Clients of the Firm, 

The 4th Quarter of 2021 has begun with continued volatility and equity markets hovering just below all-time high levels set a few weeks ago.  As autumn bursts with color in New England, the market has again embarked upon an upward climb against a wall of worries.  We have chosen to highlight two of the concerns in this note and some investment strategies to address them.   

Fed Taper 

The Federal Reserve has signaled it is likely to begin tapering asset purchases.  While short of tightening, this action is a step in the direction of less accommodation. We expect to see credit markets reflect that notion with higher interest rates over the coming months.  It is our expectation that asset purchases will taper in November 2021.  The Fed dot plot, which attempts to predict when actual rate hikes may occur based on estimates by the different Fed regions, continues to show limited tightening in 2022.  Wall Street analysts range from no rate hikes to over 100 basis points in 2022.  Suffice it to say, there remains significant debate as to the pace and magnitude of rate hikes that would be appropriate in the near future. The Fed dot plot can be found here: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20210922.pdf 

Inflation 

Inflationary concerns are real and we are seeing their impact across the spectrum of companies we cover.  Labor conditions remain extremely tight, especially in service businesses.  Wage inflation is anecdotally significant, particularly within professional services.   U.S. Bureau of Labor statistics measures of inflation are showing significant increases. Notably, the recent September 2021 PPI 12 month advance reading was +8.6% representing the largest increase in over a decade.  The release can be found here:  

https://www.bls.gov/news.release/pdf/ppi.pdf 

Over the last 12 months, the CPI, a measure of consumer prices, increased by +5.4%.  This is a significant increase and, if sustained, would likely merit further Fed tightening than currently contemplated.  The latest CPI can be found here:

https://www.bls.gov/news.release/pdf/cpi.pdf
Inflation expectations and price reality are being fueled by excess demand driven by re-opening trends and extraordinary government stimulus.  In addition, supply chain constraints from COVID shutdowns and the general lack of available labor have compounded inflationary effects in the short-term.  The labor shortage is due to several factors, including extended and enhanced unemployment benefits, older worker retirements and the delayed return to work for families due to the continued childcare challenges created by COVID.  

The Fed expects many of these conditions to be transitory and thus will lead to an easing of inflationary pressures. We are less sanguine on this point, particularly when it comes to wage inflation.  As previously noted, inflationary conditions can be a positive for equities in a growth environment where costs are passed along to consumers up to the point where they meet gains in wage growth.  Once inflation exceeds wage growth, the impact is a drain on demand and eventually earnings.  The first phase of growth with inflation tends to lead to higher interest rates to fight inflationary conditions.  This period can then be followed by a period of stagflation (stagnant growth with inflation) before bringing supply and demand back into balance.  Stagflationary periods have tended to be some of the worst stanzas for equities. The most notable of these periods occurring in the decade of the 1970’s. We certainly don’t expect stagflation in the near term with GDP growth exceeding 5%.  That said, we should remain vigilant regarding inflationary impacts on earnings and the commensurate policy action that would either help to damp its rise or accelerate price increases.           

Investor Strategies 

Investor strategies can vary when trying to deal with the current low interest rate inflationary environment.  Maintaining equity allocations allows a portion of the portfolio to participate in the upside potential of rising earnings.  We expect baseline forward P/E ratios to remain around 20X given low rates and growth in S&P 500 earnings.  This market multiple could expand if we encounter a more aggressive growth environment or shrink based on a combination of risk concerns.    

Introducing a hedged equity or split strike conversion approach can allow investors to extend equity exposure on a gross basis, but limit net exposure.  These strategies are implemented through the use of put options and collars.  While more complex and not appropriate for every investor, these strategies can help manage downside risk or even range bound an outcome in the equity market (capping both upside and downside). 

The typical fixed income allocation remains a conundrum with interest rates at extreme lows (especially for durations of less than 10 years).  In this environment, we are faced with the prospect of earning Fed Funds in stable value funds or short-term Treasury notes. The alternative in fixed income is to accept duration risk and try to achieve a higher cash flow yield.  This path is fraught with potential peril as normalization of yield levels would result in a substantial price correction in long duration bonds.  With bonds, the correlation between interest rates and price is more closely linked.  Junk bonds rather than investment grade or government paper would likely bear the brunt of the price correction as the combination of rate normalization and increased default risk (as a result of those rates) could impact pricing.   Our strategy continues to be to maintain stable value short duration assets in this category until we are paid for the risk assumed through higher bond yields and lower prices. 

Ruth Amed penned, “There is something so special in the early leaves drifting from the trees-as if we are all to be allowed a chance to peel, to refresh, to start again.”   Fall brings us a chance for renewal every year.  This year more than most, we are challenged to free ourselves from the languorous days of summer and to view our world with a sharpened focus.  Portfolio management is not exempt from this sense of autumnal reflection.  We must continue to look at our investments with a discerning eye and recognize when and if the season has changed. Electively, we can either take our coats out of storage or continue to bask in the illusory summer zephyrs that will inevitably soon shift to a north wind.  

Thank you for your continued confidence in our firm.   

Sincerely,

Peter C. Wernau

President, CEO
Wernau Asset Management

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