Client Investment Letter January 2022

“It’s like déjà vu all over again.” – Yogi Berra

Another year has drawn to a close, and yet it all seems very familiar. Stock prices are still rising with the S&P 500 logging all-time highs, earnings are still recovering from the lock-down depths, the Federal Reserve balance sheet expansion is setting new records, and the Covid-19 pandemic continues to dominate the headlines. As much as it feels eerily similar in some ways, much has changed since the last time the New Year was upon us.

First and foremost, while Covid-19 continues to run rampant as the Omicron variant becomes widespread, hospitalization and deaths from the disease have declined dramatically from prior peaks. We now have effective vaccines and even recently approved pills to prevent the worst outcomes. Home testing is now possible. And many more treatments are on the way: According to the FDA, over 600 Covid treatments are under development in addition to over 100 vaccines. Our ability to manage this disease will only improve. Covid-19 is on track to rapidly become an endemic nuisance like so many other diseases we have always grappled with. Sure, you want to avoid becoming infected, but Covid will soon be something you can expect to recover from when you catch it, and most of us inevitably will.

Despite the pandemic, the corporate earnings recovery in 2021 was robust as operating earnings per share for the companies in the S&P 500 are expected to have grown 65% this year when the results are tallied (and 28% above 2019 levels). Next year the consensus is that growth will continue at a more sustainable 9% rate. Despite all the puts and takes from the pandemic, public companies have demonstrated impressive growth. The leaders, far and away, remain large capitalization technology companies which had another stellar year in 2021 after a fantastic 2020. Trees don’t grow to the sky, though, and while we still like our tech companies long-term, we don’t necessarily expect them to continue the torrid pace of appreciation they have enjoyed the last couple years. Indeed, we see other parts of the market that have been left behind like defense, energy, and healthcare as potential beneficiaries of a maturing economic cycle. Already, you can see the leadership rotation as many of yesterday’s high-flying winners like Peloton, Zillow, DocuSign, and even Moderna have fallen over 50% from their recent highs.

The federal government played a major role in the pandemic by stepping in to provide financial support to millions of Americans during the depths of the economic shutdown. However, since September, aside from a few payments like the child tax credit, most of the additional transfer payments have stopped. Additionally, moratoriums on evictions have also run out. It remains to be seen what kind of macroeconomic impacts the expiration of these programs will have. Will more workers re-enter the workforce now that they don’t have government income? Will spending slow down without that extra money in checking accounts? Will inflation, which took off soon after these programs were initiated, return to more typical levels? Given the grand scale of what can only be described as the largest ever fiscal policy response to a crisis, only time will tell. We have no other fiscal program of such scale to look to. Even the New Deal pales in comparison after adjusting for inflation. So far, Congress has not increased taxes and regulations or done anything significant that might slow down the economy. Perhaps that will change in 2022, but political consensus has been slow to achieve so far, and the midterm elections will be upon us soon, so we won’t hold our breath.

Besides fiscal policy, the other big lever governments use to impact the economy is monetary policy, which is set by central banks (the Federal Reserve in the United States). The Fed has had a significant change in tone recently as it has rapidly begun to wind down its quantitative easing (QE) bond purchases and, after admitting inflation is less transitory than it thought, has indicated that it intends to raise rates as soon as this spring. This policy pivot is the result of a vastly improved labor market, with only 4.2% unemployment in November, and inflation that is running well above the Fed’s 2% target. To us, the combination of nearly full employment and high inflation suggests that the Fed is behind the curve on addressing an overheating economy. There is little doubt that QE will need to end and interest rates must rise to head off further inflationary pressures.

However, unlike massive fiscal stimulus, interest rate increases aren’t new. Historically, the initial increases in a rate-hiking cycle have rarely been the cause for a major recession.  Even the famous double dip recession of 1982 took a year and four rate hikes. It often requires many rate increases over a period of multiple years to induce a recession, and we believe that is likely to be the case this time as well. QE is a much newer phenomenon, born in the wake of the 2008 financial crisis. So far, efforts to reduce the balance sheet have led to risk aversion in financial markets, inducing temporary sell-offs such as the 2013 taper tantrum, but not seeming to transmit pain to Main Street by inducing recession. Of course, the Fed has hardly been able to “undo” QE. The balance sheet only managed to shrink from $4.5 trillion at its post-financial crisis peak in 2015 to $3.7 trillion in 2019, before the Fed was forced to reverse course. This time we are at $8.8 trillion and still rising. It’s a tough task – removing unprecedented levels of support to tamp down inflation while not so much as to induce a recession – and one not without risk of a serious policy mistake.

We expect uncertainty about the Fed’s attempt to thread this needle will add a fair bit of volatility to the markets this year. We see long duration bonds as most susceptible to trouble as they are facing the double whammy of inflation reducing the ultimate purchasing power of the principal and potentially higher rates rendering existing securities less valuable. Fixed income in general is susceptible to both duration risk and credit risk. To us, the most sensible course is to remain invested in high-quality companies that are supported by strong cash flow and reasonable valuations. While inflation may impede multiples if waves of risk aversion do hit the markets, we expect most of our companies to be able to pass through price increases to their customers and therefore we expect cash flow, dividends, and earnings to be able to continue growing. We always keep a little dry powder in the form of cash or short-term Treasury bills. You can expect us to use any meaningful corrections to make some new purchases for you or to continue to expand positions that we have started but not filled out yet as we were able to do with Lockheed Martin and Activision last quarter. We will be patient and try to limit the risk to your capital by not overpaying when we purchase new companies.

Thanks for the trust you place in us.  Though there will almost certainly be more volatility this year, we expect your portfolio of winning companies to fare relatively well no matter how many curve balls come our way in 2022.  Wishing you health and happiness in the new year!

Penn Davis McFarland, Inc.
January 2022