Tactical Shifts Bring Improvement
U.S. markets — stocks, bonds, and real estate — are all still very much in the process of digesting the arrival of higher rates. The recent respite from volatility may have had something to do with technical factors. First, managers who harvested losses at the end of 2021 but really still had fundamental convictions about the positions they sold have now passed the 30-day wash sale rule threshold, and were able to buy them back. This likely benefitted some of the high-flying thematic technology stocks that began their slide in November. Also, after a difficult month for indexes, many balanced and target-date ETFs — which account for the lion’s share of inflows into passive, index-following investment products — have to rebalance by selling bonds and buying equities, which would have a positive effect on index-wide performance.
With that said, there is some likelihood that progress has been made in the market’s psychological adaptation to the new incoming rates regime. Of course much remains to be done — since the evidence so far suggests that nothing like the anticipated shift in policy has been seen at this size or speed since Lord Volcker slew the inflation dragon in the 1980s.
What the Fed Can and Can’t Do
Market participants now have to factor into their calculus an apparently very hawkish Fed — which claims to be targeting high (and not-quite-so-transitory) inflation. The consensus among strategists is that the Fed will begin raising rates in March. Some are starting to say spooky things, like three, four, five, six, or seven interest rate increases in 2022. The prospects of this many hikes is scary stuff for a market that entered 2022 selling at historically high valuations… and that had become accustomed to free money.
The reality is that Fed may not be so tight. The fear of the Fed’s moves may outpace the reality and create a bottom for stocks earlier than some are expecting.
Recent poor labor-market performance and other indications of consumer weakness will soon give us an opportunity to evaluate Mr Powell’s determination to stay the course. A confluence of forces is at work to challenge the consumer, and the withdrawal of fiscal stimulus is one of them; the dynamics are likely to challenge consumer-oriented companies. On the goods side, consumers spent much of the stimulus-fueled pandemic years gorging on goods, since experiences were inaccessible. With covid increasingly becoming an accepted and endemic fact of life, they are reaching for experiences, at the expense of goods… and goods manufacturers and retailers are additionally challenged by still-ongoing supply-chain snarls that we believe will not be fully resolved this year. What about the providers of experiences? Many of them, including airlines and cruise lines, for example, levered up with debt to survive the pandemic, and their balance sheets have become more challenged. On balance, then, we think consumer-oriented stocks are likely to be challenged for the remainder of 2022 — perhaps with the exception of those operators who have been highly successful at digitization and adaptation to the post-pandemic environment, and those who have maintained strong and healthy balance sheets.
If, as many think is possible, the Fed’s late response to spiking inflation will cause them to overreact and tip the economy into recession, that will also test their resolve to persevere in the rate path they have outlined.
The current inflation that the Fed is fighting is the product of a lot of things… and only a few of them can be directly addressed by increasing the cost of money.
Higher interest rates can:
- curb excess in asset markets;
- possibly increase the dollar vs other currencies, thereby lowering some import prices; and
- curb some excess demand for homes and cars and things requiring financing.
But:
Higher interest rates will not:
- increase the supply of cheaper energy;
- increase the supply of foodstuffs;
- increase the supply of truckers or longshoreman;
- increase the supply of willing workers;
- create new chip fabs; or
- curb many of the post-COVID behavioral changes that are constricting supply chains.
Invest carefully while we are still in the fear phase. When the fear phase gives way, people will focus on strong economic fundamentals and growing earnings. Then investing will be easier. Be looking for bargains created by the fear because The Fear can actually do the Fed’s job for it.
When money costs nothing, discipline disappears. If money starts costing something, and some discipline returns to markets, it is a good thing. It’s even possible the lows in many equities were made last week. But of course, the Fed’s projected course of action will spell trouble for many holders of bonds and real-estate.
Keeping Eyes Open For Long-Term Opportunities
We don’t think the time has yet arrived for investors to return to the tech positions that have been pummeled by markets in the leadup to the Fed’s interest-rate and tightening regime change. More volatility and further declines almost certainly lie ahead for many of them as the year progresses.
However, the themes are not going away. The pandemic psychology and fiscal and monetary policies prompted an excessive chasing of certain thematic tech beneficiaries, and that created froth that needed to be removed from the market. But the fact remains that the pandemic accelerated a host of tech-related themes that are front and center in the Fourth Industrial Revolution — that suite of technologies enabled by artificial intelligence, high-speed networking, business digitization, process automation, telepresencing, blockchain and decentralized finance, digital health monitoring and healthcare delivery, and so on (and let’s not forget the cybersecurity that this new world makes essential). Not only are those themes not done — they are in the early innings of changes that will transform daily life, working life, and financial life in the course of the next decade.
With earnings season underway, all eyes are on the tech leadership, so far with strong results from Microsoft [MSFT], Apple [AAPL], and GOOGL [Alphabet], and more disappointing results from Meta [FB] and Spotify [SPOT] — highlighting again that volatility aside, many tech leaders command imposing networks that have, in their various spheres, embedded themselves in the functioning of the economy that is emerging.
Those companies that have disappointed, including FB and SPOT, have been severely punished — so it’s not all sunshine and lollipops on Wall Street. Be aware which companies have missed earnings targets. The December-ending quarter now being reported will generally show better profits than what’s likely to arrive in coming quarters. Higher interest rates will diminish the opportunity for capital appreciation, and higher costs must be passed on to customers more effectively than has thus far been the case. Consumer stocks in general have not shown good results for Q4 2021, nor have other companies relying on truly discretionary expenditures that benefitted from government largesse (and speculative gains from crypto and “stonks”).
One thing that is becoming clear: in this environment, it’s becoming harder for management to forecast, model, and set targets… and that does not lead to expanding P/E multiples. It leads to more variance in performance relative to estimates, which is the kind of uncertainty that markets do not like. Smart managements may react by guiding down — setting a lower hurdle to beat.
We highlight again that some of the air may start to come out of the ESG bubble as a general sense of reality arrives with higher rates. Inflation and an ongoing global economic recovery will mean plenty of demand for hydrocarbon energy — as fears around instability in eastern Europe demonstrate, oil still matters critically for the global economy. Legacy hydrocarbon energy companies will power the world for decades to come and return much of their cash flow back to shareholders, as evidenced by ExxonMobil’s [XOM] new $10 billion share repurchase program.
We’ll be watching a lot of companies during earnings season, and will keep bringing you updates.
Thanks for listening; we welcome your calls and questions.
