Inflation and its Consequences: Positioning for 2022
In 2022, the markets are already off to a difficult start. We believe the coming period is going to be a difficult one for several fundamental reasons: The Fed will raise the policy rate three or four times, that has the effect of putting downward pressure on P/E multiples for the market. Inflation is worse than people realize. CPI is now running close to 7%, the highest level it has seen since the early 1980s. However, we believe *transaction inflation* is double that number and closer to the 12% range given what we have experienced first-hand at the gas pump, the used car market and purchasing groceries on a weekly basis.
Inflation and Its Consequences:
David Hyman, an economist at North Carolina State University states,“Inflation can make it difficult to plan for the future and can adversely affect the purchasing power of our income and savings. When prices of goods and services we buy are subject to erratic increase over time, the result is distortions.” Furthermore, he states, “inflation does quite a bit of damage to the normal functioning of the economy. It interferes with the normal functions of financial markets by distorting incentives to work, borrow, lend, save and hold cash. Over time, erratic inflation can affect market interest rates in ways that prevent the economy from operating at peak capacity.”
Portfolio Positioning for 2022:
Bank stocks outperformed the broader market in 2021 and are likely to continue due to their stable earnings and dividend characteristics. The set-up into 2022 is quite positive as loan growth rebounds and as interest rates rise, bank earnings will accelerate. We believe markets will be choppy this year because of rising interest rates (Fed action). Going forward, we will look to lean into stock market price declines and redeploy the cash into the Energy and Industrial sectors. Currently, the S&P500 weighting in the energy sector is at a multi generation low of 2.7%. We believe the resource-based companies and the entire energy complex are a good way to off-set inflation risk. This sector is likely to get a re-rating upward based on positive demand/supply dynamics and solid cash flows and dividends. Enclosed is a price chart of WTI crude oil from the St. Louis FRED database. At over $70 per barrel, most projects in the US are profitable which should drive future earnings and dividend growth for the energy sector. Our portfolios are well positioned for what comes next. As you know, we do not own any of the speculative tech stocks that are likely to get re-evaluated downward. We have already started to see this happen in January 2022. Again, Banks are likely to have an-upward earnings per share growth trajectory as the yield curve steepens. Our holdings in financials and energy sectors should continue to outperform.
In the Rearview Mirror: 2021
In 2021, the broad-based U.S. equity market posted an exceptionally strong return with the S&P 500 up 29%. KAM-South’s value portfolio had similar results with lower risk. In September 2021, we started deliberately raising cash in accounts as we felt the investment environment had shifted to higher risk lower visibility. Some of the fundamental factors we cited were: 1) Inflation was less transient than expected; 2) Fed will start to taper and raise interest rates, which equated to a 10-Year T-bill in the range of 2.0%-2.3%. In December 2021, we exited the year with cash levels in the range of 25%-30% in client accounts. Going forward, risk control and stable income from dividends will be a major point of emphasis.
Respectfully,
Dr. Christian Koch, CFP®, CPWA®, CDFA®, RICP®
