Investing in 2022
Navigating in a rising interest rate market environment
Welcome into 2022 and I hope you have managed to achieve most of what you have set out for in 2021. Things have been rather rough but at least we have conquered 100% of the obstacles we faced. There are a few things I would like to discuss regarding the current economic environment and what we as an investor could do. I will be discussing on rising inflation and the rising interest rate as a result, followed by an overview of the market direction. Lastly, upon understanding the circumstances, I will touch on what we as an investor can do and also my view in terms of the investment approach we can take. I have written an article regarding some key economic events that led to some events happening today and, I highly recommend you to take some time to have a read.
As of December 2021, the US inflation has reached 7% and will likely run a little higher before easing later into 2022. With inflation rate running higher than the supposedly 2% target, the FED had to introduce contractionary monetary policy. The FED also has another job which is to reduce the size of their nearly $9 trillion balance sheet. The decision to increase the rates has caused the 10-year treasury yield to peak at approximately 1.9% as of this writing.
Moving forward, depending on the upcoming CPI reports, we might see FED further tightening the monetary policies. Supply chain disruption and money supply in the economy are among the few contributing factors towards rising inflation.
The FOMC Meeting
Next, I will be discussing what was brought up during the FOMC meeting (from their minutes). Even though the increase in inflation is within the FED’s expectation of 7%, they would still have to reduce it as high prices over a prolonged period is unhealthy for the economy. It is indicated during the meeting that they are ready for a more aggressive approach and in dialing back some of the economic support.
Supply chain issues have eased but will likely persist in some industries through 2022. Labor shortage has also become an issue for many companies. Higher wages and better benefits are introduced to retain people which is ideal for employees. Yet on the other hand, with this introduction, companies will likely pass the higher cost onto the consumers. Both of these situations are not ideal for the local economy.
However, we can observe a silver lining regarding the COVID situation — it seems that the Omicron variant, despite being more contagious, isn’t as serious as the Delta variant. This can be seen as inflation decreases when the Delta variant was discovered while inflation has been rising despite lesser stimuli to help the economy with the outbreak of the Omicron variant.
The need to curb rising inflation, shrinking of their balance sheet and a manageable Omicron variant has led FED to end their net asset purchases by mid-March after an increase in the interest rate.
The FED is aiming to have a few rate hikes across the span of 3 years — 3 to 4 hikes in 2022, 3 hikes in 2023 and 2 hikes in 2024. We can expect to see the rate reaching 0.9% from near zero in 2022, 1.6% in 2023 and 2.1% in 2024. This has led to the rise in the US 10-year treasury yield previously mentioned.
And how will this affect the market?
Moving forward, I do believe we will see disinflation rather than deflation. It is unlikely for us to witness stagflation for now as we have a relatively healthy unemployment rate at the pre-pandemic level (currently, but we are still faced with a labor shortage).
While we talk about inflation, there are deflationary forces within the economy such as tech advancement in the current digital age and globalization. The advancement in tech increases productivity within the business, improving operational efficiencies. This would reduce the overall cost required for companies and ideally reduce prices for consumers. However, in the current environment, this factor is not quite enough to curb inflation.
So these are my thoughts — what I think we should monitor closely is the money supply within the economy. Supply chain disruption aside, with the increase in overall money supply and limited goods, prices for each item are bidded up which translates to inflation. So with these two events (increased money supply and supply chain disruption) happening, we can see why the FED needs to introduce tighter monetary policy and sooner — rate hike and shrinking of their balance sheet.
While the interest rate increases, the cost of borrowing increases as well. This would mean that companies that finance their business operations through debt would find it more expensive to service them. A more expensive debt would mean a smaller profit margin. As the company profit shrinks, investors would have to adjust their valuation accordingly which is why companies that have negative earnings or with high valuation would normally see compression in their valuation.
A few examples includes DocuSign which plummet approximately 42% upon weak guidance and Netflix share price fell 20% as they failed to meet investor expectations on their subscriber growth. Many other companies such as Sea Ltd, Salesforce, Crowdstrike, Upstart, Affirm, Teledoc, Nio and Roku have seen a huge decline in recent months. I have written an article back in Oct 2021 which briefly discussed the effect of rising interest rates.
A rising interest would also mean a rising yield. This is reflected in the 10-year treasury yield. As yield increases, it provides a more attractive alternative compared to equities which are much more volatile in the current economic environment.
And over the past months, we can witness investors rotating out of “growth” attributed companies — mainly tech-related, and into “value” attributed companies or into the fixed income market. This has resulted in the price decline as mentioned in the example earlier.
In summary, the rising interest rate would mean equities associated with growth tend to be riskier and more unattractive. On the other hand, companies that possess strong cash flow with high certainty under such circumstances tend to be less risky and more attractive.
The Macro picture
Below are examples of countries that see a rise in their 10-year yield when an interest rate hike was introduced in order to curb inflation within their economy. As the market is always forward-looking, the US 10-year treasury yield has already reflected the notion that the FED is going to raise interest in March 2022.
On another side of the macro picture, we are also witnessing a high volume of leverages in the system. The US Leveraged Loan Price Index has soared to the highest since 2007 as investors seek for an alternative asset class to hedge against inflation and rising rates. Appetite for Collateralized Loan Obligation’s (CLOs) loans is poised to remain strong as well due to their performance in 2021 — a world of near-zero interest rate.
Additionally, the total amount of debit balance in customers’ securities margin accounts have reached a new high in December 2021. This represents the total amount owed by the customer to the broker for borrowing funds for the purchase of securities. The cash account uses only cash that can be used to purchase securities, while the margin account uses funds borrowed from brokers to purchase securities.
The US Leveraged Loan Price index closed to 2007 high indicates investors seeking higher yield from high-yield loans. Meanwhile, the margin debt in investors’ accounts is at a high. These two events might be something we have to pay close attention to as we navigate through the market.
What’s next for us and how can we navigate in this economic environment?
Many of us who have recently joined the market have yet to experience a major crash such as the dot-com bubble and 2008 subprime mortgage crisis, including myself. The crash seen in 2020 March due to the pandemic was short-lived as governments around the world got together and lifted the economy through various economic policies. Many of us who have invested in the 2019 pre-pandemic “peak” would have made substantial returns in 2020 and 2021. The SP500 had a 16.26% and 26.89% return in 2020 and 2021 respectively.
Unlike the past 2 years, 2022 might prove to be a volatile year with great uncertainty. Some might argue that staying out of the market would be a better alternative. However, with inflation on the rise, the real value of money would depreciate over time. In the real world, unlike textbook scenarios, when price increases, it hardly ever decreases. The US inflation has reached 7% and is expected to reach 7.3% in January 2022 while the inflation in Singapore has reached 4% back in December 2021.
As the FED increases interest rates to curb inflation, the valuations of companies will very likely shrink. This would result in a decline in share prices, especially more so for companies with negative earnings or high valuations. From the benchmark performance year to date (YTD), SP500, Nasdaq and Dow Jones have declined -6.52%, -11.48% and -4.08% respectively, as of 8th February. Additionally, if we were to look back, the market has begun correcting itself between October to November 2021, given the expectation of the rate hike — this was reflected in the prices of companies I mentioned earlier.
So with the indexes and innovative companies’ prices declining, is there no opportunity left in the market? I am glad to share that there will always be plenty of great opportunities waiting to be discovered, such as companies within the commodities, industrial or energy sectors. Companies in the finance sector would also perform well when interest rate rises. This doesn’t mean that we cannot invest into companies from the technology sector — it just means that we have to be extremely picky when it comes to them or any company for that matter.
When picking a company to invest into, it is very important to assume the position as the owner or a partner of the company. Conducting your due diligence would provide you with the conviction to invest into the company through volatility. We tend to seek companies with strong cash flow, a visible roadmap of sustainable profitability and management with integrity. Additionally, we can also identify great companies in the sunrise industry where they have strong tailwinds as well as companies with improving margins through an advantageous moat (pricing power, low cost, operation efficiencies, specialization).
Risk
Risk is part and parcel of our day to day life and any investment comes with a certain level of risk. I have briefly written on how we should view risk and how it benefits us in this article. And in contrast to what many people believe, high risk does not often equate to high reward. As we conduct more of our research, we eliminate the overall unsystematic risk. This allows us to have a higher conviction to hold onto our investments when the share price declines. Being able to understand the company in-depth allows us to add more positions during volatile periods. Furthermore, in investment, risk should be viewed based on the potential disruption rather than price volatility. Therefore, as we increase our understanding of our investments, it reduces the risk we are taking which leads to a low-risk high rewards scenario.
Something I share with my friends: if a company you invest in declines by 20%, will you still add more positions to them? If your answer is not a yes, it is very likely you do not understand the company enough to have the conviction, let alone continue holding them.
Valuations
Next, when we conduct valuations, we have to include multiple factors in order to determine the fair value of a company. Many would have different interpretations of fair value. However, for me, it is to have an adequate margin of safety. Valuations consist of both qualitative and quantitative aspects. A quantitative approach normally consists of numerical figures where it reflects the health and profitability of a company. Amongst the different quantitative valuation methods, the more commonly used methods are cash flow valuation or relative valuation. The qualitative aspect of valuations would include the intangibles such as corporate governance, business model, company reputation (branding) and competitive moat. Having considered both aspects would provide us with a clearer picture of our investments.
Upon completion of our valuations, we would obtain a fair value for the company we wish to invest in. A fair value would also provide us with a margin of safety towards our investment. The margin of safety is the difference between the stock price and its intrinsic value. This margin of safety acts as a cushion towards your investment, the higher the margin of safety the better. All investments would have a certain level of risk presented due to imperfect information and a margin of safety would mitigate a certain level of risk. Another reason for paying at a fair value is to increase our upside potential because it is harder for a share price to rise than to fall. (For example, a drop from $100 to $50 is a 50% decline, however, an increase from $50 to $100 is a 100% return.) Lastly, I strongly believe that a stock price would follow the fundamentals of a business, which will reflect in the long term.
“Price is what you pay. Value is what you get” — Warren Buffet
Market outlook
So looking at the market, the SP500 P/E ratio at approximately 36 is 80% higher than the market norm of 19.2, signaling an overvalued market. With that said, I do not have a crystal ball and have no idea how the market will perform in the future. We might even see events similar to the Nifty Fifty — where stocks are traded at a very high valuation over a prolonged period of time.
And in this current period, we must do our due diligence while adding new positions into our portfolio. Investing in tech or innovative-related companies is still possible, however, we have to make sure that it is justifiable based on the value we are getting in return for our investment. Companies under such a category tend to have high valuation multiples as investors have high expectations for them in the current economic environment. Given the high expectations, failure to meet them results in a fall in the share prices as seen in DocuSign, Netflix and Facebook.
Conclusion
Lastly, how we view investment would impact on the decisions made, such as investment horizon, source of capital and your investment objectives.
Firstly, the investment horizon alone would make a huge impact. A longer-term horizon alone would mitigate short term volatility risk — time in the market beats timing the market. Another factor related to our investment horizon is our age. The earlier we start our investment journey, the longer runway we have to compound our capital. Starting early would provide us with the experience of growing our capital. Another reason for starting out early is to have the ability to tolerate more risk as our responsibility at an earlier age would likely be lesser as compared to when we are in our mid 30s or mid 40s.
Secondly, having proper financial management would help shape our investment decisions toward our goals. Identifying the sources of our income and recording of our expenses can provide us with clarity on our financial health. With that, we could begin allocating our capital for different purposes such as investment, emergency savings, daily expenses and leisure. Ideally, the allocated capital for investments would also be an amount that is untouchable — an amount you are willing to lose (100% of it). Reason being, we want the capital to compound and grow without any interference. We do not want a case when there is an urgent need for money and we have to liquidate our investment or worse still, having to liquidate it during a bear market. A rule of thumb for me is to assume that whatever I have invested has been thrown into the ocean and never to be seen again. Of course, that is just hypothetically speaking. I would still be monitoring my portfolio for developments and re-evaluate them periodically. Therefore, having proper financial management is crucial towards capital preservation and growth.
Lastly, writing down your investment plans and strategies would provide you with a clearer road map on how you can achieve your goals. This would help identify the appropriate investment strategy based on your risk appetite, time horizon and expected returns.
Having understood all this, penning it down would help you immensely throughout your investment journey regardless of the market or economic environment. Let’s picture this scenario, you are a fresh graduate and have recently begun your investment journey in 2021. Now, you have a portfolio with a starting capital of $10,000 that made 30% by year-end. Your portfolio would value at $13,000 by the end of 2021. However, you start to see your gains shrink as the market begins to reverse in 2022 due to rising inflation and interest rates. Your portfolio declined by 30% and it is valued at $9,100 now. You are wondering if you should sell and prevent further losses. This is the time when having an investment plan and a clear objective helps you in gaining clarity on the actions to be taken.
Now, let’s ask ourselves, what is our investment horizon? So as mentioned, you are a fresh graduate and pretty early in your career with approximately 30 years ahead of you. Now think about this, as you progress in your career, your income would increase. This would also mean an increase in the capital allocated towards the investments over time. Now, zooming out, the initial investment made in 2021 would only be a small fraction of your future portfolio. Prices move towards fundamentals and if the research you have conducted is fundamentally sound, you could exploit the bear market and purchase the stock at a discount. As shown in the above table, we should let our investment compound over the years!
Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”
Understanding the concept surrounding investing would differentiate yourself from speculating and investing. I hope this piece of article is informative and yes, there are still many things to learn about investment. It is a never ending learning journey and this is why I decided to start investing.
Thanks for taking the time to read my article! I greatly appreciate it and feel free to drop your thoughts in the comment section below. Cheers and invest safely!
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