The Road Ahead
Investment results for the just-concluded year were generally bountiful, especially when we consider that the global covid pandemic is anything but vanquished. Large US stocks again led the parade, with the S&P 500 notching a price gain of nearly 27%. Smaller companies were positive, but less so, with a 15% total return (Russell 2000). Overseas markets were hurt by US dollar strength and posted a gain of 8.3% (ACWI ex-US). Fixed income markets finished slightly in the red, and gold dropped 4%.
Covid’s shadow remains long on the world. Spurred by a continuing gusher of easy central bank money, resilient consumer demand met multiple supply challenges, often brought on by pandemic shutdowns in overseas supply channels. Shortages of business and consumer goods were common, and in many instances remain so, giving rise to a sharp spike in inflation. Too, the US labor market remains very tight, with job openings plentiful and wage pressures abundant.
After the fourth quarter numbers are finalized, the economy should have grown in excess of 5% for the year. Growth is expected to moderate in 2022, but remain above trend. Consensus forecasts for growth fall in the range of 4.0%. Following are some of our thoughts on the road ahead.
We are now two years into an exhausting and painful pandemic. The pandemic has become politically divisive, which in turn has undermined coordinated policymaking. A winter surge in Covid cases from the new and highly contagious omicron variant has brought fresh uncertainties as well.
The spread of the latest variant is fast reaching every corner of the globe. According to data from the CDC, the omicron variant has overtaken delta in just a matter of weeks, and now makes up nearly all sequenced cases in the US.
Fortunately, evidence is suggesting that omicron is less severe than earlier variants, and correspondingly less lethal, particularly for vaccinated persons. Patients infected with the omicron variant may have increased immune protection against earlier strains, too. Ironically, if omicron ends up displacing delta and indeed proves to have milder symptoms, the pandemic may finally prove much less disruptive to individuals and societies. We continue to monitor the issue.
Inflation Remains Elevated
The unusual restart dynamics of extraordinary demand meeting bottlenecks and wage pressures have kept inflation elevated, beyond the initial expectations of the Federal Reserve. The Consumer Price Index readings from the past few months show that prices have surged by 6% – 7% on a year-over-year basis, their most rapid rate of increase since 1982. Spiking food and energy prices, together with rising rental costs, are the biggest contributors to accelerating inflation. Lumber prices are rallying once again after pulling back in the summer, and recently hit a seven-month high. Used and new car prices remain stubbornly high amid strong demand and tight inventory. Oil is trading at multi-year highs.
Covid has contributed as well, via global supply chain impacts. Dislocations are present everywhere; container ships are stuck at sea, warehouses are overflowing with goods, and trucks are without drivers. There is little chance of a quick resolution to the cascading effect on the interconnected global supply chain, and inflationary pressures will mostly likely persist in 2022. However, our expectations are that many supply-demand imbalances should start to moderate from today’s elevated levels, which should help calm inflationary pressures on the supply side.
Already, there are signs that the supply chains may be healing, slowly. In Asia, Covid-related factory closures, energy shortages, and port-capacity limits have eased in recent weeks. Ocean freight rates have retreated from record levels just a few months ago. The normalizing of demand should help with port congestion, too. Flare-ups in Covid cases can threaten to slow supply chains once again, but in general they are moving in the right direction. A sustained easing of supply chain choke points will allow production to move toward meeting demand and will lower logistics costs, which in turn should help moderate inflation pressures.
Fed Shifts to Inflation Battle
The Federal Reserve recently acknowledged that inflation has been both higher and more persistent than initially anticipated. With demand strong and payrolls showing steady job growth throughout 2021, the central bank has moved into inflation-fighting mode and has charted a path for weaning the economy off the Fed’s pandemic support.
To refresh, the Federal Reserve cut interest rates to zero, and initiated a program to buy $120 billion of bonds ($80 billion in Treasury, and $40 billion in mortgage-backed securities) monthly to alleviate investor fears and provide liquidity to the market during the onset of the pandemic. From their latest minutes, the Fed voted to reduce its bond purchases to $30 billion a month, and wind down the program entirely by March, instead of the original plan of June. By tapering its bond buying faster, the Fed is doing less to stimulate the economy with each passing month.
The Fed is also expected to begin raising short-term interest rates following the cessation of its bond buying program. At present, the market is pricing in about four quarter-point interest rate hikes in the new year.
The Federal Reserve will be under intense scrutiny as it moves toward tighter monetary policy, and walks the fine line between keeping the economic recovery on track, maintaining full employment, and controlling inflation. With markets accustomed to quantitative easing and persistent low rates, periodic market volatility may rise, as investors grow wary of a misstep in timing.
Outlook for 2022
US stock markets ended 2021 near their historic highs, despite the continuing pandemic, supply chain problems, and new inflation concerns. While the major averages showed substantial gains, underneath the surface was a messier picture; although many large stocks posted strong years, many smaller stocks had corrected sharply.
The new year has opened with a jittery tone, with elevated volatility and a selloff in high-valuation stocks, while value sectors have remained firm. Following two years of largely synchronized monetary policies, central banks from the developed world are beginning to implement tailored tightening to address inflation. This could possibly contribute to more episodic volatility in the markets, and present some possibilities for downside. In the aggregate, however, we believe the macro backdrop will likely remain supportive of risk assets in 2022.
We think the economic restart has room to run. As mentioned, economic growth will likely moderate from the last year’s levels. However, healthy household balance sheets, rising wages, and ample job opportunities place consumers in a position of relative strength, and the demand for goods and services remains solid. A major contributor to growth should be new car sales, as the semiconductor supply crunch eases. The first projects of the $1 trillion infrastructure spending package should begin to hit the economy, as well.
A potential offset could be housing. The sector was strong last year, led by the millennial generation, which is entering its prime home-buying years. Strong housing demand has contributed to a shortfall, especially among starter homes. Home prices are at record levels and affordability is strained in many hot markets. Higher mortgage rates could serve to cool the sector.
We will continue to chart our investment strategy in response to market conditions, both prevailing and expected, and the opportunities they present. We thank you for your continued confidence, and wish you a healthy and fulfilling New Year.