2022 should be the year of a full global recovery, an end to the pandemic, and a return to normal economic and market conditions that we had prior to the COVID-19 outbreak. We believe that an improved public health situation should result in a release of pent-up demand from consumers for travel and services, and from corporations for certain inventory and capital expenditures. The market should move higher, but returns are unlikely to match the last couple of years. We also expect volatility to be higher, and we would not be surprised if there is more than one pullback of 10% or more as risks of higher inflation, and a more hawkish Fed, are balanced against a still improving economy and earnings. Monetary policy is still supportive of risk assets, but a key risk to watch is a shift toward more aggressive monetary policy, tightening from central banks and lofty market valuations. While a bear market is certainly possible in the current environment, we suspect a sustained market fall is not likely to happen this year as strong economic expansion should continue around the globe.
Interest Rates, The Fed, and the Economy
Interest rates have been declining since 1981 due to demographics (aging population), globalization and technology (creating cheaper goods) and debt (rising debt levels are a drag on growth). Together they have been powerful forces that fostered deflation and falling interest rates. At the margin, these factors are changing. Millennials are about to engage in spending money by starting families, just like the boomers did in the 60’s and 70’s. Globalization and just-in-time inventories will not likely come back to where they were pre-covid due to supply chain problems and a rising anti-China sentiment. These shifts in conjunction with changes in the work environment, work from home/remote, people leaving the workforce and immigration slowing will extend an already tight labor market. Together, these longer-term forces on declining interest rates are losing their power and suggest that rates could stop the secular decline they have been in for 40 years.
The covid pandemic in 2020 – 2021 changed the Fed and Fiscal policy game plan to combat deflation by giving money straight to the population and lowering short rates back to zero. This has transpired for almost 2 years now, even as the economy and inflation has accelerated to around 7%. Normally, one would think that 7% inflation would spur interest rates higher…but they have not, largely because The Fed has expanded their balance sheet to almost $9 trillion, purchasing bonds to force rates lower. Now the Fed is in a tight spot; they need to raise rates to battle inflation, but the effect on the economy and the markets would be too harsh. Estimates of the effects of a 2% increase in interest rates would result in a decrease in GDP of 7.5%.
While inflation should moderate, it is unlikely to go back to pre-pandemic levels. Rates will not move much lower, with such a strong economy, but we doubt the Fed will let them move markedly higher. The result is negative real rates, otherwise known as Financial Repression. The U.S. did the same thing after WWII to repay the high debts accumulated with inflated dollars. This makes bonds an especially poor investment however, it is generally positive for risk assets (stocks and real estate) …and unless and until inflation gets out of control (8-10% has been the trigger for lower asset prices historically). We will be watching this very closely!
One wild card we are watching is the energy markets. The main reason the 70’s were so poor for the equity markets (unlikely the 60’s, which had inflation as well) is that energy prices shocked the market and spurred inflation. We see signs that investments in fossil fuels are too low as governments worldwide have rushed to embrace a green economy. Fossil fuels will still play a major part on the path to building a green economy, but here in the US we have made little investment in the traditional energy infrastructure while simultaneously reducing domestic energy production. Moreover, China has historically consumed a large amount of energy in the past and they are curtailing the use of coal, as it is a highly pollutive energy source. Both of those historic areas of supply are declining, but the demand for energy will increase in the post-covid world and the risk is that crude oil prices will continue to rise, as they have for the last two years.
Equity and Fixed Income Strategy
Last week the Fed warned in the December minutes that they will tighten rates sooner than the market expected. They will also complete the tapering of bond purchases faster than most expected (by March). Bond purchases have been an enormous source of monetary ease over the past few years and that is now ending. Interest Rate increases will come sooner this year and there may be 3 increases by the end of the year. Once the Fed engages in rate increases, they will also contemplate reducing the size of the balance sheet. This was the most surprising element from the minutes as this will move rates higher on the long end of the curve.
As bad as that sounds, historically it is not usually bad for the market. In the 17 tightening’s since 1946 the S&P 500 was down -1% in the 6 months around the first-rate hike but rose an average of 5.3% in the 12 months following the first increase. However, if the pace of tightening is fast, stocks fell 2.7%, while rising 11% during slow ones. There is often volatility around this first tightening, but then the markets generally move higher. That said, we are also mindful of the upcoming Midterm elections, which historically is the most volatile year in the 4-year elections cycle with an average peak to trough correction of -17%.*
History suggests higher market volatility in general while an upward trend seems likely. In the medium term, interest rates have a better chance of rising than we have seen in the past 40 years. That does not mean they will immediately move significantly higher, but the backdrop of low inflation and low interest rates have provided the equity markets, and especially growth stocks, with a wind at their back. These supporting factors may not be there much longer. Rates should go up and we see the potential for the highly valued growth stocks of the past two years to underperform and value and cyclical stocks should be able be able to outperform.
Areas of the market which have been the most exposed in the last few months, and in particular the last month, are the high beta areas of the market. Bitcoin, SPAC’s, and the mega expensive Tech stocks. These areas have done poorly since the start of the year and the Nasdaq is now underperforming the broader market. This is a substantial change in market character. We adjusted our allocations away from this space last year, which is a positive for our holdings, as most everything we own are reasonably valued stocks and Growth-at-a-Reasonable-Price type of companies.
In place of the growth names, we have added holdings in Financials, Energy, Industrial and infrastructure plays as the US starts to re-build roads, bridges, airports etc. We feel we are well positioned to this change in market character.
The duration in our Fixed Income portfolio is also very conservative and we should continue to do better than longer duration bond funds. We have been anticipating these changes and we are positioned well to benefit from this rotation. Interest rates have already started moving up after trading sideways for 8 months. We continue to keep a defensive posture in our fixed income portfolios, keeping average maturities short.
The year ahead will present new surprises, as it always does. Below are a few items which may alter the path of the market:
• Above Trend Economic Growth -The economy, and most importantly – earnings – should stay strong.
• Numerous Potential Risks – Fed Tightening, inflation, Covid and rising geo-political tensions.
• Low Recession Odds – The yield curve – one of the best predictors of inflation – is still positive. Until it is flat or negative the odds are that the economy stays on track.
• Less uniform global central bank Monetary Policies – Central banks have all been rowing with each other over the past few years to combat Covid. This may change as they re-focus on specific country issues.
• While risks are rising, we believe that we are several months if not 1-2 years away from a secular peak. It’s too early to get aggressively conservative. However, it is likely that modest tactical moves to a safer portfolio will pay dividends over the next 3-5 years.
*Data compiled using Ned Davis and LPL Research