The One-Two Punch

The One-Two Punch

The Fed announced it will reduce bond purchases (tapering) and a modification to that decision should be discussed at the next Federal Open Market Committee (FOMC) meeting on December 15, 2021.  The infrastructure bill has passed, and the reconciliation bill has moved from the House to the Senate.  The debt ceiling crisis has been delayed but is now coming up against another deadline.  These are some of the Washington-induced uncertainties that have received some clarification over the last month.

At the same time, a new one-two punch has emerged.  The new Omicron variant has raised the specter of how to respond to the accompanying uncertainties.  Little knowledge exists so confusion persists.  Over the next several weeks greater understanding will emerge, but it appears that the solution will focus upon a medical response, rather than a repeat of the economic responses (e.g. shutdowns) of the past.  Therapeutics, modified vaccines, and some indication that the effects of the new virus are mild, suggests little economic impact is likely.

The more telling market influence was the testimony of Chairman Powell before Congress, where a more hawkish tone emerged.  Powell indicated that a modification of the tapering program may be in order and he suggested the word “transitory” for inflation be retired as the Fed had achieved its inflation target.

At the next meeting on December 15, 2021, one should expect an acceleration of the tapering program, which was scheduled to reduce the $120 billion of bond buying by $15 billion a month.  It would not be surprising for the monthly reduction to increase to $20-25 billion, thereby ending the program in the spring of 2022 rather than mid-year 2020.

Increasing emphasis is now being placed upon the impact of inflation on families and the necessity to ensure that higher inflation does not become entrenched.  With the inflation goal met, “maximum” employment is the next hurdle.  The disaggregated unemployment rates (minorities, etc.)  have become more important and attention will be paid to those numbers in the coming months.  Also, the participation rate is baffling and is taking on greater significance.

From the interest rate perspective, the timeline has moved up.  An earlier tapering probably means an earlier rate increase.  Mid-2022 seems reasonable for the first increase in the federal funds rate, assuming the tapering ends in the spring and employment growth continues at a reasonable pace.

As we have just seen, a great deal can change over a few months and expectations can shift swiftly.

Given the market’s (algorithms) tendency to “shoot first and ask questions later,” when an “apparent” surprise emerges, reviewing the fundamentals can provide the framework for understanding the investment landscape.

In the face of Powell’s testimony, interest rates, particularly long-term rates—the 10 year and 30 year treasuries—experienced declines in yields.  The 10 year fell to 1.44% (it was over 1.60% several weeks ago) and the 30 year dropped to 1.78%.  Given the current inflation rate, the rate declines pushed “negative” real rate of interest further into negative territory.

Even assuming a cooling of the inflation rate in 2022, the real rate should remain negative for any forecasting period.  Assuming two rate increases next year (a market expectation), real rates will remain deeply negative.  Negative real rates are positive for economic growth and equities.

Despite the talk and anticipated magnitude of tapering, liquidity and money supply continue to grow.  Tapering only indicates the Fed is increasing its bond holding at a lesser amount than previously (but it is still buying bonds).  Money supply has grown at a 12-13% rate over the last year, 3 to 4 times the inflation rate.  This is also a positive development for economic growth and equity values.

Recent frenzied behavior in the equity market in reaction to the Omicron variant and the Powell testimony has reduced P/E multiples, despite lower long-term rates (which normally support higher multiples).  Consequently, greater value exists among equities.  Moreover, the strong earnings season, and the prospect that more and more companies are managing to sustain earnings growth and margins in this inflationary environment, provides a platform for companies to improve their financials in 2022.

The dilemma that the inflationary construct is providing—supply chain disruptions, strong demand—supported by accommodative monetary policy, places additional pressure on the pending legislation in the Senate.  The need for more fiscal stimulus is being called into greater question and delays and modifications seem very likely.  Given the improving economy, with over 500,000 jobs being added in November, according to ADP, and the Labor Department’s report of a gain of 210,000 in nonfarm payroll employment (with upward revisions in the prior two months), economic growth in Q4 2021 should record an acceleration from Q3.  The ISM survey also recorded solid gains in manufacturing with a strong new orders component.  Consequently, the bill should shrink in size and not be considered until 2022.

In a world where interest rates are becoming so pivotal to P/E multiples and the valuation process, earnings and earnings growth are likely to be more of a factor in stock performance as we enter 2022.

The strong economic growth likely in Q4 and Q1 2022 can provide the foundation for earnings growth into next year and potentially offset interest rate pressure if it occurs.

As 2022 approaches, crosscurrents are beginning to emerge.  Oil prices have fallen sharply recently, with crude falling below $70 a barrel.  COVID mandates are being challenged.  The vaccine policy continues to evolve and the timeline on the loosening of the supply chain remains elusive.

Moreover, at some point next year, as product disruptions lessen, and demand gets closer to being satisfied, another challenge will face many companies:  how to manage in a more “normal” environment and possibly one in which inventories begin to build.

Companies that continue to manage well in a changing landscape and those with secular growth characteristics are likely to be rewarded by investors.  Others will suffer.  Portfolios that recognize these factors should be well-positioned to navigate these 2022 challenges.