The Psychology of Momentum
The inflation scare is real. It’s affecting consumer confidence and is being played out in the media ad nauseam. The negative impact has been most profound at the lower socioeconomic levels. Corporations have been able to pass on much of the rising input costs, as seen in the most recent quarterly earnings reports, but ordinary consumers are feeling the pinch. While the Consumer Price Index (CPI) sits at 30- year highs, so do corporate profit margins.
Under virtually all similar past scenarios, the Federal Reserve (Fed) would have reacted by raising rates. What do they see in the data that most market mavens are missing this time around? Is the US economy still so fragile that it could not withstand a hundred basis point rise in rates to cool things off? This is an unknown that is definitely creating some trepidation among asset allocators. Is there another risk the Fed is worried about as well, like the unwinding of rampant speculation we have seen in the last 18 months, or could it just be fear of new COVID variants?
So much is dependent upon cheap money at the moment that any prick of the bubble could create a rapid reversal in areas like housing, leveraged finance, private equity or the stock market. On the flip side, all this excess liquidity and fiscal stimulus could temper any risk-off move. In addition, the 10-year US Treasury yield has barely budged in the face of rampant inflation, which would seem to indicate it is transitory in nature.
The psychology of momentum means investors feel like things are going unstoppably their way, a feeling that will be very difficult to break. A hawkish Fed could be the spoiler. This has often been the negative market catalyst in the past. The Fed’s transitory inflation explanation seems to be waning as cost increases persist and the possibility of being “behind the curve” becomes a reality.
We think it’s possible that supply chain issues will clear up in late 2022 as reflected in the recent resurgence of industrial stocks, the sector most impacted by supply constraints—but this is only one piece of the inflation puzzle. The more insidious component is labor costs. Wages can be very sticky to the downside, and when you add transitional and structural issues, we could be in the early innings of a significant rise in wages. The last two decades have seen very benign wage inflation because of productivity and globalism, and it will be critical to see continued progress in these areas. Everybody seems to have their own anecdotal evidence to share regarding labor shortages and wage increases, reinforcing how real the issue is. The silver lining could be that higher wages lead to prolonged improvement in consumer spending. New innovation, which seems to be perpetual but moves in a stair step fashion will also be critical. And globalism, for all its evils has provided a just-in-time supply of low cost goods to feed the thirst of global consumerism.
Our asset allocation looking into 2022 and beyond will continue to favor an overweight in equities. Within our stock portfolio, we are paying close attention to companies that will hold up in an inflationary environment. Those that have pricing power will outperform those who see margin erosion. In addition, we will continue to lean into technology companies that are less dependent on labor costs and have significant operating leverage. Finally, investment grade bonds will continue to be a challenge given the low rate environment. Assuming liquidity stays robust, expanding credit exposure to enhance yield and keeping duration short should rates finally start to rise is a prudent approach. On the whole, it could be hard to duplicate the equity returns of the last two years given elevated price-to-earnings multiples. We have probably pulled quite a bit of return forward, but if earnings can continue to accelerate, 2022 could be a reasonably good year.
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