The U.S. stock market, as measured by the S&P 500®, began the new year with a weaker and more volatile tone after a very strong 2021.
There is an old adage that the first week of a new year, and more importantly the first month of a new year, is a good prognosticator of market returns for the entire year.
Although it is common to be aware of seasonal patterns and old market adages, they are analogous to following the Farmer’s Almanac for long-term weather forecasting – interesting, but they should not be the basis for an investment outlook. Instead, weather forecasters look at specific observable underlying facts in making predictions.
One of the key facts used in weather prediction is the speed and directional flow of the jet stream. In investing, inflation is the underlying “jet stream” that has a strong influence on markets and returns. After years of the inflation “jet stream” remaining in a mild and monotonous pattern, providing an excellent climate for asset returns, it has suddenly begun to howl and shift. This change is beginning to affect the investment environment.
From “transitory inflation” rhetoric to monetary policy transition
For most of the past year, the Federal Reserve (Fed) clung to a view that inflation would be “transitory,” and that the underlying secular forces restraining inflation would continue to prevail as they had for years. Other central banks around the world have been less sanguine about inflation and have already been moving to tighten policy. Finally, the evidence, both statistical and anecdotal, has convinced the Fed that inflation is more persistent than they thought, and will not quickly abate, even as supply chain issues ease.
In an effort to mitigate growing inflationary pressure, the Fed has indicated that not only will they move swiftly to wind down their large bond buying program (which has repressed long-term bond yields), but also that they are poised to raise short-term interest rates by as much as 0.75% over the course of 2022, with additional hikes in 2023. Additionally, a growing number of Fed members are pushing to start shrinking their balance sheet as early as this year. This more hawkish tilt was the catalyst for the overall market weakness as the new year began. The Fed actions have transitioned from dampening volatility to triggering volatility.
The current inflation “jet stream” has been turbulent and appears to be gaining speed. Commodity prices have been rising significantly over the past year. The Goldman Sachs Commodity Index, a broad-based price index of 24 commodities, was up nearly 40% in 2021 and continued to rise in early 2021. However, commodities are a relatively small contributor to overall inflation.
The real inflation pressure tends to come when wages begin to rise and when expectations for inflation become imbedded in future wage demands. Recent statistics on wages have moved up to 5% which, if sustained, would materially change the dynamics of the current round of inflation and the possible policy response from the Fed.
The sustainability of wage increases, and the impact it may have on longer-term inflation, will be a key factor in the coming year. A more aggressive Fed tightening could potentially be averted if supply chain problems subside and inflationary pressures ease. However, we expect that inflation readings will remain hot through at least the first half of the new year, which will likely contribute to investor uncertainty and market volatility.
Some market indicators are showing less long-term concern over runaway inflation. Currently the bond market is pricing in long-term inflation of about 2.5%, primarily via the valuation of inflation protected securities (TIPS) relative to standard coupon-bearing Treasury bonds.
Another new potential market indicator of inflation expectations may be found in the crypto currency market. Bitcoin, which has been touted as a digital long-term store of value in an inflationary environment, has also been quite weak recently, declining about 40% over the past two months. However, this move may be as much about the decline in speculative excesses as it is about potential inflation expectations.
Meanwhile gold, which has been considered an inflation hedge for centuries, remains moribund. In fact, it declined more than 6% in the past year and has slumped since the beginning of 2022.
Changing investment climate
The dynamically changing inflation environment and the Fed’s transition to tightening monetary policy have led to transitions in the market as well. Long-term interest rates have reacted to stubbornly higher inflation and the Fed’s more hawkish policy pivot by surging since the end of the year. Higher bond yields have traditionally been an impediment to the valuation of high-growth, high-valuation equities. Consequently, highly valued growth stocks have declined since the beginning of the year while “cheaper” value stocks have rallied.
This significant change in sector performance at the start of 2022 is a repeat of the beginning to 2021. However, last year, the high-growth sector, led by large technology companies, quickly reasserted its leadership position in terms of relative performance. This strong performance was supported by stunning profitability and relatively stable interest rates. However, the high-growth stock market may face stiffer headwinds this year, given their current high valuations combined with the dampening effects of rising interest rates.
Meanwhile, over the past three months, there has been a decided transition in the market, where high-quality, lower valuation, dividend-generating stocks have been meaningfully outperforming the mega cap growth companies. Financial, energy, health care, and even some industrial stocks have shown solid strength relative to the mega cap technology stocks.
Turbulence in a changing climate – looking at the history
It is clear the Fed is poised to tighten monetary policy. The last monetary tightening cycle began in late 2015 and, like today, short-term interest rates were effectively 0%, while 10-year treasury yields were around 2%.
In the first couple of years of Fed tightening, the equity market performed well, with price returns of 9.5% in 2016 and 19.4% in 2017 (as measured by the S&P 500®). However, long-term interest rates were relatively stable, and inflation was benign. But in the third year of Fed tightening, the equity market stalled, with a price decline of about 6.2% in 2018 as markets reacted to higher rates and tighter financial conditions. By 2019, with the Fed backing off from tightening policy, stocks rallied 28.9% in price. By the end of 2019 and beginning of 2020, COVID-19 dramatically changed the investment climate, leading the Fed to once again support the economy and markets with massive injections of liquidity, while cutting interest rates back to 0%.
Although the Fed is once again poised to raise rates substantially, there are some key differences. Inflation was not running at a level close to the uncomfortably high level of today, and valuation in the overall market was meaningfully lower, especially in the growth sector of the market. Over the last five years, the forward price-earnings ratio (P/E) of the S&P 500 has increased (making stocks more expensive) from about 17 times earnings to approximately 21 times earningsi today. However, this move higher was supported by a sharp decline in the yield of the 10-year treasury bond. Today, it seems unlikely that bond yields would reverse their current trend and decline.
A blustery, swirling investment environment
With inflation winds now blowing more strongly and the Fed clearly showing some resolve to address this issue, 2022 will likely be a more volatile year. After such stunning investment returns during these past two pandemic years, it would not be surprising to see flat or even negative returns in 2022. However, with a huge amount of liquidity in the system and underlying economic strength, we don’t expect to see a major sustained bear market.
The current trend of high-quality, lower valuation industries outperforming the broader market averages is a favorable development in that market performance is broadening as the economy rebounds.
However, investors should be aware that becoming too cautious in their long-term portfolio positioning may be costly. Markets are highly unpredictable in the short term. Historically, the equity market has generated positive returns roughly two-thirds of the time. Also, flat market returns in a given year are fairly uncommon. Over the past 40 years, modestly positive market returns of 0 - 5% occurred only four times, and modestly negative returns of 0- 5% only three times (based on the S&P 500). In 16 of the past 40 years, market returns were greater than 15% with only three years where market returns were negative 15%. Clearly, investors should keep these facts in mind (as well as a fair dose of humility) when charting an all-weather investment plan.