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Opening Statement from the February 2022 Dividend Gems

Originally published on February 20, 2022

Overview

The big story since the release of the January issue is that the Fed is considering raising interest rates sooner than previously expected and by a greater amount due to inflation concerns. This boost in rate hike estimates represents the most rapid change over such a short time frame in years. Investors reacted to this change in estimates by selling both stocks and bonds over the course of several days.

Perhaps the second biggest story has been the tremendous surge in crude oil prices. The rally in crude should not come as much of a surprise given continued progress being made in the global recovery along with Russia’s military buildup in Ukraine. There is even talk of a Russian-led invasion of Ukraine in a matter of days. If this happens, crude oil is likely to soar well past $100 rather quickly.

Despite widespread presence of the Omicron coronavirus variant, the global economic recovery continues to make progress. But the recovery remains vulnerable to supply chain issues which will most likely extend throughout much if not all of 2022. Moreover, the tight labor force issue is adding to inflationary pressures.

To an increasing extent, the recovery is also being pressured by high and rising crude oil and natural gas prices. Oil and natural gas inventories are also at very low levels due to pre-COVID production cuts and longer-term plans that were put into place in order to help the shift to “renewable energy.”

For the first time in nearly two decades Germany will be a net importer of oil in 2022 due to an aggressive transition towards self-reliance on “green energy.” When you consider the importance of Germany’s role in the EU and global economy combined with an energy crisis in the region, Europe’s reliance on Russian natural gas and the situation in the Ukraine, the overall picture is beginning to look worrisome.

Interest rates

Investors are now betting on up to 10 to 11 rate hikes though the end of 2023, including 4 to 6 hikes in 2022. Although these newer terminal rate estimates are in line with our own estimates which we have reiterated for more than a year (i.e. rate ceiling of not much greater than 3.00%) they are much greater than what the Fed had been planning.

To reiterate, we are in favor of a fairly aggressive hike in rates in 2021; the sooner, the better. Based on inflation and employment data, as well as growth expectations and adjusting for investor sentiment, we expect 4 to 5 rate hikes (with a bias towards 5 or 125 basis points total) in 2022 depending on the data. In a worst case scenario, we believe the Fed will raise short-term interest rates (Fed funds rate) by 150 basis points in 2022.

The Fed also discussed launching quantitative tightening (QT) at a much faster pace than the previous cycle in order to reduce its balance sheet (most likely by selling Treasuries and mortgage-backed securities). It seems possible that the Fed could begin QT by summer of 2022 although it is still unknown.

The Fed initiated quantitative easing (QE) in 2009 in response to the global financial crisis. When the Fed ended QE in 2014 its balance sheet expanded from just under $900 billion prior to the GFC to $4.5 trillion. By December 2015, the Fed began to raise interest rates, albeit at a slow and cautious pace. But the Fed did not begin QT until late-2017. But the Fed was forced to prematurely end QT by September 2019 due to a dangerously low level of reserves which caused short-term rates to spike. Thus, during the previous QT, the Fed only managed to reduce its balance sheet by about 15%, or from $4.5 trillion to $3.8 trillion.

When the coronavirus pandemic appeared in 2020 the Fed began a very aggressive QE program which resulted in a massive expansion of its balance sheet to around $9 trillion. Because the Fed now realizes that it waited too long to begin winding down monetary stimulus, it intends to reduce its balance sheet “substantially” and much sooner after it begins raising rates than in the previous cycle.

We believe the intent of the Fed to introduce QT sooner after rate hikes begin could be a signal that the Fed anticipates a greater chance of a recession or something else that could cause a systemic shock to the capital markets over the next couple of years. But before we get to that period, we cannot overlook the possibility that QT in itself could cause disruptions to the capital markets.

Finally, although we previously felt there was virtually no chance of a recession in 2022 or 2023, the escalation of additional geopolitical risks along with high and rising oil prices is adding to the more lasting problem of a tight labor force and supply chain bottlenecks during what is already an inflationary environment. At the very least, we expect economic growth estimates to be further reduced for 2022 and 2023 thereby placing the economy in a position of vulnerability.

General Portfolio Guidance

For the first time in several years, we are recommending investors look for opportunities across the board to trim or even sell entire positions during opportune situations in order to raise cash. Some of the decisions regarding which and how much of each security to sell should factor in the strength of the fundamentals for each security, possible tax liabilities and the activity level of each investor.