US Strategy Weekly: The Chickens Have Come Home to Roost

In this week’s title, “the chickens” refers to inflation. After ignoring inflation for much of 2021, in early 2022, the actual toll of rising prices is finally becoming headline news. In our mind, this was inevitable. But the saddest part of the current inflation cycle is that it could have been avoided. Inflation was a predictable outcome of keeping monetary policy extremely easy despite the fact that the economy was already recovering from COVID. Inflation was also stoked by a too liberal fiscal policy that flooded the system with money even after stores and businesses were getting back to work. It is never good policy to add fuel to an economic rebound. In short, too much money chasing too few goods is always inflationary – yet Washington DC ignored rising prices for the first three quarters of 2021. Now inflation is coming home to roost.

And this is seen in many ways. Goldman Sachs Group (GS – $354.40) missed its earnings target this week and it triggered a wide-ranging sell-off in the marketplace. The company noted that its profit miss was due to weaker trading revenues and rising expenses. In our opinion, Goldman may be a bellwether for the broader economy. After pumping historic sums of liquidity into the capital markets for 18 months to offset the impact of the pandemic, the Fed has just begun to slow its purchases and indicates it will end quantitative easing by March. The Fed’s quantitative easing fueled trading activity in stocks and bonds and Goldman was a big beneficiary of the market’s rise since March 2020. But trading has already begun to slow. Goldman’s quarterly profits were also hurt by a 23% rise in operating expenses, mainly reflecting higher compensation and benefits costs. This combination of slower top line growth and profit margin contraction will be true of many companies this year and it is a concern to us.

Reverberations

Headline CPI jumped more than 7% YOY in December and this represented a 40-year high in inflation. Core CPI rose 5.5%, the highest pace in 30 years. The fact that we have not seen prices rise at this magnitude for so many decades means that many of today’s investors have had little or no experience with inflation and its various implications. Economists and analysts ignored the dark side of inflation in 2021 but we doubt that this complacency will continue in 2022. The most obvious reason is that a shift in Fed policy changes the environment for investors and inflation will now determine what the Fed must do in the coming months.

Unfortunately, we expect inflation will get worse before it gets better later this year. This is obvious to us in several ways. First, the producer price index for finished goods, which feeds into the consumer price index, rose 12.2% YOY in December and unfortunately there are still no signs of it peaking. Second, homeowners’ equivalent rent (HER) has a weighting of 23.5% in the CPI. Since prices for single-family homes were up 15% YOY in December, it is very likely that homeowners’ equivalent rent will move much higher than the 3.8% YOY seen in December. Rental fees tend to follow home prices in every neighborhood. See pages 3 and 4. Plus, WTI futures have already risen 15.5% year-to-date and this will keep gasoline and transportation prices rising in the early months of 2022. Moreover, this week’s move to $86.50 in the WTI future is a breakout from an 8-year base pattern and from a technical perspective, the chart shows the potential of moving higher. See page 9.

With headline inflation at 7% and the fed funds rate at zero to 0.25%, the real fed funds rate is nearly negative 7%. This is due to “easy” monetary policy. Reducing the disparity between the fed funds rate and the CPI is necessary to tame inflation. Unfortunately, it means the FOMC would have to raise rates significantly in 2022. Rising interest rates will be a difficult hurdle for equities since stocks and bonds compete in terms of valuation. Rising interest rates also raises the bar for speculators who are likely to leave the marketplace.

Corporations and all businesses will be facing an uphill battle with raw material, and intermediate good prices rising much faster than prices to consumers. Rising prices is also putting pressure on wages, as seen by Goldman Sachs report, and this adds to expenses. The net result of this is a major erosion in profit margins. All in all, it puts earnings at risk. See page 5.

In addition, profits are less valuable in an inflationary environment, and this puts pressure on PE multiples. In the low inflationary environment of 2008-2020, our valuation model indicated that PE’s could remain as high as 20 times. But as inflation moves above 4% this changes. Given our assumption that inflation decelerates to 5.5% YOY and 10-year Treasury note yields rise to 2.2%, the high-end of the PE range should drop to 18 times. See page 6. In short, 2022 could be a challenging year. There will be pressure on households from inflation and consumption patterns will change. Corporations may suffer from top line growth. Businesses will also be pressured by higher raw material and wage costs, crimping profit margins. And rising interest rates and inflation could also produce a decline in PE multiples.

Again, this means investors should try to insulate themselves from these risks by focusing on areas of the market that can weather this changing environment. We believe that suggests sectors such as energy, financials, and staples. It may also be wise to hold some cash in order to look to buy some high growth technology stocks later in the year.

Technical Charts and Indicators

The charts of the main indices are worrisome this week since there are signs of weakening trends. The SPX is the best-looking chart of all the main indices since it has only broken its 50-day moving average and is currently testing its 100-day moving average. Its uptrend appears intact. The DJIA looks less positive. The price trend is decelerating, and the index is below its 50-day and 100-day moving averages, but it is still above its 200-day moving average. The Nasdaq Composite index fell below all its moving averages this week and needs to rebound sharply in coming sessions to maintain a positive long-term trend. The Russell 2000 index is the weakest chart of all, having broken below all moving averages, but more importantly falling below the bottom of the 8-month trading range seen for much of 2021. This breakdown has very negative implications for the index and the overall marketplace. See page 10. The 10-day average of daily new highs fell to 174 this week and daily new lows rose to 244. This combination of both averages being above 100 per day is neutral, but the indicator tilts negative since new lows are exceeding new highs. The NYSE cumulative advance/decline line’s last record high was on November 8, 2021, and it is trading well below this level currently. The current disparity between the AD line and the SPX totals to 8-weeks, which is not uncommon, but typically indicates a correction of 10% to 15% lies ahead. Note that the longer this disparity persists, the deeper the eventual correction might be. Volume has not been rising on rally days, which is a worrisome trend. All in all, we are not surprised by this week’s weakness and would point out that the Nasdaq Composite and Russell 2000 are already trading 9.7% and 14.2%, respectively, from the record highs.    

Gail Dudack

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