Chairman’s letter Q1 2022

We need to ride out the turmoil and wait for sunnier days.




March 1, 2022

Turmoil or “Toto, I’ve a feeling we’re not in Kansas anymore.” Dorothy Gale: the Wizard of Oz

The past 90 days have been one of immense turmoil. War, inflation, rapidly rising interest rates, forecasts of economic recession, rumors of tax hikes, and soon companies are to announce quarterly earnings and the going is expected to be far tougher than the easy comparable numbers from last years covid recovery. 

In the period of the past 30 days the largest companies in the world dropped by 19% and then recovered most of those loses by the end of this month. Interest rates rocked higher causing the worst losses to bonds, the so called ‘safe assets’, in decades to investors. There was nowhere to hide.

I would advise ignoring the swings of the stock market. Its short-term forecasting skills are horrible; those are facts not an opinion. Now, we pay very close attention to the cost of money (interest rates), and that cost has risen sharply these past 90 days. Interest rates on 2-year bonds have tripled to 2.5%, and some think they could reach 3-4% in the not-too-distant future. Certainly, most market participants think that by the end of this year short term interest rates will be 2%. Heaven forbid! Not 2%!! What will become of us??

I’ve been doing this longer than most, and recall 11% interest rates, and given present day inflation of 8%, one could reasonably think that anyone lending money at 2% is a fool. The ‘government people’, who talk with ‘Wall Street People’ about what interest rates will ‘be’, are saying they will increase the interest rate that they charge banks at some speed —as yet to be determined until they chat further— and the banks will promptly charge us more. BREAKING NEWS: the real world has already raised what they charge us! Most who listen to this ridiculous banter back and forth between these ‘investment professionals’, have already moved on. The real world is already paying far more than 0.25% much less the forecasted 2% in 2 years or so.  Most are refusing to lend money at the still ridiculously low 2.5% for 2 years. The financial world is so privileged and out of touch with main street. Wall Street has little sense of the real world. 

It was just reported that the economy grew by 6.95% last quarter. That is very fast growth and will slow down—a lot. A great deal of that ‘boom-time’ number is businesses furiously rebuilding inventories, because we collectively bought everything on the shelves last year. As those inventories are rebuilt business will slow their rate of activity, and we likely will collectively pause, and some will worryingly watch with horror that which is the news which then will include banter about a recession. And yet just now, but not “headline or breaking news”, is that average earnings of workers has risen by 11% over the past year. And despite workers making more, so are good businesses. This is generally considered a good thing, so not fit for publication.  

Investors will be keenly watching these next 6 months how companies navigate rising inflationary pressures including wage costs. We believe the companies you own have the ability to navigate well these issues. This turmoil is far less scary than what we experienced in 2020, and I can assure you that I have seen these kinds of problems and worse in 37 years of experience.

We at Davis Rea are carefully assessing the cost of money as it increases. If it continues its sprint higher and does not soon moderate to a casual jaunt, we expect continued turbulence. The truth is none of us know with certainty how the next 2 years will play out. How much will the economy slow? When will inflation moderate and to what extent? How high must interest rates rise to reward lenders who are presently losing money? How will this impact profits and how will investors value those profits?

Our best judgement right now is that within 6-9 months a clearer path will begin to emerge, and it likely looks like slower growth, falling inflation, a moderation in the pace of interest rate increases, and likely some moderation in profit growth, but we also think the risks are skewed toward being cautious. We are transitioning to a new world in many respects and that always brings risk and reward. 

As Dorothy said to Toto: “I’ve a feeling we’re not in Kansas anymore.”