Market Commentary - December 2021

Monthly Update

Thanks to a four day Christmas time rally (three days before and one day after the holiday), the S&P 500 ended December up 4.4% and ended the year up 27% before considering dividends[1]. It was another impressive year after the 16% rally in 2020 and 29% surge in 2019[2]. It was like Covid never happened in terms of its market impact. That is partly because of the outsized contributions of the biggest market cap stocks, which now dominate the indices, and whose businesses powered through the virus. According to the WSJ on December 21^st citing Goldman Sachs, “Five of the biggest stocks in the S&P 500 [Microsoft, NVIDIA, Apple, Alphabet and Tesla] account for more than half of the broad benchmark’s gain since April.” Also, these five stocks “are responsible for around one third” of the entire year’s gain.

This performance also helped the NASDAQ rally by 21% in 2021, and by .7% in December[3]. Reflecting some divergence in the broader market, the small cap Russell 2000 ended 2021 higher by a more modest 13.7%, and by 2.1% in December[4]. Also diverging were markets outside the US. The MSCI ex-US index ended 2021 up just 5.5% before dividends, and again lagged US markets[5].

The notable macro event in December was the Federal Reserve meeting mid-month, where they confirmed that the pace of cutting back on expanding their balance sheet would double and would end in March. Shortly after that ends, we have the possibility of rate hikes as the Fed’s ‘dot plot’ has three of them expected in 2022. In response, the yield curve flattened in with the spread between the 2 yr and the 10 yr Treasury yield compressing to 77 basis points, from 87 in November, and vs 105 in October[6]. That is around the narrowest since December 2020. The spread between the 5 yr yield and the 30 yr yield is about the tightest since March 2020 at around 60 basis points. Typically, the yield curve flattens when the Fed tightens monetary policy on the assumption that growth will inevitably slow in response.

Corporate bonds were mixed in December. Investment grade sold off while high yield rallied. The yield on the Barclays US investment grade index rose to 1.75% from 1.68%[7]. The yield in the Barclays high yield index in contrast fell to 4.2% from 4.80% at the end of November[8]. With yields this low, though, they really should not be considered ‘high yield.’ Investment grade bonds mostly followed Treasury yields in the month, while high yield bonds mimicked the behavior in stocks.

As we look to market action and the economy in 2022, I remain of the belief that much will depend on the extent of monetary tightening that we see. As of now, the Fed plans on ending a $1.44 Trillion quantitative easing program in the next three months with likely rate hikes to follow. For context, this program is double the size of QE1 and QE2 combined, and 40% more than QE3. We will also see tightening from many other central banks around the world. As there has been a tight link between market behavior and central bank actions, this is our key focus. Inflation is the main theme that central banks are responding to, and it is something I have been talking about all throughout 2021. I do expect the rate of change on inflation to moderate in 2022 to 3-4%, but that is still well above its pre Covid trend of between 1-2%.

Central Banks & Inflation

Above I laid out what the Federal Reserve is planning to do in 2022, but I also want to point out that they are not the only one that is beginning the process of taking away some of the extraordinary easing we saw in 2020. In December, the Bank of England both ended its QE program, as expected, and raised interest rates by 15 basis points to .25%[9]. While in the face of a consumer price index print for November at 5.1%, this still microscopic yield will most likely continue to shift higher in 2022.

Also in December, the European Central Bank said their Pandemic Emergency Purchase Program, put in place in March 2020, will officially end in March 2022. However, they will mitigate the impact by partially increasing the size of their other asset purchase program. The net result will still be a reduction in the pace of bond purchases. A rate hike from the ECB will most likely be a 2023 event, if at all. The Reserve Bank of Australia might end its QE program in coming months and the Bank of Canada, who is already done with QE, will be debating rate hikes in 2022 as well. The other major developed central bank, the Bank of Japan, will be the last to shift policy.

Many other central banks in emerging markets have already begun the process of hiking rates, and will continue to do so in 2022. They are usually more responsive to higher inflation because of their bad experiences. The only central bank going in the opposite direction is the Turkish central bank, but that is a whole other conversation.

There are two main reasons for this shift. One is the higher rate of inflation we are seeing globally, and the hope that we are in the last leg of Covid with the omicron variant, at least in terms of its ability to disrupt our lives. We have clearly seen the benefits of vaccination and natural immunity in keeping people out of the hospital, and from dying, from what seems to be a less dangerous variant.

Stocks, Bonds, Valuations, and the Economy 

I cite what central banks are likely to do in 2022, as it has a direct influence on the pricing of risk assets. If there is a lesson learned with hindsight over many years, it is that valuation multiples expand when the Fed is easing, and they contract when they tighten. If this trend holds, it means it is important for earnings and cash flow to power through this as an offset.

I will take this a step further, because how markets respond to this shift in monetary policy will also impact the economy. High asset prices have helped the economy, as it helps to boost higher income spending, and the rise in the equity in one’s home encourages investment in, and cash withdrawal, from that house.

What we have now, though, is both asset price inflation along with consumer price inflation. And while the former might be a boost to the economy, the latter is a drag. It is a particular drag if higher wages do not offset that rise in the cost of living, which it is not, at the moment.

Aggressive home price gains in 2021 which saw home prices rise 20% y/o/y at the peak are now resulting in buyers getting sticker shock and pausing[10]. They are renting instead, but unfortunately rental prices through November are up 17.8% year to date according to the latest Apartment List National report.

We have also seen a very sharp increase in the price of both new and used cars, and that is making them more unaffordable. According to J.D. Power, the average price of a new automobile rose to $44,427, up 17% y/o/y. According to Manheim, the average price of a used car is up 49% y/o/y as of December, and up 70% since December 2019.

Inflation and Wages

I highlighted the two most expensive items that a typical person and/or household would buy, but the broad consumer price index saw a still robust 6.8% increase in November, with a 4.9% gain excluding fuel and energy[11]. This compares with wage growth that is running higher by about 4.5%[12]. Thus, on an after inflation basis, consumers are falling behind. This said, I am confident that leverage has shifted to employees from employers and wage gains should continue to catch up. The risk is that the rise in labor costs will not be fully offset by faster productivity gains and companies continue to raise prices. This would further increase inflation and, in turn, pressure employees to want quicker wage gains. This is what is referred to as a wage price spiral like we saw in the 1970’s. We will be monitoring this closely in 2022.

US Fiscal Support and China

I am including these two separate influences on economic activity under the same headline, because they will be an important influence on growth this year. The US government spent about $5 Trillion in 2020 and 2021 in special spending packages in response to Covid, and nothing of the sort will be repeated in 2022. Ahead of the midterm elections in November, I am sure the Democratic control of Congress and the presidency will result in more government spending. However, the rate of change will definitely slow dramatically, and thus will impact consumer wallets, who were a main beneficiary of a lot of this spending.

China will also be a key factor in the direction of global growth as the world’s 2^nd biggest economy. China is in the midst of an economic slowdown, as they are putting the brakes on its residential real estate industry, which in totality, makes up about one third of the Chinese economy. Also, the amount of consumer wealth tied up in real estate is as much as 80%[13]. I remain confident that the transition from an overly heavy reliance on residential real estate is a needed shift, and the Chinese consumer with a very high savings rate will be able to handle it, but growth is still going to moderate further.

Conclusion

It’s typically cliché to say this will be an interesting year because every year is, but 2022 could be one in particular. Hopefully it brings an end to Covid as a pandemic and it becomes just another virus that we have to live with. Optimistically, the global economy and markets can power on, but there is the wall of monetary tightening that it will have to work through. With any luck, inflation will moderate, but I still worry that a 3-4% rate is something we will have to get used to for a longer period of time.

Either way, whatever the outcome will be, it remains vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from, what I believe, will continue to be a choppy time for the economy and markets. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and these markets.

Disclaimer

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The market and economic data is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The information in this report has been prepared from data believed to be reliable, but no representation is being made as to its accuracy and completeness.

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