Barely out of the gates in 2022 and the volatility is reminiscent of Q1 2020, serving as a reminder to investors the fragility of the financial markets. Although 2021 closed out with the S&P 500 up 26.89%, January provided a chilling glimpse of what may lie ahead in the coming months, as Federal Reserve Chairman, Jerome Powell dampened sentiment with some strong remarks. As investors flock towards safety, according to Merrill Lynch “safe assets don’t look so safe. High-quality government bonds, corporate bonds, munis, and growth stocks all face serious risk as the Fed raises rates.” In this month’s issue of The Samra Report, we analyze some of the underlying causes of the volatility, and highlight areas of potential concern and opportunity.
The keyword as of late has been inflation, caused by a prolonged low interest rate environment, irresponsible government stimulus, in a low tax climate. These factors have caused a domino effect spilling over into sectors such as real estate, as investors and economist brace for the potential bubble to burst. But why now? Aiding the recent inflation hike has been fewer workers in the labor force with an appetite for higher wages, combined with supply chain disruptions and the increasing cost of fuel. Although inflation is not uniform across sector and geography, neither is wage inflation, leading to a wider gap in inequality, further exacerbated with the expiration of monthly child tax credits. Early pandemic responses led to a widening income gap, as skilled workers continued to work remotely, earning a salary while decreasing expenditures such as travel, dining, and childcare. Unskilled workers however collected unemployment benefits, without an option for remote employment.
The Feds primary tool to help dampen inflation is Monetary Policy: increasing interest rates. Low interest rates have served as a tax on the wealthy, peaking this past October as PCE inflation reached 4.59%, while the Federal Funds rate hovered at a low of 0.08%. Although Chairman Powell has cited data exhibiting the strength and resilience of the economy, at Samra Wealth Management we believe the Fed’s interest rate decisions missed the boat, and conservative rate increases should have commenced in early 2019. Analyst now speculate whether the fed will raise rates 4 to 7 times over the next 7 meetings by 0.25%, or is it just rhetoric from the Fed, enough to spook the markets.
Although the past few weeks have seen an increase in interest rates and a fall in equities from their all-time highs, it’s important consumers and investors understand the difference between expectation and reality. Although the Fed has signaled a rate hike as early as March, the market has priced in this information causing bond yields to rise, a concern for all investors regardless of risk appetite. Conservative investors, those who predominantly hold fixed-income investments, understand the inverse relationship between rising interest rates, and declining bond prices. What may be less familiar, is the Discounted Cash Flow (DCF) model used to determine valuation. According to McKinsey:
Discounted-cash-flow valuation, though it may sound stodgily old school, works where other methods fail, since the core principles of economics and finance apply even in uncharted territories, such as start-ups. The truth is that alternatives, such as price- to-earnings or value-to-sales multiples, are of little use when earnings are negative and when there aren’t good benchmarks for sales multiples. More important, these shorthand methods can’t account for the unique characteristics of each company in a fast-changing environment, and they provide little insight into what drives valuation.
A hike in interest rates in the DCF model causes an increase in the denominator, causing valuations to plunge, exhibited shortly after the summary by Chairman Powell January 26th. At Samra Wealth Management we believe the volatility is likely to continue into late Q2, and caution investors to rethink their investment strategy, since the top 8 S&P 500 companies by market capitalization are Technology companies, making up over 26% of total S&P 500 capitalization. (We included Amazon and Facebook as Technology companies, although GLICS classifications do not).
We recommend focusing on domestic holdings with little exposure to foreign exchange risk. On the most fundamental level in economics, when you raise interest rates in a domestic economy, relative to foreign economies. Demand increases for the domestic economy’s financial instruments, becoming the recipient of increased investment, strengthening the currency of the domestic economy’s currency on a relative basis. This becomes concerning for corporations accepting foreign currency, where the cost of bringing dollars back to the US becomes more expensive. Think of companies such as Walmart, McDonalds, and Starbucks, with vast international operations, there is significant risk in foreign exchange. This scenario also impacts foreign trade as American goods become more expensive to foreign consumers.
Over the past 5 years, our sector rotational strategy has seen little change:
Health Care
Health Care as a sector is in expensive
Federal government spending for health care grew 36.0% in 2020, significantly faster than the 5.9% growth in 2019. This faster growth was largely in response to the COVID-19 pandemic.
Prescription drug spending increased 3.0% to $348.4 billion in 2020.
According to the Centers for Medicare & Medicaid Services National health spending is projected to grow at an average annual rate of 5.4 percent for 2019-28 and to reach $6.2 trillion by 2028.
Wearable technology and smart phone apps collecting real time health data, is providing healthcare providers with vast amounts of data that could be monetized.
Financials
Beneficiary of rising interest rates
Lower dependence on labor from the inclusion of fintech, reduced usage of brick and mortar for retail banking.
Increased M&A activity in 2021 rose by 102 percent vs the previous year, totaling $2.1T in US-to-US transactions.
Increased loan growth due to inflation pushing up prices, and as companies replenish inventories.
Recent volatility in markets is likely to push some self-directed investors to seek professional management.
Energy
Revenues of energy companies are strongly correlated to their underlying commodities, oil & gas, providing a natural hedge against inflation.
Recent cold weather bouts across the United States have caused utilities companies to move natural gas from storage. In January, the price of natural gas increased in a single day by 72%, with a year-to-date increase of 34%.
According to the late Senator John McCain, “Russia is a Gas Station masquerading as a country”. Although Russia has come a long way since this quote, President Putin has plenty of monetary motivation to cause havoc in Europe. With sanctions in place, Putin’s pipeline, Nord Stream 2, could paralyze much of Europe. Combining this with a conflict in Ukraine could see the price of Brent surpass $100 a barrel.
With Shell and BP cutting dividends, expect fixed income investors to rotate out of bonds, into energy with the return of dividends.
In the near-term we forecast oil consumption to outpace oil demand, however oil consumption could decline in the coming months causing downward pressure on prices.
Technology
Although the sector has fallen into correction territory, we believe Monetary Policy will be accommodative, and technology will prove resilient.
Although neutral on the sector, we believe select areas of technology will outperform, and investors should be selective, with a focus on cloud, cybersecurity and companies collecting and utilizing vast amounts of data for automation, robotics, fintech and healthcare related.
As EV’s become mainstream, increased usage, infrastructure, and tax credits could be greatly beneficial to new entrants, as recent margins have been attractive.
The semi-conductor space is transforming; however, this move is too little too late, and companies such as Intel will need large government grants and tax credits to compete with Asian rivals. Although domestic chip manufacturers may be able to provide silicon for a vast array of computers and household appliances, advanced semi-conductor independence could be a decade away. At Samra Wealth Management, we believe large scale immigration reform and legislation focused on tech start-ups is key.
Industrials
Although we project inflation to be a problem up through late Q2, we believe the Infrastructure Bill, pent up demand, and improvements in supply chain will alleviate downward pressure.
Less dependence on labor and utilizing technology will increase profit margins.
Ecommerce
Select e-commerce companies Amazon, Walmart, Shopify, Mecardo Libre stand to benefit from global internet penetration and smartphone adoption.
With rising rates on the horizon, bond portfolios are already feeling the impact, similar to our January 2020 Samra Report, “we recommend hedging portfolio risk with exposure to Net Lease Commercial Real Estate and following social migration patterns for multifamily residential real estate, specifically around metro areas of D.C., Charlotte, Atlanta and Tampa”, as real estate provides inflation protection. We are bearish on treasuries and prefer high-yield and emerging market debt for those able to hedge currency risk.
Disclosures
This material is provided as a courtesy and for educational purposes only. This does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.
All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. All economic and performance data is historical and not indicative of future results.
All views/opinions expressed herein are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC.
Investing involves risk including loss of principal.
Investment advisory services offered through Samra Wealth Management, a Member of Advisory Services Network, LLC.
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