 and is expected to continue to represent a drag on growth in 2022.2 Meanwhile, a string of elevated inflation prints throughout the year—well above target in most G20 nations and at multi-decade highs in the US—appears to have forced the hands of monetary policymakers.

After months of contending that price pressures were “transitory” in nature and would ease of their own accord, the Fed made a hawkish pivot in the fourth quarter. At its early November meeting, the central bank introduced a plan to taper its asset purchases at a rate that would sunset the program by June 2022; in mid-December, the end date was brought forward to March.

A corresponding escalation of concern could be found in the Fed’s quarterly rate forecast, as the December dot plot called for three federal funds rate hikes in 2022 after September’s report found no consensus for any. To date, the UK has been the only major central bank to hike rates, though a number of emerging markets—including Mexico, Brazil, Chile, Russia and Hungary— have taken action to combat rising consumer prices.

One major consequence of the easy-money environment of recent years has been significant index concentrations in certain stocks, sectors and markets. Despite accounting for less than 20% of global economic activity,3 the US accounted for nearly 70% of the MSCI World Index at year-end, compared to 66% at end-2020 and 48% at end-2009. The index’s top 10 stocks—all of which are based in the US and all except two are tech or tech-adjacent— comprise about 20% of the index.4 Within the US, the five largest stocks in the S&P 500 Index— Apple (AAPL, Financial), Microsoft (MSFT, Financial), Amazon (AMZN, Financial), Tesla (TSLA, Financial) and Google (GOOG, Financial)(GOOGL, Financial) (Alphabet Class A and Class C combined)—command 27% of its market capitalization.5 Investors in portfolios benchmarked to the MSCI World—through either passive or active vehicles—are exposed, perhaps unwittingly, to significant stock, sector and country risk.

The US growth universe’s decade-plus dominance has often been a headwind for investors that take a globally diversified, value-oriented approach to building durable, all-weather portfolios—as we do at First Eagle. However, such investors may take comfort in the possibility that the current distortions in relative performance may represent greater potential to benefit from normalization trends. This is especially true if the underlying drivers of US outperformance begin to fade, as it seems they may.

Fiscal tightening likely will pressure corporate profit margins and earnings, while less accommodating monetary conditions may push interest rates and credit spreads—whose very low levels helped suppress the cost of capital and promoted multiple expansion in equity markets—to more normal levels. Since the late 1960s, the price of the S&P 500 relative to CPI-adjusted trailing peak earnings has been as high as it is today only one other time— during the late-1990s dot-com bubble.6 High current multiples imply that equity market returns going forward are likely to fall short of the approximately 8% they have averaged over the past century. They also imply that passive exposure to equities may not offer returns that keep pace with annualized money supply growth, even as it slows to the low-to-mid single-digit range in the absence of quantitative easing.

A strong dollar also contributed to the strength of US equities during the quarter and the year. After falling sharply with the Covid-19 outbreak in 2020, the greenback trended higher in 2021, due in part to perceptions that the relative strength of the US economy would enable it to launch a rate-hike cycle sooner than its counterparts.7 We view the dollar as expensive in real terms relative to most currencies, especially given the very large US current account deficit and uncertainty about how much the Fed can raise rates before the financial market pain becomes too much to bear.

Dear Prudence

We cannot help but notice that prudence—a key characteristic across First Eagle’s product lineup—has not been rewarded of late. Our commitment to diversification, ballast like cash and gold in certain portfolios, and defensive equity positioning served as a headwind to relative performance in a period that incentivized riskier behavior. Overweighting a narrow cohort of US names may have paid off in 2021, but such positions prevent portfolios from realizing the long-term risk-return benefits diversifica-tion—whether by region, by sector or by industry—historically has provided.

Further, it appears likely to us that many of the forces that have propelled the US markets may lose their positive influence—if not become outright headwinds—as we move forward. If the cost of capital moves up, multiples could go down. If profit margins tighten, earnings comparisons may suffer. And if money supply growth moderates, the effects of nominal rebasing may fade away, potentially causing liquidity challenges in markets.

Despite markets being expensive overall, we believe there are pockets of value to be uncovered. The price of the MSCI EAFE Index relative to the S&P 500 Index, for example, currently is less than half the 50-year average. Similar historical extremes also can be seen in the differential between growth and value stocks.8 That said, we’d caution against blindly going all-in on statistically cheap stocks in anticipation of a rebound. There are many fundamentally challenged companies in the value universe whose low valuations are deserved; likewise, there are many fine companies within the growth universe that are reasonably priced even at current levels given the persistence of their cash flows.

Instead, we seek companies that combine sound business positions—or, even better, an engine to improve their current positions—with modest market expectations as reflected by valuation multiples. Agnostic to benchmarks, our approach to portfolio construction centers on estimating the intrinsic value of a business based on the particular tangible and intangible attributes that can be expected to drive its cash flows over time. Not only does this make the idea of value a much broader tent, we believe the resulting vibrant, all-weather portfolios best position our clients for the long term.

1. Source: Factset; data as of December 31, 2021.
2. Source: Hutchins Center on Fiscal & Monetary Policy, Bureau of Economic Analysis; data as of November 24, 2021.
3. Source: International Monetary Fund; data as of December 31, 2021.
4. Source: FactSet; data as of December 31, 2021.
5. Source: FactSet; data as of December 31, 2021.
6. Source: Standard & Poor’s; Robert J. Shiller, Yale University (Trades, Portfolio); First Eagle Investment (Trades, Portfolio)s; data as of December 31, 2021.
7. Source: FactSet; data as of December 31, 2021.
8. Source: FactSet; data as of December 31, 2021.

The opinions expressed are not necessarily those of the firm and are subject to change based on market and other conditions. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics containedherein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any security. The portfolio is actively managed and holdings can change at any time. Current and future portfolio holdings are subject to risk. The information in this piece is not intended to provide and should not be relied on for accounting, legal, and tax advice.

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