Draining The Punch Bowl

2022 is likely to be a volatile period.  The monetary help from the Fed over the past two years was unprecedented.  The Federal authorities are now unwinding this help and unwinding it at a rapid pace.  We are transition from a market assisted by a friendly Fed - to one - where the Fed is a headwind.  They are draining the punch bowl.  History suggests that these transitions are volatile and can take several months to play out.  They also present fantastic opportunities in the right sectors and in individual stocks.  Before we dive into the details, let’s examine the over arching factors that affect markets.

 ​What determines market direction?

1. Earnings growth is the fuel for markets.  Today, earnings are growing, but the rate of increase and positive revisions to growth will slow in 2022.  Simply, the rocket fuel of pent-up demand from the initial phase of re-openings and government subsidies is waning.  Inflation is slowly creeping in to cost structures and will affect margins of businesses that lack pricing power.  Additionally, the strong sales and earnings (benefits of stimulus) from 2021 will present a difficult comparison for year-over-year growth for most companies.  While short-term in nature, these difficult comparisons will dominate the narrative in the first half of 2022.  Ultimately, earnings growth will continue, and propel the market higher.
2. For earnings to grow, credit should be easily available.  The yield curve, the difference between long- and short-term rates, is a gauge for bank profitability willingness to lend.  The rising lines below are pointing to easy credit availability.  Lending greases the economic wheel.  The wheel is spinning and has momentum.  The 10 year – 3 month as well as the 5 year – 3 month yield curve (below chart) reflects 1) a strong economy, and 2) and strong lending, regardless of the noise from new Covid variants.  

​Earnings growth determines long term (multiple years) market direction.  Change in liquidity (money supply) determines intermediate term (6-18 months) direction.  Fed provides and takes away liquidity.  At the outset of the pandemic, the Federal Reserve aggressively reduced rates and pumped record liquidity into the economy.  This revived animal spirits, essential during a potential bust.  Vaccines saved lives and the economy.  However, as usual, the Fed kept the party going longer than they should have.  A side effect of this monetary assistance (Fed + Govt) is inflation -  which is the highest in decades – and has stayed high longer than the Fed expected.

​Fed Actions.
Fed has a dual mandate; 1) get citizens back to work and  2) keep a lid on inflation.  Unemployment rate is back to 3.9%.  Mission 1 accomplished.  Mission 2, not so much.  The latest consumer price increase was 6.9%.  Therefore, the real interest rate (nominal interest which is at zero minus consumer prices) is deeply negative at (6.9%).  This rate is one for the history books (see above chart).  Removing monetary accommodation is the only logical choice in this economic backdrop.  In layman terms, the Fed will reduce the pace of bond purchases from $120 billion per month to $0 by March 2022.  In addition, markets are also anticipating 3 -4 interest rate increases in 2022.  Whether the Fed will follow through with these rate increases remains to be seen, but markets will have a difficult time digesting these expectations of changes in Fed policy.  A ‘full punch bowl’, aka Fed assistance, along with earnings growth, has undeniably been an important factor helping the market’s ascent.  Now, the punch bowl is at a risk of running dry.

The canary in the coal mine, the weakest fall first.
Markets are an iceberg, and what’s underneath the surface is most telling.  While the surface is serene today, the depths have shown incredible churn and angst. The poor performance of ARK funds and frothy SPACs - is the first signal - markets are anticipating reduced liquidity.   The weakest fall first.  Small cap stocks have also struggled since March ‘21 (the point of maximum money growth), as they are more reliant on outside funding and tighter monetary conditions are looming.  Both issues are well documented.  So is market breadth.  The relative weakness in discretionary stocks vs. staples stocks (as we move down market cap sizes) is also indicating a market advance that is defensive led. 

The strongest fall last.
Over the years, the S&P has evolved into a more defensive and higher quality asset.  Energy, industrials, material, and financials (value sectors) are a smaller representation.  Growth and FANG dominate.  Business valuations are determined by interest rates.  Lower rates help, while higher rates hurt.  Growth stock valuations are more sensitive to changes in rates.  While inter-twined, falling interest rates were good for the market. 
 
Now, rates are rising, which will eventually pressure all growth assets, including the strongest.  Take a  look at the Growth vs. Value breakdown by market cap.  The lines are increasingly sloping downwards as you move down market caps.  Small cap growth stocks have underperformed their value counterparts since early 2021.  As the Fed continues to raise rates, this weakness will spread to large cap stocks.
 
It is possible that these negative conditions fix themselves.  We must keep an open mind.  It would require economic growth to remain strong and inflation to show consistent deceleration.  This combination would allow the Fed to increase rates at a slower pace.  However, yellow lights are flashing.  This is also a strong sector and stock allocation signal.  Value will do better than growth, and this relative strength should spread into more areas of the market.  When the Fed is draining the punch bowl, it is a good time to be cautious and be ready for a deeper and prolonged correction in growth and low quality assets.  The good news is that, cheaper prices and bargains are around the corner. 

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​This material does not constitute an offer or solicitation to purchase an interest in Latticework Partners, LP (the "Fund").  Such an offer will only be made by means of a confidential offering memorandum and only in those jurisdictions where permitted by law.  An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal.  There is no secondary market for interests in the Fund and none is expected to develop.  No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment.

This material contains certain forward-looking statements and projections regarding the future performance and asset allocation of the Fund.  These projections are included for illustrative purposes only, are inherently speculative as they relate to future events, and may not be realized as described.  These forward-looking statements will not be updated in future.