The execution of the Fed’s reversal of its accommodating policy will dictate stock and bond market’s performance in 2022.
In 2022, the “TINA” trade or There Is No Alternative argument for overpriced equities will collapse.
“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria” said investor, Sir John Templeton.
“Those who cannot remember the past are condemned to repeat it” said philosopher, George Santayana.
The economic recovery will drive commodities and cyclical stocks higher.
“Prediction is very difficult, especially if it’s about the future” said physics Nobel Laureate, Neils Bohr.
Markets in 2022 will be driven by Fed policy as it struggles to reduce today’s unanticipated historic rise in inflation without collapsing the stock and bond markets. Not since Jimmy Carter’s double-digit inflation in the late 1970s, has the Federal Reserve been so wrong. The massive COVID-19 stimuli of the last two years are driving today’s spiraling inflation. This experience parallels the 1970s when Vietnam war spending drove an inflation spiral leading to consumer prices rising 5.7% in 1976, 6.5% in 1977, 7.6% in 1978, 11.3% in 1979 and 13.5% in 1980. To quell the uncontrollable inflation, President Jimmy Carter appointed Paul Volcker in 1979 to chair the Federal Reserve. Led by Volker, the Fed raised the Fed Funds Rate – the rate banks borrow from each other for overnight loans – to 22% by December 1980.
The Fed today must reign in monetary stimulus fast enough to reverse today’s spiraling inflation without causing a severe market decline. This will be extremely difficult to do without panicking the capital markets.
The S&P 500 trades at historically high valuations as measured by both “Buffett’s Favorite Indicator” and Noble Laureate Robert Shiller’s CAPE ratio. The counterpoint to these ominous valuation measures, is the Fed Model or Risk Premium Model, shown below. The Fed Model compares the earnings yield of stocks to the yield of the 10-year US Treasury Note. Today, the Risk Premium is a bullish 3.13%, which implies the 10-year US Treasury yield would need to rise to the 4.5% range to eliminate this singular argument for owning stocks.
While a 3% rise in 10-year US Treasury yields looks like a significant increase, these yields have been artificially manufactured by the Federal Reserve asset purchases since the Financial Crisis in 2009. The scale of the Federal Reserve’s accommodation activities is reflected in its $8.79 trillion in purchased securities on its balance sheet.
The chart below shows the asset growth of the Federal Reserve since 2009.
Source: St Louis Federal Reserve Database.
Historically, Treasury yields have normally traded in the 4.5% range and higher, particularly around periods of inflation (see the history of 10-year US Treasury yields in the chart below in red). How will global capital markets respond to the Federal Reserve’s taper, tightening and asset sales? How markets will react to the Federal Reserve’s policy reversal is particularly unpredictable because the inflation scenario unfolding today was clearly unanticipated by the Federal Reserve when it initiated its generational policy shift in August 2020. We highlighted this Fed policy change risk, at that time, in our “Generational Trends Reverse” letter.
Source: Irrational Exuberance Data Set
In sum, with a growing economy, rising earnings, ample liquidity and positive stock momentum, the stock market can continue to rise, but deteriorating market fundamentals due to rising inflation point to increasingly meaningful downside risk as the year advances. This letter will detail strategies to protect capital and preview the 2022 economy.
Three Tools of Federal Reserve Tightening:
The greatest risk to the capital markets is persistent rising inflation which will force an extreme response by the Federal Reserve that could mirror Paul Volker’s reign. While that scenario is unlikely, there are three forms of Federal Reserve tightening to monitor this year:
- First is the taper. This tapering of asset purchases reduces $30 billion per month in Federal Reserve purchases of US Treasuries and mortgages from December’s $90 billion per month pace. The taper should end in March when the Federal Reserve will no longer be buying US Treasuries and mortgages.
- Second is the Federal Funds tightening. The market expects three quarter point increases up to 1% in 2022. If inflation continues to surprise to the upside and threatens a double-digit CPI or PPI reports, the Federal Reserve will have to implement even more aggressive actions to stop inflation.
- The third tool the Federal Reserve could use is selling assets. Specifically, the Federal Reserve could start selling Treasury and mortgage holdings on the Federal Reserve’s balance sheet and this could rapidly raise treasury and mortgage interest rates.
The current Fed balance sheet expansion appears untenable. The Fed is buying an increasing share of the US Treasury’s debt issuance and the Federal Debt is approaching $30 trillion. Further, rising interest rates could cause a dangerous acceleration in federal debt service cost if inflation spirals higher. Additionally, the US risks losing its world-leading credibility as its aggregate debt to total GDP rise and as its debt service obligations rise persistently higher.
Equity Market Breadth Is Deteriorating:
Today’s equity market breadth deterioration is consistent with a topping market. That is fewer and fewer stocks are rising. This condition has led to a “stealth bear market” where many early stage companies, which lack earnings and or sport high valuations, are experiencing deep declines. This is shown in the chart below by Ari Wald, CFA, CMT of Oppenhiemer & Company below.
2021 a Year of Irrational Exuberance:
As the business cycle matures, investors tend to extrapolate the outperformance of the strongest stocks and industries leading to poor market breadth and investors piling into fewer and fewer market leaders. This is evident in the outperformance of FAANG+ stocks and cryptocurrencies that are caught up in recent momentum and speculation. The market in 2021 displayed incredible speculative fervor in Reddit or meme stocks and record option volume levels consistent with massive speculation and irrational exuberance that are emblematic of market peaks like 1929 and 2000.
The risk of today’s irrational exuberance is brilliantly captured in the chart below that shows the accelerating parallel rise of FAANG stocks and the Fed Balance sheet. Since the Fed is committed to tapering and further tightening actions, the balance sheet rise will stop this year. From September to December of 2018, when the Federal Reserve balance sheet last declined, the S&P 500 declined 20.2% and the NASDAQ 100 declined 23.5%. For this reason, we see hedging benefits in owning inverse ETFs on the S&P, NASDAQ 100 (QQQ) and US Treasuries. Because of the size of the balance sheet and the risk of today’s uncontrolled inflation, downside could easily be more severe and protracted.
Better Safe than Sorry:
As physicist Neils Bohr said “Prediction is very difficult, especially if it’s about the future.”
The economic and market data we have presented could lead to widely divergent outcomes. These outcomes could range between the following bullish and bearish forecasts.
- In the bullish case, we envision a successful taper and inflation declines to 2% in 2022. In this scenario, the stock markets could experience a few corrections and still end the year up 10%.
- In the bearish scenario, we envision inflation rising toward 10%, the Federal Reserve unable to stop inflation and interest rates rising uncontrollably. In this case, a collapse in the FAANG stocks, NASDAQ 100, large cap growth, and the S&P 500 could mirror the Technology Bubble bear markets when the QQQ declined 83% and the S&P 500 declined 52% from its peak to trough in October 2002.
Today, a prudent conservative portfolio strategy that hedges against the downside risks should hold 50% in cash, and the rest in high income securities, inflation beneficiaries, value stocks, precious metals, international, and emerging market stocks until markets revert to their long term trends.
To reduce equity risk from today’s bubble levels, we are investing in securities and industries which are out of favor, benefit from inflation, and in economies still recovering from the COVID-19 recessions.
Commodity stocks offer economic cyclical investments where the company maintains considerable pricing power. Three industries fit this profile: steel, coal, and energy. We like steel stocks with low valuations and significant earnings growth potential. We own United States Steel Corporation (X) and Cleveland-Cliffs Inc. (CLF). In the metallurgical coal sector, we like Warrior Met Coal, Inc. (HCC) and Peabody Energy Corporation (BTU). In the energy sector we are particularly keen on natural gas, which we see as a major clean energy transition fuel which will be a primary provider of energy and electricity globally while cleaner fuel options are developed. Due to the unfolding energy crises in Europe, India, and China, oil and coal will enjoy a rebound as countries must confront their need for energy to reduce poverty and empower economies with electricity.
Precious metals, gold, and silver should grow in investor popularity as inflation begins to deteriorate the real return prospects of financial assets after inflation is accounted for. Both gold, silver and other precious metals should deliver attractive returns as investors increasingly embrace these traditional safe-haven investments. Whether it is the commodity itself or miners of these commodities, the next several years could generate significant outperformance that justifies precious metal accumulation.
Emerging markets are still lagging the United States’ economic recovery. As the year progresses, the recovery from the COVID-19 pandemic will lead to better economic prospects outside the US. We have grown cautious on China as it is becoming more adversarial and confiscatory. Consequently, we prefer emerging markets ex-China. India is well positioned to be a top performing country over the next decade.
To provide portfolio income, we own several investments and asset classes which offer high yields and should benefit from improving fundamentals. Master Limited Partnerships yield between 6 and 10% and offer tax advantaged distribution yields, growing earnings and are correlated to oil prices. Antero Midstream Corporation (AM) has been a superb investment for our clients as the underlying fundamentals of its parent Antero Resources Corporation (AR) has delivered tremendous earnings growth, execution, and leverage to the natural gas renaissance. AM yields 9.6% and is using its surplus cash flows to pay down debt and expects to raise its dividend and buy back stock in the next few years. The Templeton Emerging Market Income Fund (TEI) yields 10.75% and invests in the government securities of emerging market economies which should recover as COVID-19 fades away.