Macroeconomic View & Markets
Though stocks, especially technology, have had a pullback the first week of the new year, the broad measure of U. S. stocks (S&P 500) hit all-time highs 70 times this past year even though two COVID variants roared across the globe! This was the first time in 25 years there were this many record highs in one year. Of course, there were pullbacks then, too, but they were short-lived as risk assets continued to dominate. Investors who ignored the pullbacks and stayed the course were rewarded.
The runup throughout the year was due to tremendous liquidity in the economy from both Congress and the Federal Reserve that helped propel equities to all-time highs. Congress provided additional stimulus payments and child tax credit payments to help struggling Americans. The Federal Reserve purchased Treasuries and mortgage-backed bonds ($120 billion per month), which artificially kept rates low and encouraged consumers to refinance their debt at historically low rates, and use the cash for more consumption. This stimulus was the catalyst for the 2021 rally. However, one of the unintended consequences of excess liquidity is higher prices.
As always, the macroeconomic picture is also important to understand this stock market movement. The economy has continued to recover from the global Q1 2020 shutdown: 3.9% unemployment rate (December 2021) vs. 3.5% (February 2020); monthly job growth of 555,000 since January 2021; nonfarm employment increase of 18.5 million since April 2020.
The number of people filing for unemployment benefits is drastically down. Both initial jobless claims (newly unemployed for the week ending December 25) and the four-week moving average were just below 200,000, the lowest level since October 1969. Continuing jobless claims (long-term unemployed) dropped by 140,000 to 1.72 million, the lowest level since March 7, 2020. Due to the labor shortage (See p. 1, #2, #3, #5, #6), there are still 10.6 million job openings (November 2021).
The latest Q3 GDP estimate is an annualized 2.3%. This is a notable slowdown from the 6%-7% of the other three quarters of the year. This slowdown was due to the emergence of the COVID-19 Delta variant and the recurrence of business restrictions, delayed openings, and new closures throughout the country. The Q4 GDP, however, surged to an estimated (January 4, 2022) 7.4%. The reasons include the health effects of the COVID-19 booster which have led to the return of consumer travel and dining, robust hiring, continuing consumer spending, and expanded manufacturing production lines, etc.
The U.S. annual inflation rate (Consumer Price Index or CPI) accelerated to 6.8% (November 2021), the highest reading since June of 1982. For the 9th consecutive month, inflation is above the Fed’s 2% target. This has forced the Fed to become less accommodative by expediting the decrease in its government bond purchases and by raising the discount rate. The market is now anticipating up to three interest rate hikes in 2022, a dramatic shift from a few months ago when the estimate was one. This discount rate set by the Fed has been at zero for almost two years, so the economy can handle “higher” rates. Keep in mind, the purpose of the Fed is two-fold: stable prices (low inflation) and maximum employment.
The current (1 week) downturn in stocks is due to this inevitable Fed rate hike. Although the hikes (whatever the number) will eventually slow inflation, the immediate impact is a higher borrowing cost for companies as well as individuals. It will be more expensive particularly for the smaller, growing companies to borrow in order to expand their businesses. This is why the stock prices of the younger, emerging companies, particularly in the tech sector, are down more than the larger more mature companies represented in the S&P500.
Fixed income: tax-free led for the quarter, while high yield corporates led in all other time periods. Aggregate bonds were the laggard for the quarter and 1-year. Cash was the worst performer in all other periods.
Rising rates hurt bond prices, especially longer dated, i.e., a 20-year Treasury. We will continue to closely monitor the Fed rate hikes in order to make any necessary adjustments to bond exposure in the portfolios.
Equities: real estate led for the quarter and 1-year, while large-cap led in all other time periods. Small U.S. stocks were the worst-performing equity category for the quarter due to the anticipated interest rate hikes discussed above. Foreign stocks were the laggard in all other periods.
Although the outlook for the short-term is downward volatility, the long-term outlook is positive for equities. Even though interest rates are rising, they will still be low by historical measures and consumers are expected to continue spending. Remember 70% of the U.S. GDP is based on consumer spending. We believe with a higher discount rate-even if there are 3 Fed rate hikes-consumers will continue to spend. E-commerce sales are 40% ahead of pre-COVID levels. Traditional brick-and-mortar retail sales are up 14%. This is why stock prices have continued to rise. However, the pace of this march up will not continue. Rising rates usually result in lower market returns and more volatility.