February Market Update 2022
With all the recent market volatility I thought this would be a good time to look at what’s driving the price action and how investors should be looking at this.
Clearly, the January sell-off has been unpleasant. All the major markets rallied going into the end of the month, masking some of the downdraft. The TSX ended January down 1%, the S&P dropped 5.3% and the Nasdaq lost 9.0%. The biggest declines were in the Nasdaq growth stocks, with over 21% down 40% or more at some point in January, before rallying back up in some cases.
The reason for the sell-off is all about inflation and worries about how aggressive central bankers will be about raising rates to combat rising prices. As it’s often the case, the market may be overly pessimistic in it’s assessment about how high rates will go this year. The FOMC Chair, Jerome Powell, held it’s January meeting last week and many were predicting as much as a half of one percent increase at that meeting. But the Fed Chair left rates unchanged, as did the Bank of Canada.
The current expectation is the first rate hike in March, for both Canada and the U.S. In both countries, the policy being laid out is for gradual rate increases over the next two years, with officials saying their decisions will be dependent on what happens with inflation and many other economic indicators. Currently the market is pricing in 6 rate hikes in Canada and 5 rate hikes in the U.S. Our view is that it’s too hawkish and that we will likely see 3 or 4 rate hikes of 0.25% in both Canada and the U.S. We also see inflation moderating out to year end and growth slowing as consumers spend less on goods and focus on paying down debt. This would be positive for bonds, stocks and the economy.
So far, the bond market seems to agree. The yield curve is modestly flattening, pricing in slower growth. Corporate bond spreads are not widening in any significant way, indicating no big increase in credit risk. The economy is expected to grow at about 3.8% in the U.S. this year and somewhat less in Canada at 3.5%. Unemployment is near record lows. Corporate earnings are expected to rise this year in the U.S. by about 8%. But the fiscal drag in the first quarter due to Omicron, and a pull-forward of inventory levels in late 2021, will likely mean a weak first quarter in 2022.
Of course no one knows where Covid will take us this year. If Omicron represents the last significant variant we see, then economic activity could pick up significantly in the second half of this year. It is more likely, however, that we continue to see Covid circulating in various forms for the foreseeable future. Human behaviors will adjust and we will have to learn to live with the risk of infection, even as we continue to wear masks in some places and perhaps get a booster shot every year as we do for the seasonal influenza virus.
No doubt we will see economic growth slow down this year. Inflation will likely be somewhat moderate, as a result of reduced demand for finished goods, and consumers shift to experiences (travel, eating out, etc.) and paying down debt. Supply chains will catch up, as workers slowly return to work. But the cost of gasoline, commodities and housing may stay higher. Permanent changes to supply chains, and moving manufacturing closer to where goods are consumed could also add cost to finished goods in the long run, as decades of just-in-time supply chain management trends reverse. How quickly any of this happens is impossible to know. Since inflation worries is the primary reason for central bankers raising rates, how inflation plays out is a key market risk. Long term, our expectation is for GDP growth in the U.S. and Canada, to be around 3% or less and for inflation to moderate to about 3% as well.
As a result of all this uncertainty, it makes sense for investors to take a cautious approach to 2022. Of particular concern is multiple high growth stocks with little or no earnings. These assets are being repriced by the market, with a higher discount rate. Speculative or high risk investments are best avoided. Valuation and quality are now key metrics when assessing your portfolio. A focus on high quality large cap names, dividend-payers, and names that trade at a modest P/E multiple will be good places to look when placing new money. Areas such as financials, healthcare, and energy look attractive at current levels, especially those with strong balance sheets and high levels of free cash flow.
Energy stocks are attractive given elevated oil prices which appear to have staying power this year. This sector has under-performed since 2014 when oil prices last hit triple digits. Since then energy stocks have declined to about 4% of the earnings of the S&P500. Prices are elevated due to supply being constrained by a lack of capital being deployed into expanding production, a result of new ESG and environmental concerns. But as we migrate away from carbon-based energy to renewables, we still have to find ways to heat our homes and run our cars and commercial transportation, all of which will remain dependent on oil for many years. As Covid restrictions recede, demand for energy will continue to rise. OPEC has limited capacity to expand production, with the exception of Saudi Arabia and UAE. New investment in shale oil in the U.S. will come, but it will take time. Meanwhile, oil stock prices remain at multi-year lows and are broadly under-owned in most investors portfolios. Adding to high quality large cap integrated oil producers should be a profitable trade this year, as it was last year. Many small cap names with strong free cash flows and modest debt will also do well. In the near term, oil prices could spike to as high as $100/bbl (Goldman Sachs forecast). However, in the long run, we expect oil prices to moderate to about $70/bbl.
What about technology stocks? These stocks have to be evaluated on a case-by-case basis. Some stocks such as Alphabet (GOOG-N) trade at a reasonable multiple of 25X expected 2022 earnings, growing at 18 to 20% per year, have little debt, and is a solid name to hold for long term gains. Many others would also fall into this category. These growth stocks will be an important source of growth in your portfolio in the years ahead in spite of interest rates normalizing. Others with much higher valuations or slowing growth will be under pressure this year. This is where your tolerance for volatility has to come into play, and a re-assessment may be in order.
How does this play out to year end? I expect we will see the market find a bottom later this month, presenting a good entry point for new money around the end of February or early March. From there I expect a lot of sideways runups and sell-offs into the summer months as the market tracks economic progress and waits for clarity on what central bankers will do with rates and how inflation plays out. If inflation does moderate and Fed demonstrates a patient and measured approach to raising rates, I expect a strong finish to the year and markets to be higher by year end.
As always, if you would like to talk about anything mentioned in this letter, or would like to review your portfolio in light of the inflationary cycle we are now in, please call or email me. We would be happy to arrange an in-person meeting (or via telephone or internet) to review your portfolio, or discuss any matter related to your financial well-being.
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