Questions About Investing in 2022? Answers From Our Investment Team

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Questions About Investing in 2022? Get Answers From Our Investment Team

What may impact the markets over the foreseeable future? We asked our investment team the top questions on our clients’ minds. Here’s what they had to say.

Published by Motley Fool Wealth ManagementWed, Jan 19, 2022

read time 5 min read

There’s an old saying in finance: There are only two kinds of forecasts—the lucky and the wrong.

Take 2019-2021, for example. Growth had begun to slow late in 2019 after a decade-long expansion. Then came COVID. Most would have assumed a global pandemic with economic shutdowns would have decimated the markets. And while initially, it did, fast-forward to the end of 2020 and the U.S. stock market was up 18.4 %.1

Then look at the one-year predictions from 2020 going into 2021—the chart below shows how they missed the mark…by a wide margin in many cases. These examples are not unusual because forecasts are often wrong—whether it’s in direction, magnitude, or impact.

email-chart-market_forecast

Past performance and current analysis do not guarantee future results. As of December 31, 2021. Based on consensus forecasts as of December 31, 2020. S&P forecasts are based on the average analyst target prices, generally for the next 6-12 months. U.S. inflation is based on seasonally adjusted year-on-year figures, and the actual 2021 outcome is based on the November consumer price index reading. *For GDP, actual 2021 refers to the estimated 2021 outcome of consensus forecasts as of December 2021. Source: FactSet, U.S. Bureau of Labor Statistics and AllianceBernstein

Despite the lack of reliability of prognostications, you’ve probably heard various forecasts and projections for 2022 touted as gospel. But we're here to say, "no one knows!" Not really, anyway.

Now that's not to say we don't think about the future and the many possible investing environments. But because our goal is to build long-term, resilient portfolios while minimizing volatility for any climate, short-term conditions do not fully influence the types of companies we invest in.

In other words, we probably won’t invest in an electric utility company solely because people are fearful about volatility or in a copper mining company because of concerns over inflation. But we will invest in an electric utility or copper mining company if it satisfies our four pillars of investing.  

So we look at forecasts and form our expectations on what the investing environment may throw our way over the foreseeable future. But we aren't chameleons. We don't change our process or philosophy to blend in with the economy’s short-term shifting winds. That’s because we always consider multiple futures–various economic environments—when constructing our portfolios. We also don't ignore what's going on in the markets today. That way, we stay nimble and stand ready hopefully to spot an opportunity when it presents.

To that end, we sat down with two members of our investment team—Tony Arsta, Portfolio Manager, and Shelby McFaddin, Investment Analyst—and asked them the top three questions on our clients’ minds. Here’s what they had to say:

Q: Will inflation continue to move higher and how could higher wages affect the companies in which you invest?

Tony: Prices and wages have gone up over the last year. So in my mind, the questions with inflation are: Do we flatten out now and return to more normal 2%-3% inflation? Or does inflation stay at 5% for another year or two?

We don’t think we're going back to the prices we paid in 2019, but once the supply chain corrects, we’ll see where inflation lands.

Shelby: I think that inflation is at least going to be with us through 2022, and probably a little bit of 2023. I think that's more than a reasonable assessment without getting into prediction-making.

This inflation is somewhat sticky because we understand some of the causes. It's not just that we're simply turning in the business cycle. Instead, we had a deliberate—kind of water park-like—funneling of cash directly into households. And now what's happened is that money is chasing goods that can't be created. In July they said you couldn't order a car…and they meant it!

And when it comes to higher wages, we think it’s on a company-by-company basis. It’s important to point out that when or if every large firm starts paying people $15 an hour, profits won’t be eliminated. There are companies that can still deliver large profits and shareholder value. And they can do that while raising wages because it's also going to increase productivity. In theory, if you pay people to do the job and they're happy at work and they're healthy at work, they will be more productive. There will be more efficiency in those sorts of places, so it might mean lower turnover, which could mean less training and more promotions from within.

Q: How could higher interest rates impact stocks?

Shelby: When thinking about raising rates, it’s partially a light switch effect. Technically, the Fed can raise rates like the flick of the switch. But the impact of higher rates takes a little bit longer to be felt—it won’t help reduce inflation immediately. The impact is more like flashing a flashlight in a tunnel. It's going to take a little bit for the light to reach the end.

And the switching of rates may hit the stock market before hitting households because investors tend to make their buying and selling decisions immediately. What I mean is if I’m thinking of buying a house but I haven’t laid out any capital yet, I don’t have to make any sudden moves in response to a possible rate change. But because not all investors are long term and there are millions of dollars on the line, market movement is going to kickstart faster. So the effect of hiking rates to reduce inflation will take time. But, it will likely impact demand-pull inflation before we actually start to see easing in the supply chain that’s caused much of the higher prices.

Tony: The inflation discussion always leads inevitably to the interest rate discussion and the Fed.

The only way we got out of roughly 15 years of inflation in the late 1960s through early 1980s was the Fed raising interest rates to as high as 20%.

So when we think about today, we consider the appetite for the Fed to raise interest rates above zero. And we also factor in their bond purchases and other things that could stimulate the economy.

Higher rates are something that many investors have not experienced. The last time we had a big recession was 2009 and that was a demand-side recession. At that time, interest rates were cut and they haven't risen since. Actually, since right after the dotcom bubble in 2001, real rates have hovered around zero and gone even lower, except for the period around the Great Financial Crisis.2

So when we think about the impact of higher interest rates, we see a couple of trends. One is that over the last two decades debt has essentially been free as it's been easy to borrow money. On top of banks lending money, venture capital firms have been throwing money at companies. So for this generation of workers, the strategy has been to grow as fast as possible or someone else will grow faster and take market share.

An early influencer in my career, like so many other investors, was Warren Buffett. He always talked about the idea that cash is king and if a company needs to rely on external funding to operate its business, it will not be sustainable.

Companies need to be able to generate cash from business operations to grow and have a sustainable business. When the market turns down, companies can't simply extend their credit. They have to pay it off to have a profitable business. But the individuals in upper management that last dealt with this are now retired. So that’s something we consider when we look for quality businesses.

The second is discount rates, which are tied to interest rates and go into stock market valuations. The further out that profits are in a valuation model, the more discount rates reduce a company’s value. Therefore, companies that have more out-year profits versus current-year profits will decline further as interest rates and discount rates rise.

We need to invest in companies that are profitable and earning good returns on equity and returns on capital today. We also want to invest in high-quality businesses because they have the power to adjust prices to attract employees and handle all the things that come with a high-interest rate environment. You typically don’t want commodity businesses that have limited control; instead it’s generally better to be invested in companies that can make decisions and have loyal customer bases.

Q: Could a recession surprise the market in 2022?

Tony: What we've seen over the last 20 years, whenever there's been a recession, it's been on the demand side—where people did not want to spend money. What we have now, partially because of government stimulus, is different.

The playbook over the last couple of decades is stimulus—giving cheques to people—to increase that demand side. So today, people want to spend money, they want to buy things. There's an appetite for housing, vacations, and just about everything else.

The issue is supply-side bottlenecks, and when the supply side isn't working smoothly, that's a problem. We still have shipping issues. And while the labor force is getting better, we're still not at the level of people in the workforce that we were at two or three years ago.

But, as the supply side recovers, which I believe will happen, the demand should be there. People have savings, people have money. In fact, the amount of money people saved during the pandemic and the reduction in personal debt was at levels we haven't seen for a couple of generations in the U.S. I'm optimistic that the economy will expand further once we get the supply side fixed.

Shelby: As Tony said, the supply side is a huge problem. And when we think about supply constraints, it’s something that has many layers. We know that China is not growing as fast, and they’re the leading global goods exporter.

Simultaneously, the costs of raw materials to make things are expensive. At Costco, we used to get, I don't know, I think we got like 12 rolls of paper towels and it was a set price. I swear we're getting eight now and I think it's the same price. Paper pulp is expensive. All of the resins that go into plastic are expensive. A bike…$800!

And then there are the shipping issues: There are a bunch of ships that keep getting stuck—I know, how is that possible in the 21st century? But somehow, they’re stuck. Then, we can't get the containers off the ships. We can't get people to unload them once they're off the ship.

We typically see people getting laid off in a recession. But now we're not seeing that trend. We're seeing many more people just leaving voluntarily—thus the labor shortage at the ports, and many other places.

So fixing the supply side is just going to take a really long time because you're starting from the raw material to the outsourced factories, to the fact that shipping is heavily backlogged.

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Footnotes

1https://www.slickcharts.com/sp500/returns

2https://www.longtermtrends.net/real-interest-rate/

 

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