Economic Monitor: Is the Band Still Playing?
BY: Mark Drachenberg
Last year was a great one for investors, but once turned the calendar to 2022, BOOM!, we got hit with the one-two punch of inflation-driven volatility and news of the Fed’s apparent plan to raise interest rates faster and higher than expected. The lightning-fast evaporation of 2021's gains has left many wondering if we're on the Titanic, and the band is playing its last song (purported to be "Nearer, My God, to Thee" – an apt choice, if that really was what they were playing) before the ship sinks completely below the surface.
Is the market on its way to bear territory? Is this just an interlude in a longer growth cycle? Or are the averages just catching up to us? Only time will tell, of course. Let’s take a look at the month that was before turning our gaze to the horizon.
This was not the start to the New Year anyone hoped for. After peaking on January 3rd, the markets, like snowbirds, headed south. While none of the major indices we follow ended the month in correction territory (a decline of 10% or more), all either hit that point or came close at some point during the month. In fact, some sectors (e.g., risky tech) crossed the bear market threshold, declining 20% or more.
While we were overdue for a correction, the speed with which this one occurred surprised many. Typically, we see a 5% correction once every 10 weeks (we're there now), a 10% correction once every 34 weeks (it's been over 90 weeks), and a bear market once every 143 weeks (also over 90 weeks). Clearly, we were/are due, if for no other reason than to remove the froth, setting the stage for the markets to move higher.
Fear over inflation, and the Fed’s reaction to it, drove the markets during January, and may for the rest of the year. Higher interest rates hurt equities, especially those with higher growth rates (again, tech). As the discount rate used to value stocks rises, it results in a lower valuation today. Stocks with lower growth rates (e.g., value stocks, higher dividend payers) don’t feel the effect of higher rates as strongly and, therefore, their share price doesn’t get beat up as much. Bonds also get hit when rates move higher, as prices (generally) move at an inverse to interest rates. With some economists now pricing in as many as five rate hikes this year (up from three), it's easy to see why investors are spooked.
For the month, the major equity indices, including the EAFE, all finished between -3% and -9%, and the Bloomberg US Aggregate Bond index fell 2.15%. The VIX Index is a measure of market volatility, and for much of 2021, it traded below 20, meaning the markets were generally calm. That changed in January, as the VIX traded above 20 for much of the month, and above 30 for January's second half. This means the market went from being relatively calm to highly volatile (some might say panicky) in a month. It's interesting to study what the annualized six-month forward return is when the VIX is above or below a certain level. At a VIX above 30, the median six-month annualized forward return is 36.8% (as of month-end August 2021); when it's below 30, it's a paltry 12.7%. This is because, when the VIX reaches extreme highs, it means the market may have sold off, and the potential, then, for higher rates of growth exists.
As noted last month, in some shape or form, the economy continues to be impacted by Covid. While many areas improved dramatically in 2021, the recovery that seemed so strong a year ago has slowed, due to the Delta and Omicron variants, inflation, and more.
- Gross Domestic Product (GDP): The overall measure of our nation’s economy slowed during 2021, but still finished the year at almost 6%. Expectations for 2022 vary greatly and depend upon progress made against the virus, actions taken by the Fed, economic policies from Washington, and more. Current estimates put the figure between 2.5% and 5%, with most below 4%, which is a reduction from last month’s estimates. This is not surprising, as it was/is expected that the economy would eventually revert to pre-COVID levels of activity, resulting in GDP gains of 2% to 2.5% per year.
- Inflation: Many factors have impacted inflation and caused it to be stickier than originally thought. Food and energy prices have garnered much of the attention, but costs for most goods and services have risen above expectations, due to supply-chain problems and worker shortages, among other things. The rate of inflation peaked at around 7%, which is the highest rate seen since the Reagan era. The good news is, most economists are forecasting a slower rate of inflation in 2022 and beyond, as the negative pressures gradually ease. By the end of 2022, expectations are that inflation may be between 2.5% and 3.5%, with further softening in 2023. Even so, the impact on the economy is enormous and is being felt by everyone.
- Unemployment: The job picture is a cloudy one. Though the unemployment rate has fallen to 3.9%, the participation rate is also much lower than pre-Covid levels, meaning that fewer people are looking for work. While the job participation rate has been declining for several years, with many Baby Boomers retiring early, the rate dropped especially quickly over the past two years, causing hiring shortages. Those shortages can lead to higher wages and, potentially, higher inflation. Less evident to the naked eye is that this can impact our nation’s productivity and, therefore, GDP. Part of the reason for the slower growth we experienced pre-Covid, and that we'll likely experience going forward, is due to lower productivity. Over time, however, don’t be surprised to see some of those who elected to retire early during the pandemic rejoin the workforce.
- Other: Taxes and other government-related issues seem to be on the backburner right now, as congressional talks have either stalled or ended on some of the Biden Administration's major economic legislative pieces. Having said that, these things are worth keeping an eye on, particularly with the mid-term elections this year.
The Fed is in the crosshairs of just about every investor, economist, banker, and politician right now, as it tries to steer the economy through the issues described above. It’s all about inflation. The Fed is expected to raise rates as many as five times this year, and effectively raise them further by shrinking its balance sheet.
The first hike is anticipated for March, and while a quarter-point increase is expected, don’t be surprised if the Fed starts this cycle by raising rates 50 basis points. This larger hike may surprise the markets, increasing volatility, at least in the short run. A big concern of the Fed’s is to not invert the yield curve (meaning long-term rates lower than short-term rates), which typically is a harbinger of a recession. This is something to keep an eye on and is why the Fed may not raise rates as high or fast as some predict.
Normally, rising rates can be bad for stocks, but with real rates still quite low even after expected hikes, equities should post a solid year of gains, barring any Fed missteps.
There’s a notion that implies that markets will perform for the year as January does. If that holds true, 2022 will not be a good year, and we might start hearing strains of "Nearer, My God, to Thee" playing in the background. Fortunately, the economy is strong, some of the issues affecting inflation are likely to ease (e.g., supply chains), and Covid-related problems should also lessen over time. What is true, though, is that inflation is an issue, and the Fed will be dealing with it. What the Fed does, and how the economy reacts, will be important to watch, and will impact investor behavior.
The rotation from growth to value stocks will likely continue, and the potential for international stocks to outperform has risen. Stocks with strong balance sheets, stable/growing earnings, and solid dividends should hold up better than their more speculative counterparts. As I stated last month, I have read multiple forecasts and it seems like each one points to a different strategy as to how to invest; some say small-caps, some large-caps, some value, some international. Usually there is a consensus, but not this year. A balanced, and diversified, approach towards asset selection will likely be a winning strategy this year. Utilizing hedged equity products will also be a prudent strategy, as we face increased volatility this year.