2022 Markets And Fixed Income Commentary

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2022 Markets And Fixed Income Commentary
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Below is a commentary on the 2022 markets outlook and fixed income From Bel Air Investment Advisors.

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2022 Markets Outlook

Carl Ludwigson, Director of Manager Research

“In 2022, we continue to prefer equities to fixed income as economic growth is expected to remain above trend and real interest rates remain negative.”

“While the fiscal impulse is expected to fade, the economy should continue to benefit from falling unemployment and rising spending on the services side.”

“The good news for stocks is that they are still cheaper than bonds which may allow the TINA (There Is No Alternative) trade to continue. We can observe this by comparing S&P Forward Earnings / Price (a.k.a. Earnings Yield) with the yield on bonds. By this metric, stocks are undervalued compared with the 25-year average of the Earnings Yield spread. However, other measures that focus solely on the equity market show substantial overvaluation relative to the recent history of the S&P. This means equites are likely to be sensitive to changes in interest rates as high valuations may only be justified in the context of low rates.”

“There may be added uncertainty to the path of interest rates with potential personnel changes at the Fed. Assuming rates do not trend lower, investors may need to lower return expectations.”

“Starting valuation does not bode well for future total returns in stocks given high P/Es nor bonds given low starting yield, particularly in the absence of gradually falling rates going forward. Over a one-year period, starting valuation is almost meaningless but over 5 and 10 years high starting valuation tends to result in low subsequent returns.”

“We also may be near peak margins with input costs and taxes potentially rising. Part of the increase in S&P margins is attributable to the increase in the weight of high margin technology businesses, but this sector appears most vulnerable to tax changes.”

“A normalization of the valuation premium for Growth stocks is a risk to many portfolios that are overweight the Growth factor, which could result in relative performance issues. But the real tail risk to almost all asset prices is a wage/price spiral creating problematic sustained inflation which might force the Fed to raise rates more aggressively.”

“Investors remain underweight inflation hedges like Natural Resources in an environment where supply may remain constrained due to lack of investment while capital discipline has boosted free cash flow and dividends. While hedging inflation risk seems prudent, we would emphasize that our base case is for moderately higher than average, not problematic inflation.”

“We observe that supply side issues such as shipping prices have already begun to normalize. Alternative investments in private equity, private debt and private real estate may help address the risk of lower prospective returns for traditional stocks and bonds.”

“Private markets tend to provide an illiquidity premium while smoothing portfolio volatility due to the infrequency of marks. The market has been conditioned to expect the Fed to support asset prices which limits the appeal of hedge funds as short selling is more challenging and the value of volatility dampening is diminished by the Fed put. However, if the Fed is forced to choose between managing sustained problematic inflation and supporting asset prices, expect the former to be the priority.”

2022 Fixed Income

Craig Brothers, Partner/Head of Fixed Income

  • Labor cost pressure

“Labor costs rose at the highest rate (1.3%) in 30 yrs. for the 3rd qtr. Over the last year, wages have risen 4.20%. The labor participation rate remains below pre-Covid levels which is putting upward pressure on wages.”

“Small business is boosting compensation at the fastest rate since 1984. The US is a service-based economy with 86% of all jobs in this category (up from 72% in 1980). Service jobs cannot be “offshored” like manufacturing in the 1980’s.  The United States’ aging demographics will lead to strong wage inflation in the service sector until automation supplants these jobs.”

  • Housing Inflation

“The shelter component in CPI (Owners’ Equivalent Rent, OER) makes up the largest share (31%) of the Consumer Price Index.”

“September OER rose at the highest rate (.4% monthly) in 15 years following the expiration of the federal eviction moratorium. Housing prices feed through with at 12–18-month lag which portends much higher rents in 2022.”

  • Fed’s Transitory Narrative is not credible

“The Fed has espoused a view the inflation is transitory since April. In April, CPI inflation rose to 4.20 % yoy. Over the past six months, CPI has exceeded 5% every month with the September reading at 6.2%.

“By every measure, inflation is growing at a rate far beyond the Fed’s 2% target. The Fed’s preferred inflation gauge, Core Personal Consumption Expenditure (PCE) stands at 3.6% yoy and is still increasing.”

  • Activist Federal Reserve Board

“Recently two of the more “hawkish” Fed governors (Kaplan and Rosengren) have resigned from their positions at the Fed. There could be seven (out of 19) new members coming to the Fed Board in 2022. Many Senators are pushing for Fed Governors to make climate change a priority.”

“A climate change initiative will pull the Fed away from their two mandates: price stability and full employment. As we have seen in 2021, an overly aggressive move away from fossil fuels leads to a surge in energy cost/inflation.”

  • Ten Year US Treasury Technical

“The US 10-year Treasury bond has a technical setup of a possible inverted head and shoulders pattern. A weekly close above 1.70 % presents the possibility of a measured move as high as 2.90 % in 2022.”

“Our view is that the strong wage, rent and energy inflation will allow the 10-year yield to rise above 2% in the first half of 2022 as the bond market prices in inflation that persists above 3% in 2022.”

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