The twelve months ended December 31, 2021 delivered returns in the mid 20% range for equity accounts.  Appreciation over the last two years has approximated 50%, surpassing any reasonable expectations at the time.  High single digit returns in the fourth quarter were strong on an absolute basis but lagged a robust S&P 500.

Underperformance in the quarter was largely confined to December and was linked to the emergence of the Omicron variant in late November.  Fearing the highly contagious strain would lead to a repeat of early 2020’s disruption, investors sold economically sensitive stocks and redeployed into defensive sectors such as Utilities.  This reaction depressed our concentrations in banks, travel related credit card companies, aerospace and procedure-driven medical device stocks.  Our point of view at the time and now is that the Omicron will not result in sustained disruption.  We took the longer term view by not reducing these positions and, in fact, initiated positions in an online travel agency and a cruise line.  Very early relative performance in 2022 supports this decision.

Balanced accounts in 2021 were boosted by strong equity returns somewhat offset by overall weakness in the bond market.  Fixed income holdings remain positioned with below benchmark duration and are overweighted the corporate sector.

Turning to the outlook, the financial environment changed when Fed Chair Powell decided that inflation is no longer “transitory.”  (To use his exact words on November 30th, “It is probably a good time to retire that word.”)  The implications for monetary policy will be seen on two fronts:

Money Supply

In early 2020, the Federal Reserve countered the COVID-triggered economic crisis by entering into a massive bond buying program (Quantitative Easing or QE) which expanded the money supply at an unprecedented pace.  The resulting excess liquidity found its way into assets creating a boom for stocks, bonds, real estate, and cryptocurrency.  The Fed is now walking back the process.  The first step, “tapering” or reducing the amount of bond purchases should be completed by March.  We view this as the absence of a positive as there will be less excess money fueling asset appreciation.  The second step Quantitative Tightening (QT) is more ominous because it contracts the money supply resulting in a tightening of financial conditions.  QT’s timing and magnitude are up for debate but our sense is that its impact will be felt in asset pricing before the real economy is slowed.

Interest Rates

In a more traditional move, the Fed will soon increase short term interest rates from their current negligible level.  Just prior to COVID (and before our current “non-transitory” inflation issue), Fed Fund Rates were over 2% so expect plenty of rate increases this year and next.  In other words, it looks like the Fed needs to play catch up.  Again, the impact will be felt first in capital markets.

Reducing inflation is central to the Fed’s policy shift.  Despite Powell’s reversal, there is still a transitory component within today’s 6-7% rate of price increases.  Production and distribution bottlenecks rose to the fore with COVID and continue to drive pricing in a broad range of commodities and finished goods.  For example, the semiconductor shortage constrained new auto production, leading to a spike in used car prices.  The Manheim Used Vehicle Value Index shows the wholesale cost of used cars increased by 47% over the course of 2021.  However, hundreds of billions of dollars have already been earmarked to expand chip manufacturing capacity and auto production schedules promise improvement in 2022.  We trust that the invisible hand of capitalism will lead to global supply chain improvements that peak the rate of inflation.  However, price increases are far too wide and robust to attribute solely to COVID disruption.

Wage increases are likely the broadest source of inflationary pressure.  At the most basic level, there are 4 million more job openings than unemployed.  In what may be the sign of a cultural change, job switching and quit rates are at 20 year highs.  Wage inflation is clearly visible, and it is logical to expect it to find its way into end pricing for goods and services.  Over the past two years or so, the U.S. money supply (M2) has increased by about $6.5 trillion.  Federal outlays, largely driven by the response to COVID, have increased by $7 trillion.  Add these two figures up, and it is a staggering number even on a $23 trillion economy.  Today’s inflation issue may be as simple as too much money chasing everything.  While the Fed is already addressing the problem, every analysis that we read is adamant that changes in monetary policy take at least a year to have impact.  Our call is the rate of inflation peaks in 2022 but settles at a level far in excess of the Fed’s comfort zone.

We can point to all kinds of academic models and historical examples but, trust us, higher inflation, a reversal in money supply growth, and rising interest rates hurt equity valuation metrics like price/earnings ratios.  While too early to quantify the magnitude of valuation erosion, we anticipate that it will be significant.  Valuation, however, is only a piece of the puzzle.  We tend to conceptualize stocks as an equation multiplying valuation by earnings.  The earnings outlook is much brighter than valuation.

Although net Federal spending is scheduled to contract, robust job and wages prospects supplemented by record consumer net worth should suffice to propel strong GDP growth in 2022.  Translating that economic environment to corporate earnings, we expect strong revenue increases aided by a return to net repurchases resulting in high single digit EPS growth for the S&P 500. Remember that earnings are evaluated on a nominal basis so inflation (while depressing P/E’s) helps the topline of the income statement.

Looking back at these last few paragraphs, we may have saved some ink and paper by saying that the environment for 2022 is mixed but thought our reasoning important to share.  Expect plenty of volatility and rotations as the many puts and takes play out.  Although perhaps clichéd, we expect 2022 to be a “stock pickers market” with the aggregates churning but progress will be difficult.  In other words, the Federal Reserve is no longer our friend.  We have gradually reduced exposure to the growth segment of the market and are currently underweight the Information Technology sector.  Long duration/high valuation stocks are historically most sensitive to rising interest rates.  Conversely, we are placing more emphasis on stocks benefitting from:

  • Easing of supply chain constraints (ex. traditional automakers)
  • Re-opening/normalization (ex. travel, procedure driven health care)
  • Inflation beneficiaries/pricing power (energy, select financials)

As you can see from the above, we are focused on identifying pockets of earnings upside given the challenging valuation environment.

Best wishes for the New Year,

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Craig B. Steinberg         Matt Ward                 Bob Ruland

Although the statements of fact and data in this report have been obtained from, and are based upon, sources that the Firm believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the Firm’s judgment as of the date of this report and are subject to change without notice. This report is not intended as an offer or solicitation with respect to the purchase or sale of any security. This information is for informational purposes only. Actual client portfolios may vary. Past performance is no guarantee of future results.

Craig Steinberg

Craig Steinberg

President/Chief Investment Officer

Robert Ruland, CFA

Robert Ruland, CFA

Senior Vice President / Director of Research

Matt Ward, CFA

Matt Ward, CFA

Senior Vice President / Portfolio Manager