While the Omicron variant rages into 2022, there remain many favorable investment and economic trends that will continue to co-exist within the pandemic now two years old. 2021 saw the S&P 500 surge and this irony may continue during 2022 as US economic growth is expected at above average levels while the Covid virus is likely to remain a threat across the globe.
We like to discuss actual investment fundamentals such as earnings, dividends and free cash flow trends because there is a certain (cash is king) reality to them that supports sustainable equity values. It is broadly expected that all three of these fundamental characteristics may increase by roughly 10% or more during 2022. Consumer finances and company balance sheets are both in good shape and poised for spending and investment. Government fiscal spending will remain well above pre-pandemic levels.
The flip side is, of course, the fears of what could go wrong; and there are many possibilities. Inflation and tighter monetary policy seem to be near the top of everyone’s concerns. As we have discussed, one economic relationship that has been upended during this pandemic is the supply and demand for most goods. Buyers are stronger and can pay higher prices while producers remain constrained and cannot produce all that is demanded. Therefore, prices have risen more than 6% which is higher than we have endured since the 1970s. While we recognize that many, including the Fed, previously believed these trends were more transitory and would be shorter-lived, expectations have recently been modified to include a possibly stickier and longer period of higher than target inflation.
We remain less concerned about these longer-term inflation fears. Once factories are no longer subject to disruptive closings and supply chain imbalances are worked out, we expect markets to once again provide additional supply where needed. Over the years, technology has significantly improved supply chain efficiencies. Once pandemic-induced shutdowns are in the past, we expect dramatic improvements in supply chains and far fewer shortages resulting in a lessening of price pressures.
As for monetary policy, the Fed has conceded that current inflation levels will extend for longer than they previously expected. Yet, the Fed remains stimulative and expects to be stimulative until mid-2022. They have signaled their expectation to raise interest rates later in 2022. Most investors probably view a few rate increases positively as a sign the Fed believes the economy is robust. Beyond that, we don’t think the Fed would continue to raise rates if the economy is in any danger of slowing or unemployment rising. The Fed knows the rest of the world is growing more slowly than the US and will be a deflationary force on the US.
Our largest concern for this next year remains the unknown course of the virus. The recent acceleration in the Omicron variant is concerning even if it less deadly. Governments continue to address the impacts with local policies which reduces everyone’s ability to plan effectively. These inefficiencies have widespread impact but all contribute to less effective economies and slower growth. This puts some pressure and risk on higher-growth valuations. As we have described many times here in the past, our strategy is to focus on dividend-paying, free-cash-flow-providing companies with competitive advantages and demonstrated management expertise. Our cash flow focus is akin to being invested in shorter duration equities rather than high duration, high PE growth stocks which we perceive as having greater valuation risk.
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