|Bloomberg US Agg Bond Index||0.01%||-1.54%|
The S&P 500 shrugged off its weakness from September to make new highs in Q4. The index finished the quarter up 11%, bringing its total return for 2021 to nearly 29%. Bonds were much more sluggish with the Bloomberg US Aggregate index essentially unchanged in Q4 and down more than 1.5% for the year. That marks a relatively rare loss for the bond index and its third lowest annual return since 1979.
Short term treasury yields rose significantly during the quarter. The 1 year US treasury yield rose from .08% to .39%, while the 5 year US treasury yield rose from .98% to 1.26%. Longer duration treasuries were essentially unchanged, leading to a flatter yield curve.
Heading into 2022 I think the most important trend for markets is the shift from economic tailwinds to headwinds. Fiscal and monetary stimulus formed a potent 1-2 punch in juicing the market and economy in 2021. That stimulus is going to be largely withdrawn in the years ahead, making it a much more challenging environment for markets.
For much of the decade leading up to the pandemic, monetary policy was carrying the torch for economic stimulus without much help from fiscal policy. That changed in a major way during the pandemic. However, most Covid related stimulus programs are now coming to an end. This will greatly reduce the stimulus money in consumers’ pockets. Everything from child tax credits to eviction moratoriums to student loan moratoriums look to be ending soon.
The table below shows the significant drop expected in fiscal stimulus:
2022 fiscal support may be nearly 50% lower than the aid provided in ‘21.
The Fed is currently on pace to end its quantitative easing program of asset purchases in March of this year. The majority of FOMC participants are also calling for 3 rate hikes this year (off of the existing rate of zero). The market is giving a 76% probability to 4 rate hikes in 2022.
Here’s a chart depicting the projected rate increases:
According to Goldman Sachs: “High inflation is likely to keep the Fed on a quarterly tightening path next year. We expect the FOMC to raise rates three times starting in March and to announce the start of balance sheet runoff, which is likely to proceed more quickly than last cycle. Our forecast calls for three additional hikes per year in 2023 and 2024 and a terminal rate of 2.5-2.75%.”
It’s been remarkably difficult for central banks to move off of zero bound interest rates and I think markets will once again find rate increases a tough pill to swallow. However, with the rise of inflation in the past year I think the Fed’s hands are tied. Even if markets sell off the Fed may be forced to keep tightening monetary conditions.
At the end of November, Fed Chairman Jerome Powell told Congress, “We tend to use [the word transitory] to mean that it won’t leave a permanent mark in the form of higher inflation. I think it’s probably a good time to retire that word.” When even the Fed is admitting inflation is a problem, you know we’ve got a significant issue (normally the Fed will minimize this as much as possible to try and calm investors and the public).
As the chart below shows, we’re hitting the highest levels of consumer price index inflation in decades:
Costs continue rising for everyday items and that trend does not seem likely to abate in the near future. The following chart shows the boom in food prices in both the US and Emerging Markets over the past year. Food cost inputs like fertilizers are skyrocketing. The last time food prices spiked like this it was a contributing factor to the Arab Spring. Soaring inflation (especially in the form of energy and food increases) breeds discontent. Just google the current upheaval occurring in Kazakhstan to see this playing out in real time.
The US market is in a really challenging position. Tailwinds from monetary and fiscal policy are turning into headwinds. Inflation is eating into consumers’ pocketbooks and standards of living. Meanwhile, the US stock market is priced for perfection with a valuation level that is at or near all time highs.
There are already signs that the market could be topping. Market breadth has been very poor of late as fewer stocks participated in Q4’s strong performance. Some of the frothiest portions of the market have begun unwinding. ARKK, Cathie Wood’s ARK innovation ETF, is down more than 45% in just under a year. Early covid darling Peloton is down more than 80% in the same timeframe.
It’ll be interesting to see how the market deals with this challenging environment. The combination of extreme valuation and economic headwinds sets the market up for a high risk of a major sell off. On the other hand, markets are unpredictable and generally take longer to move to the downside than most skeptical investors would expect. If the US market remains elevated I think we’ll see the yield curve continue to flatten and eventually invert in the next couple years (a common warning sign of a recession in the past).
Regardless of what happens in the immediate future, I once again believe that the only prudent course of action for investors in this climate is to take a cautious approach in their portfolio.
Scott Caufield, CFA, CPA