Gas in the Tank
The Santa Clause rally happened, and US stock indexes pushed higher to close 2021 with impressive gains. In summary, and according to public data given out by S&P Global, large-cap stocks returned more than small-cap stocks in 2021, and small-cap beat out mid-cap. In addition, the large-cap growth index outperformed the large-cap value index. However, excluding stocks under the acronym FAANGM from the growth index would put the large-cap value index ahead for the year.
In a period of inflation, price increases translate into higher nominal earnings. However, old debts with fixed servicing costs don't change with inflation. Therefore, debt servicing costs as a percentage of the nominal earnings level lessen when inflation is in the system. As a result, the inflated surplus will flow down to equity owners and raise the possibility for dividend increases.
The balance sheet process just described bodes well for the performance of value stocks. Value stocks are often leveraged and receive dividend income as a larger share of the investment return. But beware of the value stocks whose sales are in a state of decline because of obsolescence and have borrowed to repurchase company stock. Such cases will likely end in bankruptcy court.
Low inflation or deflation is good for investments that require long payback periods. Think growth stocks that are young and trying to take market share from older companies using innovation. This classification of equities has high uncertainty concerning expected outcomes. Still, owning the right companies can compound into some pretty incredible internal rates of return. Investors favor these stocks when inflation is tame since the risk of losing purchasing power isn't as great while capital is at stake in brand new revenue models. Interestingly, the recent stock performance of many growth-technology names has shared an inverse correlation with the current inflation data.
Presently, trillions of dollars voting in the marketplace price the future annual inflation rate at about 2.7% per year. That estimate comes directly from US treasury yields. Unfortunately, the expected inflation rate makes most quoted yields look negative on investment-grade assets. (However, institutional quality stocks can continue to do well because of their dividend growth.) And, this is what quantitative easing does to the markets. It makes real yields on investments negative. Investors are no longer have the luxury to think in simple terms about the investment's absolute return. The picture has changed to accept lost purchasing power as a fair tradeoff for downside protection against an uncertain future.
Companies listed in the stock market must find more ways to realize more growth to keep things positive. Fortunately, financial liquidity has spread like wildfire and has kept debt and equity markets well-funded. As a result, 2021 was another record-breaking year for capital raises. For one, the way below-average credit spread on junk-rated debt is a good indication that loanable capital is in abundant supply. And, that is a great place to be since companies can target growth by having funds for their working capital needs, startups, acquisitions, and, of course, the all-important stock buyback.
But now, the systemic risks have begun to change. Precisely, the Fed has already cut back on its monthly asset purchases and plans for even less in the not-so-distant future. Also, the expectation is short-term rates will rise in 2022. The combined effect will take money out of supply and hopefully cause the inflation rate to pull back. However, such monetary adjustments have the unintentional consequence of having prior liquidity channels dry up. That would not be great for stock market growth, and it could look like 2018 all over again.
It's good to remember that there are always two sides to the probability distribution for financial risks. The same is true for inflation. There are reasons why inflation might soften without Fed intervention, such as a pandemic keeping spending out of the economy or consumer spending may shift back into travel and leisure and alleviate the current stress seen in physical goods. Likewise, ending mandates and quarantine periods may bring workers back and slow wage inflation. No matter what, as investors, it's right to diversify against all of the unforeseen circumstances.
