2022: A Confluence of Economic and Market Confluences
Confluences are found throughout nature and usually result in turbidity. Some of the more challenging currents and rougher waters are found where two bodies of water meet. Turbidity is a natural part of the mixing process, but the range of dynamics are generally bounded in a way that a specialized ecosystem can exist. For example, some fish are drawn to the nutrients in the particles that create murkiness, while predators ambush from the murky boundary.
In 2022 and beyond, global economies and markets face confluences of money flows, inventory flows, labor flows, and others. Any one of these areas could merit its own essay, and in fact we have written essays on these topics in the past because of the turbulence that any could cause, especially in stock market valuations. However, as we look forward, we expect a “confluence of confluences” to occur and see a variety of potential paths that economies and markets may traverse.
Regarding a confluence of money flows: On one hand there is the “don’t fight the Fed” cliché, and on the other is “the great rotation.” “Don’t fight the Fed” refers to a well-documented influence that the monetary policy actions of the Federal Reserve Bank (the Fed) can have on investment markets. Liquidity is created if the Fed stimulates the economy through lowering interest rates and/or purchasing assets. (While assets used to only include U.S. Treasuries, it has expanded to include such things as government agency bonds, collateralized mortgage-backed securities, and even corporate bonds.) When an asset is purchased, cash comes from the Fed to a seller who uses that cash in the economy. Some of the excess liquidity created by these actions finds its way into other investment assets such as the stock market, thereby influencing stock prices to rise.
Since the first wave of the pandemic, target interest rates were decreased from 2.0% - 2.25% in July 2019 to 0.0% - 0.25% today1. Total assets held at the Fed have ramped from approximately $4 trillion at the end of 2019 to approximately $9 trillion today. The Fed made money cheap and plentiful as the economy entered unchartered territory at the start of a global pandemic2. We give the Fed high marks for the actions taken in the early phases of the pandemic because we feel devastating collapse was avoided.
The market cap of the U.S. stock market, the total equity value of its constituent companies, was $34 trillion at the end of 20193 and was approximately $53 trillion at the end of 20214. So, it is easy to see how if the Fed raises interest rates and sells $5 trillion of assets over a few years (effectively taking $5 trillion of money out of circulation), the result would be a smaller pie of money to invest as well as a more attractive return from bond markets and therefore increased selling pressure on the stock market. However, the scope of the above mentioned “tightening” in Fed policy would still place the overall stance of monetary policy as remarkably “easy” versus the bulk of post WWII policy levels. This marks one edge of the money flow confluence in the Great Confluence.
The other edge of the money flow confluence is that, if the Fed raises interest rates and sells $5 trillion of assets over a few years, there would also be increased selling pressure on the bond market. The total U.S. bond market is similar in size to the U.S. stock market. If interest rates are expected to rise enough, perhaps because of increased and persistent inflation, one could imagine several trillion dollars of bond investments being reallocated elsewhere, including to stock investments.
While the money flow confluences intersect to directly create turbidity in the markets, inventory flows are creating turbidity in the economy, and it is hard to predict with any certainty what the future holds.
We have previously written about how some economic cycles, especially decades ago, had been driven by the over- or under-ordering of inventory, prior to the advent of “just in time inventory” management. However, “just in time inventory” creates its own set of risks to the sectors in the economy and potentially the overall economy. When systems and processes rely on an ability to order what you need when you need it, company operations and cash flows run more smoothly until of course, when you cannot get what you need when you need it. We have all seen how shortages of basic components led to shortages in inventories that caused used car demand to surge and long lead times on common household appliances, computers, etc. The question we are wrestling with is, “Can the capitalistic markets work to resolve or isolate issues in one sector and limit spillover effects in the rest of the economy?” Capitalistic ingenuity was on full display helping people and nations adapt and change during the pandemic, and as such we remain cautiously optimistic. It is also worth noting that U.S. companies were responsible for the vast majority of pandemic related innovations, in our observation.
Labor flows is a confluence we prefer not to discuss in detail as the discussion can often become politically charged. However, the economic potential of the economy is impacted by the portion of the working age population that is employed. If there is a significant change in the people willing to and/or needing to work, the total work done in the U.S. will change. Fair points are available on both sides. Corporations should provide adequate wages, increasing the willingness of people to work, and the government should not provide too great a safety net, thereby maintaining the need of people to work. Our general thought is corporations should do more and the government should do less when thinking about 2022 and beyond versus the past two years of the pandemic. (For example, Fed Chair Jerome Powell recently advised the U.S. Senate that the economy did not need further stimulus.) Rising wages potentially creates a confluence of compressing profit margins and increasing overall demand and economic growth. This would create a bit of turbidity that smooths out over time, in our estimation.
The edges of the various confluences that align with a bull market could hypothetically result in stellar returns from the stock market going forward several years. However, the edges of the various confluences that align with a bear market hypothetically result in several years of melancholy. Such disparate paths will probably be “debated” in the markets resulting in significant turbidity, that is price level volatility. One moment it might seem one way and the next moment the opposite will be holding people’s attention. Extreme market moves and levels, whether bullish or bearish, rarely endure and often provide rational investors the opportunity to benefit from emotion-driven levels. We will do our best to study the confluences to find companies that will take off given new economic environs and those that will power right through the turbidity, while selling those that might not. Furthermore, it is still our belief that companies that provide highly valuable products or services as demonstrated by the growth in profits will remain the best alternative for investors to compound their wealth over time.
1. Fed Funds Target Rate History (Historical) (fedprimerate.com) http://www.fedprimerate.com/fedfundsrate/federal_funds_rate_history.htm
2. Assets: Total Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level (WALCL)|FRED|St. Louis Fed (stlouisfed.org)) https://fred.stlouisfed.org/series/WALCL
3. Market capitalization of listed domestic companies (current US$) – United States|Data (worldbank.org) https://data.worldbank.org/indicator/CM.MKT.LCAP.CD?locations=US
4. Total Market Value of U.S. Stock Market | Siblis Research https://siblisresearch.com/data/us-stock-market-value/
Redmond Asset Management, LLC January 2022
The opinions contained in the preceding commentary reflect those of Redmond Asset Management, LLC. The stated opinions are for general information only and are not meant to be predictions or an offer of individual or personalized investment advice. They also are not intended as an offer or solicitation with respect to the purchase or sale of any security. This information and these opinions are subject to change without notice. Any type of investing involves risk and there are no guarantees. Redmond Asset Management, LLC does not assume liability for any loss which may result from the reliance by any person upon any such information or opinions.
Redmond Asset Management, LLC (RAM) is an independent, SEC registered investment management firm located in Richmond, VA and is not affiliated with any parent organization. RAM was founded in 2005 and registered with the SEC on 22 Dec 2005. The company offers investment management services for equity, balanced and fixed income portfolios to corporate, institutional, and individual investors.