January Investment Comments
The Federal Reserve operates under a dual mandate with the goal of fostering conditions that achieve both stable prices and maximum employment. Recent developments signal the Fed has pivoted from seemingly prioritizing maximum employment to combating inflationary pressures that could pose a threat to the recovery. The Fed’s move made in response to the pandemic more than a year ago towards easier monetary policy and significant stimulus has had the intended effect. Both U.S. and global GDP have recovered to the point that they have surpassed pre-pandemic levels. U.S. real GDP growth is expected to exceed 5% in 2021 with anticipated growth next year of approximately 4%. The pace of growth from here is contingent upon many factors, including the course of the virus and potential future variants. Early indications for the Omicron variant suggest it is more transmissible but has lower severity. While not exactly an ideal development there is some optimism that can be gleaned from that combination.
The November jobs number was held back by Covid-related uncertainties, but individuals continue to return to the workforce. The economy added 210,000 jobs in November, the smallest gain this year and a shortfall versus expectations for more than half a million new jobs. However, prior months’ job gains were upwardly revised, and most indicators of the labor market are reflecting strength. The unemployment rate fell to 4.2% from 4.6%. The labor force participation rate increased from 61.6% to 61.8%, the highest since the start of the pandemic when it was above 63%. The roll-off of stimulus and higher pay, with average hourly wages up 4.8% last month, has helped bring people back into the workforce. Still, roughly 4.2 million more people remain out of work versus the start of the pandemic. While we are not necessarily at “maximum employment” things appear to be trending in that direction.
Given the rapid improvement in the labor market, the Fed outlined plans in early November to gradually wind down its $120 billion monthly bond-buying program by June, at which point it would begin to lift interest rates. However, in an abrupt pivot just weeks later Chairman Powell said the Fed was prepared to speed up its tapering process, setting the table for earlier rate hikes. Shortly after receiving his nomination from President Biden for a second term, Powell noted the increased risk of higher inflation that prompted the shift, saying, “The economy is very strong and inflationary pressures are high, and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases perhaps a few months sooner. This decision was formalized at the Fed’s December meeting with the taper now on track to be completed by March.
Powell noted the Fed may have been mistaken in its earlier estimates about how long inflation would remain elevated, suggesting it was time to retire the broadly scrutinized word “transitory” and be clearer about its expectations going forward. Supply side problems continue to contribute to price pressures, complicating the inflation picture, though the hope is that these abate in the coming year. Prices as measured by the consumer price index jumped 6.8% in November from a year ago, a 39-year high, with broad increases across categories. Gasoline, shelter, food, and used and new vehicles were among the larger contributors. The core measure, excluding volatile food and energy prices, increased 4.9%. The Fed’s preferred inflation measure, core personal consumption expenditures, most recently increased 4.1% versus a year ago, representing the largest increase since 1991.
These measures are all running comfortably ahead of the Fed’s symmetrical 2% inflation target, which has prompted greater urgency. Implied annual 5-year inflation based on Treasury Inflation Protected Securities has increased from just below 2% at the start of the year to approximately 2.75% currently. Most forecasters anticipate inflation will decline meaningfully in the second half of 2022, but Powell highlighted that the Fed can’t act as though that is a certainty.
Moving forward, stopping bond purchases offers the Fed greater flexibility in terms of potential rate increases. The fed-funds futures market reflects expectations for the first hike to occur in June with a second hike priced in for September and an approximate 60% chance of a third increase in December. In response to earlier anticipated rate hikes, over the past month the yield on the two-year Treasury note, which is most sensitive to rate increases, has increased from approximately 0.50% to 0.65%.
Meanwhile, the longer end of the yield curve has been subdued, with yields on the 10-year Treasury lower over the past month, currently sitting below 1.50%. This reflects a belief that while the Fed is likely to raise interest rates, future economic growth will not be strong enough to result in higher long-term rates, which historically have tracked nominal GDP. If yields on the longer end don’t move higher it could limit how many rate increases the Fed ultimately pushes through. This is because an inverted yield curve, where short-term rates exceed long-term rates, has preceded every U.S. recession over the past half century. This is something of which the Fed is acutely aware.
As we wrap up 2021, stocks have had a good year. With just over two weeks to go, the S&P 500 has advanced more than 20%, but the action under the surface has not been quite so strong. More than 90% of index constituents have experienced a greater than 10% decline from peak, and a significant proportion of the index’s strong performance, particularly in the second half of the year, has been driven by the ten largest stocks. Headline returns have been helped by the faster-than-expected snapback from the pandemic reflected by strong corporate earnings. Overall earnings for the S&P 500 in 2021 are expected to increase approximately 45%, helped by easy comparisons from a year ago. Looking ahead to 2022, consensus projections are for solid earnings growth of 9%. The current forward P/E on the S&P 500 is approximately 21x, elevated relative to history but at least partly justified by the low interest rate environment.
The question is what happens to rates as major central banks begin to pull back on the liquidity that has supported financial markets since the start of the pandemic? If rates remain low and projected earnings growth comes to fruition, favorable conditions remain for stocks to perform well. Things become more challenging if rates materially increase, pressuring multiples. This is especially true for high-flying growth stocks where meaningful cash generation isn’t anticipated until well into the future. Though monetary policy is likely to tighten, the anticipated slow pace at which it does so would help the market digest this headwind.
As we move into 2022 there is greater uncertainty, but the prescription remains the same. A long-term plan that includes ownership of reasonably valued, growing companies generating free cash flow is an important component of long-term investment success.
James Skubik, CFA