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Quarter 1 2022 Market Update - The Federal Reserve Versus Inflation

January 2022

By Eric W. Hilliard
CERTIFIED FINANCIAL PLANNER™
Branch Manager
Raymond James Financial Services, Inc., Member FINRA/SIPC

We hope you are doing well as you read this Market Update Letter. This is our quarterly newsletter where we review the past quarter and share our current and forward-looking perspective.

Fourth quarter and 2021 performance

2021 was a year of sector rotations beneath the surface, while the S&P 500 index overall gained. it is important to be aware that as 2021 progressed fewer and fewer stocks contributed to index returns. If the five largest stocks were removed from the NASDAQ, the index was actually down 20% through mid-December.

Additionally, the average Russell 3000 stock was 36% below its all-time high, as noted in Day Hagan Asset Management’s January 2022 webinar. Before we go on to discuss the potential impact of higher inflation and rising interest rates, please take a few moments to review fourth quarter and full-year 2021 returns.

While market action has been volatile to begin 2022, as of January 21st of the companies in the S&P 500 who have reported earnings so far, 73% have beaten estimates, according to Mike Gibbs, managing director of Equity Portfolio and Technical Strategy at Raymond James. All eyes and ears are on data concerning inflation and what the Federal Reserve (aka The Fed) intends to do regarding interest rates. The economy remains on solid footing overall and is expected to improve and stabilize further as conditions normalize coming out of the pandemic.

Federal Reserve preparing the market for higher interest rates

After extremely accommodative policy maintained to support the economy the past two years as we grappled with COVID-19, the Fed has indicated it is time to begin raising rates from zero where they are currently. The Fed feels it is time to increase rates from extremely low levels because unemployment has dropped and the economy is in good shape. On the other side though, the Fed also believes they need to begin raising rates in order to try and tamp down inflation. After a few decades of extremely low inflation, we are now experiencing the highest levels of inflation since the early 1980s.

Inflation sources are many and not as transitory as the Fed initially believed

Government stimulus

Two years of massive government stimulus spending padded the pockets of consumers and since they were not spending on travel and entertainment the money went towards purchasing goods. A lot of dollars chasing limited amounts of goods results in the price of those good going higher.

Rising energy prices

Some government leaders have demonized the fossil fuel industries and regulated against them as they have been pushing the country towards “clean’ energy. In response there has been drastic underinvestment in the energy sector and less production. Alternative energy sources are just not ready to power the world and fossil fuels are still in high demand, especially coming out of the pandemic. Higher demand and lower supply results in higher costs for consumers.

Rental and Home prices

Housing and rental prices have risen significantly the past two years. Mortgage rates have remained low, demand has been strong and the inventory of homes nationwide has not been high enough to keep up with demand. Shortages of labor and materials (hence higher material cost) have restrained supply and increased prices as well.

Lockdowns and labor shortages

All of this has been exacerbated by COVID-19 lockdowns across the globe, as it resulted in labor shortages and manufacturing delays. Labor shortages occurred because many people lived off generous government stimulus during the pandemic and did not need to seek jobs. They also occurred because schools were closed and child care was hard to come. Intermittent labor shortages have occurred across industries as waves of COVID-19 caused people to isolate at home after exposure or while sick. As the economy re-opened businesses across all sectors, from small to large have struggled to hire and consistently maintain the number of employees they need and have been forced to increase wages to attract workers. When business has to pay more for labor, they pass those costs on to the consumer.

Lockdowns and labor shortages have led to multiple supply chain problems. Fewer goods were produced to meet demand. Ports experienced bottlenecks, leaving some goods sitting on cargo ships at docks or offshore for long periods of time. Less trucking capacity to transport goods across the country has also contributed.

All of these factors (and probably a few more not mentioned here) have led to the increase of goods in all aspects of our economy from homes, cars, clothing and food. For the past year the Fed has stated they believed the inflation was transitory, caused by economic disruptions during COVID-19. In recent months they have finally had to admit there is evidence inflation is likely to be stickier than they once though and they need to act before it rises to levels that could damage the economy.

Some inflation is likely to be transitory and some is likely to persist

Factors we expect will help ease inflation in coming months:

  • Supply chain issues globally should resolve, at least somewhat, as we (hopefully) learn to live with COVID-19 and resulting lockdowns are on the decline.
  • Some of the demand for goods will likely shift to increased spending on services and travel. That should help bring the supply-demand balance back towards normal levels and prices to stabilize.
  • Demand has grown for copper, aluminum and nickel and inventories have been low, but capital spending on new production is likely to result, which will eventually bring prices down.

Equity markets can continue to rise as rates rise

Since the start of Fed hiking cycles tends to come when the economy is strong, higher interest rates historically have not kept stocks from rising. Bloomberg notes in their January 23rd article “U.S. Stocks Historically Delivery Strong Gains in Fed Hike Cycles” the S&P 500 averages 9% return in 12 rate-rising cycles since the 1950s. It can result in more volatility though, especially in reaction to other negative influences. The Fed communicates its intentions more clearly than was done 20 years ago, so while the volatility of the market has increased in advance of the Fed beginning to raise rates, market reaction to the actual increases themselves may be more muted.

If the economy is strong and growing, as it is now, it can sustain reasonably higher rates.

If the Federal Reserve sees evidence of inflation moderating, they are more likely raise rates gradually, watching how the economy and inflation adjusts between rate increases. There is some evidence of improvement in port congestion. Additionally, while still in short supply and up in price, manufacturing commodity prices have been dropping recently. This scenario should be more supportive for stocks, as the overall economy is still growing. This is our baseline expectation, but we will continue watching inflation and the Fed closely in coming months.

Fundamental trends remain healthy, which is supportive of overall market trends

  • US consumers are financially in good shape. U.S. household debt service burdens are at the lowest levels on record, according to JP Morgan’s Eye on the Market Outlook 2022
  • Supply chain issues should gradually resolve throughout 2022, which should help inflation decline and stabilize.
  • The world’s consumers are learning to live with COVID-19 and should transition towards more typical consumption behavior.
  • Earnings estimates continue to get revised higher. According to Mike Gibbs, Raymond James’ base case 2022 earnings and valuation estimates produce a S&P 500 price objective of 5053. He suggests using pullbacks as opportunities to add to investments with available cash.

The S&P 500 has not experienced a pullback of 10% or more since February 2020 as the world was adjusting to the new pandemic. On average a 10% correction occurs approximately once each year and a 15% correction occurs on average every 2 years. Gibbs notes in his Market Thoughts 1/25/22 the average intra-year pullback for the S&P 500 since 1980 has been 15.2%, while the average annual return has been 10.7%. This in itself does not mean a more meaningful correction will occur during 2022, but it does increase the likelihood of it happening. Currently the market is trying to adjust to expectations of rising rates, so we find ourselves in the midst of a more meaningful correction than what we have experienced the past year and a half. The market may over-react on the downside before finding its footing. Keep in mind, corrections are normal, temporary and we remain in a secular (longer-term primary trend) bull market.

We continue working hard to evaluate all pertinent information and guide you towards your long-term goals. We will also continue e-mailing you invitations to informative conference calls when they occur. Please also check our website and social media pages regularly for timely updates on all these topics.

Website: http://www.raymondjames.com/hilliard/
Facebook: https://www.facebook.com/hfgraymondjames
LinkedIn:
Eric Hilliard, CFP®, Branch Manager https://www.linkedin.com/in/ewhilliard/
Wade Stafford, CFP®, Associate Financial Advisor https://www.linkedin.com/in/ericwstafford/
Jenny Hilliard, Investment Executive https://www.linkedin.com/in/jennyhilliardrj/

As always, please let us know of any significant changes in your life or situation that could impact your financial plan. In the meantime, we continue to follow the processes we have developed over the years that enable us to provide you our very best.

Thank you for your trust in me and in our practice.

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DJ GLB Moderate Conservative Index - The DJ GLB Moderate Conservative is a total-portfolio index that allow investors to evaluate the returns on their portfolios considering the amount of risk they have taken. These profiles are defined based on incremental levels of potential risk relative to the risk of an all-stock index. It's made up of composite indices representing the three major asset classes: stocks, bonds and cash. The asset class indices are weighted differently within each relative risk index to achieve the targeted risk level. The weightings are rebalanced monthly to maintain these levels. The DJ GLB Moderate Conservative index is 40% of All Stock Portfolio Risk.

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