Happy New Year to you and your loved ones. This new year marks the end of the second year of learning to live with COVID and the year ahead is likely to look different than the last; both in the markets and in everyday life. 2021 was a year in which equities had above average returns with below average volatility, while traditional bonds struggled. The rapid and widespread Omicron variant will further boost immunity in the population and 2022 will hopefully be the year the pandemic becomes an endemic, and we can return to life as we once knew it. While a return to normal in life is welcome, a return to normal in the markets may be less pleasant. Normalization of accommodative fiscal and monetary policy seen throughout 2020 and 2021 will start to apply the brakes to the economy, while rising interest rates will put downward pressure on bond prices and challenge equity valuations. While we expect the economy to continue to grow and equities to have a positive year, it is likely to be more volatile with lower returns than last year.
The US economy grew significantly in the first half of the year with real GDP growing 6.3% in the first quarter and 6.7% in the second quarter. Economic growth slowed to 2.3% in the third quarter and accelerated again in the fourth quarter with forecasts around 6.8%. It was thought that this rapid growth would continue into the first quarter of 2022, but the spread of the Omicron variant along with the start of some fiscal drag will likely put downward pressure on growth. Economic output is now greater than it was in the fourth quarter of 2019. After the fourth quarter 2021 GDP number is factored in, it is likely that economic output will be at the same level as it would have been if the economy continued to grow at trend if COVID never had happened. This suggests that there is not much more potential for the economy to grow as quickly, and it will approach trend growth of 2% over the year ahead.
Throughout the COVID-19 pandemic, we have been watching some of the high frequency data to better understand the fast-moving nature of the economy. The below table illustrates some of this data:
This data was steadily improving until early December, when the spread of the Omicron variant began to influence consumers decisions, particularly impacting restaurants and hotels.
While the Federal Government spent an enormous amount of money in 2020 and 2021 to fight the COVID pandemic and provide aid to those affected, we expect to see a return to a more normal amount of spending in 2022. The federal budget deficit was 12.4% of GDP in 2021 and is forecast to fall to 4.7% in 2022, which will result in some fiscal drag on the economy. Passage of the Build Back Better Act would have alleviated some of this drag largely by extending the enhancements to the child tax credit, earned income tax credit, and dependent care tax credit. 35 million families were receiving monthly checks for the child tax credit. This program was aimed at middle- and lower-income families whose discretionary budget is largely spent on food and basic items. Likewise, over the last two years we’ve seen a significant increase in spending on food which will likely wane in the first quarter. It is possible that some version of Build Back Better is passed this year, however, if it is fully paid for like Senator Manchin insists, it will have a net neutral impact in terms of its overall fiscal impact.
In addition to fiscal drag, we expect to see tighter monetary policy in the future. With the economy nearing full employment and inflation remaining elevated, the Federal Reserve (FED) made a pivot at the December Federal Open Market Committee (FOMC) meeting and announced that they were going double the speed of the taper of their asset purchase program, bringing it to an end in March of this year. The market is now pricing in four rate hikes in 2022, with the first being announced at the March FOMC meeting. This could, of course, change and we may only see three rate hikes this year. It is important to note, that the number of rate hikes, or overall magnitude of the tightening anticipated by the committee hasn’t changed, it has just been moved forward six to nine months. The FOMC estimates it will raise rates six times by 2024 and another two times in 2025. The market, however, is only pricing in five to six rate hikes in total. Six rate increases would leave the Fed Funds rate at 1.5%, which happens to be where it was after the FED cut in 2019 but before COVID hit. There has also been mention of using quantitative tightening to help raise longer term interest rates to keep the yield curve from inverting as the short-term rates are increased. We don’t think this will result in the FED selling bonds in the market, but rather allow its balance sheet to run off by not reinvesting the proceeds from maturing bonds.
Much of the reasoning behind the FED’s hawkish pivot was to combat persistently high inflation. The COVID pandemic was a shock to the global economy and is the underlying cause for the high inflation we are experiencing. This is not the first time we’ve witnessed high inflation after a disruption of this magnitude. High inflation also occurred after the Spanish Flu pandemic, World War II, and the Korean War. In each instance, inflation spiked and then plunged. While today’s circumstances may differ, it is reasonable to think that inflation may follow a similar path of these past events. Inflation has been caused by too much demand and not enough supply of goods. In addition to the increase in demand, largely due in part to the record amount of stimulus, demand also shifted from services to goods exacerbating the supply/demand imbalance for goods. The combination of fiscal drag and tighter monetary policy should decrease demand. January and February are historically the slowest months for retail spending, so if production is maintained or increased and distribution catches up, some of the supply side constraints may also be resolved in the first half of the year. Additionally, energy prices increased 34% year-over-year contributing to the headline inflation number. Even if energy prices remain where they are over the year ahead, they shouldn’t influence future inflation. At this price level, producers are likely to increase production while demand is likely to fall as the economy slows, resulting in lower energy prices and putting downward pressure on inflation. We hope inflation settles back down but it will likely remain at a higher level than that seen in the last economic cycle.
While the prospect of fiscal drag and tighter monetary policy being introduced at a time when the economy is already slowing due to the Omicron variant sounds like it may cause the recovery to stall, we do not think that is the case. The economy is quite strong, and we do not think beginning to raise to interest rates, off the current zero level, will derail it. The demand for labor is extraordinary, leading to a tight labor market with 11 million job openings and record low layoffs. Payrolls rose 537,000 per month in 2021 and the unemployment rate fell to 3.9% (below the 4% that the FED considers full employment). The headline nonfarm payroll number has missed expectations four of the last five months, but the civilian employment survey has been rising fast. This suggests a possible surge in small-business start-ups and entrepreneurship, which bodes well for the future. Average hourly earnings were up 4.7% last year while average hours worked were up 5%. Combining these numbers means total worker pay was up 9.9% in the past year. This is important because it means total worker pay has kept up with inflation and it is now roughly back to where it would have been if COVID never happened.
Equities have performed extraordinarily well since the COVID bottom, particularly in the United States. The run up in the market will be met with the headwinds we mentioned above in 2022. This will likely result in more volatility in the year ahead. A market correction, or drawdown of 10% to 20%, occurs on average once every two years. We think the combination of significant gains in the stock market and tighter monetary and fiscal policy in the year ahead may lead to a correction in 2022. Even though the stocks in S&P 500 index had a great year last year, the companies within the S&P 500 had an even better year with earnings up 72%. This led to a decrease in valuations even as stock prices soared. We expect earnings growth in the high single digits in 2022, which over the long run is supportive of equity prices. Additionally, as of November, there was $4.6 trillion in money market funds still on the sidelines that could be invested. The last two times money market assets peaked, in January 2003 and January 2009, the subsequent 3-year average annual return was 16.4% and 19.2% respectively.
Investing in traditional fixed income will likely prove challenging in the year ahead. The combination of low but rising interest rates means we could see another negative year for the US Aggregate Bond Index. We think an investment in US Treasuries may give you a negative real yield (return on the bond minus inflation) over the course of this economic cycle. To invest in this environment, we try to keep the portfolio duration (interest rate sensitivity) low and employ alternatives to diversify away from the traditional risks encountered in fixed income investing.
In conclusion, 2022 will hopefully be the year COVID turns from a pandemic to an endemic and as a result life can return to a new normal. However, as we work toward normalcy, so too will the economy and the markets. This means we will have to learn to live without record amounts of fiscal stimulus and extremely accommodative monetary policy, likely resulting in higher volatility, lower returns, and slower economic growth. We do hope this year proves to be an uplifting one full of connection, well-being, and positive returns for the market.
Take care and be well,
The Management Team
Michael, Michelle, Jolie and Nina
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