January 2022 Thoughts and Insights

Michelle Trouvé |

As always, we would like to start by wishing everyone a Happy New Year filled with an abundance of health, happiness, and prosperity!

The Process

2021 was quite the year of market changes as the economy and interest rates shifted gears multiple times during the 12-month period. The DTIM team had a year of evolution as well: refining our process, relying on data series and sequential math to help guide our investment choices, and learning how to ignore all the noise and clickbait found in the headlines.

As a reminder, the Hedgeye process we follow is based on reported economic data. The growth forecasting model contains 30 features such as personal consumption expenditures, savings rates, retail sales, mortgage purchases, production indexes, and labor/wage inputs to name a few. The inflation forecasting model contains 50 data points including Producer Price Index, Consumer Price Index, import prices, home prices, used car prices, oil, gasoline, commodity prices, and more. All these data points are nationally reported indexes.

Hedgeye’s analysts then project forward estimates and the conditional probabilities of Quad outcomes based on the data. The reason we use these projections is because the reported data points come in monthly lags, and the market is always a forward predictor of the economy. Our job is to invest where the market is going with the information we have. I have added the growth and inflation data charts below to visually illustrate the process. You may not be able to read the small type, but I do want you to notice the arrows indicating the movement of the bars. Again, growth and inflation move up and down, and the combo of the two indicate the economic cycle.

Our Portfolios

Our focus entering the last quarter was transitioning from Quad 3 Stagflation (growth slowing/inflation increasing) to a more positive outlook in Quad 2 where both growth and inflation were increasing. On the growth side, the previous economic challenges caused by the Delta variant receded, home sales hit record highs, and travel and reopening activities resurged. We added overall equity exposure in SCHB a broad market index, QQQ Nasdaq, XLC Communications, XLY Consumer Discretionary, and XLF/KRE Financials.

Inflation continued to accelerate through mid- November with shipping rates, oil prices, fertilizer/food/agriculture, and labor costs hitting highs. However, by late November the data suggested that oil and agriculture prices were peaking so we took our profits in XLE Energy, DBA Commodities, and MTCH Match.com. We also sold our SLV Silver that never participated in the commodity rally. Interest rates also had appeared to peak, so we sold our investments in XLF/KRE Financials.

Looking forward, with growth nearing peak and inflation peaking, the probable economic outlook for Q1 2022 is Quad 1 or narrow Quad 4, as the numbers fall near the zero line on the graph below. Looking farther out to Q2 2022, the math is inevitable that both growth and inflation will decline, resulting in a Quad 4 disinflation cycle (albeit inflation still high but declining). Picking investments for a 3-month time horizon has its challenges, and in line with our goal of continuously improving our process and performance, we will be shifting our investments to a more defensive stance over the next three months towards a Quad 4. Otherwise stated, we will remain fully invested as growth peaks but will take profits to rotate into more defensive sectors such as Consumer Staples, Utilities, and Gold.

For Fixed Income, interest rates have been volatile over the past several months as the Federal Reserve now acknowledges inflation is not “transitory” but will remain higher for longer. Fed members are forecasting they will raise rates three times this year and Wall Street is predicting four rate hikes. The market has priced in rising rates which is why the 10-year treasury is now 1.78% and the 2 year is 0.92% even though the Fed has yet to do anything. Our focus on income generating and shorter duration investments has kept our fixed income positions positive throughout the year. Remember, when rates fall, bond prices appreciate which will also do well in our Quad 4 outlook.

The biggest risk to the market right now is if the Fed raise rates in March when growth starts to decline. One of the largest components of GDP (growth) is government spending. If you compare last year’s government’s pandemic spending to this year, the budget forecast is down by $1.3 trillion (growth declining). Chairman Powell should be aware of this; however, we never know what politics will play out, so we are keeping a close eye.

We are grateful for your trust in us managing your investments. We are dedicated to serving you and, as always, welcome any questions you may have.

Michelle