- Inflation has been rising for months, and with this December’s CPI data, it has likely peaked at multi-decade highs for this cycle.
- The Fed had been late to acknowledge the duration and magnitude of the rise in inflation but has recently pivoted to a much more hawkish position to address it, including rate hikes. A return to policy normalization will mean a return to normal, i.e., more frequent, volatility.
- Bond yields have risen sharply in reaction to the Fed’s hawkish pivot and in anticipation of their transition to policy normalization. We continue to focus on active management in our bond allocations, given their ability to react quicker in response to changes.
- On the equity side, we will continue to overweight U.S. stocks relative to non-U.S. stocks but will likely begin to lessen the extent of that U.S. overweight. In addition, we expect to increase our use of active management in non-U.S. and small- and mid-cap U.S. allocations.
The Policy Winds Are Shifting in 2022
The Fed is Getting Ready to Hike Rates
Source: B.Rich, Hedgeye.
On November 3, 2021, the Federal Reserve (the Fed) announced that it would start to scale back its bond-buying program. This set the stage for the Fed to begin a long-anticipated process of “normalization”, in other words, a gradual removal of the substantial pandemic-era monetary policy accommodation. For months market participants had been debating whether the Fed was “behind the curve” on inflation and that the Fed’s position that inflation was “transitory” was misinformed. It is fair to say the market won that argument, as the Fed has now effectively retired the term “transitory”, and at its December monetary policy meeting the Fed not only reaffirmed the tapering of its bond-buying program but announced that it will accelerate the pace of that tapering.
Additionally, Fed officials were suddenly expecting 3 rate hikes in 2022, up from only one just weeks before. A look at the December release of November inflation data shows just why the Fed finally gave up its transitory narrative and sped up its timetable for policy normalization. As shown below, both consumer inflation (CPI) and producer inflation (PPI) surged to decade highs. These will likely go up even further with this week’s release of the December figures which are expected to be CPI rising to +7.0% and PPI rising to +9.8%.
Inflation Surges to Decade Highs
Consumer Price Index (year-over-year % change)
Here’s what has happened with market rates – all are at their highest levels since the pandemic and are clearly indicating that rate hikes are coming.
Rate Hikes are Coming
Treasury yields are at their highest levels since the start of the pandemic
The surge in yields have in turn rattled financial markets. The first week of 2022 brought a sharp countertrend rotation in financial markets from growth to value. The 10-year U.S. Treasury yield has jumped from 1.34% in early December to around 1.85% recently. This has put pressure those sectors of the market with the most stretched valuations and that have had the most outsized returns in the aftermath of the pandemic. Moreover, technology and growth stocks are the most sensitive to rising rates because investors pay for the promise of future earnings.
With the Fed’s pivot, 2022 becomes a transition year in which we move from record policy support towards something slightly less than record policy support as the Fed first ends its bond-buying program — and eventually towards actual policy tightening when the Fed begins hiking rates, which are now priced in for March, May and perhaps a third hike in the fall. Remember, rising longer-term interest rates is generally a positive, it reflects optimism about economic growth. Nevertheless, the transition from nearly two years of extraordinarily low interest rates will require adjustments by market participants.
That means the pickup up in volatility we’ve experienced the past few months is likely to be the template for the foreseeable future. Those nearly two years of unprecedented policy support may have made investors complacent and in need of a reminder that markets can’t go straight up without disruptions. So, what is normal volatility anyway? Well according to data compiled by Capital Group, since 1951, the S&P 500 has experienced a market “Dip” of a -5% or more decline about 3 times per year and a “Correction”, which is a decline of -10% or more, about once a year. In 2021, the S&P 500 only experienced a single -5.2% decline over 21 days, which recovered in just 13 days. As shown in the table below, the index hasn’t suffered a correction since September 2020—and even that is technically questionable since it was ‘only’ a -9.6% decline, but we’ll call it close enough. Of course, the worse declines of -15% or -20% haven’t occurred since the trough of the pandemic bear market in March 2020. Of course, past results are not predictive of future results, but each downturn has been followed by a recovery and a new market high.
Market downturns happen frequently but don’t last forever
Standard & Poor’s 500 Composite Index (1951-2021)
Source: Capital Group, Standard & Poor’s.
*Assumes 50% recovery of lost value.
# Measures market high to market low.
From the lows on March 23, 2020, through the end of 2021 the S&P 500 had gained 113%, and 119% if you add in dividends. The index has never gained more in any 21-month period over the past 60 years. All the while it only pulled back -9.6% at its worst—and just -5.2% during the last year. Simply stated, we shouldn’t expect to see that same kind of subdued volatility combined with historically high returns going forward. The Fed’s recognition that the economy is more than healthy enough not to need quantitative easing anymore is a positive. And the volatility that arose at the end of 2021, and carried into early 2022, is just a resumption of the typical, and episodic, bouts of volatility that occurred before the pandemic and all of the subsequent fiscal and monetary policy response.
What does all this mean for our portfolios? We will continue to focus on active management in our bond allocations where portfolio teams have the flexibility to position for higher inflation and keep durations lower relative to the passive market indices. Remember, lower duration means lower interest sensitivity. Additionally, active managers will have the ability to react quicker in response to changes in the Fed’s monetary policy as that evolves. On the equity side, we will continue to overweight U.S. stocks relative to non-U.S. stocks but will likely begin to lessen the extent of that U.S. overweight. Non-U.S. equities have lower valuations than U.S. stocks and are less exposed to technology and consumer cyclical sectors than U.S. stocks, areas of the market that are more vulnerable to rising rates. In addition, we expect to increase our use of active management in non-U.S. and small- and mid-cap U.S. allocations. From a risk-reward perspective, we prefer active managers that can focus on quality, profitability and growth at a reasonable price compared to the passive market indices that have a higher preponderance of higher valuation companies and unprofitable, lower quality businesses.
The bottom line is that in 2022 the Federal Reserve, and other global central banks, will begin shifting to tighter monetary policy in response to rising inflation. Bond markets have already anticipated the central bank hikes with higher market yields and that is pressuring technology and other high-valuation sectors of equity markets. The immediate result will likely be a resumption of market volatility that more resembles historical trends, with periodic dips and corrections, versus the unusually low volatility that occurred over the last 18 months in the wake of the substantial monetary and fiscal stimulus that was added to the financial system as a response to the Coronavirus pandemic in early 2020.
See what typically happens to the market with rate hikes: