The New Reality

Q3 2021 Compass Review

Last quarter we reached an inflection point, and the markets are trying their best to adjust. Part of that adjustment is simply recognizing what the current reality is, and the other part is trying to anticipate what the new reality will look like next year and beyond.

At this point, much of the economy has recovered from Covid.   Corporate profits hit a new high despite supply chain issues, labor shortages and transportation disruptions.  The question the market is trying to answer is what happens to margins and profitability next year as inflationary pressures, supply chain issues, and labor shortages become a bigger problem.   

The bears would have you believe that we’ll see the return of deadly “stagflation”, a term coined in the nineties to describe an economy where inflation runs so out of control that it sinks the economy.  The bulls, including Fed Chairman Powell, believe that the inflationary pressures are transitory, and the recovery is full speed ahead in 2022.

Despite some rocky days lately, the stock and bond markets are siding with the bulls.  Stocks saw a significant rotation from growth to economically sensitive industrials and financials.   Some of this is just reflecting the new reality of inflation and somewhat higher interest rates but it also assumes that the economic recovery will mean better profits next year for cyclical companies.

Last quarter also marked the end of the Fed’s promise to keep interest rates near zero forever and to finally begin phasing out their massive market intervention.  Consumers felt the change almost immediately as mortgage rates went above 3%.   Amazingly, markets took it in stride.  We had a brief hiccup in the stock market and slightly higher Treasury rates, but hardly anything that looks like a capitulation to stagflation.  If the bond market really believed the stagflation story, the ten-year Treasury would go from 1.5% to 2% or 3% and the yield on junk bonds would have skyrocketed.   That didn’t happen.

Nobody knows what happens to interest rates when the Fed finally begins to exit the bond market but if inflation was caused by money that was too cheap and an economy that was too hot, interest rates should not be a big problem as the economy slows next year.

Markets appear to agree with this prediction of slower but positive economic growth.   It would be more worrisome if the markets hadn’t had something of an internal correction to let off the steam in some of its excesses.  SPAC mania has faded as the SEC began to ask questions greedy investors didn’t.   The Robinhood traders look like they are running out of firepower to run nearly worthless stocks to the moon.  Crypto has held up amazingly well despite being outlawed in China and staring down the gun of a new SEC sheriff vowing to bring some law and order to the wild west.

As always, our economic conflicts are tied to the rest of the world.  China’s future is at the top of the list.  Recently they have alienated much of the world with a combination of military belligerence and economic self-destruction.  On the political front, it is a bad sign when one of your trading partners signs a new deal to put nuclear submarines off your coast.   Economically, they might be able to survive without the foreign money they are discouraging by punishing foreign bond holders. 

But the collapse of the Chinese speculative housing market and its seemingly insatiable demand for raw materials makes it unlikely that inflation in that area is anything more than transitory.  So much for stagflation. Whatever happens, it is clear that China can no longer be assumed to be the growth engine of the world.   

We find it frustrating that the markets only show brief periods of volatility without a real correction that would allow us to buy great companies at bargain prices.   There are plenty of stocks 20 -30% off their highs but most of them were up over 100% before they started to come down to earth.  Not our definition of a bargain.

Still, some areas look attractive.  Alternative energy stocks have given up a lot of their gains recently as all the attention has turned to high oil and gas prices, but high energy prices are exactly what wind and solar need to be even more competitive with fossil fuels. An economy with modest growth and some inflation is traditionally kind to consumer stocks so we like the ones that are trading near their normal valuations despite improved prospects. Even multinational industrials can be an attractive long-term investment in a world with higher input costs given their superior supply chains and pricing power. 

We fully realize that the markets and us could be totally wrong about next year.   Maybe stagflation will be more than just a historic reference and the world economies will suffer from a bigger than expected double dose of inflation and higher interest rates.   That will no doubt lead to an eventual reduction in commodity demand.  Along with a reversal of Fed policies that will allow for a correction, or maybe even a short-term bear market but hardly the end of the recovery.  In the meantime, our natural resource stocks will be printing money.

If there is a recession next year it looks like it would have to be self-imposed by the world’s economic powers. We consider that very unlikely given that China has a big party conference coming up, and no Fed chairman wants to be the guy that triggered a recession in front of the 2022 midterm elections.

If there is anything that investors need to take away from the new reality, it is that we have gone from recovery mode to an economy that needs to walk on its own without the training wheels of Fed intervention and government assistance.  The go-go years of the outsized profits by betting on the recovery are nearing an end.  The new reality will be slow growth, conservative returns, and an adjustment to a new world order.  That’s a new reality we know how to invest in.

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}