When sitting down to the task of forecasting the year ahead, it is normal for one to define the present in terms of proven value yardsticks developed over years of market experience. This effort to “get our bearings” is no different than the physician’s diagnostic discipline of getting your “vitals” before rendering a diagnosis. Unfortunately, the world’s, as well as our country’s, economic vitals have recently been out of sync in unprecedented ways.
The normal linkages between various determinants of value are now often conflicted. Market interest rates, for example, are set by bond prices in the open market and normally are priced to cover the risk of inflation, credit, and taxes before providing the lender with a reasonable rate of return. Why lend money at a rate that doesn’t compensate one for these risks?
Currently, the long term (20‐year) Treasury bond yield is just below 2% while the inflation rate is close to 6%—a negative real yield of 3–4%. Why have lenders decided to “lock up” their money for the long term with a guaranteed loss of value each year?
These artificially low interest rates have been caused by periodic Federal Reserve accommodations designed to prevent a market collapse. The result? Money instead has moved into stocks, causing the price/earnings ratio (P/E ratio) for stocks to climb to abnormally high levels. The P/E ratio merely discounts earnings growth into the future. The higher the growth rate, the higher the P/E ratio. The lower the interest rates, the higher the P/E ratio.
Accordingly, investment results (most specifically for the S&P) have been distorted by a handful of stocks with high earnings growth rates and astronomically high P/E ratios.
So, what’s ahead of us? What is the outlook for interest rates? An increase in rates will certainly affect the stock market by lowering its P/E ratio. Additionally, a weak economy can also affect the market by lowering the actual earnings outlook (the E in P/E). Clearly, much of our future is in the hands of the Chairman of the Federal Reserve Board and we have no idea about his operational beliefs or plans.
Chairman Powell recently announced his plans to “taper” the accommodative stance of the Federal Reserve Board. In other words, we know that tightening of the monetary aggregates will begin in the third month of 2022—but how fast, and to what degree the tightening will be applied is unknown.
There is another new unprecedented factor that will affect any tightening process put in place by the Fed Chairman. Approximately 70% of our monetary base is currently sitting in bank reserves. This is a result of Federal Reserve loan repression policies put in place over the last
few years. I mentioned these growing reserves in a commentary to clients in June of 2020. Normally, bank reserves take up approximately 10% of the monetary base, but they have grown to 70% and have increased by $1.5 trillion over the last year and a half since I first mentioned them. The excess reserve amount is now approximately $4.3 trillion.
In a fractional reserve banking system, each bank is required to reserve a small percentage of all deposits and loan out the balance. Consequently, the money supply multiplies by a factor of 10x–12x on each deposit. Currently, this multiplier effect has been circumvented by the Feds and much of the recently “printed” money that Wall Street believes to be circulating is still sitting on the sidelines. Will Chairman Powell release these reserves and allow banks to lend it out? If so, the multiplier could create $50 trillion of new money. That will undoubtedly unleash a new inflation problem.
If Powell eliminates the excess reserves by selling Treasury bonds, we could find ourselves in an overly tight situation which would create an opposite scenario. How, then, will he try to normalize? Perhaps you can now appreciate the convoluted set of circumstances that relegates the forecasting of interest rates, P/E ratios, economic growth, and stock market direction to a guessing game.
Basing a projection only on what we do know brings us to a moderately decent year. This projection assumes the best case with regard to the management of the Federal Reserve as well as the rest of the government.
We can expect the economy to gradually slow from a 4% growth rate to a 2% growth rate by the end of the year. The Fed will have a lot to do with this as it begins to tighten, slowing growth gradually. We can then project rising short‐term interest rates, but gradually declining long‐term rates. In this scenario the stock market can grow between 5–10%, but the real money will be made by finding new leaders in the market. Our guess is that value will outperform growth for the next year or so.
Government is another outlier as we enter this election year. The simple fact that we avoided the draconian tax increases that were promised by the Biden Administration, leads us to believe that any new legislation or regulations emanating from the White House will be somewhat moderated. The polls will carry increasing weight over the next 10 months, and will act as a governor on overzealous political ambition.
The pandemic is another unprecedented issue. How deep will COVID bite into our economy and how quickly will it subside? This issue can almost instantly invoke a recession and we have no way of predicting the economic cost of this latest wave. We simply must watch it unfold.
The supply chain issues and the inflation that surrounds us is a serious risk to economic stability. Certainly, a bad energy policy served to exacerbate the effect, but our opinion is still found in the word transitory. We believe that inflation will gradually decline toward a 2–3% rate by the end of the year, compared to the present rate of 5–6%.
War is almost an unmentionable term when projecting economic scenarios. War, however, has increased as a possibility over the last year as the U.S. has lost respect around the world. Poor planning and poor execution were very evident in Afghanistan and this has clearly been observed by our enemies. The intensifying rhetoric from Russia over the Ukraine or from China over Taiwan is proof that they believe in our weakened state. We must remain vigilant over the coming year.
All these wild cards tell us that the coming year will be one requiring close observation. Staying current and being flexible will be the key to managing risk and preserving capital while investing for a good rate of return.
The path is not yet clear, but you have our assurance that we will spend the necessary time and effort to be a step ahead of most in this difficult environment.
From all of us at Cadinha & Co., we wish you a happy, healthy and prosperous New Year.