Volatility finally took a slight breather the past few days with somewhat muted stock and bond movement after violent swings back and forth since Omicron was discovered a few weeks ago. Following a 5% – 10% correction in most major averages, we are already within shooting distance of new highs. However, we are still 10%+ below peaks seen in the more interest rate and cyclically oriented Russell 2000 benchmark which fell another 2.3% yesterday. The Dow Jones Industrial Average finished flat. After massively oversold bounces higher, fund flows continue to flip back out of sky-high P/E and long duration assets while shifting towards high quality mega cap leaders. Google#, Apple#, Microsoft# and others were fractionally lower on the day, but Coinbase, Square, Roblox, Atlassian, GameStop, MicroStrategy and other cult favorites were down ~5% or more, yet again.
While some high flyers are going to keep dropping, plenty are trying to form a base. This continues our transition phase as we look towards future winners that have real products, quality leadership, lasting revenue streams and are not reliant upon a never-ending punch bowl of free money from the Fed. As we enter 2022, separating the wheat from the chaff will become even more critical. High beta growth stocks need to find a floor first, before becoming aggressive on new purchases. Never catch a falling knife. Drops of 40% – 60% are rarely followed by spikes back to new highs. Bases are likely to form first for those that survive.
Fears of Omicron becoming a dominant and deadlier strain have been mostly erased as positive data points keep coming forth. We are not out of the woods by any stretch but plenty of officials who have followed this pandemic correctly, such as Dr. Scott Gottlieb, indicate this variant is less virulent. If this trend continues, reopening will keep moving forward. Our biggest risk might just be overreactions from Governments around the globe causing more shutdowns that impact recovering supply chains.
Looking ahead to next year, many headaches will be cleared up if Omicron data keeps trending positively. Senators Schumer and McConnell agreed to a one-time fast track process bill for raising the debt ceiling. Congress will be allowed to raise our debt limit to a specified number, likely encompassing Government spending through next year’s elections. If polls are anywhere near accurate, which has not been the case lately, Republicans will take back the House and/or Senate in 2022 elections. Vindicated by their potential win, newly elected officials will demand some spending concessions from their battered President, creating a more critical debt ceiling showdown in early 2023. That is another day’s problem.
Other headaches are subsiding as well. Shipping costs have started to roll over, which is a pre-cursor to improving delivery times and lower inflation. Many commodities have cratered 25% or more already, also helping inflation. After a covid-induced slump in Q3, economic forecasts are calling for nearly 10% growth in Q4. Corporate stock buybacks are setting records. Couple that with slightly higher margins and earnings could grow in the mid-teens for the final quarter of 2021. Reopening efforts and pent-up demand point to double digit EPS growth next year as well. An accelerated tapering timeline is all but known at this point and realistically, should have already been done. Markets have priced much of this in.
In my mind, the biggest wild card for next year is our Federal Reserve and their battle with inflation vs employment. Today, all signs point to a rapid increase in tightening monetary conditions. The speed at which we battle inflation and increase interest rates will be the main driver for overall equity performance. We basically know earnings will be solid for most, but at 22X earnings, real yields need to stay low to maintain elevated P/Es.
Our last tapering phase lasted from January 2014 thru October of the same year. Fed chatter indicates this time around it will be completed in 5 months instead of 10. Once tapering is complete, questions will arise on what happens next. Phase II of the punch bowl withdrawal will be Fed rate increases. Phase III is an outright decline in bond holdings on the Fed’s balance sheet, if we get that far.
After our last tapering phase, Fed officials began to raise Fed Funds off their 0.0% – 0.25% floor in 25bps increments. This was a full year after tapering ended. The first rate hike wasn’t even repeated for another full year as well, bringing Fed Funds to 0.50% – 0.75% in December 2016. That was 50bps in 24 months following the taper. Currently, market expectations are for an immediate increase in Fed Funds once tapering is complete and 2 more rate hikes during 2022.
In 2017, another 25bps was tacked on every quarter for two more years. Even though fiscal and monetary conditions tightened for several years, stocks advanced over 40% from the first hike through the fifth one which was two years later. From the start of tapering through the 5th rate hike, it took nearly 5 years where stocks posted 65%+ returns. Simply put, tapering and a rate hike are not a death knell to bull markets.
However, this proved to be too much for markets to handle and the last three rate hikes in 2018 were reversed within a year. Our yield curve inverted in early 2019 and the S&P declined 20% in quick order. Slow ride up, fast ride down. It was an inverted yield curve that helped stoke the decline, not simply raising rates a few times.
Today, futures markets are also pricing in another 3 hikes in 2023 as well. This is much faster than our last tightening period and is a slight cause for concern. Questions arise on what is a proper pace today. Compressing what took 5 years last time into just 2 is unlikely to be a stable event. Debt levels are even more excessive than in 2015. Every 25-basis point increase for interest rates tacks on another about $75B in interest payments for the Government. Combine that with increased cost of funding for corporations who are also loaded up with debt and one can see how backed into a corner we are, along with most developed economies. While markets could handle 8% 10-year Treasury yields in the 1980s and 5% levels twenty years ago, they could not handle 3% just a few years ago.
As noted above, 5 – 7 rate increases are expected in just 2 years. That puts Fed Funds at 1.75%. Assuming a normal yield curve slope, 10-year rates will be higher than that. After packing on trillions of dollars in new debt, can our economy really handle higher rates? An equal rise across the board would result in $525B in additional interest payments from our government, not including additional debt being piled on.
Policy rate cycles are never one and done. Our first increase has almost always been followed by several more. The speed of increases will be a key determinant for equity prices next year and that will be directly tied to inflation, as many agree jobs will keep pace. It should also create more volatility, not unlike what we’ve witnessed the past few months as tapering discussions are leading to an outright acceleration.
Much of these concerns are what is driving profit-taking in speculative and sky-high multiple stocks today. Eventually, the cost to fund long-term programs is too much and growth rates come down. A rerating takes hold. This is already happening. Any acceleration or deceleration in inflation, jobs, wages and, therefore, Fed rate hikes will be key to unlocking which stocks work in 2022. For now, we continue to emphasize quality, leadership, companies with growth above GDP and clean balance sheets. Taking undue risk is becoming an increasingly difficult proposition. However, stock markets have never peaked after the first-rate hike. Longer term outlooks are quite solid.
Chef Bobby Flay is 57 today.
James Vogt, 610-260-2214