As shown in the graphics below, predictions of 7% consumer price inflation (CPI) have come true in the January 12th announcement of December data. We are at levels not seen since the 1980s. Even if this data is peaking, its influence will remain high. Recall that the Federal Reserve’s former target was 2%, so even if 7% proves short-lived, we will still be in hot territory for some time. Up to four interest rate hikes are now expected in 2022 alongside a more rapid run-off of the Fed’s balance sheet which promoted quantitative easing.
Consumer Price Index, Percent Change from a Year Ago
All items in U.S. city average
source: CNBC online
The Federal Reserve did what it had to do to get the economy through COVID, particularly in a time where other policy makers struggled to coordinate a response. Taking the artificial stimulants out of the market is now an appropriate and necessary move to contain inflation. The Fed is trying to engineer a soft landing but coming down from such a height (of stimulus, of market valuation, of inflation) without disruption to the stimulus-addicted stock and bond markets will be extremely difficult. The notion of “policy error” is often cited as what ultimately ends bull markets and causes recessions. In this case, it might not be fair to call the outcome of pandemic triage an error, but nonetheless, the risk of triggering a recession when attempting to stop inflation has certainly risen.
Market Outlook and Q4 Summary
Overall Asset Allocation
After a year of over 20% performance for US equities, we anticipate more volatility and less upside potential for 2022. We retain a general recommendation of a small overweight to equities, a larger underweight to bonds, and modestly overweight cash, with some of that cash reallocated into gold and diversified commodities.
The strategy of being overweight equities and underweight bonds served clients well in 2021 with a gap of over 20% between the two. We do not expect such a profound gap to play out in 2022. Equities are still more attractive than bonds on a relative basis, but equity valuations are a far cry from being outright attractive. There are a variety of statistics demonstrating this dynamic. One such example is the number of IPOs in 2021 (see chart below). Private companies do not generally come to market when they perceive valuations to be “cheap”. Fundamentals of quality companies remain strong, and there are arguments that equities are fairly valued, but there are fewer arguments that they are any sort of bargain on a macroeconomic level.
US VC Public Listing Activity
Source Pitchbook, as of Dec. 9, 2021
If we trim our stock allocation, the proceeds may be temporarily allocated to cash. Bonds are not (yet) an attractive offset to equity risk because one of the primary reasons for the stock market being at risk is that rates are rising (bond prices falling). A cash cushion protects and preserves capital while awaiting better entry points for risk assets. Fortunately, expected interest rate hikes should also finally put some small yield back into cash markets.
Q4 brought a final uptick in the market to close the year. With Omicron spreading rapidly, the mood clearly leveled off in the final week and has softened in the early days of 2022. US stocks again outperformed international with the S&P up 11% for Q4 and the MSCI All Country World ex-US up only 1.5%. Our overweight to US and underweight to international served client portfolios well.
Varied performance across industry sectors continued. Interestingly, the top performing sector for 2021 was not technology (despite being up 35%), but the top performers were energy (+54%) and real estate (+46%). Abundant liquidity and investor risk appetite helped all sectors with even the “worst” performer, utilities, up 18%.
Profit margins are high and stable, but we are closely monitoring earnings for any deterioration. There has also been less chatter about regulation and taxation. We expect both issues to revive in 2022, especially the regulatory, privacy and anti-trust angles facing technology and related internet businesses.
Bonds turned in a mixed but mostly down year for 2021. Overall, the bellwether Bloomberg Barclays Aggregate Bond Index was down 1.5% for the year. US Treasury bonds, especially in middle and longer maturities, were down 3-4%. Corporate bonds and other credit spread product also tended to outperform US Treasuries, which validated the positioning in most client portfolios. Municipal bonds fared better than Treasuries and were up slightly as dedicated taxable buyers crowded into the space and absorbed all supply. High yield bonds, the best barometer of credit risk appetite, were up 5% for the year.
We still recommend a standard holding to bonds, though at an underweight position to benchmarks due to real yields (the yield after subtracting the rate of inflation) still being deeply negative. However, despite their relatively low yields, bonds do serve as a flight-to-quality asset for the world during times of deep crisis. Also, though we are by no means rooting for a bond market pullback, we would welcome the opportunity to put more capital back to work at more attractive yields and have our shopping list ready.
Other Asset Classes
The Bloomberg broad commodities index was down slightly in Q4 but finished the full year at +27%. Some Q4 weakness, combined with an S&P 500 rally, saw commodities finish just behind the S&P 500 for the year. Commodities did strongly outperform bonds and cash, which were the primary funding source for creating our commodity positions. It will be very hard for commodities to replicate 2021 performance, but diversified commodity exposure remains appropriate to offset inflation risks and diversify beyond solely stocks and bonds. We continue to expand our research in non-traditional asset classes with work ongoing in areas such as timber, infrastructure and renewable energy.
As conditions have changed, we have done some rotating within our holdings and expect to do more. Depending on market conditions, we do adjust between growth and value stocks, US and international exposure, as well as stocks, bonds and other asset classes. In any case, we remain uncompromising in our approach that client portfolios are always best served by being predominantly in high-quality stocks and bonds for the long term, even if those characteristics temporarily fall out of favor.
The Fed remained patient hoping for an easing of inflation pressures that has not materialized. With supply still unable to meet demand in a variety of ways, the Fed now has no choice but to try to cool demand. The Fed has supported markets (and the banking system) in recent years by broadly assuming financial and market stability into its mandate. However, its true dual mandate does not explicitly include stock market support. When forced to choose, its primary mandate of price stability and full employment is supposed to carry the day, despite the consequences for markets and political pressures that come with market volatility. Should a recession and “hard landing” that impacts the job market or price stability ensue, then the course is reversed and so goes the business and economic cycle. In these regards, a recession might not be imminent, but we are likely getting into the later stages of the business/economic cycle.
Our expectation is that 2022 will see more volatility and fewer bargains. As always, there will be opportunities, but they are more likely to be longer term in nature. We will look to stick with quality, long-term holdings and stay patient while they compound and mature. Importantly, our orientation toward high quality companies should provide stability through the changing economic cycle. The instant gratification of 20+% returns on hyper growth stocks is likely behind us. It remains to be seen how a largely impatient “meme stock” investor set handles this changing environment and what it does to asset flows and short-term technical trading. Patience will be important.]]>
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