Mid Quarter Update
We wanted to reach out to give a quick update as 2022 is full of uncertainty and January certainly made an entrance. Markets had been taking mounting risks and headwinds in stride, but January was the tipping point. The surge of the Omicron variant rattled markets, followed by a 7% inflation reading, rising geopolitical tensions in Ukraine, a Fed meeting which sparked a rate hike tantrum, and the beginning of an earnings season where markets were priced for perfection and many growth names had very lofty expectations.
Fiscal and monetary support are fading and passing the baton to the private sector for growth. Central banks easing are turning to central banks tightening policy. Inflation is really putting pressure on central banks to raise rates.
The Federal Reserve acknowledged they have met the employment piece of their mandate and inflation is at a point where the price stability portion of their mandate requires them to step in. They are likely to begin tightening in March when their asset purchase program ends, especially given the strong January employment report. The Fed admitted at the January meeting that inflation had gotten higher than they predicted and was more persistent than their forecasts. It remains to be seen whether the Federal Reserve can stick the soft landing, slowing the economy enough to bring down inflation, but not sending the economy into a recession.
Markets typically absorb the first couple rate hikes reasonably well, despite increased volatility. However, this time is a bit different as we have higher inflation than we have in 40 years so the Fed may need to tighten more quickly than typically necessary, especially after the January 7.5% inflation reading. There is mounting evidence that they may be behind the curve and Covid, deglobalization, demographics, and decarbonization have all contributed to an inflationary story and are not things fixed easily by Fed policy.
Why is inflation such a concern? Inflation means that each dollar buys less. While most households remain healthy, the lower income consumers are the ones that have a higher marginal propensity to spend. Less stimulus and higher oil and food prices, act as a burden and a tax on low-and-middle income consumers and make them less likely or able to make discretionary purchases. Wages are not rising as fast as inflation is, as seen in the chart. Real average hourly earnings are adjusted for inflation and are in negative growth territory. Higher energy costs also hurt industries in which energy is a major input such as the transportation industry if they are not able to fully pass on price increases to consumers. Interest rates are also rising ahead of the Fed policy tightening. This means borrowing costs are higher at a time when inflation is also higher.
Our leading economic indicators are signaling we are entering a later phase of the economic cycle. GDP growth has likely peaked, and we are headed for slower growth. However, at this point our base case is not a near-term recession. This should prevent equities from going significantly lower from here, though that likelihood is certainly increasing. We were taking risk off into year-end and have continued to do so through this volatility. The risk of policy missteps is growing. If inflation stays stubbornly high, forcing the Fed to tighten more than expected, we will need to reduce our risk exposure further. We will also continue to reduce risk on market rallies. This isn’t the type of market to be taking big bets. We are watching the bond markets, the Fed, and economic data closely.
Despite the correction, markets remain fully valued. We expect more muted returns in 2022. High valued growth names are likely to continue to get hit as interest rates move higher. We continue to have a strong quality and high free cash flow tilt to the portfolio. We want companies with healthy balance sheets and companies with pricing power that can pass on higher input costs to consumers. We believe that multiple expansion is less likely to drive returns from here and earnings are going to matter more going forward. Difficult comparisons, lofty expectations as well as issues impacting corporate profitability such as inflationary pressures, supply chain bottlenecks and labor shortages make it difficult to see a market much higher from here in the near-term.
Volatility is a normal part of investing and increases as the economic cycle progresses. It is important to stay disciplined and keep your long-term goals in mind. There may no longer be a rising tide to lift all boats. Some will and should sink. Discipline, selectivity, flexibility and active asset allocation will be important in this environment.
As always please reach out with any questions you may have.
Kasey Wopperer, Director of Equity Research and Investments at kwopperer@gencapmgmt.com.