Global Markets: Quarterly Review Q4 2021

Monetary Stimulus: Shifting into Reverse  
Global monetary authorities have begun removing extraordinary pandemic-related stimulus as economies recover and as inflation is making a comeback. Until late in the quarter, the Federal Reserve stuck to its characterization of the recent rise in inflation as “transitory” on the belief that it was supply constraints – due to the pandemic – that was driving up prices and that these would fade relatively quickly. In December the Fed changed its mind, recognizing that there was also a significant demand component to price pressures; that a distorted labor market was bidding up wages; and that inflation was also moving to services in addition to goods. The Fed announced an acceleration of its taper of Quantitative Easing (QE – Bond Buying) to bring it to a close in March and expectations of interest rate hikes have risen from none in 2022 to a likely three or four. We – along with many market economists – now expect the first interest rate increase in March to coincide with the end of QE and a reduction in the Fed’s holdings of securities to commence as early as mid-year. Whether there will be two, three or even four rate hikes will depend on the evolution of the pandemic, the pace of economic recovery and, of course, the path of inflation.

Year-on-year headline Consumer Price inflation ended 2021 at a rate of 7.0%, a number not reached in decades. While the Federal Reserve’s preferred measure (PCE) has yet to be released as of this writing, it hit 4.7% as of November and was expected to exceed that at year-end. While supply disruptions were a significant factor early on, the risk that inflation becomes more entrenched is a significant concern for policymakers. House prices have been rising at a near 20% rate year on year and rents are expected to continue to rise for some time as well. The impact on inflation from goods prices are expected to fade due to an easing of shortages as well as base effects, however, the rise in wage pressures and concomitant increase in service sector prices has raised alarms.

That alarm was noted in the minutes of the December 15th Federal Open Market Committee meeting which was notably hawkish. It was at this meeting that the taper was accelerated but also where Fed officials moved rate hike expectation dramatically. One notable pull quote of many: “it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated. Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate. Some participants judged that a less accommodative future stance of policy would likely be warranted and that the Committee should convey a strong commitment to address elevated inflation pressures.” On the release of the minutes the equity and fixed income markets experienced a significant, if short-lived, sell-off.

The release of the minutes appears to have opened the possibility that the unwind of the Federal Reserve’s balance sheet could begin as early as this summer. The unwind involves the Fed allowing its bond portfolio to mature with the proceeds not being reinvested in new bonds. The previous conclusion of a QE policy involved the Fed reinvesting maturing bonds back into the market for two years before allowing a true reduction of the balance sheet to commence.  

Given the insight provided by the meeting notes, we do not believe it is likely to take nearly as long this time.

At issue is the risk that inflation is becoming more entrenched and inertial. When price increases appeared to be largely due to supply chain disruptions it was considered transitory. If inflation is “too much money chasing too few goods” then either demand for or supply of goods and services could be the culprit for rising prices.

The Fed has a dual mandate: Price Stability and Full Employment. Prior to the 1990s and “The Great Moderation” it appeared that the two were at odds in that as labor markets tighten wages are bid up leading to a general rise in prices as firms needed to compensate. Economists used to consider the NIARU: Non-Inflation Accelerating Rate of Unemployment as a hard constraint. Once unemployment falls too far, inflation was expected to rise and often risking a wage-price spiral. But with the decline in union membership, offshoring of production, and an increase in automation, labor seemed to lose its pricing power. The question was raised in the Fed meeting notes whether the former trends would reassert themselves and temper future wage gains or if that time has passed. We believe it is unlikely that the former trends could have the same impact they once did. The cost differential between domestic and international labor is not nearly as large as it once was, and the US economy is much more services oriented than it was in the 1970s. Most service sector jobs are difficult of offshore or automate.

While it is still early, wages have begun to rise either in response to rising prices or helping to drag prices higher. The labor market is tightening and with over 10 million job openings and millions quitting, the impulse to higher wages could continue for some time. This dynamic is likely to accelerate the Fed’s decision to hasten policy normalization.

The Consumer: Releasing the Clutch  
The reduction of fiscal and monetary stimulus leaves the outlook in the hands of the real economy which is driven by the consumer. In aggregate, the consumer is in a good shape. The pandemic delayed consumption, increased savings, and reduced household indebtedness. As pandemic restrictions are eased and normalcy begins to return, these factors have become a significant tailwind for recovery. One complication, however, is a significantly distorted labor market. The pandemic pushed millions out of work and while most have returned to the labor force millions still have not. Some have characterized it as the Great Resignation, and no one seems to be certain how it will play out.

The charts illustrate the situation well. While unemployment has now fallen below 4% and is reaching levels often characterized as “full employment” the participation rate remains approximately 2 percentage points below pre-pandemic levels. Job openings have exceeded 10 million while the pace at which people have been quitting one job for another is also at an all-time high. This complicates the outlook for the economy and inflation. It is possible that the decline in the participation rate is temporary and reflects fear of catching Covid; the lack of childcare; or any other temporary matter. Or it could reflect early retirements or other more permanent reasons for people to leave the workforce for good. The presence of a high quits rate coupled with a high job openings rate may well portend additional wage inflation. That could lead to the feared wage/price spiral even as it highlights the strength of the economic recovery.

Should those millions return to the workforce and start filling open positions it would be a significant boost to economic activity. If they do so without needing significantly higher wages as an inducement, then the risk to inflation is muted. But, if they only return because of higher compensation then the risk of inflation rises and tightening by the Federal Reserve becomes more likely.

Covid 19: Shifting into High Gear  
The arrival of the Omicron Variant of Covid-19 has prolonged the pandemic and begun a new global surge in cases. With its very high transmission rate, Omicron has displaced Delta as the chief variant of concern and appears poised to spread rapidly. On the positive side, Omicron also appears to have lower hospitalization and mortality rates. There are many who hold out hope that in its aftermath, and coupled with continued vaccination efforts, a level of herd immunity will be reached. Covid-19 could eventually become endemic like the flu or common cold. This would make it a more manageable problem that would not necessitate shutting down the economy. On the contrary, economic activity continues to show signs of improvement as previously noted.

It would be unwise to completely discount the risks posed by the most recent stage of the pandemic, nor of the risks of new variants. But it does appear that between vaccination and infection the disruption caused by the virus on aggregate has become more muted and accommodated.

Markets: Accelerate as the Fed Grows More Diligent
Q4 played out the same as 2021 as a whole; gains were consistent and sell-offs short and shallow. October proved to be the best month of the year (7.0%) as COVID concerns were waning and Q3 earnings reports handily beat expectations. That rally carried over into November, but when inflation hit its highest level in over 25 years and the new Omicron variant began to emerge, markets turned negative. They quickly recovered as Omicron proved to be less severe than Delta and optimism about the recovery renewed. December finished strong across all equity asset classes, but leadership in the month favored value stocks and international equities in developed countries. In the end, the S&P 500 posted an 11.0% return in Q4, the seventh straight quarter with positive returns.

The benefit of accommodative fiscal and monetary policy on stock performance has been well documented. The lack of attractive alternatives to stocks has kept capital from leaving the market when historically it might have. And corporate earnings continued to provide the necessary validation for investor optimism; currently FactSet estimates year-over-year earnings growth for 2021 to be 45%, the highest in over 13 years. This translated to another stellar year for the S&P 500 (28.7%); the second-best year since 2013. According to Reuters, the S&P 500 hit 70 all-time highs in 2021 (the second highest of all time) and went the entire year without a drawdown (decline from any peak) of 5% or more.

From an asset class perspective, Q4 was a microcosm of the year at large. Every major stock index posted positive returns except for Emerging Markets Equity. Large Growth (11.6%) outperformed Value (7.8%) in Q4, reversing the Value leadership trend that started earlier in the year. At 27.6% and 25.2% respectively, both Growth and Value provided some of the strongest returns across major asset classes for 2021. This is far different than 2020 when Large Growth (38.5%) and Value (2.8%) where light years apart. Small Caps trailed Large Caps in Q4 (2.1%) and for the year (14.8%).  

International equities continued to lag compared to the U.S. More stringent COVID restrictions in Europe, weakness in Japan, and U.S. dollar strength have hurt international equities. The 11.3% return in 2021 represents the 4th year in a row that Developed International has underperformed U.S. equities. Emerging Market equities had another dreadful year and owned the distinction of being one of the only equity indices to post a negative return for both Q4 and 2021. China’s draconian response to COVID hurt an already slowing economy. China represents nearly 1/3 of the entire Emerging Markets Index and the Chinese stock market ended 2021 down 22.8%.

Fixed income markets struggled in 2021, with the Bloomberg US Intermediate Aggregate Index down 1.3% for the year. The benchmark 10-year Treasury yield began the year at .92%, rose to 1.75% by March 31, dropped to 1.27% by the end of July, then rallied to finish the year at 1.51%. The 2-year Treasury yield started at .12% and ended the year at .74%, leaving the 2-10 year spread (slope) about the same. Corporate bonds performed better than Treasuries as credit spreads narrowed slightly. Investor’s willingness to take risk pushed High-yield bond performance (5.3%) to top-of-the class within a group that provided little to no return in 2021.

Outlook; Positive, but may be safer in a different gear?
The famous adage “don’t fight the Fed” has proved to be great advice since the beginning of this pandemic. Unprecedented fiscal and monetary stimulus masked much of the economic pain and, more importantly, allowed investors to ignore the crisis directly in front of them and focus solely on the opportunities on the other side. As a result, investor sentiment remained high, alternatives to equities remained scarce, and investors were rewarded for being long equities. With the probability that will soon change, so should the way investors view the markets. It’s not that you can no longer make money in stocks, it just may be a bit harder without the Fed’s safety net.

As the Fed begins to pull back its support, the true strength of the economy will undoubtedly emerge. We expect the recovery to resume as inflation subsides, COVID concerns dissipate, and investors appreciate that normalizing interest rates isn’t as severe as tightening. At the same time, we do believe that inflation is likely to be stickier than first believed, which will push interest rates higher.

Equities have been an effective inflation hedge historically. This inflationary outlook and the expectation for a powerful economic restart leads us to still like equities over bonds. The fact that the Fed will be less accommodative in the coming months brings with it more risk than before. In our opinion, the best way to lessen that risk is by owning assets that benefit from the re-opening trade, have lagged the broad market, and represent “short duration” assets within a respective asset class.

For fixed income, that means short-term bonds. We expect Bond markets to struggle in 2022 as policy rates rise, official purchases end, and more realistic pricing achieved. Negative real yields (bond yield minus inflation) are unsustainable. This favors shorter-term bonds to minimize losses in a rising rate environment.

For equities, long-duration companies are those that expect to receive a high percentage of cashflow in the distant future – Growth stocks. Short-duration equities like cyclicals and financials are more economically sensitive with greater value in the immediate future – Value stocks. The two main themes for 2022 – rising inflation (interest rates) and economic resurgence (economic re-opening) – both favor Value equities. Add the fact that Value stocks have been cheap relative to Growth for more than five years and you have a trifecta of catalysts for Value stocks to outperform. In fact, we are seeing it already. In the first nine trading days of 2022, the Russell 1000 Value (1.0%) has outperformed the Russell 1000 Growth (-6.4%) by 7.4%; a reminder of how swift mean reversion can materialize.

International stock markets are also dominated by value-oriented cyclicals. In fact, less than 10% of the MSCI EAFE Index is in Technology companies. This compares to 27% for the S&P 500. The signature of the post-pandemic market advance is that of a narrow market dominated by a select few U.S. Technology stocks. As the recovery expands, and short-duration assets provide greater leadership, international stocks could also recover. After all, the same trifecta applies to international stocks. The only difference is that international valuations are even cheaper and have underperformed for even longer. The US dollar has been strong as investors anticipate higher US growth and a more aggressive Federal Reserve. As this becomes reality, and growth broadens, the U.S. dollar could weaken, which would add further support for international assets.

As the Fed implements its plan, the risk of greater volatility rises, and the possibility of a correction grows; one could even argue a correction is long overdue. However, stocks have historically performed relatively well as the Fed begins tightening assuming the rate of change is gradual. In our view, it is natural for markets to grow more cautious, but as more of the world emerges from this pandemic, there still seems room for stocks to provide good relative gains, even if they might fall short of historical standards.

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