“Until I know this sure uncertainty…”
Shakespeare, The Comedy of Errors
While we languished through a second year of pandemic, markets, despite no shortage of uncertainty, were anything but languid in 2021. Ambiguity and crosscurrents always surround markets and the economy, but uncertainty and paradox loom especially large as we enter 2022 with stock indexes near all-time highs. Consider:
- The virus: Omicron variant is now dominant here and new US cases have soared well past prior weekly record highs for the pandemic despite 73% of US adults being “fully vaccinated” and nearly half of those being “boosted.”
- Inflation: The latest year-over-year consumer price inflation was 6.8%, the highest in 39 years. Yet, the yield on the 10-year Treasury Note as this is written is only 1.6%, which is 5.2% less than inflation! This negative 5.2% gap - the “real yield” – measures the after-inflation yield on Treasury paper and hasn’t been this negative since the mid-seventies when it signaled distress for financial markets, preceding a bear market in stocks.
- Sentiment: Corporate insiders have been selling in droves, yet corporate earnings have been hitting records highs. The unemployment rate remains 0.7% above pre-COVID levels, yet there are nearly 4 million more unfilled jobs than there are unemployed Americans. By some measures, consumer confidence is plummeting, yet Americans are leaving jobs to seek new ones at a record pace.
- Geopolitical Tensions: Russia is openly speaking of a potential land grab in the Ukraine. China is increasingly aggressive toward Taiwan and in the South China Sea generally. And Iran has moved closer to possessing nuclear capability.
- Monetary Policy: Federal Reserve policy is in transition from “very accommodate” to “less accommodative” while expectations rise about a shift to “somewhat restrictive” as early as mid- to late-2022. The Fed primarily manages only short-term interest rates directly. Yet, as of this writing, T-Bill rates are 0.053% which is lower than their level this time last year and, like longer rates, well below current inflation.
In all, it’s enough to make your head spin. But it hasn’t been enough (so far) to sink soaring stock markets. Large US stocks hit new record highs toward the end of the year, and the Russell 3000 US stock index soared 25.7% in 2021. Small stocks lagged as the Russell 2000 index was up “only” 14.8% for the year. Non-US stocks gained less, up 7.8% in 2021 (which includes a 2.5% loss in emerging markets for the year). The blended stock index, accounting for stocks large and small, US and international, returned 20.6% in 2021 as earnings surged more. Last year’s best sectors included both the prior year’s winner, Technology, and its losers, Energy and Real Estate. Real Estate Investment Trusts (REITs) were up 41%. The leading bond index posted slight declines for 2021 – its first loss for a year since 2013 - but most municipal bonds and lower quality taxable bonds managed modest gains as a strong economy rewarded taking credit risk. Treasury Inflation-Indexed bonds were the standout performers among bonds, with returns of 6% for the year.
Looking ahead, even at this bleakest moment in the pandemic in terms of new cases, there is growing evidence the Omicron variant may be less lethal than Delta. Moreover, anti-viral treatments from Pfizer and Merck have just been approved and should be available in good supply within weeks. In addition, both South Africa and the UK, which each preceded the US in their Omicron surge, have in the last week seen their new case surge roll over and decline as deaths remained relatively low or even declined in recent weeks. With better therapeutics, more vaccinations and booster shots, and with wider natural immunity, we are collectively getting stronger in our fight against this virus even as it has apparently taken a milder turn in more widespread infection. There are solid reasons now to look ahead with measured optimism on the health front even as current headlines grow more dire.
Economic growth is booming. However, inflation remains a looming question, and the Federal Reserve, which had formerly labeled the price surge “transitory,” recently removed that word from its communication, implying more concern about inflation as a longer-lasting problem. “Owner’s equivalent rent” represents nearly a fourth of the Consumer Price Index (CPI) and the 6- to 12-month lags built into the convoluted calculation of this part of consumer inflation means home price jumps which have already occurred are likely to boost inflation readings for several months to come. On the other hand, widely noted supply chain problems will likely be addressed sooner or later and should provide some inflation relief in 2022 as supply and demand imbalances abate.
We had $3 Trillion of specific, COVID-related stimulus in 2020 and another $1.9 Trillion in 2021, but additional stimulus beyond the already large and growing federal budget deficit now looks less likely in 2022. Federal deficit spending was funded by borrowing, which was accommodated by money growth from the Federal Reserve.
That stocks generally did as well as they did in 2021 in the face of large, and in many cases, growing uncertainties is evidence of the Fed’s immense power of money creation. Valuations drive stock returns in the long term more than most people understand. But in the short term, markets are most often dominated by the Fed. And now, the Fed’s long-anticipated “taper” is upon us, implying monetary policy remains constructive for markets but materially less so than it was for each of the past two years. Moreover, a shift to headwinds from the Fed is increasingly likely to begin later in 2022.
This collectively implies a likelihood of rougher sailing for markets this year. Investors are often tempted by the siren song of market timing, especially during heightened market volatility. But the likely whipsaws resulting from current extraordinary levels of uncertainty could make market timing even more challenging to employ in 2022 than normally (and in “normal” conditions, it is too difficult to attempt). Instead, we take comfort in the size of attractive market opportunities currently afforded: small stocks, “cheap” stocks, and non-US stocks are priced at unusually appealing valuations both relative to large growth stocks and absolutely in the context of current low interest rates. For tax-bound clients, in early 2022, we will look to batten down the hatches by utilizing the capital gain flexibility of the new tax year to both reduce equity allocations that have grown past targets and to reposition portfolios by trimming some technology stock positions and other recent winners in favor of much cheaper value stocks, small stocks, and non-US stocks whose relative valuations are at their most attractive levels in many years.