In the now almost two years since the beginning of the pandemic, it has often been said that its effects would accelerate already existing trends. The asymmetry of risk and return in a world pulled in alternate directions by geopolitical forces, more than a decade of experimental expansionary monetary policy, the approaching fiscal cliff of obligations for middle class entitlements (anyone remember Simpson-Bowles?), juxtaposed by the wonderous potential of a fourth industrial revolution, has come into fuller view.
As the most supportive monetary and fiscal policies in history bandaged many macro economic problems while simultaneously exposing social wounds and income disparities, so may its withdrawal accelerate many of the existing trends which may relieve some of those same pressures. The bleeding of those wounds has resulted in forces like the Great Resignation, but also the highest totals for new business formation in history (the Census Bureau reports that new business formation in 2020 was 51% higher than the 2010-2019 average). Supply chains choked by stimulus fed demand, have led to the highest inflation rates since the early 1980’s; they have also stoked trends in industrial automation. The tech transition to the cloud continues apace, reinforced by trends toward “work from anywhere”.
As we enter the early first quarter of 2022, markets are at the beginning stages of looking for their footing as to how stocks and economies will react to a less accommodative monetary policy. The prospect of higher interest rates has already significantly repriced growth sectors of the market. This has happened because the distant future earnings of high growth companies must now be discounted more deeply because of higher rates. Our investments in biotechnology have been especially negatively impacted. Our semiconductor companies, on the other hand, have held up overall, with the onset of 5G and the new emphasis on reshoring production.
Yet, this adjustment has been just an initial knee-jerk reaction. Yes, higher rates necessitate the further discounting of future cash flows. But this repricing does not take into account the possibility of investors failing to comprehend the speed of disruptive change, and so the beginning dates of those future cash flows. As we politicize and debate vaccine policy and acceptance, we seem to have forgotten our initial marvel at the speed of their creation, for example. Only a sense of the interrelatedness of disruptive innovation in fields of genetics, artificial intelligence, robotics, and energy creation and storage, can yield a vision of how quickly we are careening toward a new world.
In addition, there is widespread disagreement about the pace and terminal level of interest rate adjustments meant to curb inflation. Federal Funds futures contracts currently anticipate the virtual certainty of three rate increases this year, with a 60% possibility of a fourth in December. The market further anticipates a longer term terminal rate of Fed Funds at 2 ½%, sometime in 2024. These would take us back to merely prepandemic levels.
The key to understanding what may lie ahead is in anticipating future levels of inflation. Investors may remember the Fed’s last tightening cycle in 2018 and its dampening effect on stock prices. But then, the Fed was tightening into a weakening economy with only steady employment income. This time, the economy is strong and consumer’s incomes and savings are growing. Not only is the acceleration of digitization itself disinflationary, but rate increases and the end of fiscal stimulus will slow the economy, making companies who can grow more quickly more attractive.
As the pandemic becomes merely endemic later this year, clogged supply chains should normalize. The loosening of semiconductor shortages should increase auto inventories, especially at the lower end (whose pricing most directly impacts used car prices) as manufacturers are no longer forced to allocate their limited supply of chips to the highest margin vehicles. Consumers will likely redirect their spending impulses to experiential services, away from newly stockpiled goods. Finally, the negative experiences of crowded ports and limited supplies will accelerate the reshoring of domestic manufacturing, begun cautiously after the Great Recession and expanded more aggressively after the Trump corporate tax cuts and Chinese tariffs (both of which, surprisingly, remain in effect). All of this should accelerate the growth of capital goods expenditures by American businesses. Many have compared this tech boom with the dot com bubble of the 1990’s. But the cap-ex boom of that period was driven by hardware and the simple capturing of consumer eyeballs. The current cycle is about software and data. The growth therefore, is exponential rather than linear as digitization touches ever larger parts of the economy, increasing productivity and so our ability to afford higher wages.
Corporate cap-ex cycles are always long, usually about thirty years. The offshoring of US manufacturing jobs lasted some thirty years. This repatriation of those investments and jobs has tremendous implications not only for income disparities, but also for technologies which reduce labor requirements as the total costs of US manufacturing again becomes more competitive.
The confluence of the simultaneous withdrawal of pandemic induced liquidity, with the technological change reaccelerated by its withdrawal, creates an investing environment in which there is the broadest range of potential outcomes in decades. The asymmetry of those possibilities sets the stage for markets experiencing widespread volatility. The early part of 2022 has begun with a laser focus on the prospects for higher interest rates. As these are priced in, markets should begin to redirect their attention to other structural crosscurrents in the economy whose disinflationary impacts may soften the need for some of the interest rate increases the market currently anticipates. As we enter this period of years during which markets must reprice risk relative to the new yardstick of higher rates, so should they also ultimately reflect opportunities which may grow from those challenges.
Respectfully,
Timothy Dougherty
Asymmetric Capital Advisory
Investment advisory services offered by Bay Colony Advisors, a registered investment advisor, doing business as Asymmetric Capital Advisory. No Advice may be rendered by Bay Colony Advisors d/b/a Asymmetric Capital Advisory unless a client service agreement is in place. Bay Colony Advisors does not provide accounting, tax, or legal advice. Insurance is offered separately by Tim Dougherty as an independent insurance broker. Bay Colony Advisors does not supervise the insurance activities of Asymmetric Capital Advisory or Tim Dougherty. No part of this newsletter should be considered investment advice. If your financial circumstances have changed, you should contact your investment advisor representative. Principal Office: 86 Baker Avenue Extension, Suite 310, Concord, MA 01742. Phone: 978-369-7200.