Sorting Through Mixed Signals

So far this year markets have already seen a full-fledged, double-digit correction for almost all major stock indexes, which in and of itself should not seem too surprising given the better than double price return on the S&P 500® between late March 2020 and early January 2022. That said, we expect volatility to continue more frequently and at higher magnitudes than in the past year, as various investor concerns and market uncertainties play out in the months ahead. 

These uncertainties and our perspectives on their potential impacts include: 

Inflation continues to rise at multi-decade highs

Inflation continues to rise at annualized levels not seen in almost 40 years. Moreover, it is now painfully obvious that the “transitory” label put upon it by Federal Reserve Chairman Jay Powell, as well as other public officials and market pundits, was an incorrect one. The consumer price index headline number touched down at an annualized rate of 7% for the month of December, and the personal consumption expenditures price index reached 5.8% for that same month, both representing their highest rates since 1982. 

While we expect inflation reports throughout 1H22 to remain running hot, these rates could begin to mitigate in 2H 2022, perhaps subsiding to more manageable levels in the 3% range, as supply chain challenges begin to ease and we reach the one-year anniversary of last year’s initial surge in consumer prices.  

COVID-19 case trends have fallen fast but remain high

The initial onslaught of the Omicron variant now appears to have peaked in mid-January at a seven-day average of more than 800,000, as this statistic has since fallen to fewer than 250,000 (Worldometer, February 7). However, despite the dramatic decline in average daily cases over the past few weeks, they remain close to the CY 2021 daily high of approximately 300,000 in mid-January of last year. In the months ahead, the markets and society at large will be watching these trends anxiously to see if an Omicron burnout might infer further and substantial declines in virus trends.

In our judgment there is a realistic probability COVID cases continue to trend downward and that by year-end 2022, the virus could shift from pandemic to endemic status.

The Fed initiates a new tightening cycle

The Federal Reserve stands ready to begin raising rates in March and reducing its nearly $9 trillion balance sheet shortly thereafter. Since late 2021, market expectations as to how many quarter-point federal funds rate hikes will be implemented in 2022 and how fast the Fed will begin reducing its existing bond holdings, have increased at a fast and furious pace. Currently the federal funds futures market is expecting five quarter-point rate hikes between now and year-end, though these expectations are fluid and can be impacted by future economic data.

We believe the Federal Reserve is likely to raise the federal funds rate by an even 1% in CY 2022, concluding the year with a target range of 1.00%–1.25%. It is also likely the Fed begins reducing its balance sheet at a pace of close to 1 $trillion annually, thereby lowering its bond holdings by perhaps about $3 trillion over the next three years. We see a realistic range on the 10-year Treasury yield of 2.25%–2.50% by year-end 2022.

Recent economic data has been confusing 

Recent economic data has also added to uncertainty. The Atlanta Fed is currently tracking 1Q GDP growth to be only slightly positive (0.7% as of February 8). However, this trend is questioned by perhaps the strangest jobs report in recent memory when, on February 4, the U.S. Bureau of Labor Statistics January nonfarms payroll decimated concerns of a potentially negative number with 467,000 new jobs added to the economy. Moreover, positive revisions to the November and December reports added more than 700,000 new jobs to those months, essentially increasing the employed work force count by almost 1.2 million over the three-month period. 

While these numbers are certainly encouraging and perhaps represent an early sign that worker shortages might be mitigating, they do little to provide confidence in the accuracy of ongoing government employment data during these historically unique economic conditions.  

We continue to believe the U.S. economy can achieve 3% gross domestic product growth in CY 2022, providing for a favorable backdrop for equity and credit investors. Inflation stands a good chance to slow into the 3% range as supply chain constraints and worker shortages improve in 2H 2022 and COVID-19 trends move the virus closer to an endemic rather than pandemic status. 

Corporate earnings growth looks to remain positive though well below last year’s pace

Following the blistering hot profits growth in CY 2021 likely to come in north of 45% on S&P 500 net operating earnings, current estimates seem to be coalescing in the 8%–10% range for CY 2022 (FactSet Earnings Insight, Feb 4). While this is still a favorable rate of growth, the markets may need to absorb this slower pace as companies complete their 4Q21 earnings reports and provide updated guidance for CY 2022.   

We believe given a potentially stronger pace of earnings growth in 2H 2022 and what could be accelerating comparisons in CY 2023 — as COVID-19 and inflationary trends subside to some extent amid 3% or better economic growth — that equity investors could be well rewarded for staying the course over these next few months. We continue to see a strong probability overall stock total returns through 2023 will be in line with realized earnings growth.    

The world remains on edge regarding a Russian invasion of Ukraine

As the Russian buildup of troops and military weaponry along the Ukraine border continues to increase, the expectation of an invasion has risen materially as many now believe such a confrontation is simply a matter of time. In the event an invasion does occur, the U.S. has promised strong economic sanctions on Russia will follow, though details are intentionally vague at this point. Speculation of such actions the U.S. and its allies might take have included locking Russia out of certain international financial systems and blocking profits from their oil and gas production.

In the event a Russian invasion of Ukraine does in fact happen, it is likely markets could react with more inflationary concerns and a rotation away from equities and credit-oriented fixed income and toward safe harbor type assets such as gold and U.S. Treasury bonds. We caution such an immediate reaction would likely be short term in nature, as history has typically shown markets to recover shortly after selling induced by geopolitical or military events.

In summary, investors will likely be facing a wider array of uncertainties and short-term market volatility throughout 1H22. However, we believe potential trends within and resolutions to these uncertainties favor a continuing longer-term upward trend for stocks and a favorable fundamental environment for the credit markets.    

Investments are subject to market risk, including the loss of principal. Asset classes or investment strategies described may not be suitable for all investors.

Past performance does not guarantee future results.

INDEXES ARE UNMANAGED AND AN INVESTOR CANNOT INVEST DIRECTLY IN AN INDEX.

Equities are subject to market risk meaning that stock prices in general may decline over short or extended periods of time. Indexes are unmanaged and an investor cannot invest directly in an index.

Fixed income investing is subject to credit rate risk, interest rate risk, and inflation risk. Credit risk is the risk that the issuer of a bond won’t meet their payments. Inflation risk is the risk that inflation could outpace a bond’s interest income. Interest rate risk is the risk that fluctuations in interest rates will affect the price of a bond. Investing in floating rate loans may be subject to greater volatility and increased risks.

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