RHP Market Talk

2022 Outlook: A Roller Coaster Ride

January 10, 2022 Royal Harbor Partners Wealth Management Episode 15
RHP Market Talk
2022 Outlook: A Roller Coaster Ride
Show Notes Transcript Chapter Markers
In our first podcast for 2022, Glenn Royal and Natalie Picha with Royal Harbor Partners Wealth Management discuss the new year and why we should hang on tight for a roller coaster ride in the markets.

Get to know us at: www.royalharborpartners.com

Introduction:

You're listening to the RHP Market Talk Podcast, from Royal Harbor Partners Wealth Management located in the beautiful Gulf Coast of Houston, Texas, and serving families from across the country.

Natalie Picha:

Welcome to the RHP Market Talk Podcast and a new year! This is episode number 15. I'm Natalie Picha...

Glenn Royal:

...and I'm Glenn Royal.

Natalie Picha:

...and together with Michelle Jones, we are the founding partners of Royal Harbor Partners Wealth Management. Today, we want to kick off the new year, by setting the stage for markets in 2022. Wow. We've already been on a roller coaster ride, for sure. But we still believe that there's gonna be a positive year for markets overall. And here with Glenn today, I just wanna talk a little bit about what we think is going to be coming up this year.

Glenn Royal:

You know, if we could just re-record last year's podcast this time, and use that when we were containing our enthusiasm. How great was that? But no, we're set up for another good year, I think Natalie. But albeit with bouts of volatility.

Natalie Picha:

Yeah. Well, we're seeing that volatility just in this week alone. I think a great place to kind of start off is to give everybody some perspective in why we think the markets are still going to come out positive this year. And so you and I have been talking a little bit about GDP, right? Pre-pandemic numbers, and then what we've seen through this pandemic and what we're expecting through this year, and maybe even into 2023 and what those estimates look like. Can you give us a little bit of perspective on that?

Glenn Royal:

Yeah. Let's think about GDP in a sense of where we've come from. So, prior to this pandemic in 2020, we were running 2, 2.5% GDP. And we kind of consider that kind of a secular stagnation. It's not enough to get the economy growing, but not enough to, you know, pull us in to a recession. It's just enough. As a result of 2020 and the response by both federal governments, as well as central bankers and all that wall of stimulus, they came in with, what we're seeing GDP , where we took a dip in 2020, to a negative 3.4% gross domestic product growth. That bounced back sharply last year to 5.6% as a result of all that stimulus. But, coming forward this year, we still expect growth. And I think that's the key thing. Is the growth rates we're looking for this year are close to 4% on GDP, which is almost double our long-term average that we've had. So, I still feel very good about the growth rates , just based on GDP and the consequences of earnings growth that we will get out of S&P 500 companies.

Natalie Picha:

So, we always kind of use GDP just as a kind of a marker for, okay, how's the economy doing? What's the growth trajectory look like. But we've got earning season coming up and we're seeing this market, you know, pretty chop in here right now. We're seeing some of our, what we call growth stocks, a lot of the tech stocks kind of coming under pressure. What do you think earning season's gonna look like coming up?

Glenn Royal:

Well, you know, we're rotating from the growth stocks to value cyclical, because of the setup that's happening since December 31st in the bond market. With rates rising so much. So, we're coming into this earning season in a risk-off mode, which actually may make the earning season, and do okay. We're kind of front running bad things now with this market. You've seen this backup in the 10-year treasury, that's almost , you know, quarter of a point, almost 1.8%, 1.77% since the end of the year. And that's the bond market and the participants, the investors, that are front running the fed before they even...

Natalie Picha:

The Fed hasn't even done it yet .

Glenn Royal:

...fired that first shot, right ? Yeah.

Natalie Picha:

They're ahead of it.

Glenn Royal:

They've just, jawboned it, as we say.

Natalie Picha:

Exactly.

Glenn Royal:

They just came out, the Fed in December, spoke at the last meeting, and Powell said that basically, because labor got so hot, they've had to change their focus.

Natalie Picha:

Well, labor is a really good point. I read a statistic just recently and I was really surprised. The lowest jobless rate at 3.5% and the highest at 14.7% in unemployment , since the seventies occurred just two months apart in 2020. And I know we're looking for labor rates to come in, I think in the next month or so. And we were already back down to 4.2% in November of this year. So, I mean, those jobless rates, those numbers are looking pretty good compared to where we were in 2020.

Glenn Royal:

They were, and I want to throw a little history in here for us, to know where we come from, in order where we're going to go. Back in 2008, the unemployment rate shut to about 10% during that banking financial crisis. It took a number of years. And the way the fed got employment back , for the average worker, was they took the balance sheet from about 1 trillion in assets to 4.5 trillion. They really expanded how much money went out in the system to re-employ workers and get the economy going. This time around, and I have my reasons, I can go into that if we want. It's my pet peeve, that's the way things are. A lot of portfolio managers have that. But, what we're seeing this time around is, we went from that 3.5% rate of unemployment to almost to 14.8%. Nearly 15% unemployment like that. It was instantly. We had 3 million people were out of work at the peak of this COVID. When this pandemic first hit, in 2020. That now, because the feds expanded their balance sheet , double again from 4.2 trillion up to 8.8 trillion in assets, that's had the effect of getting this explosive growth of these stock markets , cryptocurrencies, NFT, whatever you name it, all risk assets have lifted as a result of that wall of money, right? And the consequences we've seen, unemployment come down to this morning , lower than the Fed might have expected at 3.9%. We're now below 4% unemployment, the Fed's long run expectation is that we're gonna get down to 3.5% percent unemployment by the end of this year. The key with that is the participation rate. There's a couple keys. One, so the participation rate is still a couple percentage points lower than what we had been seeing, around about 61%. And that's where we're unsure of what is going on in that space. Is it under reporting? We're seeing some evidence that perhaps the bureau of labor statistics gathering this last round, not enough participants responded that normally would to these surveys. So, you're seeing a little funkiness with the numbers, but in a positive sense. So, employment is done. And we go back to the Feds mandate again, central bankers or the world all have mandates, everyone in the world. Central bankers has the inflation mandate to control inflation. Our feds, the only one with the dual mandate, which fighting inflation, but also full employment. They've met that first target of full employment So, now the shift is focusing on fighting inflation. You're seeing it in the bond market. With higher rates.

Natalie Picha:

So, let's talk a little bit about inflation. You know, last year, this word transitory got thrown around quite a bit. And we've seen supply chain issues , obviously, that have also added to the inflation story. And inflation's still here with us.

Glenn Royal:

It is. Actually, next week we're going to get a print. The last print for inflation was for the November data and that was close to a 40 year high at 6.8%. The expectations for our next CPI print next week is going to be 7.1%. So extraordinarily, how what we think about inflation and, that's the one call we really got wrong last year. If I had to go back and revisit, while we were right on the direction of the markets, we were wrong on inflation. And a lot of that happened because of the Delta Wave. If you remember, that occurred in the summer, and that just threw everyone back in shutting down the economy, followed a little bit by Omicron at the end of the year, right? So, what we see Delta COVID related is that it affected logistics. It affected labor. And affected semiconductors, right? So, those three key components, we are seeing anecdotal evidence that they are improving. I still have a couple of other areas of inflation that's gonna stay sticky and high for awhile. And that one is likely rents. As rents come up, we don't expect those to back off. So, expect rents to stay high, but as logistics, and all these other things, we do expect inflationary pressures to come down towards the latter part of this year. The other key thing to focus us on, and we've talked about this before in these podcasts, is the primary driver of inflation is wages. It's labor, right? We're seeing wage gains. Wage gains this morning reported at 5%. And that's pretty strong. Now is that a function of retail having to pay up for labor? That's not coming back into the workforce yet. Those things are yet to be determined, but I do expect those average hourly pressures to start to come down, as more people come back into the workforce. And the thing that's really going to get, you know, the positive that we could see this year, is the pandemic becomes endemic and inflation pressures come down. That sets us up for another good year.

Natalie Picha:

So, what does it mean when the inflation number is coming down, and the interest rate is going up?

Glenn Royal:

Well, okay. It's a good question, actually. And what the Fed is trying to engineer by raising rates, is to get the federal funds rate, that they control equal, to the rate of inflation, which we call a neutral rate. And if I go back to my history again, the last time they were on a rate rising cycle, which is good because chairman Powell was running it. So, he has experience of rate rising cycles. Was in that 2017, 2018 period. And you had a case where the Fed raised interest rates to where they were 1% above inflation. But compared to the 10-year treasury. That's that real rate of return that we talk about. That was the dinner bell for us to buy bonds at that time. Since then, these real rates have now come negative. And you know, that's, that's gonna be the big buzzword. Well, real rates come back up positive . What are real rates? And basically, it's your purchasing power. So, what's the biggest thief that we have that comes in the middle of the night, is inflation. It erodes the value of the dollar and your ability to buy goods. You know about it buying milk and bread. You buy gas. You know what it happens when gas prices go up, right? It robs your purchasing power. So, we're in a situation where the nominal rate or the top line rate. The coupon that we get on a treasury, is below inflation. Was about 1% below inflation, and that's now backed off quite sharply with the rates coming up, to down about seven-tens below inflation. So, we're watching that very, very closely, these breakeven rates of where we go. If I get back to that positive real rates, again, we will be rebalancing our balance portfolios and running over and increasing the fixed income, because I'm finally being paid on bonds. But we're not there yet. We've got some ways to go.

Natalie Picha:

Right. Right. Which is why our portfolios at the moment are still positioned a little heavier to the equity side.

Glenn Royal:

Yeah . 5% overweight equities .

Natalie Picha:

You know, I know we say this in almost every podcast, but it's just a reminder, that sometimes, what you think is the safest part of your portfolio, which is your bond component, general speaking, can still take a hit. And when interest rates go up, bond values go down. I just always want to remind our listeners that's how the bond market works. Because it is what really determines what the economy's going to look like going forward.

Glenn Royal:

Yeah. Last year was a year we had rising rates, except for the riskiest bonds. High yield. The bond market was down on average, year-to-date. We're down on average. You know, we finished last year, I think the AG was down about 2.5%. We were down four-tenths of a percent. I consider that a win, in the bond market. My hope is to be able to repeat the same performance this year and keep this flat. As I get out the next few years, and again, that real rate comes up, then you're gonna see me extend maturities out. And lock those higher positive rates in, and you know, de-risk the portfolios as a result.

Natalie Picha:

So, let's talk about the fed just a little bit. And like you just said, Powell has had experience in a rising rate environment. What do you think the Fed's going to do and how are they gonna handle this?

Glenn Royal:

Well, the market is telling you that they're going to raise rates in March and there's two things going on here that I'm uncertain about. And we're going to have to see how it develops out. One is the fed pairing down this 8.8 trillion balance sheet. Are they gonna let that run off? Are they just going to stop reinvesting in new assets and just let it, you know , pair itself down. Which is a way of taking liquidity out of the system. Right ? And the other that's a really stronger force is raising that interest rate. So, the market is forecasting the Fed, by the time they're through at this hiking cycle, they're going to go from a quarter of a percentage point of the current top end of Fed funds right now to two and a quarter, two and a half percent, at the end of this cycle. We'll see if they're able to do that, much like 18. They tried and they couldn't get there. And they had to back off. So, time will tell. But, we could see as many as three hikes this year. You know, starting in March. And a lot of this has to do with the Fed , with labor being so fully employed, right? So, with inflation getting away. So, I expect the hikes this year, two to three. The market is now pulled forward three with the price action that we've seen this year. That's what the market is telling you. And then you could see another couple in the following year. So, where will the Fed take this fed funds rate ? They're going to take it back to inflation. So, what we're looking for is inflation to come down is measured by CPI, at the time the Fed's raising rates. And we're going to meet at that neutral point. And the Fed's probably gonna have to stop. In the period in the nineties, a big part of my career, the Fed typically kept the federal funds rate one and a half to two percentage points above inflation. Now, I had a budget deficit that was much less at the federal government. There were different setups than we have today. So, we're seeing the Fed really having a struggle to take that federal funds rate above the rate of inflation. So, that's still very easy financial conditions. It still allows , companies to do things. But, what it does do in a rising rate of environment, is it exposes leverage. You know, this is something I wrote about in the last report. Warren Buffet's old quote , "when the tide goes out, you see who doesn't have the shorts on." Right. And rising leverage i s seeing t hat. I think you're seeing it i n there's a lot of margin debt. Record levels of margin debt. And rising rates is going to cause some pain i f you're over extended in this market. You're seeing it a bit in the more riskier assets like crypto, and certainly in investments, you know, noted portfolio manager, K athy Wood is a fantastic manager, but she focuses on innovative companies, n amely in t he tech space. That are all on the future in terms of making any earnings. This is the thing. We call long duration assets. Not getting paid anything today. So, you've seen her fund fall about 45% from its peak, spring of last year. Under pressure down 10% year to d a te. W hat we're trying to do to combat th at a n d, doing a good job is we've com e ba ck into, as th is economic cycle continues to evolve. We've gone from the early stages. Now , we 're kind of going to mid sta ge wi t h th e Feds, talking about raising rates, before we get to la te stage and actually do it. It benefits early sta ge cy clical value sto cks. S o, you've seen financials take off . Y ou are seeing energy, I would say there's some structural issues as well, that's lifting, you kn o w, o il, a nd you're seeing it in ma terials and in dustrials, S t ocks like GE and Dee re ar e right through the roof this year. Schlumberger. We're up, you know, 15% year-to-date in those stocks. Now, I can tell you Microsoft. I can look at Tesla. I can look at all these Google Alphabet, all these guys, and they're all down for this year. So, I still like those big tech stocks tha t I just mentioned, e x cept for Tesla. And I'm fascinated by Tesla, but it's not something I wan t to ow n. Tesla, to give you an idea. I k n o w I' m kin d of go ing off the map here, but Tesla trades at a p r ice earnings multiple of 34 5 times earnings. So, basically I'm paying $340, $345 for every dol lars wo rth of earnings it makes. Rig ht. I can get Ford for 14 times earnings. I can get GM for eight times. I can get BMW at five times earnings. So, what my question is, is Tesla because I don't get. I don't get the rockets. I don't get the boring inc ome. I don't get all that cool stuff. I just get the auto, right. But By 2030, V o lkswagen, Audi, Porsche has ann ounced that the y're going to be entire electric. You're seeing all the models come on-board. Once Tesla's automotive group has to compete against the rest, a traditional auto manufacturer. What happens with the se multiples? I'm just really fascinated and curious by i t. As much as I am about crypto.

Natalie Picha:

So, let's talk a little bit about that. I think what COVID did to the business cycle is, it compressed a business cycle to a very, very, very short time period. We're used to seeing business cycles. So, we're used to seeing innovators come online. We're used to seeing this is not unusual , them having to have competition and things like that. I think what is unusual, is to see the business cycle compressed, to this small timeframe. So, when we talk about what's the 2022 setup , let's talk about that compressed business cycle. What does that mean for Tesla versus Ford? You know, going forward, we look at the value stocks versus the high flying tech stocks.

Glenn Royal:

If that compressed business cycle pushes us to late stage a lot quicker, that's going to hurt cyclical because what it means is interest rates are going to probably hit that neutral level, if not go higher. Where that's, you know , two and a half percent fed funds rate that could be problematic. You could see stocks , the tech stock , I would expect we're going to see some pressures in the equity market. Which is why we'll be rebalancing over to fixed income at that time. Yeah, absolutely. It'll be a little competitive. What I don't know is, the end terminal rate of where will the 10-year ultimately go? What's the terminal nominal rate of the ten- year. Two and half and this cycles over with? And then we go back to where we were. Are we able to handle, what I've in my time, you know, in my career, when I started , in the business, I had , the US ten-year, this is pretty interesting. It was yielding , 12.4% with CPI at four and a quarter. And I'm looking at 7% with a 10-year, you know, one in three quarters, you know , 1.8%. Something's n ot kosher here. And I'm trying to figure that out. And that's what we're trying to get through. Part of it may b e productivity. Part of it may be the focus of 2008. My pet peeve t hat I started going on. And I'll tell you, is that I think Congress has abdicated their p hysical responsibility of managing, t he p hysical spending ever since 2008. There've been nothing, but they, they come together w hen you have to, and they're forced to in a crisis. But then they completely a rgue a nd f ight a nd they can't e ver get anything done since then. So it's been on the shoulders of the federal reserve to respond to these crisis. And I think one of the reasons we saw such a huge spike in the Feds balance sheet go to 8.8 trillion, in that weekend, when this came about us, Greenspan, I mean, excuse me, chairman Powell on t he Friday said, well, things look okay. W ell, i t be a ll r ight. And on Monday morning there was a n emergency 50 basis point cut to the federal funds rate. S o , you see that kind of activity going on a nd, it's accelerating, what we're, we're going through the business cycle and productivity as well. You know, we just had our tr aining t o day o n this new office telephone sy stem w here we don't skip a beat. You know, so much productivity gains have occurred in the last couple years. We pu lled f orward five years. And I think that's all supportive for assets. But its what I think about at n ight. At two in the morning. If p e ople w ant to know.

Natalie Picha:

Well, I think , all of this is really good information. But the reality is the set- up for 2022 is a roller coaster ride. I think ultimately, we end up in positive territory. Overall, again, you can't deny what you see in the markets and where we are in supply and demand, and things like that. I mean, everybody seems to have something on order right now that they're waiting for. Everybody.

Glenn Royal:

They are. And you're seeing some signs of a start . And also, you know, these big companies have had two years to deal with this. They can handle a lot better today than they did at the beginning. So running of orders, you know, bringing stuff in, so they're not short inventory. And the other thing I'm seeing is whamification? I don't know what you wanna call it. But, let's think back when the COVID hit, you couldn't find hand sanitizer, a mask anywhere. Right? Well, now they're in a dollar store discount bin. Those things are everywhere. Right. It happened right after that. But what's gonna happen with these testing kits for COVID? Governments just ordered up 500 million. Enough for everybody to order, get two from the government. And they're gonna be , I imagine a couple months you're going to see testing kits, just all over the place, you know, 50% off and all that. So, that's what we're seeing in the response. There's like, you know, inflation makes you go down and fill up your truck really quick, or buy the groceries and milk and bread. And that's what people are doing. The shortage of goods and the run out . And then the supply chain catches up. And then we're over supplied. And then the prices come down. So that's one of the things, reason why we think inflation will come down. The supply chain will catch up on all these things and they'll start putting excess supply in the market.

Natalie Picha:

Well, I mean, it's a feast or famine. That's...also goes back . That's where we are right now. Feast or famine.

Glenn Royal:

So, that's just one thing on the stock though. I will tell you this. What I'm looking for there, to kind of give you an idea, a rule of thumb. You take the earnings and then plus dividend, earnings growth, expect it for S&P 500 at roughly 8%. This year dividend two, gives about a 10% targeted rate of return for equities. All things being said.

Natalie Picha:

Pretty nice setup for 2022. Rollercoaster ride and all.

Glenn Royal:

Yeah. Bonds, you know. Hey, not too good on the bond market, but , nothing to be fearful of. We don't need a bend of bonds. They served their purpose. They provide cashflow. They are stored value. But we're just not going to be making any money.

Natalie Picha:

Right. Well, we want to thank our listenership for listening to us in 2021. And we want to wish you all a happy and successful new year. If you have any questions, or would like to discuss today's topics, please feel free to contact us through our website@royalharborpartners.com At RHP, we are passionate about planning for your financial future. We are devoted to our relationships with multi-generational families, for the creation of successful legacies, through our one-on-one conversations, we can help you navigate your personal wealth management and investment journey. How different will your life look with the right advice?

Disclosure:

Royal Harbor Partners is a registered investment advisor and the opinions expressed by Royal Harbor Partners on this show are their own. All statements and opinions expressed are based upon information considered reliable. Although it should not be relied upon as such. Any statements or opinions are subject to change without notice. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investment, or investment strategies. Investments involve risk, and unless otherwise stated are not guaranteed. Information expressed does not take into account your specific situation or objectives and is not intended as recommendations appropriate for any individual. Listeners are encouraged to seek advice from a qualified tax, legal or investment advisor to determine whether any information presented may be suitable for their specific situation. Past performance is not indicative of future performance.

Introduction
Volatility and the GDP
The Earnings Season
The Hot Labor Market
Inflation Is Still Here
The Bond Component
The Fed In A Rising Rate Environment
The Covid Business Cycle
The 2022 Roller Coaster Ride
Disclosure