Challenging Times

Markets like to climb walls of worry. Therefore, all markets are challenged today by the many issues we are dealing with such as the coronavirus, a more hawkish Fed, fiscal policy disarray, shortages, and supply line issues now hitting energy supply around the world.?

The good news is that we are getting our arms around the coronavirus. Cases and death are falling, and it appears that we all will be vaccinated within six months, with amble booster shots available for all in 2022. We also expect that vaccinations for children will be approved within two months. The best news was that Merck has come up with an anti-viral pill that dramatically reduces hospitalizations and death rates. A game changer.??We, therefore, see growth in the world reaccelerating as we move through the fall into 2022. On the other hand, shortages, and supply line issues, including energy, are hitting production, and raising costs. These problems will not go away quickly, but we still assume that the worst will be behind us by the end of the winter, 2022, which will lead to higher production, reduced costs, and more robust margins/profitability.?

While we remain favorably inclined to the financial markets over the next 12 to 24 months, we did make some midcourse corrections adding more financials and some energy companies to our portfolios, reducing a few high multiple technology companies as we expect a steepening yield curve and higher energy prices as we move through the winter months. Like most commodity companies, energy companies have maintained discipline in controlling capital spending, which will result in higher prices as demand grows and considerable increases in free cash flow. Saudi Arabia's huge energy company is public and is doing the same thing.?

Our longer-term thesis of higher operating margins and profits remains intact, but there are challenges immediately ahead. We have entered a technological revolution with positive implications for years to come, and managements have learned to do more with less during the pandemic. Shortages and supply line issues will diminish as we move into the second half of 2022, which will boost production while enhancing profitability. And we have entered a period of stepped-up capital spending worldwide, not even including trillions of governments’ backed infrastructure programs on the horizon.??

We realize that corrections are challenging, but successful investors view them as opportunities. Patience is needed.??Even though the Fed sounds more hawkish, monetary policy will remain overly accommodative for another 18 months.??We expect fiscal support, too. The preconditions for a market top are not present, so we must all stay the course.

The key to a reacceleration of global growth remains to get our arms around the Delta variant. The news continues to get better by the week as the number of cases over the last two weeks has fallen by 26% domestically and 17% worldwide. The number of deaths continues to lag but improves, increasing only 2% domestically while declining 13% worldwide. More than 6.25 billion doses have been administered worldwide across 184 countries at a rate of 30.3 million doses daily. In the U.S., 392 million doses have been distributed at an average rate of 706,711 per day. At this pace, it will take less than six months to cover 75% of the total population, creating herd immunity. The vaccines are successful in reducing hospitalizations and deaths. It appears that the current wave has peaked here and abroad, setting up for a reacceleration of growth moving forward. We expect the FDA and CDC to approve vaccinations for children and booster shots for all before November. Pfizer, Moderna, and J&J will have more than enough doses available worldwide to handle all contingencies, which supports our belief that the virus will be in the rearview mirror by the spring of 2022, and we will get annual booster shots much as we do for the flu. And now we have Merck’s anti-viral pill on the horizon. What great news!

Powell and the Fed are facing some tough decisions as hiring has slowed while inflationary pressures have picked up due to shortages and supply line issues. Powell is under attack, too, for the lack of oversight over some of the members' financial transactions. Powell commented last week before Congress that supply line bottlenecks and other challenges related to the reopening of the economy have been larger and longer lasting than anticipated. “But they will abate, and as they do, inflation is expected to drop back toward the Fed’s goal of 2%.”Odds favor that the Fed begins tapering by year-end and finish by the end of the third quarter of 2022. We do NOT expect any rate hikes until early 2023. All of this is naturally data-dependent, and the key will be growth in employment and the end of shortages and supply line issues which we expect to diminish by mid-2022.?

What more can I say about our government’s ability to govern than it is a mess and dysfunctional. Without a traditional infrastructure bill that we all want, a budget resolution, and the debt limit extension. The progressive wing of the Democratic Party is holding Congress hostage, acknowledging that this is a once-in-a-lifetime opportunity to pass their social agenda. Fortunately, it cannot happen as is without the support of moderate Democrats who have held firm. Congress did pass a temporary bill to keep the government operating until December, but lots more needs to be done. Senator Manchin has publicly stated that he will not support a social infrastructure bill above $1.5 trillion, which would mean a more minor increase in individual and corporate tax rates, which is a good thing.?

The economic picture has been a mixed bag as we are just putting the Delta variant in the rearview mirror. Unfortunately, shortages and supply line issues are holding back production while boosting inflationary pressures. It appears that areas hit most by the Delta pandemic are improving, such as travel and entertainment. The high-frequency data is getting better, too, pointing to more robust growth ahead. Interestingly, unemployment claims continue to rise, so to 362,000, a seven-week high, which suggests another disappointing employment number ahead, complicating the Fed’s next move as inflationary pressures remain strong even though they may be transitory. The production side continues to do as well as possible with all the constraints, with durable orders increasing 1.8%, shipments fell 0.5% due to shortages and supply-side issues, unfilled orders rose 1.0%, and inventories increased 0.8%. Home prices have increased an impressive 19% year over year, adding to record wealth for the U.S consumer. On the other hand, consumer confidence fell further in September to 109.3, not an alarming number; the present indication index fell to 143.4, pretty good too, and expectations declined to 86.6. Nevertheless, the U.S economy is on the cusp of reaccelerating, which will pick up steam even more as shortages and supply line issues diminish in 2022.?

China, the second-largest economy globally, has slowed as evidenced by the decline in the September manufacturing PMI, which fell to 59.6 while the non-manufacturing PMI bounced back to 53.2. Interestingly, the Caixin/Markit manufacturing PMI increased to 50.0. Goldman lowered its growth forecast for 2021 to 7.8% from 8.2%, we agree. China is suffering from shortages and supply line issues, especially energy, which is penalizing growth. The PBOC vows to ensure a “healthy” property market and protect homeowners. The central bank continues to inject billions of liquidity into the banking system. Evergrande sold an asset raising over a billion-dollar last week, and its bonds lifted. We expect the PBOC to lower reserve requirements and the government to announce a significant fiscal program to boost growth and employment.?

The Eurozone economy is recovering to pre-pandemic levels as the number of Delta variant cases decline. The OECD weekly tracker of economic activity is improving as the labor market remains strong; job vacancies are at record highs; Europeans are spending less time at home and spending more out; use of public travel has surged, consumers are more confident, and flights are increasing. We are concerned about the high prices paid for energy as it could penalize growth in cold winter. Interest rates in the Eurozone, while still negative, have increased considerably as the reflation trade is alive and well as it is here too.?

Vaccinations have increased considerably in India, and their economy is primed to accelerate. The services sector is resuming expansion, and manufacturing activity picked up growth in August. Japan elected a new Premier, Fumio Kishida, a former banker, who pledges to steer away from “neo-liberal” economic policies. Finally, Australia’s economy is picking up steam too.?

We continue to expect improving growth here and abroad in 2022, supported by easy monetary and fiscal policies.?

Investment Conclusions

Global economic growth is on the cusp of accelerating as we get our arms around the Delta variant. It will only get better in 2022 as shortages and supply line issues abate. Despite all the problems in 2021, S & P earnings and margins will reach record levels hitting over $210/share vs. $163/share in 2019. We expect further improvement to over $225/share in 2022, which may prove conservative as??shortages and supply problems ease. The real story will be cash flow generation. We expect record buybacks and dividend hikes in 2022, which will support the market. Our long-term improving margin thesis is alive and well. We expect operating margins to get close to 14% in 2023 vs. 11.5% in 2019 and earnings to reach nearly $240/share.?

Monetary policy here and abroad will remain overly accommodative even if tapering begins before year-end. Tapering is NOT tightening. Fiscal policies will be supportive of growth too. We expect infrastructure spending to accelerate everywhere in 2022 on top of significant increases in capital expenditures.?

We have adjusted our portfolios to reflect higher energy prices and a steeper yield curve as the Fed appears more hawkish.??We added energy and financials which sell below market multiples and have been out of favor for years, so we see an opportunity for revaluation on top of higher earnings, increased buybacks, and higher dividends.?

Challenging times are opportunities for those willing to invest with a 12–24-month time frame. Sell when participants are overly optimistic but buy when pessimism is at high.?