- “You are what your record says you are.” – Bill Parcells, two-time Super Bowl winning NFL coachFourth Quarter Summary
Most indices rebounded from their summer swoon. U.S. large cap and technology-related stocks led the way, with China once again weighing down emerging markets. Shorter maturity Treasury yields spiked, while longer dated bond yields were little changed. Commodities, such as oil, copper and lumber as well as safer havens such as gold and the dollar, all rallied.
During autumn, the economy attempted to snap back from the Delta variant, as people started traveling and going out to restaurants once more. Consumer spending was strong, especially in October, as shoppers heeded advice to do their holiday shopping early to avoid potential shortages from supply chain issues.
More Persistent Inflation and the Subsequent Fed Response
Inflation gauges such as the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) along with food, gasoline and durable goods prices continued to accelerate, affecting consumer pocketbooks. Acknowledging this, the Fed began a program of tapering bond purchases (known as Quantitative Easing, or QE) to end in March, with increases in short-term borrowing rate to follow. The markets soon began to factor in three rate hikes for 2022.
Then, early this month, the minutes from the December Fed meeting revealed some members were even considering four rate hikes, along with a reduction in the Fed balance sheet (known as Quantitative Tightening or QT). This shook the markets. The ten-year Treasury yield spiked almost 30 basis points to 1.80%, eclipsing late year’s high. Higher long maturity yields normally translate into lower valuations for equities, since stock earnings over time are worth less due to a higher discount rate. This hit the highest valuation stocks (especially in technology) the most. A rotation from growth to value stocks began.
Omicron – Another Covid Variant
Originating in South Africa, a new Covid-19 strain, Omicron, quickly spread to developed nations by the second half of December. Because so many workers were getting sick, flights were delayed, conferences were cancelled and stores and schools had to close due to staff shortages. Though more transmissible than previous variants, Omicron appears to have a shorter duration. More importantly, the illness has been resulting in fewer hospitalizations and deaths. First quarter 2022 real GDP will be hit by these disruptions, but should bounce back in the spring — similar to what occurred last fall with the Delta variant.
Inflation 2022: Its Effect on the Economy and the Markets
How inflation plays out this year will be crucial to the Fed, U.S. economy and market outcomes. Current data suggests that an alleviation of supply chain issues, goods in short supply and base effects (when year-over year comparison get easier) should lead to inflation peaking in the winter.
The question then becomes how fast will inflation go down to the Fed’s preferred rates of 2.00-2.50%. Wage inflation may stay elevated due to shrinkage of the labor force, which may not recover all the way back to pre-pandemic levels. Also, the increase in home prices has not fully worked its way yet through the economy. These last two variables may keep inflation from falling very fast and thus, remain at uncomfortable levels.
Although consumer spending should hold up well with more people holding jobs, the erosion of purchasing power may cause spending to moderate. Overall, companies have managed to pass higher costs through to the consumer, but it remains to be seen how much longer they can continue to do this.
Strategy for the New Year
We are responding to the new hawkish Fed policy by trimming positions in our core large cap equities. This will be accomplished by:
- Giving “haircuts” to mega cap stocks, along with other high valuation stocks (with high price to earnings multiples)
- Repositioning into cheaper, more defensive names with enduring pricing power to weather the elevated inflationary environment
We anticipate a choppy market in 2022. Unknowns such as progress on the fight against inflation, new Covid strains and an election year (mid-terms are in November) are expected to produce volatility throughout the year. Regardless, equities will still offer the potential to offset the loss of purchasing power over the longer term. We urge investors to be patient as we move forward.