2021: Strong Markets, Economic Growth, Fed Action, & Enduring Inflation
Overall, equity markets delivered strong returns in 2021, while bonds, pressured by higher inflation and expectations for higher interest rates, flagged during the year. Please refer to the attached “Q4 Market Review for data on how investment asset classes performed in 2021.
We entered 2021 with an optimistic market outlook. With vaccines widely available and improved therapeutics becoming available, it appeared the worst of the pandemic was behind us. The economy expanded throughout the year, and labor markets made continual progress. Despite the Delta wave, the equity markets kept the uptrend intact, still supported by the liquidity delivered to offset the pandemic’s economic impact. The massive liquidity, combined with supply chain challenges, produced hotter and more persistent inflation than anticipated by the Fed.
December brought two significant developments for the economy and the markets – the spread of the Omicron variant and a hawkish pivot by the Federal Reserve to contract monetary policy faster than previously stated. The market mostly took it all in stride, and Santa came through with a rally the last two weeks of the year, propelling major stock indexes to, or near, all-time highs.
The abundant money supply (aka liquidity) in the economic system was a driving economic and market force in 2021 and will continue to fuel the economy in 2022. The graphic below charts the M2 money supply from the 1980s through November 2021. (1) The sharp increase beginning in 2020 illustrates the historically high amount of money injected into the economy. The 2020 – 2021 rise in M2 makes the M2 increase of the 2008 Great Financial Crisis (GFC) appear as a mere pittance.
The Fed has two fundamental mandates: full employment and stable prices. In 2020, the Fed went all-in on monetary stimulus and relaxed its stable price target by signaling a willingness to let inflation run higher than its 2% trend inflation target. The rationale was to avoid nipping a nascent economic recovery in the bud, especially with the uncertain direction of the pandemic. In 2021, even with significant tightening in the labor markets, the Fed doggedly insisted on evidence of “significant progress” towards full employment before taking its foot off the gas.
To get a feel for how the Fed’s policy stance evolved over 2021, consider the Fed’s signaling during the year. In April, Federal Reserve Chair Powell said the central bank was “not thinking about thinking about” withdrawing monetary accommodation. Powell and the Fed committee removed “transitory” from their lexicon to describe their inflation expectations by December. In addition, they doubled the speed for reducing bond and mortgage purchases, pacing Fed buying to be done by the end of March 2022. Also, the committee’s consensus September forecast of zero 2022 rate hikes jumped in their December forecast to an anticipated three rate hikes in 2022.
In his “Closing Thoughts on 2021”, Jeremey Seigel reiterated his expectations that the Fed Funds rate will be more than 2% before the end of 2022, which significantly differs from the Fed committee’s outlook and is very likely not priced in by the market.
In Siegel’s words, “But the Fed stance can change quickly. Just three months ago, the September dot plot revealed that not even half of the Fed participants expected one rate hike in 2022. Those participants changed their views quickly and now have a median expectation of three hikes in 2022—one of the fastest pivots I have ever seen. This will continue to move higher by our next dot plot in March, but their action shows how far behind the curve the Fed is.”
2022: Moving from Pandemic to Endemic with a Growing Economy fueled by an Abundant Supply of Money
We enter 2022 guardedly optimistic. Optimistic because the pandemic appears to be entering an endemic state. The highly contagious Omicron variant is yielding milder symptoms and less lethality. The speed with which Omicron spreads may disrupt economic activity in the first quarter, but will our populace benefit from Omicron antibodies effective against other variants? I am hopeful this is the threshold of the post-pandemic era.
In 2022 COVID will likely relinquish the newsfeed’s center stage to inflation, interest rates, and the Fed. The labor markets are tight, inflation is hotter than desired, and the Federal Reserve has kicked off a reversal in its accommodative monetary policy. Thus, the Fed will continue to play a significant role in the economy and investment markets throughout 2022.
Froth vs. Investment Fundamentals
Though the 2021 headline market results are strong, the market’s internals reveals a divergence of returns and valuations for different sectors and equity styles. We see a fundamental divergence as speculative and highly valued styles get pressured from increasing interest rates. High multiple stocks are more vulnerable to price hits as interest rates go up. This assertion is based upon simple financial arithmetic known as the discounted cash flow (DCF), a method of estimating the present value of a stock.
There are two primary factors to DCF stock valuation. First, what are the company’s anticipated future financial operating results, and when are those results (cash flows) expected to occur? Secondly, at what rate will the future cash flows be discounted back to a present value. The higher the discount rate, the lower the present value, and vice versa.
Gene Munster of Loup Ventures cautioned fellow tech investors to brace themselves for the risk of higher rates to highly valued stocks. Munster quantified the risk by citing that a 1% increase in the Federal Reserve Funds Rate equates to a reduction in the valuation of a highly-valued company of 10 – 20%. The higher the valuation, the more significant the impact.
We believe that investors will gravitate away from highly valued equities and towards quality stocks of companies with more certain, nearer-term cash flows, solid balance sheets, and growing dividends. This rotation appears to be underway, and the forces beneath it will likely continue throughout 2022.
Even with higher interest rates, the prospects for the economy and markets are good. Overall, consumer and corporate balance sheets are strong, and their credit is good. Financial institutions will gladly lend to them, which is part of a growing economy’s virtuous cycle. An increase in bank lending should translate to even more of an expansion of the country’s money supply. This dynamic is called a money supply multiplier, which may be a compounding factor supporting continued, economic growth in 2022.
You may remember the “multiplier effect” if you took Econ 101. The effect occurs when banks lend money out. That money has been deposited with another institution that in turn lends against that deposit, and so on. The size of the multiplier depends on the percentage of deposits that banks are required to hold as reserves. The reserve requirement is another tool available to monetary authorities to tighten and loosen credit; when the reserve requirement decreases, the money supply reserve multiplier increases and vice versa.
Before the pandemic, the Fed reserves requirement for institutions with more than $127.5 million of reserves was 10% of total deposits. However, the Fed reduced the required reserve ratio to 0% as part of its pandemic economy response to add liquidity.
Financial institutions are in good shape, and their corporate and consumer borrowers are not overleveraged. Both have paid down debt and built-up cash reserves. Bank loan growth has been mostly flat, but a growing economy will likely increase demand for loans. Analysts point to better spreads on loan interest charges and deposit interest paid and loan growth for the financial sector.
The economy will continue to be fueled by the M2 money supply and the virtuous cycle a growing economy creates. Corporate earnings have been very good, and the outlook for cap-ex is strong. These factors make us optimistic that the economic reopening and expansion have room to run, which bodes well for investors over the next 3 to 5 years.
The past 18 months have delivered good returns for equity investors with a relatively smooth ride. We are guarded because there is complacency, froth in corners of the market, and federal policy changes underway that could result in volatility and market corrections. Investor complacency can be recognized in the shrinking spread between investment-grade bonds and high-yield bonds and the declining VIX (the CBOE volatility index). It is not a stretch to believe that investors that have enjoyed 20 months of great returns with no significant corrections could be overconfident.
By froth, we mean crypto, SPACS, meme stocks & highly valued growth stocks where prices defy the gravity of fundamental valuation have begun to simmer. Some investors appear to be oblivious to fundamental valuation and buy because prices are increasing. Buying begetting buying is not new, but neither is selling begetting more selling when the mood changes! Furthermore, the Federal Reserve’s hand can be forced to close the liquidity spigot faster than the market expects. A hot labor report with higher-than-expected wage inflation could spark fear that the low rates beneath the bull market could rapidly fade.
This guardedly optimistic viewpoint, accompanied by patience, is expressed in our portfolio allocations. We believe bonds will continue to face stiff headwinds and therefore have a reduced allocation to bonds. For the bonds we do hold, we have focused on credit, short-term, and inflation-protected bonds. Equities have historically done well in growing, inflationary economic times. Thus, we currently maintain a full stock allocation given a client’s risk tolerance. We use alternative investments that target mid to upper single-digit returns with lower correlation to stocks. And finally, we hold a modest amount of extra cash so that we have dry powder to patiently wait for corrections that may offer more compelling buy points.
In addition, we believe it is advisable to up weight U.S. stocks over many international stocks, especially from regions that have export-reliant economies. The forces of deglobalization are significant and more exacerbated by the pandemic.
On January 5, as we are finalizing our commentary for distribution, the Federal Reserve released the minutes of its December meeting. A revelation that caught the market by surprise was the Fed committee spending significant time discussing reducing its bond holdings in 2022. The Federal Reserve has been a big buyer of bonds and mortgages since the onset of the pandemic. The Fed has committed to accelerating its “taper” of bond and mortgage purchases in recent prior meetings. In addition, they have signaled three to four increases in the federal funds rate throughout 2022. The new development is the Fed’s focus on “running off its balance sheet” – becoming a seller of bonds and mortgages. When the Fed holds a bond or mortgage that matures, it takes the cash rather than buying a replacement bond or mortgage, reducing its balance sheet. The Federal Reserve unwinding its massive balance sheet is a significant development not anticipated by the market. On this news, equity markets sold off, especially the highly valued sectors of the market we described as “frothy.”
The sentence in the meeting minutes which caught market participants by surprise reads, “Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate.” The reasoning behind the moves is to respond to higher and more persistent inflation than the Fed had anticipated, which bodes for higher interest rates, including mortgage rates.
Returning to normal monetary policy after the extraordinary events and massive support the federal government put in place to address the crisis is not necessarily a bad thing. However, policy changes’ implementation, timing, and communication can create havoc or opportunities, depending upon your perspective.
When corrections might occur is uncertain, but prior episodes of economic surprises and changing Federal Reserve policy actions have delivered correction triggering markets surprises. The Fed is not the only factor, but when combined with high valuations, investor complacency, and frothiness in corners of the market, it feels like the market could be treading upon fertile ground for a correction.
It is challenging to determine “why” the market does what it does. There are always risks to an investment outlook, some known, many unknown. Rather than obsess over what we cannot control, we will continue to focus on what we can control. Specifically, we will remain committed to investment strategies that are first informed by our client’s financial plans and unique investment profiles, as well as portfolios that are well-diversified, cost-effective, and tax-conscious. Thus, we focus on a longer time horizon to smooth the market’s short-term gyration and make tactical tilts to add value at the margins.
A new year brings a sense of possibility and excitement. It is a time to check in and recalibrate goals. It is an ideal time for us to check in with clients to review the prior year’s results and plan for the new year and what follows! Your year-end portfolio reports have been deposited in your eMoney vault, and we will be reaching out to you to offer times and availability, or you may self-schedule here to pick a convenient time for you.
We are grateful for the trust you placed in us throughout 2021 and are excited about what a new year will bring for you and yours. We look forward to connecting soon!
Thank you!
Tim
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- M2 is the sum of liquid funds available for consumption and investment. M2 is a measure of liquidity in the economy. The St. Louis Fed defines M2 as a measure of the U.S. money stock that includes M1 (currency and coins held by the non-bank public, checkable deposits, and travelers’ checks) plus savings deposits (including money market deposit accounts), small-time deposits under $100,000, and shares in retail money market mutual funds.
- Factset, Earnings Insight. Page 2. December 17, 2021
This material contains an assessment of the market and economic environment at a specific point in time and is not intended
to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and
uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied.
Information is based on data gathered from what we believe are reliable sources.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra
Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to
provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial
professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance
are not intended to be forward looking and should not be viewed as an aindication of future results.
