Will they blow in a new investment climate?
Coming up, will shifting inflationary winds blow in a new investment climate?
From Thrivent Asset Management, welcome to episode 23 of Advisor’s Market360™. A podcast for you, the driven financial advisor.
There’s an old adage that the first week of a new year, and more importantly the first month of a new year, is a good predictor of market returns for the entire year. And while it’s fun to trot out these old market adages, in reality they are like the long-term weather forecasts found in the Farmer’s Almanac – interesting, but not something one should use as a basis for an investment outlook.
Real meteorologists, unlike the prognosticators at the Farmer’s Almanac, rely on specific, observable, underlying facts to make their forecasts. And as investment professionals, we too must rely on the quantifiable. So, while the first month of 2022 seemed to portend a bearish year for market returns, the reality is that the winds of change are swirling – and it’s still not clear exactly where we are heading.
One of the key factors 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, which has provided an excellent climate for asset returns, it has suddenly begun to howl and shift. And this change is beginning to affect the investment environment.
For most of the past year, the Federal Reserve, or 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 hopeful 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 it.
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 2022. 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 show upward movement of 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 this year, which will likely contribute to investor uncertainty and market volatility.
But 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 relative to standard coupon-bearing Treasury bonds.
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.
Now let’s dig a little deeper on the 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. Last year however, 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.
With inflationary winds picking up speed, how will the resulting turbulence affect the market climate? As is often the case, we will let history be our guide.
It’s 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 as measured by the S&P 500® with price returns of 9.5% in 2016 and 19.4% in 2017. 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 of the S&P 500 has increased—making stocks more expensive—from about 17 times earnings to approximately 21 times earnings 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.
So, what should we make of this 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. Based on the S&P 500, 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. 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, along with a fair dose of humility, when charting an all-weather investment plan.
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Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. Learn more about us at thriventfunds.com and find other items of interest to you, the driven financial advisor. Bye for now.
All information and representations herein are as of February 15, 2022, unless otherwise noted.
Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
Past performance is not necessarily indicative of future results.
Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC, is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.