Expect the Unexpected

Expect the Unexpected

The world is always in a state of disequilibrium.  It is just a matter of degree and the level of uncertainty it creates as it strives to move toward the ever-elusive equilibrium state.  Over the short term, market participants are constantly adjusting to changing expectations and thereby inducing market stress and often conflicting developments.  However, over the longer term what really matters is what actually happens.

It is reasonable to assume that after 3 years of strong market performance one should expect a more challenging investment environment, particularly as the monetary policy landscape is changing.

However, it is important to keep in mind that one of those years (2020) encompassed a “bear market” decline of 37%, which was the shortest in history.  Moreover, given the current market structure, we should not be surprised at the speed of market changes (swings).  Also, despite the performance of the averages in 2021, within the market there have been significant corrections in individual stocks and sectors.  Some of the most aggressive names, particularly those with no earnings and no visible path to profitability (dream names), have fallen more than 40% from their peaks.  In addition, many of the SPACs, meme stocks, and IPOs have been failures in 2021.

Just recently, according to Goldman Sachs’ trading data, hedge funds shorted tech stocks the last two days of 2021 and engaged in outright selling the first four days of 2022.  This was a record level (in dollars) of sales.  That selling probably contributed to stop losses getting triggered and margin calls being executed, given the record level of margin debt.  The momentum algorithms most certainly added to the downward pressure.

It appears that the Federal Reserve minutes from the December meeting provided the catalyst for the Thursday, January 6, 2022, follow-through decline.  What surprised people was the discussion of the path for reducing the balance sheet, thus moving the timeline closer in 2022.

Expectations now seem to be that in March tapering should end and the first-rate increase should occur, and then the balance sheet reduction would start mid-summer.  This appears to be indicated by the Federal Funds futures.  Jim Bullard, president of the Federal Reserve Bank of St. Louis, is pushing for the faster timeline.  Keep in mind the St. Louis Fed supports the monetarist school of thought.

It is very unlikely that the timeline on monetary policy will shorten further, and other members of the FOMC may prefer a less aggressive reduction of the balance sheet than Bullard.

These expectations are based upon a set of economic and international assumptions which can be dislodged at any time by a multitude of variables – COVID, excess inventory building, supply chain shortages or easing, the EU’s less aggressive approach to inflation, China’s property crisis or its new monetary policy, international conflict in Iran, Korea, or China, weather, etc.  Although market rates have adjusted somewhat, the reality is the Federal Reserve has not changed its pace of tapering and the Federal Fund rate should be unchanged until March.

Chairman Powell’s comments during his Senate confirmation hearing do not support the view expressed by Goldman Sachs that there would be four rate increases in 2020 or Jamie Dimon’s similar stance.  Powell suggests that it will be a long road back to normalization.

At this juncture, the Fed’s forecast stands at a Federal Funds rate of .9% at the end of 2022, 1.6% at the end of 2023, and 2.1% for yearend 2024.  Most likely at the January 26th meeting these forecasts will be revised upward.  However, given “it’s a long road to normal from where we are”, real rates are likely to be negative in 2024.  Once again, this is a positive for economic growth and the equity market.

From a strategy perspective, the market has largely discounted these events as evidenced in the rise of the 10 year and 2 year Treasuries.  Moreover, with investor sentiment now weakened sharply, and stop losses and margin selling likely to be running its course, consolidation with volatility and a focus upon earnings season should begin to take hold.

Earnings and revenue growth, profit margins, and future guidance should be reported next week, as earnings season begins in earnest.  Given the economy’s strength, the inflation pass-through, tech’s top-line growth, and the semiconductor shortage, we would expect good results.

From a forecasting perspective, very seldom is such a broad consensus on rates, growth, and inflation right.  Too many things can change, particularly given the fluidity created by COVID.  Individual, corporate, and government behavior is changing constantly as the virus spreads.

Expect the unexpected!!  How rigid will the Fed be?  How embedded will the inflation rate be?  Does the consumer retrench in the face of inflation and real income pressures?  Recent data casts an increasingly cautious view of consumer behavior.  Retail sales were quite weak in December and revised downward in November, while the consumer confidence index from the University of Michigan fell to 68.8.

Don’t be surprised if the second half of 2022 has a very different profile in contrast to the first half and the outer years scenarios change meaningfully.  Once again, the companies that are able to manage successfully through the changing economy are likely to be rewarded.