In our last commentary, we discussed how the stellar performance in 2021 was setting the market up for a game of expectations in 2022. The resiliency of margins and profit growth helped to guide the market to double digit returns despite the twists and turns of COVID, supply chain disruptions, and cost pressures. An accommodative Federal Reserve created a supportive backdrop for this rally, with consumer spending also boosted by stimulus payments.
As we start 2022, the economy is still roaring ahead, so much so in fact that the focus has shifted from avoiding a recession to ‘taming the horse’. The Fed is not just pulling back, but signaling imminent interest rate hikes to contain inflation pressures. The labor market likewise has recovered so fast that talk of job losses has been replaced by the abundance of job openings. Consumers are benefitting from a rise in wages but are spending less confidently as prices rise. The speed of this economic ‘180’ has amazed economists and investors alike, and accordingly, markets have seen some volatility in recent weeks as they reprice to reflect this new environment.
Most notably, we’ve seen equity markets pull back on rising interest rates. Higher rates translate to a lower present value of future profits, which disproportionately impacts high growth stocks. The multiple investors are willing to pay for a company’s earnings has also moved lower, as sales growth has slowed in some areas and higher rates create opportunities elsewhere in the market. This dynamic is what’s behind the January pullback, with speculative tech stocks hardest hit. Sectors valued more on their present cash flow, like energy or utilities, or which directly benefit from higher rates, like banks, have fared much better. This is why the tech-heavy NASDAQ for example has sold off more than the blue-chip heavy Dow Jones, after years of outperforming during declining interest rates.
This shift has translated into changes in market leadership, not just between sectors but within sectors too. This is true no more prominently than in Tech, where the ‘stay at home’ stocks like Peloton and Zoom have given up most of their pandemic gains, all while investors ‘hide out’ in the high cash-flow megacaps. But even within this ‘FAANG’ group there’s been a shakeout, as pandemic beneficiaries like Facebook and Netflix dropped on lowered guidance, while Apple and Google demonstrated more staying power in their results. As the pandemic tide recedes, those companies with the best fundamentals and competitive advantages are separating themselves from the pack.
As we look ahead, we remain constructive while recognizing this volatility is likely to persist. Most importantly, expectations for interest rates will depend on the Fed’s actions, which in turn will depend on inflation data. Also critical will be whether earnings can continue to outperform, or whether cost pressures and moderating demand starts to hit the bottom line. The market can certainly withstand higher interest rates if profits continue to grow, but as we’ve seen lately the market is not looking too kindly on stocks lowering their guidance. Lastly, the tension in Ukraine will remain as an overhang; however, as the recent rise in oil prices shows markets are already repricing to reflect the situation to some degree. The flipside to all of these factors is that the volatility also creates opportunities for the astute investor willing to take a long-term view.
This market is demonstrating the value of broad-based and sector-diversified approach to investing, as the shifting cycles rapidly move individual sectors in or out of favor. Investing for the long-term requires a balanced approach that can withstand these movements, all while being on the lookout for opportunities. Greenwood Gearhart stands ready to act in portfolios as these opportunities present themselves.
We welcome any questions or comments you have, and wish you and your families well. Thank you for watching.