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Ferris Capital is incredibly proud of our many community engagements and contributions to charitable organizations around the country. This blog is intended to share these many achievements as well as notable news from within the Ferris family and important financial updates that could affect our clients. Please check back often and don’t hesitate to call us if you’d like more information on anything you see here.

February 18, 2022

2022 : We Remain Cautiously Optimistic

Summary:

After a strong 2021, the equity markets have shown significant volatility to kick off 2022. Investors are considering the impacts of the Federal Reserve beginning to start the rate hike cycle and some of the highest inflation levels in decades. Even given this backdrop, we believe that 2022 should bring positive returns for equity market investors while fixed income investors will likely find a challenging environment. Accordingly, we wanted to share our broader economic and capital market views.

In this update we address:

  • Omicron: the current trajectory and its potential effect on the economy
  • Federal Reserve: what rising rates mean for the coming months and beyond
  • Inflation: how long will it last?
  • Valuations: S&P 500 compared with the broader market
  • Geo-Political: what does Ferris Capital think of the Russia/Ukraine stand-off

Overall Outlook

Given the backdrop of the Omicron surge, rising tensions in the Ukraine, an uncertain regulatory environment in China, and a market trading at or above long-term valuations, capital markets were due to give back some of the gains. A market correction has always been a distinct possibility in our view. Longer-term, we believe there is upside in the stock markets for 2022 as the Fed moves are being priced in and there are no major storm clouds on the horizon. While we are unlikely to see valuations expand, we do expect both GDP and earnings growth to be supportive for stock prices. Also, potential upside surprises such as Omicron helping us move on and live with COVID faster than expected and inflation being more transitory than expected could further drive the stock markets in 2022. However, given the potential for a rapidly rising rate environment, we believe that investors should be very careful in their bond weightings and selections.  As such, we are encouraging investors to remain fully invested in stocks given the growth and inflationary backdrop and below long-term target weightings in fixed income. In arriving at this view, we considered the following factors in our analysis.

Omicron

As viruses mutate, a less virulent strain normally becomes the dominant strain endemic in the population. We believe that Omicron may be a blessing in this regard. It appears to be much less deadly than previous variants and much more contagious. We’ve seen incredible spikes in infections without the corresponding hospitalizations and deaths that we saw with Alpha and Delta. Moreover, Omicron appears to lend immunity to the previous variants whereas they did not confer immunity to Omicron. Additionally, we believe that the cases are very significantly underreported due to the prevalence of home rapid testing, asymptomatic infections, and non-testers. Cases in the US and Europe will likely collapse in the coming weeks and bring back more people into the economy which should help the service industries and workers and keep growth on a strong trajectory.

Effect: Positive

The Federal Reserve

After almost two years of extremely accommodative policy, the Federal Reserve has begun to end their bond purchasing program (quantitative easing) and has signaled that they intend to raise rates in 2022. Wall Street predicts four .25% rate hikes in 2022 beginning in March with the potential for more if inflation does not abate. The Federal Reserve tries to target a 2% inflation rate, and after a decade of below expectation inflation, they are finally faced with the prospect of using policy to combat inflation. They were considering exactly the opposite in 2019. We do not envy Jerome Powell, who will be walking a tightrope in 2022, because the Fed overshooting with policy is one of the biggest risks to the markets in 2022. We believe much of the action is already priced into stocks as companies that rely on borrowing for growth have been severely penalized over the past couple months, but the risk of inflation being more transitory in nature could lead to the Federal Reserve slowing the economy more than anticipated. However, the Federal Reserve has remained steadfast in their insistence that much of the inflation is transitory and it is unlikely that they will act as they have historically. The chart below from Blackrock illustrates their estimates for inflation and rates and how they differ from what would be the normal Fed response.

US CPI Inflation.png

Effect: Neutral to Negative

Inflation

Instead of going on vacations or eating out during 2020 and 2021, Americans bought goods at record levels. In particular, they purchased durable goods which saw demand grow by almost 50% with sub-categories such as sporting goods climbing even further. Please see the chart below from the St. Louis Federal Reserve.

Personal Consumption data.png

Nevertheless, after a decade of low inflation, we believe inflation will run above the Federal Reserve’s target of 2%. Moreover, the dollar weakened at the start of 2021, but then recovered towards long-term relative values (see Bloomberg chart below). Further, currency weakness, a traditional driver of persistent inflation, is not substantial enough to warrant strong action. Inflation running between 2-4% is the expectation for the next 12-36 months. Keep in mind that owning stocks is historically one of the best hedges against inflation.

While some inflation will remain persistent, the record demand in many sectors like durable goods should fall off over the coming quarters as supply chain issues work themselves out and people return to normal pre-COVID activities. Additionally, the microchip shortage is expected to begin to abate by the mid-point of the year. This will impact several areas with the biggest beneficiary likely to be the automotive sector, where inventories have remained stubbornly difficult for both new and used vehicles. Furthermore, Omicron’s decline may help ease some of the supply chain issues and transitory inflation quicker than expected, resulting in an upside surprise. The chart below from Vanguard illustrates inflation expectations.

How long will inflation last.jpg

Effect: Neutral to positive if transitory inflation abates quickly

Valuations

After a large run up in stock prices, valuations on the S&P 500 became extended as the big technology stocks at the top of the index drove the index well above its long-term averages. However, the S&P 500 doesn’t tell the whole story. The broader market that includes other styles and indexes were trading near long-term averages and below recent highs. If the economy recovers from the lingering effects of COVID quicker than anticipated, it could lead to higher valuations, but it is unlikely that multiples expand and more probable that ratios remain closer to their long-term averages and current levels over 2022.

  • S&P 500
    • Current Forward P/E: 19.7
    • 10 Year Forward P/E Average: 16.5
  • Russell 2000
    • Current Forward P/E: 21.6
    • 10 Year Forward P/E Average: 20.5
  • MSCI EAFE
    • Current Forward P/E: 15.1
    • 10 Year Forward P/E Average: 14
  • MSCI Emerging Markets:
    • Current Forward P/E: 12.4
    • Forward P/E Average: 12.5

Effect: Neutral to Slightly Negative

Geo-Political

We believe there are two geo-political risks brewing at the beginning of 2022: a Russian invasion of the Ukraine and a Chinese invasion of Taiwan. Of the two, a Russia-Ukraine conflict holds much higher likelihood of occurring as Russia is strongly signaling its intentions and it is unlikely that there would be much appetite for military involvement from Europe or the United States. Even still, it is also very likely that Russia and Putin are posturing for pipeline negotiations and conflict is largely avoided.

On the other hand, it is also very unlikely that a true China-Taiwan military conflict happens in the near to intermediate term. Firstly, it is not a foregone conclusion that China could easily overtake Taiwan. Any armed conflict would likely be protracted and result in a decimation of Taiwan’s economy,

 which would leave China with an economic drain rather than a developed asset. Additionally, the political fallout on the world stage would be significant and would further hamper the Chinese economy. While China may continue to control their economy through regulation which could be a headache for emerging market investors, it is unlikely that we see a true China-Taiwan conflict in the coming years.

Effect: Neutral to positive if the Russia-Ukraine situation resolves peaceably

Wrapping-up

Ultimately, although stocks have had a volatile ride from the highs of 2021 to the lows we’ve seen in the first month of 2022, our Investment Committee believes that investors that can see the “forest through the trees” and stay long quality (and primarily US-based) equities will be rewarded. History has long shown us that the best place to be in an inflationary environment is in stocks and hard assets. While we feel that 2022 will continue to prove much more volatile than last year in public markets, there will inevitably be buying opportunities that present themselves. We plan to encourage clients to lean towards a more selective equity allocation as the easy money has been made since the lows of Covid-19 were experienced in 2020. Along with a cautious stance regarding interest-rate sensitive fixed income and having some strategic cash available to jump on potentially undervalued sectors, there is reason to believe that there is still room for growth assets to shine in an ever more complex global landscape. Although the past 24-months have crammed in what seems like a lifetime of significant events, there are reasons to feel cautiously optimistic as we move further along into 2022.