November Market Update 2021

As we head into the final months of 2021, it’s helpful to review the major themes driving the markets this year, how they will impact the markets in 2022, and how investors should be positioned to benefit from these trends.

First and foremost is Covid-19. The pandemic has dominated the headlines all year and rightly so. The virus has dictated market movements, first abating as we entered the spring with high expectations that the vaccines would provide a quick solution, setting us up for a major second half recovery. Then in June the Delta variant emerged and set the economic recovery back on it’s heals. Cyclical stocks (industrials, energy, retail, transports, tourism) sold off and technology stocks rallied. As we head into November, the variant appears to be receding once again, and again cyclical stocks are rising, this time taking technology and growth stocks along for the ride as Jay Powell and the US Federal Reserve announce plans to begin tapering their bond buying program but delaying raising rates until the middle of next year at the earliest. With no rate hikes until next year, investors believe expensive growth stocks are free to rally higher for now and will worry about any negative consequences next year.

The other major theme this year of course, has been inflation. As the economy begins to right itself and demand rebounds, supply chains have struggled to keep up. A shortage of workers has been a major problem, with workers hesitant to return to their jobs and risk infection. Employers have had to offer higher wages and benefits to fill critical jobs. Raw materials have also been in short supply, causing delays and adding additional costs to manufactured goods. Not surprisingly, costs of hard goods have seen significant price increases as manufacturers pass on their higher costs to consumers.

Another major inflation source that seems to have caught everyone by surprise has been the cost of energy. Oil prices have risen 75% this year to as high as $85 a barrel and natural gas prices have risen to over $6 per mcf from $2.50 at the start of 2021. Blame it on the shift towards clean energy that has seen governments around the world implement policies that shift  energy production away from carbon-based sources like oil and coal, to cleaner energy like wind and solar. This has caused oil producers to pull back on new production (who wants to spend billions on new oil production for 4 years if you don’t know if anyone will want to buy it) and instead focus on developing carbon reduction strategies, buying back shares and increasing dividends. This worked well last year when demand for energy evaporated with the global shutdown, but has resulted in serious heating and transportation energy supply shortages this year as demand recovers. The world’s oil and gas markets have responded by raising prices. In the North Sea, a lack of wind due to climate change has left Europe with gas shortages going into the winter heating season. In Asia, where natural gas is mostly imported from Australia and the west (LNG), countries are taking all the cheap natural gas they can get from North America to meet the demand, once again pushing up prices for natural gas here as well.

Much as been written about inflation and whether it is transitory or structural (ie, permanent). Certainly we can expect the recent wage increases, and more likely to come in the new year, to remain in place. Undoubtably this will mean higher prices for many hard goods but also labour intensive products and services such as food production, restaurants, travel and commodities of all kinds.

But some of the inflation we are experiencing now will be more transitory. As workers continue to return to work we will gradually see supply chains recover and goods will once again flow to meet demand. Existing home prices will also moderate with less people moving to adopt a work-from-home lifestyle. Oil and natural gas supplies will slowly increase to meet higher demand, taking some of the pressure off high energy prices. All these adjustments will take time of course, and so we can expect elevated inflation for some time, with supply chains not returning to normal for many products such as semi conductors and electronic equipment until the end of 2022.

Meanwhile we have central banks around the world grappling with the challenge of normalizing monetary policy (ie, moving interest rates back up to pre-Covid levels). The market never likes to see interest rates rise. When they do, the cost of borrowing goes up, and the value of future earnings are less, causing stock valuations to fall. This is especially true of fast growing but unprofitable technology stocks, but less so for the profitable ones. Real estate prices can also be negatively affected if the cost of buying a home becomes more expensive when mortgage rates rise. Generally, rising rates will slow economic activity, reduce spending, increase saving, and cause investors to reduce their tolerance for risk assets like stocks.

As a result, 2022 will be the year the market has to begin to adjust to the reality of somewhat higher interest rates. At the same time the market is anticipating benefits from the continued recovery of the economy as Covid-19 impacts continue to dissipate. Current expectations for growth in 2022 are still quite positive, with forecasts for S&P500 earnings up 10% for next year. The challenge for central bankers will be to slowly reduce stimulus and raise rates but do it in such a way as to not spook the market or cause a recession.

If experts like the US Federal Reserve are right and we see inflation moderate next year, this will give time for the Fed and Bank of Canada to slowly raise rates and avoid a market disruption. It will also limit the amount of rate hikes that will be necessary to keep inflation in check. Estimates range from 1% to 2% rate increases over the next two years or so. History has shown that during most periods of rising interest rates, the market goes higher because it is occurring at the same time as the economy is doing well.  So it is important to keep in mind that while investors naturally will worry about imminent rate hikes, it often results in some short term volatility but with markets ultimately heading higher.

Another noteworthy development this year has been the bifurcation of the market into two segments, one rational and one quite irrational. The rational segment is based on fundamentals and valuation metrics that historically have determined stock prices. The irrational segment is  the meme stocks, crypto currency names, non-fungible tokens and SPACs (Special Purpose Acquisition Companies). These are names that trade without any concern for valuation or fundamentals of any kind. Part of the reason why the market averages are up as much as they are this year is because of the excessive runups in some of these stocks. Names like AMC, Gamestop, anything related to crypo currencies like Bitcoin, and Tesla are just a few examples. This is the domain of the undisciplined who are willing to take irrational risks and are being rewarded with huge gains, while more disciplined investors who avoid these names are experiencing more modest results. This happens when markets are flooded with excessive amounts of capital from government stimulus but eventually ends with these stocks coming back to Earth. The most recent example of this was the Internet Bubble that burst in 2000.

This is not to say that Tesla the company is not doing amazing things and creating solutions that will change the world. Nor does it mean that crypto currencies will not have a place in the future world of banking and finance. I am only saying that the excitement surrounding these names, together with too much money in the economy with not enough things to spend it on during the Covid-19 pandemic, has resulted in excessive valuations in a segment of the market that will eventually have to be corrected, most likely in a painful way for those who stay too long in these stocks.

SPACs (Special Purpose Acquisition Companies) are another manifestation of this excess. Millions of dollars are being “invested” in these shell companies with nothing more than a promise from the issuers to do something that will generate a profit, often over a 7 year period, with little or no accountability or over-sight. This rarely ends well.

I believe these stocks are the most at risk for a major correction in the coming years. This phenomena will likely end badly once the excessive amounts of liquidity in the economy begins to be withdrawn with higher rates. I have avoided these names entirely this year and would advise all investors to do the same, except for those with a very high risk tolerance and who can accept significant losses.

In terms of specific areas to focus on for investors during a rising rate environment, there are a couple of areas worth mentioning. Banks and life insurance companies typically do well when rates rise. Banks benefit from higher loan rates and margins increase, provided the rate increases are modest. Insurance companies hold large bond portfolios as reserves for future death benefit payouts, and when rates rise they can earn more interest income. Industrials and consumer stocks can also do well, especially if they can raise their prices and pass along higher costs. Energy and commodity stocks can do well in a inflationary world due to their strong correlation to the inflation rate and rising demand. Real estate can also do well but mostly in commercial sectors related to the economic recovery. Healthcare stocks are typically seen as defensive areas to invest as they are largely immune to inflation’s impact on demand for their services.

Areas to avoid as we go in 2022 centre around the highest valuation stocks. This is often technology stocks, as well as biotech names. However companies in this space that are profitable and that trade at reasonable multiples will be good names to hold. In fact, the best offset to rising rates is often strong earnings growth. When the market sees profits rising in spite of inflation, they tend to push these stocks higher. Companies that can pass along price increases, or who are essentially immune to inflation, tend to do well (software companies or engineering and consulting businesses, for example) in spite of high valuations. Companies with highly leveraged balance sheets (ie, high amounts of debt), or small capital intensive businesses that may not have access to loans when credit access dries up should be avoided. Transportation stocks that rely on high priced oil will see their profits impacted. Finally, bonds will struggle to generate positive returns as rates move higher (bond prices fall as rates rise). Long term bonds will fair better as their prices are more dependent on expectations for economic growth than what the Fed or Bank of Canada does.

In summary, I expect to see periods of volatility next year as the market grapples with the unwinding of Covid-19 era stimulus and the start of modest interest rate increases, but it ultimately will not prevent the market from advancing once again, provided we see the Covid-19 infections abate and the global economy continues it’s recovery as we return to full employment.

As always, if you would like to talk about anything mentioning in this letter, and would like to review your portfolio in light of the inflationary cycle we are entering, please call or email me. We would be happy to arrange in in-person meeting to review your portfolio, or discuss any matter related to your financial well-being.

 

This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices services, investment banking or other services for, or have lending or other credit relationships if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2021.

If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor.