4th Quarter, 2021
Political decisions often skew market forces which in turn affect economic outcomes.
THE MARKETS
Market volatility continued during the quarter largely in response to increased inflationary expectations, apprehension about changes in Federal Reserve policy, and the heightened uncertainty created by a new COVID variant. Equity markets also have been buffeted by short term strategies, notably algorithmic trading and the use of Exchange Traded Funds (ETFs) as a vehicle for rebalancing hedge fund portfolios. A common feature of the foregoing is reliance on financial leverage to achieve excess returns, as evidenced by all-time high margin debt. This is an additional source of potential turbulence. Long-term fundamental investors appear to be minority participants in the present market environment, a characterization likely to shift when the Federal Reserve returns to a policy of interest rate normalization.
COVID induced inflation has finally forced the hand of the Federal Reserve, which now acknowledges that greater, more persistent inflationary forces call for an accelerated tapering of bond purchases and interest rate normalization. We do not expect these policy revisions to overtake inflation in the manner accomplished during the tenure of Paul Volcker and note that the markets continue to perform as if the supply of cheap credit is not presently imperiled. Both stock and bond markets remain mostly unfazed by the impact of future tightening.
At present, high profit margins are helping investors look past the pressure that will affect corporate profits if pricing cannot offset higher input costs. Current earnings forecasts for goods producers do not reflect that possibility and may prove overly optimistic, while the effect on services may take longer to manifest, thus sustaining their high valuations. In the longer term, both would be constrained, with valuations coming under renewed pressure.
Just as there is complacency regarding profit margins, there also is lack of major concern about liquidity. However, several factors affecting liquidity continue to expand: margin debt is approaching 2.6 percent of GDP and substantial amounts are being allocated to derivatives which in themselves are significantly leveraged. Further, we have the Crypto phenomenon which has taken in some $2.7 trillion dollars of liquidity and in which the use of leverage is opaque.
The growth of leverage in a global environment of rising geopolitical tensions and the uncertain path of future COVID-19 variants needs to be taken seriously as a threat to the rapid rise in asset values experienced in the last two years.
THE ECONOMY
As we enter the third year of the global COVID-19 pandemic, economic forecasting continues to be befuddled by global responses to the pandemic which can vary widely and are often in conflict with scientific findings. As such, political decisions often skew market forces which in turn affect economic outcomes.
At present, the domestic economy propelled by massive public sector stimulus has rebounded well beyond earlier forecasts and chalked up a record GDP rebound in excess of 6% in the first three quarters of 2021. However, the economy is now beginning to throttle back due to a combination of demand composition, the ongoing challenges of supply chain dysfunction, and inflation.
Looking ahead to 2022, with the expectation of minimally constraining COVID related policies, the economy should be able to adapt to the emerging new norms and satisfy consumer demands. This would result in above trend GDP growth. All this acknowledges the Federal Reserve’s pivot to stimulus withdrawal and a gradual return to a normalized interest rate environment. The latter point is a large bone of contention in financial markets and as such, is not a foregone conclusion.
Final demand shifts between services and goods will be the key determinants as to the actual GDP growth figures and overall revenue, sales, and earnings projections for 2022. The current weight of data support above trend growth, albeit at a lesser rate than 2021. Elsewhere in the G7 world, growth has lost momentum due to the continued fallout from COVID-19 variants. Should we be spared more severe new variants, the prospects for a strong rebound in Europe appear well grounded. In Asia, growth appears to be well supported by strong external demand rather than domestic consumption, which continues to be hampered by energy deficiencies and supply chain issues.
Domestically, continued supply chain pressures, inflation, and attendant pandemic pressures (even in the absence of new variants) may pressure corporate profit margins. This could impede earnings growth rates, exposing equity markets to the risk of excessive valuations, notwithstanding a continuation of above trend GDP growth. All in all there are enough ifs out there to skew present expectations to the downside. Investors should not ignore these risk factors in 2022.
INVESTMENT STRATEGY
In our previous letter we commented on the resilience of the economic recovery and the challenges of continued asset appreciation in an environment of easy money with rising inflationary pressures and the likely ascent of a third wave of a new COVID variant. We are now well into the third wave with Omicron, a Federal Reserve pivot focusing on gradual tapering of stimulus and a plan to attempt interest rate normalization in late 2022 or mid 2023, with global inflation that has leapfrogged the definition of “transitory”.
Yet in the face of these real concerns, equity markets have moved to record highs despite bouts of severe sector volatility wherein individual stocks have recorded intraday price swings of 10%-20%. Further, margin debt keeps rising alongside that of share prices.
In the meantime, geopolitical risks appear to have moved from nascent concerns to real time global risks with the potential for serious armed conflicts. The specter of a Russian/Ukraine conflict, Xi Jinping’s changing ambitions to annex Taiwan, and the Iranian nuclear conundrum are real concerns that have the potential to defy diplomacy and wreak incalculable human and economic suffering and disruption.
We are now poised at an inflection point that requires a focused review of our investment strategy from the perspective of laying out a defense to protect current client asset values and the cash flow required to support your personal circumstances.
Balance sheet strength and business resilience in the face of adversity are pillars of our strategy. The tested ability of managements to successfully navigate rapidly unfolding economic and social risks remains a critical element of IIM’s stock selection. We will focus on sustainable new norms and the opportunities created by economic and social change as we build and manage equity portfolios expected to be durable across a range of outcomes.
In the current environment of negative real interest rates, bond portfolios should continue to be short duration, tailored to reflect liquidity requirements. Real asset growth and risk control must be reflected in an ironclad equity portfolio built on the criteria IIM has laid out. Articulating your cash needs in the early part of 2022 will provide greatest flexibility in funding them opportunistically, and we look forward to working together to achieve your investment objectives.
DEFICIT TRENDS: MORE ROUNDS OF KICK THE CAN IN PROSPECT
Recent Bank Credit Analyst forecasts estimate a likely 1% annual real return on balanced portfolios over the next ten years versus a real return of 6% achieved during the preceding 20 years. Such projections are heavily predicated on the long-term forecasts by the Congressional Budget Office of national debt trends as a percentage of GDP and the rising cost of annual debt service. While some of the servicing scenarios are debatable depending how the outstanding debt and future deficits are financed, the long term trend suggests the debt as a percentage of GDP is likely to approach 200% of GDP by 2050 versus the current level of roughly 100%. By contrast, the major European economies which have a higher tax structure than the US are expected to achieve a net reduction in debt as a percentage of their GDP based on current IMF forecasts.
Looking to the future and assuming above trend domestic growth and a continuation of populist trends, the US will continue to post budget deficits unless the tax base is raised to contain the deficit, as there is no public stomach for austerity at present. In addition the annual practice of raising the national debt ceiling and “kicking the can down the road” will continue our dependence on foreign purchases of US Treasury debt. At some future time, there is likely to be an inflection point where the Treasury needs will face a crowded bond market and long rates will likely move higher to counter the resistance of foreign buyers and competing corporate credit needs.
Historically, fixed income securities have provided at least a neutral real return while offering a diversification against the higher volatility of equities. At present, real returns on bonds are negative which persuades us to carefully match the amount and duration of fixed income securities in our client portfolios to each investor’s tolerance of equity volatility. As noted above, market forces and investor preference for positive real returns will eventually require higher interest rates. This normalization will be painful for long duration bondholders and likely result in higher equity volatility. For investors with a finite amount of risk tolerance, fixed income investments still have place in their portfolios but only as a short duration “anchor to windward” against the short-term vagaries of the stock market.