Blackstone Talks Tapering

 Joe Zidle is a managing director and Chief Investment Strategist at Blackstone's Private Wealth Group.

We usually visit him when he is doing his quarterly chat  with Byron Wien but here he is teamed up with Prakash A. Melwani, Global Chief Investment Officer of Blackstone's Private Equity Group.

From Blackstone, November 2:

Joe Zidle: The Investor’s Guide to Tapering 

Where should investors look for returns in an environment that will likely feature higher inflation, less policy support, and muted returns? At Blackstone, our answer is to pursue sectors that we believe will experience secular growth, which we call “good neighborhoods.”  

In Douglas Adams’s sci-fi masterpiece, The Hitchhiker’s Guide to the Galaxy, a supercomputer named Deep Thought is tasked with providing the answer to the “Ultimate Question of Life, the Universe, and Everything.” After 7.5 million years of analysis, Deep Thought determines that the answer is, of course, 42. My team and I may not constitute a supercomputer, but we have been pondering the “Ultimate Question of Investing during Fed Tapering.” And in our view, the answer may not be as simple as 2013.

In December of that year, the Federal Reserve began tapering its asset purchases to wind down its Global Financial Crisis (GFC)-era quantitative easing program. The Fed finished tapering in January 2015 with its balance sheet at $4.5 trillion. By that December, the Fed’s rate-setting committee lifted its benchmark policy rate for the first time since 2006. Rate hikes continued for the next three years while the Fed maintained the size of its balance sheet.

During this period, the 10-year Treasury yield traded in a range from 1.3% to 3.1% and back again. Equities were lackluster: stocks returned just 7% annualized from the start of the Fed’s tapering to its final rate hike in 2018, well short of their 17% per annum average for the full bull market from 2009 to 2020. Consumer inflation fell, and growth stalled. Ultimately, the economy proved too weak to endure a tightening cycle, forcing the Fed to cut interest rates.

If You Remember Woodstock, You’re in Luck

Now, we’re preparing for another Fed taper as the economy emerges from the COVID crisis. In my view, this environment is more reminiscent of the back half of the 1960s than the post-GFC decade – and not just because we’re launching people into the stratosphere again.

Tie-dye, economic growth, and equity volatility  In the late sixties, interest rates and inflation broke out to the upside, in part due to rising oil prices and government spending. Lyndon B. Johnson expanded upon John F. Kennedy’s  “New Frontier” by launching important social initiatives, including Medicare and the Food Stamp Program. Taxes increased, but deficit spending still soared. Seventy astronauts went to outer space; four made it to the moon.

Market volatility accompanied this period of major fiscal spending and robust economic growth. Headline equity indices struggled to make much progress; S&P 500 annual returns swung between large corrections (1966, 1969) and double-digit gains (1967, 1968). Against this volatile backdrop, the most cyclical companies, including value stocks, small caps, and industrials, outperformed the overall stock market. As interest rates moved higher, long duration assets underperformed.

Similar colors decades later  Today, healthy household and company balance sheets have fueled robust demand, which suggests that the current expansion will feature persistent inflationary pressures and strong economic growth. Taxes are set to rise, though the Biden administration’s push for spending on “social infrastructure” means deficit spending will likely outpace increases in government revenue.

I’ve written at length this year about my expectation for an economic recovery driven by fundamentals. If I’m right, then the Fed won’t be forced to quickly resume policy support after tapering ushers in higher interest rates. Even if markets experience bouts of volatility, an inflationary environment would raise the bar for the Fed to use its balance sheet as a backstop for public markets. For companies, 4Q21 probably marks peak liquidity as the printing of helicopter money starts to slow down. As a result, investors should prepare for the performance implications of these changing macroeconomic conditions in 2022 and beyond.

The Fundamental Investor’s Checklist

Equity duration an important concept  We’re all used to the idea of duration in the context of fixed income products, but it’s relevant for stocks, too. For example, consider the most speculative tech company available for purchase in public markets. The more time it takes for that company to become profitable and return stockholders’ initial investment, the longer that stock’s duration. That doesn’t mean portfolios should rotate away from all tech companies or growth stocks as higher rates make it more expensive to do business. Rather, investors should develop a keener eye for companies that have strong fundamentals and can deliver free cash flow sooner rather than later.

Up in quality, down in beta  The hiking cycle I’ve described will introduce greater volatility into markets because less liquidity and higher rates imply a higher cost of capital. Over the last cycle, disinflation, falling rates, and policy support helped fuel multiple expansion. In this cycle, higher inflation, rising rates, and the end of COVID stimulus will likely be headwinds for valuations. That means returns in public markets will increasingly rely on earnings growth, resulting in a market environment with greater breadth and opportunities for outperformance by assets with strong alpha....

....MUCH MORE