QPD Podcast – 2022 Outlook (part 1)

KEY TAKEAWAYS:

• Inflation and interest rates are highly likely to be the big topics for investors in 2022.  We don’t see a lot of inflation relief until the latter half of the year
• We’ve entered into an environment where we’ve gone from having a surplus of labor to a  labor deficit. The only way out is you’re going to have to make workers more efficient
• There are three types of stock markets out there right now – Vanilla, GAMMA, and the Robinhoods

TRANSCRIPT

Brian Barish:

What you’re going to have a phenomenon of, and I think it’s going to go on through most of 2022, is that for manufacturing businesses, consumer businesses, retailers, you had revenue rising faster than cost in the first eight months, nine months of 2021. And in the last three months of 2021, now you’ve got costs rising faster than revenue. And that’s going to continue into the first half of 2022.

Investors like linear earnings and revenue developments. They just like that. And what they don’t like is a lack of linearity, where one quarter you’re earning 50 cents. The next quarter you earn 20 cents. The next quarter you earn 30 cents, and this isn’t a seasonal thing. This is how it actually looks. That drives investors bananas. And they tend to get emotional and sell things, sometimes a little bit capriciously when that happens.

So, we think that’s going to create opportunities, but it’s going to be kind of a wild ride as these cost and revenue volatility elements kind of careen through the vanilla stock market.

Host:

Hello and welcome to the latest episode of the QPD podcast. This is part one of a two-part series,  and today we are talking 2022 and what could be ahead for investors after two years of extreme volatility. My guest today is Brian Barish, CIO, and president of Cambiar Investors. Brian has over 32 years of industry experience, spending the last 24 at the helm of Cambiar Investors. Brian is also the portfolio manager of the Large Cap Value Strategy and Cambiar Opportunity Fund, which was named the 2021 top multi-cap fund by Refinitiv Lipper. More information about this award can be found at our website, cambiar.com.

Brian, welcome to the show.

Brian Barish:

Thanks, Jim.

Host:

Great, so before we dive into your outlook for 2022, can you briefly reflect on 2021 and just give us your sense of how it ended? Did anything surprise you? I think a reflection on that year would be helpful for our listeners.

Brian Barish:

Sure. Well, I think your starting point in 2021 was that we had just gotten word of vaccines that worked and had the potential to put an end to this plague upon humanity, but they hadn’t actually gotten into people’s arms yet. So, we still had about four to five months of very restricted activity, depending on what city and state you live in in the United States and around the world. Starting in May, most people, at least in the United States, had an opportunity to get vaccinated, and then caseloads fell, and you started having a full reopening of an economy that had been shuttered in varying degrees.

And that’s when the narrative starts to get a little bit more interesting in terms of the degree and severity of supply chain challenges. If you go back to 2020 and the onset of the pandemic and various government programs, including Federal Reserve programs, to some extent, they modeled their behavior after what happened in 2008, which was the last major economic calamity. And you had a credit collapse and a demand-side collapse, and basically, various programs such as Federal Reserve bond-buying and economic stimulus plans from the federal government were intended to push demand up and avoid deflationary problems from a lack of demand.

And as the year progressed, it’s pretty clear that that was the wrong diagnosis. We don’t have a demand problem. The financial system worked. The financial system was able to channel credit and money effectively to people. It’s also true that the size of the fiscal stimulus, the monetary stimulus, were greatly larger than 2008. Be that as it may, we’ve had no problem with demand. The problem has been supply, right? So, whether it’s iPhones, or new cars, or washing machines, availability has been very challenged throughout the year.

So, it’s really a very different paradigm that we have been dealing with. So, that’s been the narrative for most of 2021. And then, more recently, in the latter part of 2021, you have seen the virus come back in varying degrees with the Delta wave in the early fall, Omicron wave as we speak. The virus isn’t dead, but humanity is winning, effectively, at this point.

Host:

You touched on inflation. In my opinion, I think it’s a key topic discussed by many investors. And for many, it’s probably one of the greatest concerns as we move forward. Can you get in a little bit more detail about your thoughts on inflation and concerns for investors as we move forward into 2022?

Brian Barish:

Yeah. Inflation and interest rates are highly likely to be the big topics for investors in 2022 because we legitimately have an inflation problem. You could make a pretty strong argument, and a lot of commentators did, that the Fed needed to make an adjustment to their thinking in mid-2021 and, for some reason, did not. They’ve been dialed into a model that is based off of the United States’ experience with demobilization after World War II, and you had a lot of supply chain and demand imbalances during that time period.

I don’t know how you can use that model today. It’s so long ago. It speaks to a very different economy that was not globalized the way that the current economy is. And by the end of 2021, Jerome Powell basically retired the term transitory, just said, “We don’t want to use this anymore.” And I think effectively they’re retiring their demobilization model as well and moving back towards some kind of neutral policy, as opposed to highly accommodative. That’s basically what they are saying.

So, in the interim between now, which is right before Christmas, and when they get to neutral, we’re going to have a lot of inflation. So, we’ve done our own modeling on this. And when you look at inflation, you have prices of goods that you would buy in a store, and then you have these kind of larger items like the rent for your home. And what’s important to understand here is that the rent for your home or, what they call homeowner’s equivalent rent because not everybody rents their home, most people actually own their home, that’s a very lagging variable, and it’s building in a big way. So, the inflation numbers as we’ve modeled them for 2022, you’re just not going to have a lot of let-up in the statistics.

In other words, we ended 2021 with inflation over six for CPI and pushing towards 5% for the core CPI that excludes food and energy. We don’t see a lot of relief for either of those variables until the latter half of 2022 at the earliest. And I think we’ll get there. If the Fed is not supplying this inferno with more money, it should bite. But you’ve got a lot of inflation and a lot of lagged variables of inflation that have already built into the system.

The supply chain issues can get better for sure, but you’ve also seen a lot of businesses put forward wage increases to their employees with full expectation that they’ll be able to recoup that in pricing. So, the way that inflation propagates in a developed country like the United States is through a wage-price spiral, and we’ve got elements of that in place. I don’t think it’s completely out of control, but we’ve got elements of that in place, which means that if you are thinking about COVID in the arc of economic history, it’s probably going to be a two to three-year inflation bulge. And that’s how we’re thinking about it, so a tax in effect on all of us to deal with COVID. That’s basically what it’s going to turn into.

And we’re not making highly-specific predictions on inflation beyond the end of 2022. Hopefully, it moderates. We think it should, but whether it moderates at 2.0 or 2.5 or 3.0, we don’t know. There’s just too many variables there. But that’s going to be the big issue, and that is very, very powerful. There’s an expression that the chairman of the Fed is the second most powerful person after the president. And the difference between number one and number two is, is not as big as you might suppose. The power to control money supply is a really big deal.

So, where kind of the rubber, I think, meets the road is whether the Fed raises rates quickly or not and also whether they start shrinking their balance sheet. But if they do, what’s called, double tightening, where you’re both shrinking the balance sheet alongside rate increases, which is what they did in 2017 and 2018, that’s got a good chance of biting the financial market. And so, we’re agnostic right now as to whether they’re going to do double tightening or not, and a lot will depend on, I think frankly, political noise as well as just how bad the inflation numbers are in early ’22.

Host:

Before we move on, and you touched on it, but I think a lot of investors have felt in this cycle that low-interest rates fueled equity markets. So, in a higher interest rate regime, do you have an opinion on the impact of equity markets? Will it still be the place to be? I guess our listeners would want your opinion on that.

Brian Barish:

Yeah, so I got a lot of thoughts. I’m not sure I’ll be able to contain them to one podcast, but so there’s a term, TINA, there is no alternative, that has been used repeatedly with respect to equities because basically, your returns, your return envelope is so bad in fixed income, whether it’s treasuries or investment-grade corporates, that just there’s no practical alternative to equities. I think the intellectual reasoning there is weak. That’s a form of Greater Fool Theory. In other words, I’ll buy stocks at prices that I probably shouldn’t buy them at because other people will need to buy them too. That’s not very robust intellectual reasoning there.

There’s huge questions, Jim, about long-term economic policy in the developed world, where you basically have very little population growth, a lot of incremental usage of technology to decrease prices, to increase automation, a lot of excess savings for a variety of reasons. And what it adds up to is that it’s hard to come up with a scenario where the terminal rate, that is to say, where the Fed tops out at before it gets to a restrictive policy. It’s hard to come up with a very high terminal rate.

So, in the last raising cycle, we got up to 2.5. The market basically screamed at the Fed, “No more.” And we had a very quick -18% in the fourth quarter of 2018. And then the Fed turned around and brought interest rates back down under 2%, and then things were okay. So, that was the market’s way of saying that 2.5, that was actually restrictive, and something around two, I think it was 175 is where they cut back down to, was more like a neutral rate.

So, this is a little bit obtuse, but just try to follow me here. So, monetary policy in the 20th Century, the Fed didn’t do all this balance sheet stuff. That was very rare. They just controlled the short end of the curve, and basically, by controlling the short end of the curve, you could incentivize or disincentivize banks to make loans and incentivize or disincentivize businesses and consumers to take on debt. And so, it was the banking system that multiplied money, and it would multiply it faster or slower, depending on the short-term interest rate.

Since 2008, that dynamic has not worked correctly, and basically, the markets and the economy has been dependent upon the Fed to do some monetary edition on top of the normal money multiplication capabilities of the financial system. It’s not just the banks. Obviously, big corporates can go directly to the market, and there’s various direct lending schemes by consumer finance companies and so forth, but it’s mostly a banking sector phenomenon.

That phenomenon became turbocharged in 2020 and 2021, with the Fed adding basically $5 trillion to its balance sheet. Now, $5 trillion sounds like an incredibly large amount of money because it is, but that’s just a drop in the bucket compared to the size of the bond market and compared to the size of the equity market. But those reserves get multiplied over in the financial system. So, as the Fed stops adding to its balance sheet, which basically they’re going to by the end of March, can the financial system multiply money adequately?

Prior to now, the answer has been no. They don’t multiply the money supply adequately, and that factors into how stocks trade, bonds trade. So, that’s why the market is super sensitive to quantitative easing. I am skeptical that the banking system can do it all by itself, but there is a pretty strong argument, and it’s worth articulating, that we’ve entered into an environment where we’ve gone from having a surplus of labor courtesy of China joining the WTO in 2002 to a labor deficit. And if that’s true, the only way out is you’re going to have to make workers more efficient.

And clearly, there has been a step function upward in potential efficiencies as a result of COVID. So, we see things like telemeetings and teledoctor and teleuniversity. That’s all a new thing that didn’t really exist in a meaningful way before COVID. So, that’s just one example of how there is productivity gains to be had by using technology. So, sort of the question is, do we need this big-time CapEx cycle? Or maybe it’s a moderate CapEx cycle because this is mostly going to be technology-driven anyway, which means we don’t have enough money multiplication in the system, which means the Fed is going to have to get back into it.

It’s a very esoteric economic concept, and I appreciate the listener bearing with me here, but it’s very meaningful in terms of whether you are going to have a high terminal rate by the Fed or really a very low one because it’s just really hard to get enough money multiplication in the system to keep the system going. And it’s kind of worth pointing out as a side comment that the U.S., in particular, our economy has become so heavily financialized in all kinds of ways. There were lots of predictions after 2008 that surely there’d be less financialization as a result of what happened. That hasn’t been the case.

Host:

Yeah, I agree.

Brian Barish:

And this seems like entropy in chemistry. It’s like a one-way development. So, a lack of money multiplication in a heavily financialized economy… you can kind of have … I wouldn’t call it a cardiac arrest. You can suddenly find yourself without enough liquidity surprisingly quickly. So, that’s just something that’s out there to kind of think about. Monetary policy in the 21st Century is a weird topic.

Host:

We’ve highlighted a bunch of challenges in there, risks, also a number of positives. I think it’s a good time to just get your outlook for 2022. What are some of the key variables that investors should be thinking about as we head into the new year?

Brian Barish:

Sure. Well, let think about just the stock market in general. So, I heard this analysis from Leon Cooperman, who is a guy I respect, in a different podcast, and I’m just going to steal it but credit Leon. There’s really three stock markets out there. There’s the vanilla stock market of banks, and industrials, and consumer product companies, and healthcare companies. And their stocks are going to go up, and stocks are going to go down. And we’re not calling bear market or bull market or anything. We just say there’s opportunities there.

There’s the FANGs, and I think the new name for the FANGs is GAMMA because a couple of stocks like Facebook’s changed its name. So, you lost the F in FANGs, right? So the GAMMA, the GAMMA stocks, that’s 25% of the S&P 500. It’s a staggering concentration, and it’s kind of its own multi-trillion dollar parallel universe of defensive growth, or that’s how it’s been for years and years now. And so, that has continued to perform. It performed great in 2020. It performed pretty darn well in 2021, despite the reopening trade being on. I’m not going to make any predictions there, but if you own index funds, you’re very concentrated in the GAMMA names.

And then you have a third stock market that I would call the Robinhood stock market, and it’s a lot of very speculative businesses. A lot of them are smaller cap. You have the cryptocurrencies in there. Those aren’t stocks. That’s not our business, but it’s very a speculative landscape there, SPACs and all kinds of things. I would say, for the most part, people don’t really know what they’re doing there.

It feels like a speculative blow-off is probably going to happen if you have a less accommodative Fed. And I think that’s where the biggest risks are is that you get a rapid meltdown in that part of the stock market. If you look at the Russell 2000 Index, and a lot of these stocks are part of the Russell 2000 Index, 45% of the Russell 2000 stocks, so 900 of them, do not make money. And this is in the context of record profits in the S&P 500, record profits as a percentage of GDP. So, we don’t have a lack of profits recession issue. We have the opposite.

And yet, we have a record number of non-earning companies in the Russell 2000. So, that doesn’t smell good at all. That smells very dangerous to me. So, that’s our forecast is volatile earnings. I mentioned the Fed becoming more neutral, potentially a bit restrictive, but probably more neutral. The other thing is you’re going to have a lot of fiscal drag. The federal government had a multi-trillion dollar stimulus in 2020 and 2021, and they’re not going to have that in 2022, so you’re going to have a negative version of that, whether that child tax credits or other kinds of financial assistance programs.

It doesn’t look like the Biden Administration’s going to be able to legislate too much else, at least at this time. So, those are top-line negatives while you’ve got costs that are still galloping. I think when you get to 2023, probably things settle down. That’s what we’re anticipating.

Host:

This is all very interesting and a logical stopping point for today’s discussion.  Thank you Brian for being here today. 

To our listeners, please stay tuned for part 2 of this interview as we discuss what could be some additional risks to the markets in 2022.  If you’re looking for more information about the blogs or awards we mentioned earlier in the show, please visit cambiar.com.