Through the Looking Glass
Clients of the Firm,
Each year around this time we posit a forecast for the coming year based on the known risks and opportunities we see before us. It is an exercise in analyzing the matrix we see the market through and then forging a strategy forward for dealing with it. As Lewis Carroll penned for Alice, “It’s a great huge game of chess that’s being played- all over the world.” This letter will attempt to peer through the looking glass to try to see what the market chess game looks like in 2022.
We wrap up the 2021 year with the Omicron COVID-19 variant surging throughout the globe. Continued disruption to ordinary life from the virus has become the norm as we learn to live with this omnipresent scourge. Recently, we have also seen that there seems to be almost no negative correlation to equity markets as a result of variant outbreaks. Evidence from the U.K. and South Africa indicates that Omicron is the most contagious variant yet. That said, other studies indicate it may also be less prone to trigger severe illness and hospitalization than previous variants. Despite record case counts from Omicron, the combination of natural immunity from prior infection and vaccinations may prove to help prevent further lockdowns. Therefore, from an investing perspective we should focus more on fundamentals than PCR test results in our quest to generate a positive return on invested capital.
Consensus earnings forecasts for the S&P 500 in 2022 are $223.48. This implies a bullish range of valuation for the year-end 2022 target of 4,469 to 5,587. The S&P 500 closed before Christmas at 4,735. If estimates were to fall 10% short of targets, fair value would be closer to 4,000 at the low end of the range. To develop these projections, we used a 20 X multiple which remains appropriate in our view given the continued low level of Treasury yields (a proxy for the risk-free rate of return). The 10-year Treasury is at 1.45% as of this note.
Thus, domestic equity markets remain investable at current levels, though it will be hard to achieve the type of return we saw in 2021 given valuation levels. Our expectation is for growth with more volatility than we saw in 2021, a year which featured near historically low volatility for the major averages. The balance of this letter will focus on the drivers of volatility and risks to our growth forecast that may impact market performance in 2022.
We have seen dramatic rises in inflation throughout the second half of 2021. The question is whether this inflation will be sustained or not. The Fed has recently called this condition “transitory”. In our view, certain key elements of inflation are unlikely to be transitory. These items are primarily focused on wages and price inelastic goods. Wage increases tend to persist as raises are given out to workers and then very rarely taken away. In a period of labor shortage, as we have today, wage increases can exacerbate due to a supply and demand imbalance. The reasons for the labor shortage are multifurcated. Some reasons postulated have been retiring baby boomers, government subsidy disincentivizing work and fears of COVID-19 keeping workers out of the work force. More recently, we have coalesced around the idea that wage increases and government subsidies have provided enough support to allow people working two to go down to just one job. Thus, we believe we have seen a great resignation in the labor force from second jobs that is showing up particularly in supply chain jobs and the trades.
In order to attract labor, many companies have had to dramatically increase low wage positions to entice workers. This is probably evident to the reader as you see “We’re Hiring” signs on almost every fast-food restaurant, small business or big box retailer. The wage increases are meaningful and will help to regulate the supply and demand imbalance. These increases are inherently inflationary and are also unlikely to return to previous hourly levels. We believe that current labor conditions meet the Fed’s criteria for maximum employment. Moreover, the stickiness of labor costs will not be transitory in our view and will likely drive price increases in price inelastic industries like quick service restaurants and margin compression in others like retail.
Supply chain disruptions have also been a big driver of non-wage related inflation. The ability to ship and distribute goods globally has been impacted by the labor shortage as well as supply disruptions from COVID-19. Unlike wage inflation. we believe that this driver of inflation is likely to be transitory. We expect supply to come back online in force after the holidays and the current Omicron surge. In fact, there is a significant risk of oversupply as many retailers over bought supply in order to ensure they would meet holiday demand. The excess supply of goods from this process may produce a discounting wave in Q1 2022 in order to clear seasonal channel inventory. Discounting would actually be deflationary for these retail goods. Likewise, energy demand shocks will likely moderate over time as the carbon energy replacement cycle accelerates and fossil fuel supply comes online both domestically and particularly in Europe from LNG supplies. As supply chains normalize over the first half of 2022, we expect the inflationary pressures from the supply shock to abate and prices to adjust with them.
International affairs continue to be a potential risk to markets. Every year we contemplate this risk and somehow policy makers seem to avoid total calamity. This year acute risks lie in the buildup of forces and rhetoric over Ukraine and the dispute over the South China Sea and Tawain. While the risk of Iran and North Korean nuclear intentions persists, the first two issues raised have the potential to devolve into global confrontations. Tawain has strategic economic importance as the world’s largest producer of microchips. Supply disruption from Tawain would have profound economic consequences for the world and a conflict whether hot or not would certainly have an impact on manufacturing for the United States. This issue is a continuation of the China trade war and an example, like Hong Kong and the belt and road initiative, of a China policy that is looking to consolidate power globally to compete with the United States as a superpower.
The Ukraine standoff risks engaging NATO in a protracted armed conflict either as a proxy for Ukranian forces or direct engagement with the Russian military. In addition, this hotspot has the potential to be a prolonged clandestine war, where previous engagements involved the use of Russian “little green men” instigating violence in the country.
Low interest rates have been a hallmark for the past several years. Our projection for interest rate normalization was early and perhaps 2022 will finally be the year where the Fed and markets change their POV on where rates should reside. As mentioned previously, our view is for growth in 2022 with maximum employment and some persistent inflationary pressures. This view is consistent with a Fed policy of tightening interest rates now that target inflation of over 2% has been met and full employment appears to be in place. As announced, the Fed will first end its bond buying program and then turn to tightening as a path to normalize rates and fight inflationary pressures. This will likely lead to a correction in prices in the fixed income market, become a headwind to interest rate sectors like real estate and become a tail wind to bank earnings. We don’t expect a mild tightening of short-term rates will be difficult for the stock market to absorb, but would likely impact certain interest rate sensitive sectors on the margin. An aggressive tightening, which we don’t expect, would be disruptive as it would be a shock to short-term funding markets and could cause liquidity concerns. Risks continue to reside heavily on the longer end of the bond maturity and duration curve. Here investors are paid very little for assuming prolonged risk. Much of the investment grade bond market does not even exceed inflation expectations on a pre-tax basis and the return profile is even worse after taxes. We continue to selectively invest in longer duration fixed income assets only where a special situation or price dislocation allows for a sufficient capital return profile.
When markets get elongated on valuation, we tend to see alternatives show up to engage participants in speculation. This year was no exception as Crypto and NFTs came into the mainstream narrative. Anecdotes abounded in our daily lives with constant questions about these speculative assets from most people we encountered. From clients to the barber to the coffee shop worker, we fielded many questions about the price of these assets and almost none about their value. In our experience, speculation usually ends badly for the many and works out spectacularly for the few. While these assets seem to have staying power, they are nascent in terms of price discovery and would fit our definition of speculation versus investment. They may have a small place for the most adventurous portfolios but contain risks not appropriate for many investors.
Benjamin Graham said, “If you have an opinion about the level of prices, it should be an opinion based upon your concept of the values of securities in relation to price, rather than on any prophecy or expectation of changes or of the continuation of a given moment”. One thing the last two years have taught us is that we should expect the unexpected. Basing our investing decisions on the continuity of a trend or stability, even in our way of life, has not proven reliable. What we have encountered however, is the incredible durability and adaptability of the U.S. economy to an everchanging dynamic landscape. Innovation, medical science and creativity have combined with unprecedented government financial support to create an excellent outcome in financial conditions.
May we rely on these hallmarks of our society to see us through the mist and mystery of another year. With humble appreciation, we wish you and your families the best in 2022.
Sincerely,
Peter C. Wernau
CEO Wernau Asset Management
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