Newsletter

SECOND QUARTER, 2022

THE ECONOMY: FEDERAL RESERVE PROGRAM TO TAME INFLATION EXACERBATED BY RUSSIAN – UKRAINE WAR

The Federal Reserve, in their program to control inflation, started with a 25 basis point increase in the Federal Funds rate in March from a rate of 0 to .25%. However, inflation is currently running at approximately 8.5% in March over March of last year, far in excess of their desired 2% rate. This higher than desired inflation is compounded by the supply chain interruptions from the pandemic and war in Ukraine. To combat inflation, the Federal Reserve is most likely to be more aggressive with several 50 basis point increases. Short-term interest rates should move up from 25 basis points to 2% by the end of 2022 with another 1% – 1.5% increase in the first half of 2023. The likely target for the Federal Funds rate is between 3 – 3.5%. The Federal Reserve will continue to shrink the Treasury Bonds and mortgage-backed securities they own, which will have a contractionary effect on economic growth. As we know from history, this is an important effort because economies with low inflation tend to have stable growth. But high inflation economies tend to be very cyclical.

The economic medicine of low interest rates lasted too long and was too much. The concern now is that raising interest rates too much and too quickly could precipitate a potential recession. HDA is of the opinion that while growth in GDP was 5.7% for 2021, it will slow to 2% for 2022, and avoid a recession. The main drivers for weaker growth this year are continued supply chain disruptions, exacerbated by the Russia-Ukraine conflict, higher prices, particularly for food and energy, and a much more aggressive Fed policy to fight these high prices.

Oil prices have, in our opinion, peaked at $100 a barrel for West Texas Crude. The war in Ukraine has also increased food and industrial metal prices and will further snarl the global supply chain at a time when global shipping costs had been rising because of China’s Omicron-related lockdowns of major economic hubs.

America’s labor market soared back in March adding another 431,000 jobs and bringing the unemployment rate to 3.6%, a new pandemic-era low. The economy is now just 1.6 million jobs or 1% short of where it was in February 2020, before the pandemic. Leisure and hospitality led the gains followed by professional and business services and retail trade. The strong labor market has given policy makers confidence that they can slow the economy somewhat without causing a recession.

The Institute of Supply Management (ISM) index of national factory activity fell slightly to 57.1 in March from 58.6 in February. A grading above 50 indicates expansion in manufacturing, which accounts for 11.9% of the U.S. economy. The slowdown in manufacturing reflects a shift in spending back to services and a significant decline in Covid-19 infections, which has resulted in the rolling back of restrictions in the United States.

Consumer confidence was up slightly in March after declines in January and February. However, expectations weakened further with consumers citing rising prices, especially at the gas pump, and the war in Ukraine as factors. Meanwhile, purchasing intentions for the big-ticket items like automobiles have softened somewhat over the past few months as expectations for interest rates have risen. The seasonally adjusted rate for 2022 total new vehicle sales is expected to be 12.7 million units down 5.1 million units from 2021.

Existing home sales in 2021 were the best in 15 years, reaching 6.12 million homes. Prices followed suit rising 19.8%. Record low mortgage rates and households flush with cash from savings and federal stimulus payments drew new buyers into the market while willing sellers found willing buyers. Labor and materials shortages held back new construction while tight inventories of existing homes for sale drove prices higher. However, for this year a combination of rising mortgage rates and a decline in affordability should slow the market down – still healthy but more like pre-pandemic levels.

The United States can curtail importing Russian oil supplies (8% of U.S. oil consumption) because of the Russian invasion of the Ukraine. European leaders are under pressure to end the European Union’s decade long dependence on the country’s oil and gas from Russia as well. However, the European Union imports about 30% of its oil and 40% of its gas from Russia. It would be difficult to remove Russian gas from the European energy mix without imposing stringent curbs on individual consumption that could curb economic growth. Weaning Europe of Russian oil would be challenging. Getting rid of Russian gas would be harder.

In Europe, for the 19 countries that use the euro, soaring energy and food prices driven by the Russian-Ukraine conflict pushed inflation upward by 7.5% year over year in March. Adding to the economic strain on Europe are surging costs, as supplies of wheat, corn and barley remain trapped in Russia and Ukraine, which produce a major portion of these crops for world consumption. Consumer prices increased year over year in Germany 7.6%, Spain 9.8%, and the Netherlands 11.9%.

THE STOCK MARKET: MARKET TAKES A BREATHER AFTER REACHING NEW ALL-TIME HIGHS IN 2021

The S&P 500 Index posted its worst quarter in two years. The S&P 500 Index declined 4.95% and the NASDAQ declined 9.1% during the first quarter. The market absorbed multiple blows during the first quarter: inflation at its highest level in four decades, the war in Ukraine further crippling already tight supply chains and the Federal Reserve increasing interest rates.

Consensus earnings estimates for the S&P 500 Index are now approximately $231 per share for 2022. Using a 20x P/E multiple on the consensus S&P earnings estimate for 2022 of $231 equates to a year-end value of 4620, or 2% upside from current levels.

During the quarter ending March 31, 2022, Harold Davidson & Associates decreased equity exposure. We added to our value strategy mutual fund positions. We sold shares in a semiconductor company, a digital payments company, an enterprise software company and reduced exposure to the health care sector.

The composition of the assets currently managed by Harold Davidson & Associates is as follows: Cash and cash equivalents – 4%; municipal bonds – 3%; corporate bonds – 3%; bond mutual funds – 10%; equity mutual funds – 14%; common stocks – 54%; and real estate equities – 12%.

THE BOND MARKET: FOMC BEGINS RAISING RATES

The Federal Reserve’s Federal Open Market Committee (FOMC) increased the Federal Funds rate by 25 basis points during the first quarter to a new target rate range of 0.25-0.50%. Over the next three years, the FOMC is unwinding its bond buying stimulus program which began in March 2020, by reducing the balance sheet of $4.6 trillion in Treasuries and mortgage-backed securities in an effort to tighten credit markets and lower inflation.

Typically, the stock and bond market move in opposite directions; however, the bond market also declined during the quarter in anticipation of higher rates. The Federal Reserve raised rates during the first quarter for the first time since 2018, sending the ten-year U.S. Treasury to 2.32% from 1.52% at the end of 2021. In addition, rates on some shorter-term Treasuries rose above longer-term bonds, creating a flat or inverted yield curve during the quarter.

Our bond purchases are concentrated on quality issuers and low duration. Inventories for both high quality corporate and municipal fixed income securities remain tight, and we selectively substitute purchases of individual bonds with institutional-quality bond mutual funds offering favorable maturity and yield, particularly inflation protected bond funds.

REAL ESTATE: DUE TO RISING INTEREST RATES BOTH COMMERCIAL AND RESIDENTIAL PROPERTY VALUES HAVE SLOWED THEIR RAPID INCREASES

During the past quarter commercial real estate prices hit all-time highs and it is widely anticipated that due to raising interest rates, values may have reached a plateau. Higher borrowing costs for real estate investors usually translates into lower prices. However, with a significant shortage of quality real estate available for sale, demand is outpacing supply, and prices have remained relatively stable. Industrial real estate and apartments continue to be the most sought-after asset classes followed by retail and hospitality. Office continues to be the least desirable asset class.

Residential real estate home sales have slowed due to rising mortgage interest rates and a shortage of homes available for sale. Nationally, buyers are finding the highest interest rates since 2019 which is limiting their affordability for new homes. The rate of increase of residential values has slowed significantly but demand has continued to propel the residential real estate market.

We are of the opinion that in the short-term real estate values will remain relatively unchanged. As interest rates continue to increase, there will be downward pressure on values. However, continued increased demand shall overcome the downward pressure and we anticipate real estate values ending the year similar to their current levels.

SUMMARY & CONCLUSION:

Aggressive moves to increase the Federal Funds rate by the Federal Reserve to tame inflation are in progress. Continued supply chain disruptions and higher interest rates will contribute to slowing economic growth but avoid a U.S. recession. The stock market will have modest growth this year at best. Shorter maturities are optimum for bond purchases in a rising interest rate market. Real estate values will be challenged by higher interest rates, but limited available product should help maintain pricing.

CLIENT REFERRALS

We greatly appreciate the referrals of new business that we continue to receive from our clients. If you have acquaintances, who, in your opinion, can benefit from receiving this investment newsletter, please contact Doreen in our office at (310) 553-5551 or email: dferritto@hdainvest.com.

“‘Economic Outlook & Investment Perspective’ is designed to serve as a regular forum for the discussion of pertinent economic and market issues that are of concern to individual investors. However, this newsletter is not, and under no circumstances is to be construed as giving financial or investment advice and/or as an offer to sell any securities. Harold Davidson & Associates, Inc. and its officers and employees may have an interest in some or all of the investments, industries or securities, mentioned herein. The information set forth herein has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis of the investment, industry or security involved.”


FOURTH QUARTER, 2021

THE ECONOMY: RAPID ECONOMIC GROWTH CONTINUES IN THE U.S.

Consumer spending accounts for approximately two-thirds of U.S. Gross Domestic Product (GDP). If consumer finances are any indication of the strength of the consumer, there is reason to continue to be optimistic. Households remain in good shape with consumers in the aggregate actually underspending relative to current income. Even though enhanced unemployment benefits have expired and no longer provide a boost to personal income, the loss is easily offset by the savings that was stockpiled since the pandemic began. Going forward, income growth should benefit from strong employment and wage growth. Also helping to add to income and spending will be Child Tax Credit checks, which will continue through December.

The Federal Open Market Committee (FOMC) is now projecting annual 2021 economic growth at 5.9%. The unemployment rate has dropped significantly and only stands at just over 4.8% currently. The acceleration in wage growth is a clear indication that demand for labor is strong and that the lack of qualified available workers, not a lack of jobs, remains the major hurdle to robust hiring.

The economy remains supported by record corporate profits. Coronavirus infections are trending down which is already leading to a rise in demand for travel, other high-contact services, and packed sports venues.

Businesses need to replenish depleted inventories, which will keep factories humming. The September Manufacturing Purchasing Managers Index (PMI) registered 61.1%, an increase of 1.2% from the August reading of 59.9%. This figure indicates expansion in in the overall economy for the sixteenth month in a row. Yet, companies and suppliers continue to deal with an unprecedented number of hurdles to meet increasing demand.  All segments of the manufacturing economy are impacted by record-long raw materials lead times, continued shortages of critical materials, rising commodity prices and difficulties in transporting products, including congestion at the ports of China and the United States.

International economic growth is continuing in many of the largest nations, including: Japan, Germany, the U.K., France, India, South Korea, Canada and Brazil.  By contrast, nations with declining growth include China, Russia and Mexico.

Industry forecasts for automobile sales from July through September were less than 3.4 million, down approximately 14% from a year earlier. This translates to a seasonally adjusted annual rate of just 13.1 million, down from 15.2 million in 2020 or 17.1 million in 2019. The severe decline is due to the ongoing shortage of semiconductor chips for new vehicles. Analysts predict supply will improve mildly in the fourth quarter and continue to improve throughout 2022.

United States total residential construction starts are forecast to increase 4% in 2021, moving from $728 billion to $810 billion before climbing another 8% in 2022 to $875 billion, surpassing the 10-year high point of $856 billion in 2019.  An impediment to these projections would be dramatically increasing interest rates, should they materialize.

Contributing to inflationary presence, oil rose to over $80 a barrel, a 3 year high, because of tight supplies by the Organization of the Petroleum Exporting Countries (OPEC). OPEC is facing pressure from consumers such as the United States and India to produce more to help reduce prices.

The Federal Reserve’s 2% inflation target has been exceeded for the last four months.  The commerce department’s core personal consumption expenditures, which excludes volatile food and energy costs, has averaged the last four months at an annual rate of 3.6%. Economists argue that price pressures will ease as bottlenecks resolve so that increased inflation is transitory. Harold Davidson & Associates, Inc. (HDA) is of the opinion that the Federal Reserve will reduce its stimulus program by tapering its bond purchasing as early as November 2021, and gradually raising the Federal Funds rate as early as fourth quarter 2022.

Both President Biden’s bills for “Build Back Better” have been challenged. The proposed $1.2 trillion infrastructure bill will likely be trimmed to approximately $1 trillion. The social safety net programs, projected at $3.5 trillion, in HDA’s estimate will be trimmed to $2 trillion to get approved by Congress. These bills will likely get passed at these reduced levels.  If this happens, perhaps there may be less impactful increases in the proposed tax levy as well.

THE STOCK MARKET: RECOVERY STALLS

The S&P 500 Index picked up steam during the third quarter as economic recovery continued; however, a nearly 5% decline in September left market performance flat for the quarter. The S&P 500 Index rose 0.2% during the third quarter and 14.7% year-to-date.  The NASDAQ ended the third quarter also flat and up 12.1% year-to-date.

This year, 2021, remains on track to be the biggest year on record for Initial Public Offerings (IPOs).

Economic recovery stalled slightly during the third quarter due to supply-chain disruptions as well as a ramp up in cases of the Delta variant of COVID. S&P 500 earnings estimates increased 8% during the quarter. Using a 22x P/E multiple on the consensus S&P estimate for 2021 of $202.9 equates to a year-end value of 4464, or 1% upside from current levels.

During the quarter ending September 30, 2021, Harold Davidson & Associates decreased equity exposure. We purchased shares in an artificial intelligence computing company and a cyber security company. We sold shares in a telecommunications company, an airline, a retailer, and a social media company.

The composition of the assets currently managed by Harold Davidson & Associates is as follows: Cash and cash equivalents – 6%; municipal bonds – 3%; corporate bonds 3%; bond mutual funds – 9%; equity mutual funds – 13%; common stocks – 54%; and real estate equities – 12%.

THE BOND MARKET: FOMC SHIFTS STANCE

The Federal Reserve’s Federal Open Market Committee (FOMC) kept the target rate range at 0.0 – 0.25%. The Fed indicated that it will start to scale back its bond purchases as early as November and may increase interest rates next year, sooner and faster than expected, and a reversal from the stance at its June meeting.

The yield on ten-year U.S. Treasuries ended the quarter at 1.528%. Yields rose at the end of the third quarter as inflation may stay longer than expected. Our bond purchases are concentrated on quality issuers and low duration. Inventories for both high quality corporate and municipal fixed income securities remain tight, and we selectively substitute purchases of individual bonds with institutional-quality bond mutual funds offering favorable maturity and yield.

THE REAL ESTATE MARKET: REAL ESTATE VALUES CONTINUE THEIR DRAMATIC RISE AND SHORT-TERM THERE IS NO REASON TO ANTICIPATE AN END

During the third quarter nearly all sectors of commercial real estate hit new all-time highs. Due to low interest rates, investors have looked to real estate as a desirable investment alternative to equities and bonds. This insatiable demand has driven real estate returns to extremely low levels, which in turn has increased real estate values to   unprecedented highs. Industrial and multifamily properties have been the leader in investor appetite with retail and hospitality lagging, but still increasing significantly. There is ample investor capital chasing low supply, and values should increase or remain stable for the foreseeable future.

In the single-family residential sector, homes continue to trade at near record level prices as demand continues to outpace supply. With many businesses now being partially or fully remote, values have increased both in urban city centers and rural communities throughout the United States. There are varying opinions as to whether this demographic switch will prevail, or if more people will move back to the urban city centers and drive-up prices further. Historically, September is the beginning of a six-month slowdown in home sales which often leads to slight decreases in value, followed by robust activity once again beginning in March. During this slowdown, values usually decrease slightly but often increase, once buying activity resumes.

Harold Davidson & Associates, Inc. is of the opinion that potentially increasing rates by the Federal Reserve will not derail the real estate market. Demand will continue to exceed supply and prices should remain stable or continue to escalate for the next several quarters.

SUMMARY & CONCLUSION:

Consumer income and spending, and a robust housing market tempered by a modest decrease in government stimulus, should result in U.S. GDP growth of approximately 5.9% for all of 2021, modestly lower than HDA’s last quarter projection. Encouraging news is that unemployment continues to moderate and is now 4.8%. Corporate profits are continuing upward to record levels. The stock market should end the year with a double digit increase over last year. Modestly increasing interest rates should not deter a currently robust real estate market.

CLIENT REFERRALS

We greatly appreciate the referrals of new business that we continue to receive from our clients. If you have acquaintances, who, in your opinion, can benefit from receiving this investment newsletter, please contact Doreen in our office at (310) 553-5551 or email: dferritto@hdainvest.com.

“‘Economic Outlook & Investment Perspective’ is designed to serve as a regular forum for the discussion of pertinent economic and market issues that are of concern to individual investors. However, this newsletter is not, and under no circumstances is to be construed as giving financial or investment advice and/or as an offer to sell any securities. Harold Davidson & Associates, Inc. and its officers and employees may have an interest in some or all of the investments, industries or securities, mentioned herein. The information set forth herein has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis of the investment, industry or security involved.”