The past year has once again proved to be quite successful for broadly diversified equity investors. The substantial continued liquidity provided by monetary and fiscal accommodation has undoubtedly helped boost economic growth and, by extension, stock market returns. Revenues and profits for S&P 500 companies rose more than 15% and 45%, respectively, year over year. Obviously, the outsized growth rates are a function of 2020 being rather weak due to the COVID-19 pandemic. However, overall, American businesses are producing significantly more sales and profits than in 2019 (pre-pandemic), despite the fact that some industries have yet to fully recover. Much like the Delta variant of COVID-19, the emerging variant of Omicron does not appear likely to pose significant risks to the functioning of global economies. We are learning to live with this virus through practical mitigation efforts, while avoiding some of the more draconian measures first established in 2019. For this reason, we expect continued, albeit more normalized, growth in the future. ‘to come up.
As we move towards 2022, the subject of inflation takes center stage. The latest consumer price index (CPI) release on December 10 showed inflation rose 6.9% year-on-year, the highest rate of increase since the early 1980s. Even when we remove the impact of food and energy from the CPI calculation, which are often considered transitory goods, inflation is up 5% year on year on the other. Whether you bought or sold real estate, bought holiday gifts, or bought a gallon of milk, inflation (higher prices) has become evident in our daily lives. To be clear, inflation can be a pernicious force for consumers, especially among those who live paycheck to paycheck.
As investors, it is important to remember that many sectors of the stock market tend to do well during periods of inflation. For example, companies with pricing power – the ability to raise prices without hurting demand – tend to perform very well. Commodities, real estate and other durable assets generally increase in value, and the owners of these assets protect themselves against erosion in value. We also continue to believe that value-oriented, dividend-paying companies offer slightly better long-term return prospects than many of their growth counterparts. As interest rates rise on risk-free assets (such as US Treasuries), the rate at which future cash flows are discounted increases when valuing stocks. In other words, higher interest rates lead to lower valuations of companies, with more of their current valuation tied to unproven future cash flows. Conversely, this is also the reason why long-established companies that pay dividends are seen as more attractive in a rising interest rate environment, given that their respective valuations are less dependent on the unknown future.
On December 15, the Federal Reserve Board announced an increase in the tapering of its asset purchase program, reducing the amount of bonds it buys by $30 billion per month. They also expect to start raising the federal funds rate next year. The Fed’s withdrawal of economic stimulus and policy tightening is aimed at pushing up interest rates, which, in turn, reduces inflationary pressures. However, the Fed is only a market player and does not control the entire interest rate complex. We will be watching closely as capital markets digest policy changes to fight inflation. We should expect higher levels of market volatility as investors adjust to changes in monetary policy. However, as long-term investors, we always encourage our clients to stay the course. Inflation is more damaging to investors who insist on holding cash to avoid market volatility. Holding cash in times of inflation guarantees a negative real rate of return. Like any other time period, there are risks to consider. Inflation is just another variable to manage when making investment choices on behalf of our clients. We will continue to focus on finding and managing high quality investments for our clients, while taking into account the associated risks.
Ian N. Breusch is the Chief Operating Officer of The Sanibel Captiva Trust Company.