High Level Commentary

MARKET PERFORMANCE-As Of January 21, 2021

CI Hi Level 211231

Federal Reserve “Tapering”, Increased Interest Rates and Negative Performance:

The Federal Reserve’s belated recognition of inflation risks and it’s policy shift has spooked markets and caused negative returns for most asset classes so far in January.  The shift to higher interest rates is described as the end of easy money, and the narrative is now characterized as how far and how fast. 

The policy shift was publicized by the Fed on December 15, 2021 with commentary that that they are “tapering” their bond purchases and introducing a policy to raise short-term interest rates to combat inflation.  Tapering means that they are greatly reducing their massive bond-buying program.  The bond purchase level will be reduced by $30 billion/month so that bond purchases will cease by early spring.  The government bond purchases began at the height of the pandemic to help support the economy and markets when businesses were closed and unemployment skyrocketed.  The government bond buying helped reduce interest rates.  (Interest rates on existing bonds declined because Fed purchases drove up bond prices and correspondingly reduced interest rates.)

The Fed also announced a policy to raise short-term interest rates. Their median forecast shows three interest rate hikes in 2022.  The Fed’s so-called “Dot Plot” also indicates three additional rate hikes in 2023 and three more rate hikes in 2024.  According to this forecast, short-term interest rates would rise from the current level of near 0% to around 2.25% by 2024. 

Short-Term Positive:

Corporate earnings continued to surprise to the upside during 2021.  According to FactSet, earnings for the S&P 500 increased 45% in 2021on a year-over-year basis and revenue increased 16%.  Earnings are expected to increase 8% in 2022.

Retail sales have been strong.  Retail sales were down 1.9% in December due to omicron, but are still up a solid 16.9% on a year-over-year basis.

The $1 trillion infrastructure package passed with bipartisan support, and economists believe that this spending has the potential to increase economic growth and productivity.  Growth and productivity gains will be modest, however, since the funds will be spent over a number of years.  The approximately $1.75 trillion “human infrastructure” Build Back Better reconciliation bill has passed in the House is headed to the next political battleground in the Senate.  Negotiations are expected to drag on through the rest of 2021.

The $1.9 trillion government stimulus package passed back in March 2021 helped economic growth exceed expectations so far in 2021.  Forecasts are now being revised downward on current inflation fears, but growth should remain solid into 2022.

Some of the stimulus dollars moved into the markets.  This provided short-term investment demand to push prices higher.  There continues to be significant retail “cash on the sidelines” that could still come into the market.  This cash is available to “buy on the dip”, a strategy that has worked for the last ten years, and this has helped support markets during downdrafts.

Pent-up savings, pandemic constrained spending and pent-up demand are increasing near-term economic growth.

Investment performance for 2020 was led by technology, but performance has broadened out in 2021.  The “Reflation Trade” favors energy, industrial and financial companies that are both cheaper and that offer more upside as the economy recovers.

-Some investors believe we are in the early stages of a new bull market and are describing the current market environment as the “Roaring 20s.”  This optimistic perspective is based on sustained upside to economic growth and corporate earnings.

Short-Term Negative:

Consumer inflation is increasingly reflected in current data as the December Core Consumer Price Index shot up 5.5% over the last 12 months, a level not seen since August 1991.  Federal Reserve officials previously said that inflation was “transitory” due to supply chain problems, but inflation is broadening into wages, and this raises the potential for a wage price spiral.  History shows that inflation is hard to contain after it has gained momentum.  The market is very concerned that inflation may prove to be more than transitory. 

Powell Pivot:  Fed Chair Jerome Powell, acknowledging that inflation is becoming more concerning, said on November 30 that it’s “probably a good time to retire that word (transitory) and try to explain more clearly what we mean.”  The Fed previously maintained that inflation was “transitory”, but it now recognizes that inflation may persist longer than expected.  As a result, the Fed an acceleration of their timeline for phasing out their $120 billion monthly purchases of treasury and mortgage bonds.  This policy was formally announced at the December 15 Federal Open Market Committee meeting. 

As these developments push up interest rates, they provide a headwind for long-maturity bonds and stocks.

President Biden’s Build Back Better legislation is currently on hold as discussion continues on a scaled-down plan.  With posturing for the mid-term elections already in progress, it is difficult to know what legislation might be passed.

The so-called Fed Put gave investors a measure of downside support for the markets over the last decade.  (In the options market, a “Put” position increases in value when markets decline and thus provides an upside offset or hedge against market drops.)  Although there was no actual market “Put”, the Federal Reserve purchased massive quantities of bonds and kept interest rates abnormally low to support the economy and the markets.  Now that the economy is strong and inflation is uncomfortably high, the Fed no longer has the latitude to keep interest rates low to support the market.  Instead, there is a need to raise interest rates to mitigate against inflation.  As interest rates rise, consumer and corporate spending growth rates decrease, the economy slows, and long-maturity bonds and stock market performance face increasing headwinds.

The Federal Reserve’s monetary stimulus kept interest rates low but it has the effect of distorting markets by shifting investors towards risky assets.  As stimulus is phased out, markets may move down, and the move downward may be volatile and deep.

Asset price inflation (both stocks and bonds) has pushed market prices above average fundamental valuation levels.  Valuation levels are particularly expensive for long-maturity bonds and U.S. stocks.

The Omicron variant is the latest wave of the COVID virus and it is forcing another round of lockdowns that are putting a drag on global growth.  There have been over 5 million coronavirus deaths globally and the pandemic is expected to continue into 2023.   

Investors have taken out record volumes of margin debt to finance their stock purchases.  Buying stocks on margin is extremely lucrative as long as stocks continue to move up, but a market downdraft would cause heavy selling to meet margin calls.  Option volumes are also at record high levels according to the Options Clearing Corporation.  Purchasing Options in a rising market allows much larger gains than buying stocks, but losses are amplified in a sharp sell-off.  Market makers who sell options to investors typically hedge their position by purchasing the underlying stock.  When markets decline and option purchases decline, market makers sell their stock holdings.  Although margin debt and option purchases have provided upward momentum, these trading tactics also have the potential to cause severe negative volatility.      

Evergrande is a Chinese property developer that defaulted on recent bond payments in its $300 billion debt holdings.  Other Chinese property developers are also experiencing cash flow problems, and the market fears “contagion” that spreads throughout the Chinese economy and international markets.  Optimists believe that the Chinese government will intervene to prevent any collapse.

Speculative red flags include GameStop, Bitcoin, AMC, Tesla and the proliferation of SPACs.  This speculative demand is driven in part by increased retail demand and especially investors who are confusing gaming with investing.  Current speculative momentum could reverse quickly.

Climate change constitutes a significant longer-term global challenge.  Although governments and corporations are taking steps to mitigate the impact, recent increased energy costs have caused a consumer backlash.  It is much easier to talk about reductions far out in the future, than it is to implement current steps to make actual changes.

Longer-Term Fundamentals:

U.S. Economic Statistics Remain Positive but inflation concerns are increasing.  Economic statistics dropped precipitously due to the government-induced shutdown in 2020, but then rebounded well above consensus expectations.  Most recently, economic reports are showing a softening growth rate. 

-US third quarter 2021 GDP moved up 2.3% on an annualized basis.  This was a disappointing report, but the market believes this was a temporary slowdown due to the Delta COVID variant and growth is expected to pick up again in the fourth quarter. 

-Retail sales advanced a solid 0.3% in November, and are now up 18% on a year-over-year basis.  Fiscal stimulus has ending but U.S. households accumulated over $2.5 trillion in excess savings during the pandemic, and this should drive strong consumer spending into 2022. 

-Unemployment (at a 50-year low of 3.5% in February 2020) spiked to 14.7% as the pandemic shut down the U.S. economy, but has since dropped to 3.9% for December.  Job creation for November came in at a disappointing 210,000 new jobs but the overall employment trend remains positive as companies scramble to find workers to meet strong demand.  

-Industrial production gained dropped -0.1% in November as supply chain constraints negatively impacting manufacturers.  Semi-conductor chip shortages are particularly problematic, especially related to domestic car and light truck production.

-Housing has been strong due to low mortgage rates, but new construction is currently negatively impacted by rising mortgage rates and rising construction costs.  These rising costs impact housing affordability.

-Inflation has been low, but is currently increasing.  The Core Consumer Price Index came in at a trailing 12-month 4.9% annualized rate in November.  The Core CPI is now at the highest level since August 1991.

-The Leading Economic Indicators came in at a strong 0.8% in December.  When the pandemic first hit, the data was negative with March 2020 down -7.5% and April down -6.3%. These statistics showed a sudden, large shutdown of the U.S. economy caused by the unprecedented coronavirus pandemic.  Since that time, the U.S. economy has recovered much faster than expected.

-The European Union grew at a 9.1% annualized rate in the third quarter (2.2% quarter-over-quarter.)   The EU has maintained solid economic growth despite lockdowns and is expected to grow at a 4.8% rate for calendar-year 2021.  The EU is forecasting 2022 GDP at 4.5%.  The EU contracted 6.0% in 2020 due to the pandemic.

-Japan’s 2021 Q3 GDP came in at a -3.0% annualized rate, down from a 1.5% gain in the second quarter.  Widespread COVID-19 lockdowns have crimped consumer spending.  Japan is expected to recover for the remainder of 2021, and the consensus expectation is for a 3% 2021 GDP increase compared to 2020. 

-China reported 2021 Q4 annualized GDP growth at 4.0%, below consensus expectations due to power shortages and supply-chain problems.  China’s growth is clearly slowing for the manufacturing and export sectors.

Performance:  U.S. stock indexes moved up to record-high levels based on government stimulus and optimism with COVID-19 vaccine in 2021, but January has been negative.   Energy, industrials, financials and small cap stocks have performed well in 2021as the market rotated away from some of the tech darlings.  Small cap stocks are cheaper and have more earnings upside as the economy recovers from the COVID-19 lockdowns. 

Longer maturity bonds underperformed in 2021 as interest rates rose.  While fiscal stimulus was necessary due to COVID restrictions and lockdowns, there is a growing concern related to persistent inflation and to huge government budget deficits.  Investors are less willing to accept historically low longer-term government debt, and this is pressuring long-maturity bond prices lower as yields move higher.

GameStop, Bitcoin and Dogecoin were big performers in 2021.  Retail investors have added volatility to speculative stocks in 2021.  They first targeted Gamestock.  They initially drove the stock up as they purchased the stock and call options on the stock, forcing hedge funds with short positions to cover their short positions.  Investors with short stock positions essentially borrow stock and then buy it later to close out their positions.  Investors take short positions when they expect the stock to decline.  GameStop has been a favorite stock to short because it is a bricks-and-mortar video game store with declining revenue and profits.  Short positions on stocks can be lucrative if stocks decline sharply, but are very risky when stocks rise.  Retail investors used Reddit’s WallStreetBets, web site to coordinate stock and call option purchases as they encouraged one another to upset the Wall Street status quo.  This was described as a David and Goliath story.  Although many retail investors achieved huge short-term gains and have forced huge losses on the hedge funds with short positions, there is little fundamental reason to hold these stocks on a long-term basis.  So far in January, these stocks have suffered big losses, and there is little fundamental support for these names in 2022.

Market valuations remain rich.  At this point, markets are trading on heightened valuation concerns.  Various valuation metrics (like Price/Earnings ratios) for 2022 remain elevated.  It is important to remember that valuation doesn’t predict short-term performance, but valuation definitely impacts long-term performance potential.  In other words, markets could continue to get move up on a short-term basis, but the longer-term performance might be a 5-7% average long-term return/year rather than the historic 10%/year return.

Stimulus packages helped in the short run, but debt keeps growing.  Three stimulus bills have been enacted since the beginning of the pandemic in March 2020.  These bills are summarized below: 

-The $2.2 trillion CARES Act, passed quickly in March 2020, provided $1,200 direct payments and enhanced unemployment benefits.  

-The $900 billion Pandemic Relief Bill passed in December 2020.  This provided $600 in direct payments to eligible individuals and $300/week in extended unemployment benefits through March 2021.

-The $1.9 trillion American Rescue Plan passed in March 2021.  This plan included $1,400 direct payments to most Americans and extended additional unemployment benefits through the summer. 

The U.S. federal debt stands at $28 trillion, and is expected to continue to grow for the foreseeable future.  Although current interest rates remain low, future inflation could cause rates to rise, and this would cause sharply higher debt service costs.  This is clearly a headwind on a longer-term basis.

 

For more detail see:

Markets & Economics

Market Performance

Valuation

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