The fourth quarter of 2021 ended on a positive note after mixed performance in late November and much of December. The quarter opened strongly as markets rebounded from late summer/early fall shutdowns sparked by the Covid-19 Delta variant and moved higher across the board through early November. Most domestic equity benchmarks reached new all-time highs during the first week of November then meandered in a dull, low volume drift until the Omicron Covid variant startled investors at Thanksgiving.
Sharp selloffs and general weakness continued into early December before realization that the new mutation was less threatening than previous iterations, albeit far more contagious, regardless of immunity from either existing inoculation regimens or previous infection.
Seasonal market strength around Christmas largely persisted through year end with a few popular indexes scoring new highs amid persistent weakness in the small cap and value sectors. Quarterly results were widely mixed but failed to counter strong YTD gains as many indexes finished near annual highs. Performance of global equity benchmarks for the periods indicated are shown below.
US economic activity continued strong over the past three months with only persistent inflation clouding consumers’ outlook. Retail sales and overall private sector spending remain in strong uptrends and more than $5 trillion is parked in money market funds as of November 30.1 Consumer sentiment remains strong.2
We believe two central factors could either reinforce inflation or mitigate it in the coming quarters. The November JOLTS data shows 10.6 million jobs remain unfilled. Additionally, the report indicates 4.6 million workers quit current jobs many likely seeking higher paying positions, the sign of a robust, expanding economy and labor market.3
Annual wage gains have been reported at better than 4% for several months but are not keeping pace with rising prices and companies are readily acceding to worker demands for higher compensation to maintain living standards. Should this trend continue, it will prolong and possibly increase the rate of inflation.
There is little reason to expect a spiral of higher prices spurring wage increases to reverse without either material increases in worker productivity or more unemployed returning to work but another problem is government actions during 2021 that have produced energy supply constraints while demand surges, which is the underlying impetus for pricing pressures in virtually all sectors of the economy.
The Fed holds the short term key to reining in inflation, but only if it takes steps to diminish money stock growth. After nearly two years purchasing roughly $150 billion of bonds and mortgage backed securities monthly, the FOMC has now concluded It is time to cease stimulating.
The question, which cannot be answered in advance, however, is whether the central bankers have waited too long to move and will face intractable price uptrends that can only be reversed by far more draconian measures than currently (publicly) contemplated.
Just as the country underwent the Modern Monetary Theory experiment in 2021 (unrestrained deficit spending), we now embark on another experiment that will determine whether the Fed can effectively wring inflation from the economy without overreacting and precipitating an unmanageable slowdown. Can the Fed orchestrate a “Goldilocks” scenario?
Any effort to control spending and debt growth must begin with reducing or eliminating borrowing. Whether the Fed is willing to inflict pain in an election year by initiating meaningful money growth slowing remains a huge question.
Chairman Powell and his colleagues have myriad tools available to forestall economic overheating but the most visible is the level and trend of interest rates. Minutes from the FOMC’s December meeting show that the Committee’s inclination is to begin increasing short term rates sooner than suggested in Chairman Powell’s news conference in mid-December.4
Credit markets are taking the Fed at its word. The uptrend in all Treasury maturities that began in late December has propelled yields to within striking distance of or above last summer’s highs. The present plan in place is three rate hikes in 0.25% steps during 2022.5 Opinions among bond market observers split on whether this course is appropriate or insufficiently aggressive.
“Hawks” are exhorting the Fed to increase the Fed Funds rate in .50% increments and to begin sooner than March. We suspect that with mid-term elections less than 10 months ahead, Mr. Powell will be cognizant of the potential for electoral impact if policymakers take this route, but another inflation surge could push the Committee onto this course involuntarily.
“Doves” believe that inflationary pressures from supply shortages will diminish without more rapid Fed tightening. We point to the developing wage/price spiral noted above, which may prove more persistent than anticipated given data in the November JOLTS report.7
What is abundantly clear is that interest rates will be moving higher for the foreseeable future, barring an unexpected event negatively impacting economic activity. The US Treasury yield curves on September 30, 2021, December 31, 2021, and January 6, 2022, are illustrated below.
Source: Quotestream online quotation platform, www.quotemedia.com
We have added the Treasury’s two-year note to the curves. Until last September, this instrument had essentially mimicked the 3-month Bill’s rate but since, has begun to rise along with other maturities, reflecting anticipated Fed policy changes.
Additionally, while the main takeaway from the above chart is the strong upturns at short and intermediate maturities over the past three months, we now see the first uptick in 3-month rates since Spring 2020.
Why is this important?
In real terms, yields remain negative at all maturities on the curve, i.e., the nominal rate minus roughly 6% annual inflation. This configuration is highly stimulative. If Fed Chairman Powell’s expectations are met, a controlled increase in borrowing costs coupled with contraction of new money creation will act as a brake on demand and afford supply breathing room to “catch up.”
It’s a delicate balancing act. Too heavy a hand, hiking rates too much, too quickly, could turn expansion into stagnation as credit becomes tighter. On the other hand, too timid a response would allow inflationary pressures to remain unchecked, setting the stage for 1970s style “stagflation”.
Only time will tell, but in our view, the Fed must begin to reliquefy its balance sheet by ending bond purchases and beginning a program to reduce asset holdings. The trick will be to diminish the rate of money supply growth sufficiently to retard inflation without slowing the economy too rapidly, tipping the country into recession.
Investors enjoyed an unusually prosperous 2021 with few tax changes and for most, sufficient liquid resources to maintain consumption. With new government direct payments off the table because of an impasse in the Senate over President Biden’s Build Back Better legislation, the unemployed are becoming impelled to reenter the job market, which has the potential to augment productivity increases.
Corporate earnings for the first and second quarters of this year will continue to expand, but comparisons to 2021 results will not be as eye-popping as those of 2021 to 2020’s depressed numbers. Regardless, markets will effectively and efficiently digest upcoming political and economic developments, including inflation trends and interest rates. Bond yields may rise significantly during 2022 but equities will likely remain the best game in town for investors seeking long term returns that outpace inflation’s impact on purchasing power.
1 “U.S. Money Market Fund Monitor,” www.financialresearch.gov, data as of November 31, 2021. 2 “Consumer Confidence Improved Again in December,” www.conference-board.org, December 22, 2021. 3 “Job Openings and Labor Turnover Survey,” www.bls.gov, January 4, 2022. 4 “Fed Minutes Point to Possible Rate Increase in March,” www.wsj.com, January 5, 2022. 5 Ibid. 6 Op. Cit., www.bls.gov.
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