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COVID-19: Our Yorktown Battle
Think back to the American Revolutionary war and The Battle of Yorktown which proved to be the decisive engagement of the war. The British surrender forecast the end of British rule in the colonies and the birth of a new nation—the United States of America.
So many resources were spent in attaining independence, but now the real battle begins. The period following the Revolutionary War was one of instability and change as our young nation experienced the growing pains of independence and scale. It’s like climbing a mountain, an immense effort is spent trying to reach the next peak, only to find a much larger summit after that.
COVID-19 was our summit to scale or “Yorktown Battle.”
As COVID began we saw record amounts of stimulus packages passed through to businesses and consumers. An enormous amount of monetary stimulus was released into the economy over the last two years which enabled a quick rebound in the market in 2020 and a strong consumer.
This also resulted in inflated asset prices as the stock market traded well above the historical average Price-to-Earnings (P/E) ratio.
As you can see, COVID cases have come down to essentially an all-time low since the initial outbreak and high-frequency data is telling us that consumer spending on goods is well above pre-pandemic levels and spending on services (travel, entertainment, etc) has almost fully recovered to pre-pandemic levels as well.
Navigating Through The Fog
Our economy is throwing off both positive and negative signs. If we look out the negative window, we see the Federal Reserve raising interest rates and reversing quantitative easing.
We see supply chains that are disrupted and shortages of natural resources. We see an unexpected war in the Ukraine pushing oil prices higher. If we look out the positive window, we see an economy that is recovering. The consumer is in great shape with low debt, low unemployment, and rising wages.
This is like driving your car on a highway and expecting fog. When the fog hits you shouldn’t slam on your brakes nor drive recklessly. You should slow down and be prepared for possible hazards. Likewise, we are taking steps to raise cash and to migrate portfolios toward companies that are undervalued and are expected to perform well in a rising inflation environment.
Four Street Signs to Watch For In The Fog
After a few strong years of market performance, we have been left with a choppy market in the first quarter and a lot of uncertainty heading into an important earnings season.
We need to pay attention to the street signs and navigate safely through the foggy drive ahead.
Inflation remains red-hot as Headline CPI reached 7.9% year over year as of February 2022 driven by both transitory factors such as food, energy, and new/used cars as well as sticky inflationary pressures such as shelter, household goods, and cost of services.
We see both Cost-Push and Demand-Pull inflationary pressures in the current market.
Cost-Push inflationary pressures are more so driven by supply-chain bottlenecks.
Cost Push Inflation:
Oil markets are a textbook example of this as the number of active rigs decreased by about 75% in 2019 through the middle of 2020. Now that demand has returned, there is a shortfall of supply which is driving prices higher.
The same can be said for new and used cars where supply-chain disruptions have been even more pronounced, and car lots have little to no inventory.
Demand Pull Inflation:
We see more Demand-Pull inflationary pressure in the market from COVID-related stimulus whereby we saw new excess savings skyrocket in 2020 and 2021, followed by increased spending. There were more dollars in the system chasing the same amount of goods, which pulled prices upwards.
We are also seeing this effect in the travel industry whereby airplanes and hotels are now able to attract higher prices per consumer as demand has returned.
The issue with inflation as it currently stands is that a great portion of the inflation we are seeing today is being driven by supply-chain shortages, which will not necessarily be relieved by quantitative tightening.
It will be interesting to see how the Fed chooses to navigate these waters in order to keep employment high and the economy stable while attacking inflation.
2. Quantitative Tightening
The Fed will attempt to battle inflation through aggressive quantitative tightening by both increasing interest rates and reducing the Federal Balance Sheet. The Fed now expects to raise rates to about 2% by the end of the year and 2.4% as a long-run projection. ²
Investors have seen a quick spike to the short-term rates and slight inversion in the curve at select maturities, which is not a sign of a healthy markets.
However, that did not last long and over the last couple of weeks we have seen the spread in the 2y/10y increase
3. Economic Growth and Productivity
Economic Growth is back to its pre-Covid trendline of ~ 2.0% growth.
Real GDP growth is expected to be 2.8% in 2022 as per the latest Fed projections which would put the GDP growth above trendline to end the year.
Wages and Unemployment have also impressed, with unemployment at 3.6% which is almost back to pre-covid levels of 3.5% (the lowest level the market has seen for the last 50 years).
Wage growth was 6.7% as of March 2022, well above the 50-yr average 4.0% growth, yet real wage growth is negative due to heightened inflation.
4. The Stock Market
Growth stocks do not like when interest rates rise as they are valued on future expected cash flows typically at higher multiples than value stocks.
An increase in interest rates could impact future cash flow growth as the company might have to raise debt at higher rates. Higher interest rates also increases the discount rate for the company used in valuation, which has an inverse effect on intrinsic value.
We have seen growth stocks experience multiple compression which has been more pronounced in Small and Mid-cap companies.
Corporate earnings have been strong this year increasing 4.1%, meaning that since the market is down 5% YTD as of 3/31/22, multiple growth has been about -9%.
Valuations have come down to 19.46x from their high of about 23x in 2021. While this is a more reasonable P/E multiple, it is still above the 25-yr average of ~ 17x.
The top 10 companies in the S&P500 are driving the high P/E multiple as the cohort has an average P/E of 30.7x versus the remaining 490 stocks at 16.6x.
As of 3/31/22, the top 10 companies in the S&P500 make up about 31% of the weight in the index.
Driving Through The Fog – Our Plan
1. Slow Down Around The Curves
When there is a lot of uncertainty in the equity markets it’s important to slow down and focus on the cash flow that companies pay off on a regular basis in dividends. As we always say, don’t kill the goose that lays the golden eggs.
We build our portfolios with a focus on high quality cash flow growth that will sustain temporary headwinds and higher interest rates.
We are taking this time to selectively buy more of these great companies that are high-quality cash flow generators trading at large discounts to fair value. Fear in the markets provides buying opportunities for high quality companies.
2. Fill Up All The Tires
Just like a car, investors want their portfolios to have a balance across different asset classes. Diversification is extremely important here as many defensive industries have outpaced growth in Q1.
We continue to favor Energy, Materials, and other sectors that have been out of favor in the last 2-3 years. Stay nimble and don’t take big bets on any one individual company. Also be weary on the concentration risk of the market-cap-weighted indices such as the S&P500 where big companies receive the biggest share of the index.
3. Listen to the GPS!
When you are driving down the road and your GPS updates your route, follow it!
Private investments are a space we favor currently as a diversifying asset that can provide cash flow and relatively stable pricing even when the public markets are going through turbulent periods. We have built up a cash-reserve in our model portfolios as ‘dry powder’ for continued market volatility. Look for us to sit on an elevated cash position until we find attractive investment opportunities in high-quality companies.
FROM THE DESK OF: Scott Pinkerton, CFP®, CIMA®, CPWA® | Partner, Planner CONTRIBUTING AUTHOR: Jake MacFarlane| Research Analyst
1. JPM Guide to the market (all charts)
2. Federal Reserve March Meeting Minutes (https://www.federalreserve.gov/monetarypolicy/files/monetary20220316a1.pdf)
3. U.S. Bureau of Labor Statistics (https://www.bls.gov/)