The Free Lunch Is Leaving & The Stock Market Is About to Tighten Up
The influence of fiscal and monetary stimulus on asset values, as well as a solid rebound in corporate profitability, drove stock prices higher in 2021.
In estimating the stock market’s forecast for the year 2022, four factors should be considered: inflation, policy stimulus, COVID-19, and geopolitics.
The last few years have been characterized by the Fed’s financial stimulus propping up the markets and cheap money driving consumer spending.
And with the Fed expected to hike interest rates up to 4x this year (see the Goldman Sachs prediction), we feel it will leave the average investor looking back over their shoulder saying, “Well…. it was good while it lasted.”
Because deep down, we all know there’s no such thing as a free lunch and things eventually change.
Here’s why we think things are about to change dramatically:
The Effects of Inflation
If the present inflation rate continues, central banks will be significantly behind the curve, causing a significant increase in volatility (which is GREAT for us stock traders!) and a difficult environment for long-only investors. Furthermore, the rate at which monetary policy accommodation (i.e., liquidity) is removed from the market will be determined by the trend in inflation.
The Fed had expected that pricing pressures would abate concurrently with the normalization of the global supply chain until US Federal Reserve Chair Jerome Powell bowed in December on his earlier conviction that inflation was temporary.
However, because each country’s COVID experience and the resulting impact on its industrial operations are different, it looks that the globe will continue to encounter supply shortages. We believe the current supply-demand imbalance will last until late 2022, if not longer.
Food costs are likely to rise significantly in the first quarter of this year for the same reasons that other prices are rising: labour, transportation, and underlying item supply limits. Energy costs are also expected to remain elevated for a long time, posing a headache for the Federal Reserve.
Given the heated property market that cheap money has fueled on both sides of the border, rental costs are certain to climb further. Furthermore, even at present wage levels, the current supply-driven pricing pressures risk switching to the more subtle demand pull kind of inflation.
The Effects of Policy Stimulus
U.S. loan growth has begun to accelerate for the first time in years, and that commercial banks now have an infinite supply of cash to lend following years of Fed money creation. A further growth in credit demand might be significantly inflationary, making the Fed’s job more difficult.
The most important factor driving financial market success in 2021 was policy stimulus. The significance of changes in fiscal policies will be dwarfed by monetary policy shifts.
The Continuing Effects of Covid on the Economy and World Markets
The pandemic is next on the agenda, and let’s all hope that the optimists are accurate in predicting that COVID will evolve into a virus that is considerably less virulent as a result of Omicron.
The Geopolitical Risks in the Markets
Our third thing on the list is geopolitics, which is always a popular topic, but it feels more relevant this year.
The number of flashpoints appears to be growing:
2) Iran (39 percent inflation, 60 percent debt-to-GDP ratio and rising)
3) China/US/rest of globe
4) US midterm elections, and
5) the impact of Germany’s newly formed left-wing government.
We’ll leave it to you to speculate on the financial implications of each of these scenarios.
Moving on, we expect GDP growth to increase until the middle of 2022 (ideally) before dropping in the second half — providing we get past Omnicron.
China’s economic expansion will be modest. The economic performance of Europe will once again be underwhelming. And, like the United States, Canada will follow suit with a slowing property market in the second half.
Unless the European Union surprises to the upside, the US dollar should stay strongly bid, while the Canadian currency should enjoy a quiet year.
Meanwhile, 10-year Treasury rates are expected to fall into the low twos by the end of the year.
Breakeven rates will fall if inflation returns to the Fed’s two-percent objective. Real rates and TIPs (Treasury Inflation-Protected Securities) are predicted to grow as the Fed reduces liquidity. Our prediction that nominal yields will trade with a two-handle this year is based on the assumption that breakevens would remain relatively stable, while real yields will rise.
If real rates rise, large-cap tech companies will be put under pressure, and GAAP stocks will fall much more.
To wrap this all up, we feel there are three inflation scenarios:
- Inflation becomes an issue, wage growth accelerates, and the Fed is perceived to be much behind the curve. As a result, rate hikes and liquidity withdrawals accelerate, and bond and stock prices plummet.
- If pricing pressures remain persistently above the Fed’s objective, a better balanced supply chain could help to prevent additional inflation and wage increases. If Consumer spending slows in late 2022, it could force the Fed to suspend rate rises, causing bonds to soar. Factor and style rotation across companies drives equities higher, and the more growth-oriented US indices outperform Canadian indices in this scenario.
- This summer, inflation levels are showing indications of returning toward the Fed’s objective, wages are levelling off, and low inflation allows consumer spending to stay strong; Treasuries are rallying, and equities are trading at new all-time highs, headed by macro-cap tech firms.
My trading team & I feel that markets are beginning to reverse the market trends of the past few years. As rising real rates cause price-to-earnings multiples to drop more, we believe that predictable profits growth will become increasingly important. (Where they haven’t been of primary importance in stock performance in the post-Great Depression era of monetary expansion.)
We also believe with the removal governmental support through additional liquidity being injected into the markets (in the form of various stimulus packages), the market will reward stock pickers over those blindly chasing market beta. Because overall returns are expected to be lower, controlling drawdowns becomes even more important.
Quality growth, or GARP (growth at a reasonable price), stocks, and some of the sectors normally associated with value are expected to succeed in the stock market, according to our research.
We are growing increasingly positive on oil prices, notwithstanding our caution in the medium term. Banks are seen as safe but unspectacular investments for the next 12 months, with values having stabilized.
Finally, assets that are frequently referred to as bond proxies should have a difficult time delivering any financial gains.
Overall, investors must recognize that financial asset returns will be riskier and provide less potential than in previous years.
And this is why we feel it’s important that if you’re managing your own portfolio, that you know what you’re doing.
Now — more than ever — is a time where you need to be financially well-educated in order to avoid the coming pitfalls as markets tighten up.
But with change comes opportunity, as we feel there will be an increased level of volatility into the markets — making traders like us light up with joy!