The new year has brought shifts in the investment environment. While not unprecedented, there are some unusual forces that investors should keep in mind as they consider their investments.
In these first few weeks we have seen volatility rise and broad swings in investor appetites. There are several influences driving these dynamics, however there are a few central and interrelated points that will be with us for at least the first half, if not the full, year.
Below are some thoughts about the economy, financial markets and positioning investments going forward into 2022.
“It's tough to make predications, especially about the future." - Yogi Berra
Major Forces: Inflation, Interest Rates and Stock Market Valuations
GDP continues to expand and expectations for growth globally are about 4.4%, with the U.S. at 3.9%, Europe running at 4.2% and China close to 5.3%. Economic growth will be largely motivated by an increase in consumer spending and the eventual de-clogging of supply bottlenecks. This, of course, could continue to push prices upward and inflation expectations for 2022 hover around 3.5%
In general, consumer demand should continue to grow organically as the global economy recovers and expands. Supply chain issues and product shortages will hopefully resolve, however strong demand will most likely drive continued upward pressure on prices. The Federal Reserve had generally assumed that inflation was transitory and was reluctant to shift from its highly accommodative monetary policy set forth in response to the pandemic to a more neutral stance. However, responding to the exponential and persistent rise in prices, the Fed has recently changed its position shifting to a more ‘hawkish’ stance by ending its program of quantitative easing that kept interest rates low.
The Federal Reserve’s shift to raising interest rates (essentially the price of money) and making the cost of borrowing more expensive has two immediate effects:
First, companies borrowing to invest in their businesses will find the break-even price of projects rise; that increase may cap or reduce their growth expectations. Lower growth expectations should lower the value of their stock as investors discount future earnings.
Second, as savings rates and fixed income (bonds) become more attractive, and the cost of investing (margin loans) becomes more expensive, funds may shift out of the equity market into fixed income assets. Investment funds flow to where they are best treated, and if a reasonable rate on less risky assets becomes appealing, the general demand for stocks may decline.
For 2022, the Federal Reserve will struggle to balance tightening monetary policy in line with the overall financial markets and economic growth. The Fed’s task at hand is to rein in inflation without disrupting financial markets and sending the economy into a recession. As investors react and adjust their expectations a ‘push-pull’ dynamic may arise.
A challenge facing the economy is the significant decline in the workforce participation rate. With a limited pool of job candidates, companies have had to adjust how they recruit and maintain talent. Wages and benefits rise accordingly to entice new workers, which in general is a good thing, however, the risk of spiraling costs to companies ultimately impacts profit margins and growth prospects.
At the same time, stock market valuations are at all-time highs. One metric of measuring overall market valuation is to compare the total value of the stock market with the domestic GDP. As pointed out by Warren Buffett, the percentage of total market cap relative to the U.S. GDP is “probably the best single measure of where valuations stand at any given moment.”
With rising interest rates and high market valuations, we may continue to see investments in more speculative companies come under pressure, and financially strong companies with competitive advantages and stable long-term earnings expectations perform better.
The good news is the global economy continues to grow, and recessionary pressures are distant. Jobs are plentiful and major strides are being made toward managing public health concerns. Inflation and monetary policy response may play a bit of havoc with financial markets, but consumer demand remains strong.
Parkview Capital has the knowledge and experience to help investors navigate the changing market tides to tailor investment decisions to match clients’ unique goals and priorities.
David W. Malmgren, CFA
Founder and Principal
Parkview Capital
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