Dear friends,
We hope you and your family have enjoyed a restful holiday season and a good start to 2022.
For investors, the new year comes with many continuing questions around trends in public health, government monetary policy and the rising cost of goods and services.
Perhaps weighing most heavily on investors’ minds is the recent surge in Covid Omicron cases. In the US, we are now seeing the highest number of weekly cases documented since the pandemic began. Globally, the US and EU appear to be the most heavily impacted in terms of case numbers. East Asian countries that have adopted immediate, effective lockdowns and mandatory isolation to reduce community spread are seeing smaller rises in new infections. Despite vaccines and various protective measures, this fast mutating virus remains with us and retains the capacity to cause widespread public health damage and economic disruption. Thus far, US markets have had a muted response to the new wave of infections, largely driven by the reluctance of state and federal governments to impose any form of lockdown to stall community spread.
The Covid crisis has, in many ways, made a lasting impact on the global investment landscape. Most white collar workers have now spent much of the past two years working from home. Technology usage in most businesses has accelerated, which has prompted investors to bid up prices for technology stocks to nose-bleed levels, with many trading at multiples of earnings not seen since the tech bubble of the late 1990s. There continues to be a long-term case for investing in technology stocks, but as with most investments, the levels at which you buy can often make the difference between profit and disappointment. At current levels, it is difficult to make a value driven case for most large, publicly-traded technology companies.
Tesla, in particular, is an extreme example. It is currently trading at a market cap that makes it more valuable than the 10 largest auto-makers combined. Those 10 automakers generate roughly 50 times the revenue that Tesla does, and each has an electric vehicle offering. Though Tesla has a devoted client-base willing to pay a premium for their product, it does not enjoy a meaningful technology edge, even in the premium car market, where German and Japanese car makers will offer stiff competition in the near future. Along similar lines, Zoom Communications offers a cautionary tale for speculative growth investors. When the effects of the pandemic were first being quantified, Zoom appeared unassailable and its stock price rose very quickly. In response, larger competitors strengthened their offerings, and as a result of this increased competition plus a decline in investor enthusiasm, Zoom is now 70% off its high from 2020. We’re starting to see similar trajectories for other high growth speculative tech names.
In general, equity multiples remain at elevated levels despite a remarkable surge in earnings during 2021. The broad S&P 500 index is trading at nearly 30 times the past 12 months earnings. The average multiple historically has been closer to 15. Corporate earnings are themselves at elevated levels, which implies even higher risk. If earnings and P/E ratios both revert towards the historic mean, prices would decline further and faster than if it were just one of these factors impacting markets.
In our view, it looks increasingly certain the Fed will follow through with its plan to raise interest rates this year. With unemployment under 4%, and the most recent CPI (inflation) reading for December registering at 7% –the fastest pace since June 1982– we see no conventional impediments to the Fed tightening rates. This of course means we will likely be entering a rising interest rate environment for the first time since late 2018. As a result, the support equity markets have enjoyed from rock-bottom interest rates will disappear. Investors holding long-dated bonds should expect some deterioration in the value of their holdings, as long-term rates generally rise alongside the short-term Federal Funds rate.
Underlining the anticipated rise in interest rates is the growth in debt issuance across the world. During the Covid pandemic, the US Federal government has added over 5 Trillion in debt. This is the sharpest rise in the past 30 years, though the trend has been steadily upwards. In 1990, US Federal debt stood at under 4 Trillion. 30 years later the US government has borrowed over 28.4 trillion. Debt as a percentage of GDP has risen during the pandemic as well, from 108% to over 120%. This is the highest it has ever been for the US. Other large economies have seen similar increases in debt levels during the pandemic, including China, the EU and India. Meanwhile, interest rates have remained below inflation in much of the world, minimizing the cost of servicing this debt. As rates adjust to more normal levels, public finances will need to be modified as well. In many countries this will lead to a search for revenues in the form of increased taxes. Higher tax rates would reduce corporate earnings, placing additional pressure on stocks.
We continue to recommend maintaining balanced portfolios, with a bias towards lower risk. Given the uncertainties we face and very high levels that equities are currently trading at, we advise investors to remain cautious and avoid the temptation to aggressively jump into what appears to be a very late-stage bull market. When bull markets break, they typically provide opportunities for investors to purchase high-quality companies at discounted prices.
With interest rates likely to continue rising this year, bond investors need to evaluate the maturities and duration in their bond portfolios. We recommend trimming longer term bond exposure and adding to shorter/floating rate bonds.
We expect 2022 will bring increased volatility in both the equity and bond markets. We think this volatility will also present compelling buying opportunities for investors in both markets.
Disclosure: Neither Subir nor Louis hold Tesla (TSLA) or Zoom (ZM) in their personal accounts. Tesla (TSLA) or Zoom (ZM) are not held in any discretionary portfolios at WSCM. Tesla (TSLA) is held in non-discretionary accounts at WSCM while Zoom (ZM) is not.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

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