Warren Barnett 30 December 2021
The New Year will bring all sorts of changes. A stock market floating on cheap money and excess funds will learn to float with less or capsize in the process. Many speculative enterprises like cryptocurrencies, electric vehicles and the like will face a time of testing. Not all will survive. Inflation will become both more entrenched and more of a source of concern. Interest rates are slated to rise but will need to rise more than forecast to rein in inflation.
The Economy
At this time, the American economy is slated to rise around 4 percent in 2022, net of inflation. This will be down from an estimated 6 percent for 2021, but ahead of the 2-3 percent rate the economy is expected to fall back to in 2023. 2-3 percent is considered “normal” economic growth for an economy of the size and maturity of the United States.
Most forecasts for 2022 are front-loaded, meaning the bulk of the growth will occur in the first two quarters. This is due to the waning effects of the various stimulus programs launched by the Federal Government to shore up the economy during the Covid-19 pandemic. If the pending round of stimulus is rejected by Congress, expect the economic deceleration to occur sooner than would otherwise be the case. Even if passed, the economy will slow down in 2023 as the effects of no population growth impacts domestic demand.
The sectors most likely to expand in 2022 are those related to health care and infrastructure. Health care is driven by demographics, while infrastructure benefits from the government programs already passed as well as potential future programs.
The most vulnerable sectors are those who find themselves left out of the current economic environment. Office-based firms are grappling with surplus space, given the number of workers who continue to ply their trade from home. Passenger transportation is struggling as people become fickle and price-sensitive about travel and up to half of business trips are probably gone for good. While movie theaters are falling behind, even their streaming replacements are having a problem as more outlets compete for the same audience.
Ancillary leisure businesses like hotels and restaurants will also feel the pinch. Restaurants on the surface have bounced back, but higher menu prices may translate into
fewer customers. Staffing is a major issue, with many who once worked in food service the most personally knowledgeable about the fatal nature of Covid-19.
Inflation
A tight labor market is the surest precursor of inflation. While logistical bottlenecks will get better in 2022, supply chains are not the biggest inflation worry. Finding qualified workers at a cost that still provides a profit is an ongoing battle. Unless matters like childcare are addressed, there is little reason to believe things will get better.
In this regard, larger companies who can spread the cost of labor, including benefits, over a larger volume of business have an edge over smaller firms. Smaller firms can often offer a better work environment and sense of affiliation. With inflation so much of an issue, these advantages may become less enhancing.
The biggest driver of inflation currently is the cost of housing. Those with houses have benefitted from the appreciation of real estate. Those who do not own a house have not. This accounts for why more turnover is evident in the lower end of the job market than the higher end. In some cases, the cost of housing is close to 50 percent of a lower wage family’s income. This is not sustainable.
There is another aspect of inflation that most do not yet talk about: this is the expectation of more inflation in the future. Inflation expectations are important. They serve to make workers demand a certain rate of pay increase for inflation that does not yet exist. By doing so, future inflation becomes more manifest.
The Federal Reserve has done a dismal job of convincing the public that the current inflation is “transitory” as they once put it. As inflation stays at the current level, the Fed’s credibility will be further reduced. Their signaling of three interest rate hikes in 2022, along with tapering bond purchases, may be inadequate to the task. The key question is whether the Fed has it in them to get ahead of inflation or if, by lagging, they will make it worse.
Already businesses are moving away from just-in-time inventory, where inputs are minimized, to keeping more inventory in stock. While this was done originally to address the effects of supply chain disruptions, businesses are earning inventory profits on what they are holding. This is being passed on the form of higher prices. When holding assets earn more than holding cash, all bets are off for price increases.
Interest Rates
Interest rates and the availability of funds are the two most obvious ways the Federal Reserve directs the economy. Back in the days of Alan Greenspan, the Fed would cut interest rates to counter declines in stock market levels. This strategy took on an additional impetus in 2008 when Ben Bernanke was Fed Chair. He believed that prodigious quantities of cash pumped into the economy was the best way to avoid another Great Depression. Jerome Powell has continued this approach with interest rates now below the rate of inflation and cash being pumped into the economy by way of bond purchases that now total some $8 trillion.
More recently, Powell has indicated he will begin to taper off the bond purchases which will have the effect of taking about $300 billion in cash out of the economy. He has also signaled a desire to raise interest rates, although a timeframe is not yet known. In this regard, Powell is trying to avoid the mistake of the last taper in 2018. At that time, the stock market fell 20 percent in two months, until the Fed reversed itself in January of 2019.
More recently, the economic trauma of the Covid-19 epidemic again caused the Fed to provide abundant funds and close to zero interest rates. The issue is how to raise rates to combat inflation without killing off the economy.
In a less complicated time, the chief job of the Federal Reserve was to control inflation. More recently, the Fed has been tasked with the job of providing full employment. In some ways, the additional mandate conflicts with the original one. Full employment is usually inflationary. Less than full employment is not.
Only during the Trump administration were the two goals met in tandem. This is attributed to an abundance of imports, which kept domestic inflation down as other countries wanted US dollars. Currently, inflation is world-wide, as those same exporting countries grapple with the effects of labor shortages of their own, and Covid-19 compromises the output of many areas lacking adequate vaccination supplies. Add to the mix supply chain stresses and what was a steady source of non-inflationary goods disappears.
For 2022, look for the Fed to tighten in an effort to reduce inflation and regain its credibility. If inflation is not contained, a Paul Volcker approach of rapid increases above the inflation rate to tame not just inflation but inflation expectations will be warranted. Look for inflation to be around four percent officially, perhaps more for those who rent.
The Stock Market
Higher interest rates and more restricted lending are the enemies of inflated equity prices. However, even the overall market can contain elements of appreciation if one knows where to look.
The most vulnerable sectors of the stock market are those that are the most overvalued. Large technology firms that may have good prospects but have gotten ahead of themselves in terms of price is an obvious example. Some of these companies have aided the appreciation of index funds in years past. As an index is carried by fewer names, it becomes less of an index and more of a potential trap, at least in terms of appreciation.
Most people forget that index funds came into prominence around the time of the last market upturn in 2009. They have not experienced a full market cycle in terms of a decline of any duration. The investment issue is this: if index funds decline and stay down for a period of time, will investors sell them to go on to other things, or will they stay the course until the next upturn?
Market strength should be found in health care, some home builders, infrastructure, and other special situations. Markets that move sideways or decline are more the province of individual issues rather than packaged investment products. For those who have sufficient funds to construct a portfolio, the results can be gratifying over time.
We at Barnett & Company wish a safe, happy, and prosperous New Year to you and yours!
Warren M. Barnett, CFA
December 30, 2021
Barnett & Company is a fee-only registered investment advisory firm registered with the Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations. For a brochure on the company and its available services, please contact Elizabeth at 423-756-0125 or [email protected].