TIFF Investment Management 3Q21 Quarterly Commentary
COVID Dynamics and Evolving Market Risks
The world is currently amid a COVID Delta variant surge. Vaccines seem to be working fairly well
against this new and more virulent Delta variant, but not perfectly. Exact data has been hard to come
by, but for the most part the serious cases of infections are so far occurring predominantly in
unvaccinated people. With football starting and stadiums filling with excited fans we will really put
vaccine efficacy to the test this fall. The economic assistance programs that kept many countries afloat
during the initial outbreak are ending, causing enormous numbers of people to face the dilemma of
risking their health to work, or risking their financial well-being to stay home. Rather than reinstituting
assistance programs, many governments, including here in the US, are taking a harder line, and
implementing mandatory vaccines for workers. Mandatory vaccinations by governments and
businesses will likely remain a controversial topic this fall and winter. What we will try and do in this
letter is outline what we believe are the potential impacts of these developments on the financial
We supported the initial government fiscal support programs when COVID hit, and we believe they
saved many businesses and individuals from financial ruin and kept the economy out of what would
likely have become a depression. Without the quick implementation of these massive programs, we
might still be in a deep economic hole. Instead, the US economy today is larger than it has ever been,
having made up for the entire COVID-related downturn and moved to new record levels of output. The
US has nearly 11 million job openings posted and only about 8 million people unemployed and actively
looking for a job, the fewest potential employees per open job ever. The economic recovery has been
The markets have benefitted from these fiscal programs too. Stocks, which in 2020 had the fastest
decline from a record high into a bear market ever, dropped by 33% from their pre-COVID highs to a
low of 2237 (on the S&P 500), and subsequently rallied by over 100% to a new record high of 4536 in
September of 2021. There have been 53 record highs so far this year in one of the strongest and
sharpest rallies ever. Booming corporate earnings, to new record highs, have supported stock gains,
which have been further helped by the Fed keeping interest rates low and monetary policy supportive.
As investors try to value stocks, they often attempt to predict earnings out into the future and then
discount those earnings back into a present value – asking themselves, “what should I pay for $1 of
earnings in, say, 10 years?” The lower interest rates are, the higher the present value of $1 in earnings
in 10 years, and hence today’s elevated stock prices. Interest rates can be a huge influence on stock
prices and stock professionals need to worry about the level and direction of interest rates.
With the COVID Delta variant rising quickly, why aren’t markets plummeting as they did in the late
winter/early spring of 2020? We believe the main reason is that investors believe the vaccines are
good enough to ultimately beat COVID. Yes, we may need to get a booster shot every year in the
future, much the same way we get an annual flu shot, but the huge uncertainty that COVID initially
represented is now considered to be a “livable risk” for most. Many now think the days of completely
shutting down an economy due to a COVID outbreak are behind us, and thus the days of massive
declines in consumer spending and hence corporate earnings are also behind us. If so, then today’s
estimated earnings of $1 in 10 years can be at that level or higher, not on the way to $0 or less in a
future COVID lockdown.
Earlier this year some investors started to worry that the economy was expanding too fast, creating
bottlenecks, leading to inflation. This may yet happen. We have written about this topic in the past and
so will only re-state our view that there are good arguments for and against this view. The Fed
continues to believe the current spike in inflation is transitory; the markets seem to believe the Fed and
are keeping yields on 10-year Treasuries at about 1.35%, even while the CPI hovers above 5%. These
low interest rates levels certainly suggest most investors believe inflation will retreat like bonds today.
Negative real rates are not attractive to investors who believe these low inflation rates will persist.
Some smart investors who dislike fixed income today believe that rates are as low as they are because
investors are attempting to discount what the Fed will do, not what inflation will be. There is an old saw
in our business, “Don’t fight the Fed.” With the level of economic intervention that has occurred in the
last 18 months, this conventional wisdom has been as true as ever, if not more so. Some believe that if
current Fed policies begin to cause other unwanted outcomes, such as sustainably higher inflation or a
declining US dollar for example, the Fed likely will have to reverse course and raise rates to ameliorate
these “new” more important problems. The economy, they believe, will be (already is) able to stand on
its own without further economic support. Accordingly, the Fed will likely have the freedom to raise
rates to address inflation without causing a recession, though it will hurt bond prices in the process. We
don’t know if the Fed will prove correct and inflation will prove transitory, or if inflation will rise enough to
push the Fed to raise rates as some suggest. Regardless, we continue to believe that even if the Fed
is correct and inflation is temporary, real rates are negative and not attractive to long-term investors.
Higher rates would only exacerbate this unattractive investment proposition. This analysis keeps us
underweight fixed income and short duration vs our benchmark.
If we are right and the US and most western economies adopt a “live with it” COVID policy, then you
may ask what the financial implications of something like a Delta surge could be. Our best guess may
seem counter intuitive. Because markets are today concerned about over-heating and inflation, it is
plausible that the pauses or temporary economic slowdowns caused by Delta or future variants may
prove less disruptive to markets than most believe. If, of course, a very deadly and vaccine resistant
strain develops, this is wrong, but with that caveat here’s why. Businesses will have less pressure to
rebuild their employee bases and supply chains in a compressed period, allowing them to do a more
thoughtful job while not having to pay top-dollar for everything. This scenario could help to dampen
inflation and inflationary concerns, allow for higher profit margins, and keep the Fed from having to
change its focus to some new area of concern. Hence, future earnings could be higher for longer and
interest rates could be lower for longer. Both results should be good for stock prices.
You might wonder, what if we are wrong and the economy does shut down again? Our best guess is
we would see something similar to what we saw last spring. Stocks would drop, but hopefully not as
much because there will be some increased level of confidence that another vaccine can be developed.
Financial markets would not be as negative as they were, but major declines in the value of portfolios
would be likely. The Fed likely would keep interest rates low in an effort to support the system and help
prevent a depression. Assistance likely would be reinstated, though possibly not as generous because
of the growing budget deficits. To us, this outcome is difficult to forecast and presents a tail risk, though
it would not be a complete surprise as some investors (although not us) are today positioned for just
such an outcome. This is part of the wall of worry the market continues to climb.
Still, we remain concerned about the impact that rising inflation could have on bond and stock prices.
Although we do not currently see one side of the inflation argument as more likely than the other, we
are continuing to analyze the potential impacts of both. To that point, we received several interesting
pieces from TrendMacro (an economic forecasting firm to which we subscribe) that we thought worth
sharing. The charts below demonstrate why the market has performed so well since March 2020. The
top graph shows the change in analysts’ earnings estimates for the coming year over the last 30 days,
annualized. You can see on the far right that analysts have been very aggressively raising their
estimates over much of the last year plus. The improving fundamental backdrop has supported these
higher revisions. The bottom clip shows how actual S&P 500 earnings compared to the estimates
analysts had posted. Even after massive rises in analysts’ estimates, actual earnings exceeded these
estimates by the widest margins in a very long time. (You may wonder how actual earnings beat
estimates in the first and second quarters of 2020, and the answer is that analysts had marked down
their estimates below what companies actually earned. Since then, analysts have not kept up with the
enormous earnings rebound.) The stock market has been in the sweet spot of “beat and raise” for
nearly a year and a half. The big question, as always, is what comes next?
Caution: we’re going to get a little technical, but hope you’ll find it worthwhile.
Investors generally seek to compare prospective risk and returns of one asset to another as they
construct their investment portfolios. This comparison includes one stock to another, one bond to
another, stocks vs bonds, etc. This last comparison (asset allocation) is very important. One way to
make this stocks vs. bonds comparison is to compare the expected earnings yield of stocks (most use
either (1) the expected 12-month forward earnings divided by the current price or (2) the expected
earnings in dollars divided by the current market capitalization – both methods work) to the current yield
on a bond. We will use the first calculation method and a 30-year treasury bond here.
In mid-September, the S&P 500 12-month forward earnings estimate is $207.53 and the price is
4458.58, giving us an earnings yield of 4.65%. This compares to a 30-year treasury bond yield of
1.93%. The difference between these is the equity risk premium (ERP), today equal to 4.65% – 1.93%,
or 2.72%. This 2.72% is the additional return expected from an investment in stocks today vs. bonds
today. Over approximately the last year the ERP has been in a range of about 2.25% – 3.25%, so
today rests near the middle of the range (as you can see on the following TrendMacro graph).
Longer term the ERP has ranged from as low as negative -2% (in the tech bubble) to as high as nearly
7% (in the great financial crisis of 2008-9). If you pushed us, we would suggest the current ERP is within
a reasonable range of fair given the ongoing economic recovery, the fiscal and monetary support that both
abets economic and market advances and dampens their volatility, and the current very low level
of interest rates.
A few things jump out from the next TrendMacro chart, which shows how each yield has moved for the
last 40 years. First, the blue earnings yield line (for S&P 500 stocks) and the red 30-year treasury yield
line moved pretty much in tandem from the Volker era (early 80s) when inflation began to come under
control right up to about the bursting of the tech bubble in 2000. In the early 2000s investors began
demanding higher returns from their risky stock holdings than from their 30-year treasury bonds,
pushing up the ERP. Treasury yields have continued to trend lower ever since the tech bubble burst.
The earnings yield for stocks rose through the great financial crisis, but has turned lower since, moving
more in line with Treasury yields. The resultant orange ERP is shown along the lower part of the chart.
You may well ask “what’s the risk” if rates rise? Do stock prices or bond prices go down more if 30-year
rates rise to 4% in the next two years? We have two responses to that question. First, see the table
below, which shows annualized equity market returns during periods of rising 30-year interest rates.
Surprising to many, over the last nearly 70 years (based on TrendMacro data) 30-year treasury yields
rose by ~1% or more on 24 separate occasions. On 21 of these occasions equity prices also rose. That
is, when bond prices went down (yields rose 1% or more), stock prices went up. That might happen
because investors see an accelerating economy and faster earnings growth, as many forecast today,
more than compensating for an increased discount rate. Even in the instances when rates rose the most,
equities hung in better than many would expect. It was not until later, after the rise in rates began to slow
the economy, that stocks came under pressure and posted more negative returns. The takeaway here
is that usually the early phases of a rate rise are less harmful to stocks than most anticipate. (Note: We
are assuming that the rise from March 9, 2020 to September 10, 2021 was not enough to impede the
The second response is harder and more specific, requiring us to look at history, to imagine how things
could transpire to push rates to 4% today, and then do some math. Here’s our summary. If in two
years it turns out the Fed was right and inflation has settled back into a comfortable 2% zone and the
economy has continued to make positive progress without having to shut down due to a more severe
COVID strain, then real returns on 30-year treasuries would likely move back into normal historical
ranges of about 1-4%, so using 2% seems reasonable. Alternatively, maybe inflation will be a little
higher than the Fed is targeting at, say, 3% and real rates peak at 1%. In either scenario, envisioning a
roughly 4% yield on 30-year treasuries is not particularly difficult.
The investment implications for holders of 30-year treasury bonds, however, are less “normal” than
investors may expect. A rise in yields today from 1.94% to 4% over two years would shave about 34%
off the value of today’s 30-year bond. Adding back two years of yield still leaves an investor down –
On the equity front, we need to estimate earnings growth and what the final ERP might be. These
estimates are hard to get right and change quickly, so we’ll outline a few different scenarios. First, let’s
assume earnings grow at a compounded 15% rate (about the current consensus estimate) and that the
ERP remains unchanged. If rates rise to 4% in this scenario, then equity prices would decline by about
7.5%, plus two years of dividends produces a total return of -5% for equities. Using 7% earnings
growth and the same ERP results in a -17% loss for equities.
The possibility that as investors flee bonds, the ERP could decline is equally plausible to us. If we use
the same earnings growth from above and the ERP declines by 1% from today’s level to 1.72%, then
equity returns in the 15% earnings growth scenario turn positive at 11.6%, and only fall to a -3% return
in the 7% growth environment. Finally, for those interested in what might cause equities to lose more
than bonds, there are lots of combinations but something like 0% earnings growth and an ERP of 3%
gets you there, as does 7% earnings growth and an ERP of 4%. While there are a multitude of
possible combinations where equities underperform bonds, we continue to believe that the risk/reward
of owning equities today is superior to that of owning fixed income.
We would make the following points as we try to summarize a fairly complex and technical letter:
1. COVID is a horrible disease that science is allowing most countries and individuals to live with.
2. Future COVID disruptions are likely to be shorter and shallower, and may extend the economic
and market cycles, becoming the economic pause that refreshes.
3. The equity market rally reflects the tremendous economic and earnings recovery, and earnings
multiples are contracting – making valuation appear somewhat less stretched.
4. Rising inflation and bond yields are a potential risk, though perhaps not as troubling for equities
as many investors fear. However, they will definitely hurt fixed income returns if they become
5. Future returns are unlikely to be as strong as what we’ve seen in the last 18 months but could
continue to be decent for some time longer.
As always, we sincerely appreciate the opportunity to manage your capital and to help you achieve
your organization’s financial goals. We are here to assist you, so please do not hesitate to contact us.
We hope 2021 is proving to be a better year than expected for you, your family, and your organization.
***All investments involve risk, including possible loss of principal.
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