by William Henderson, Vice President / Head of Investments
The equity market continued its slide downward last week with poor returns across all three major indexes: albeit modest negative returns. Inflation continues to be the word of the year with a release last week of December 2021 CPI (Consumer Price Index) topping 7% for the month compared with 2020, which arguably was exactly what was predicted by economists. The Dow Jones Industrial Average fell by –0.9%, the S&P 500 Index lost –0.3%, and the NASDAQ also fell by -0.3%. Last week’s returns give us two weeks of negative returns meaning obviously poor year-to-date figures. Year-to-date, the Dow Jones Industrial Average is down -1.1%, the S&P 500 Index down -2.1% and the NASDAQ down by -4.8%. Bond yields moved higher last week, reacting to the inflation news and an overall sentiment that the Fed will raise interest sooner and faster than originally predicted. The 10-year U.S Treasury bond rose five basis points to close the week at 1.81%.  

While the inflation reports seem high and are impacting all markets, we must remember that the Fed wanted inflation, which is part of its dual mandate of “price stability and maximum sustainable employment.” The Federal Reserve’s FOMC (Federal Open Market Committee) sets interest rates (monetary policy) at appropriate levels to achieve the dual mandate. We clearly have inflation and CPI releases surprised to the upside for most of 2021, but the November and December CPI figures were right in line with expectations. Further, employment numbers continue to be strong, and the current unemployment rate is 3.9%, almost near pre-pandemic levels. (See the chart below from YCharts and Valley National Financial Advisors – shaded sections = recessions). 

With inflation running well above the Fed’s 2.5% target and employment nearing sustaining levels, higher rates are clearly coming, and everyone knows this already. Fed Chairman Jay Powell has been very transparent with his plan for the economy and rates: tapering bond purchases, removing quantitative easing and raising interest rates. Fed Fund Futures markets are currently pricing in 4 25 basis point rate hikes in 2022, for a final target of 1.00-1.25% on the Funds Rate. Thus far in 2022, markets are reacting negatively to this, especially growth stocks which rely on low interest rates for borrowing and expansion. Last week, we showed a chart where markets rallied even during periods of rising interest rates. Further, modestly higher interest rates, both short-term and long-term, will still allow for continued economic expansion and will in no way be restrictive to growth. The shift in Fed policy certainly points to their concern about inflation but also underlies the strength of the labor market and the economic expansion. Lastly, higher interest rates, especially savings rates, will be a net positive for Americans with bank accounts and money market funds which are currently paying nothing to 0.01%. Since the onset of the pandemic, due to significant decreased spending, stimulus funds and increased savings, M2, the total supply of retail savings deposits and money market funds, has skyrocketed and as of December 2021 stood at $21.6 trillion. (See chart below from Federal Reserve Bank of St. Louis).   

Reasonably higher savings rates on these deposits will be beneficial to savers and also give consumers more money to save, invest or spend – all of which are good for an expanding economy.   This week will bring the start of earnings season and Wall Street analysts are predicting increases in net income and EPS but also predicting that EPS will be impacted by higher labor costs and actual labor shortages and increases in raw material costs. There’s been a lot of talk about a rotation from growth stocks to value stocks and certainly earnings season will exacerbate that trade one way or the other. Recall, January 2021, when Wall Street strategists predicting the same rotation trade only to see growth pick up steam after the first quarter.  The Fed’s “hawkish” pivot to higher rates, strong inflation and slowing earnings growth are more than offset by a near-historic low unemployment levels, massive savings accounts piled up by the consumer and healthy pent-up demand for goods and services. A well-balanced portfolio and a long-term outlook better portend a successful investor and that is our mantra at Valley National Financial Advisors.

View/Download PDF version of Q4 Commentary (or read text below)

Stocks
The three major U.S. equity indices – The Dow Jones Industrial Average, the S&P 500 Index and the NASDAQ Composite were each up between 21.0 – 28.7% for the full year of 2021. Continuing the year-long trend of equity industrials and dividend heavyweights outperforming technology, the S&P 500 Index came away as the big gainer for the year notching a stellar return of 28.7%. Regardless of the divergence in returns, the strong performance of all three market indexes shows the strength, depth, and breadth of the current bull market. In fact, the VIX, the standard measure of market volatility, fell throughout the year and provided very few large market pullbacks or sell-offs. Rather, the run up in stock prices in 2021 was slow and steady.

Bonds
During this record rise in stock prices, fixed-income markets, while selling off early in 2021, regained some composure mid-year and stayed relatively steady into year-end. In late November 2021, on the news of the new omicron variant of COVID-19, there was a flight to quality and as a result yields on bonds fell once again. The 10-year U.S. Treasury opened 2021 at a yield of 0.91%, hit a high of 1.74% in March and then closed the year at 1.51%. While not a year for strong bond returns, for the few occasions in 2021 when risk assets sold off, it was important that smart investors held anchor positions in risk management assets like bonds. 

Economy and Outlook
The Fed successfully orchestrated a recovery from the pandemic-induced recession of 2020, which gave consumers the confidence to spend on everything from leisure activities to new homes and renovations to existing homes. While inflation became a concern along with supply chains disruptions, labor markets were hot all year and unemployment slowly fell to 4.2% as hiring continued across all sectors of the economy. The omicron variant could have some impact on the future hiring process and worker’s willingness to return to work. However, the strength and virulent activity of this strain has proven weaker than previous variants. Further, it seems logical to assume that as the strains expand and mutate, they get weaker and eventually the pandemic becomes an endemic. 

As we look to 2022, there are headwinds and tailwinds to consider. While monetary stimulus will slowly get removed as the Fed reduces its bond buying and then moves to higher interest rates, fiscal stimulus could continue in the form of big policy spending like the Biden-proposed $1.8 trillion Build Back Better Bill. The consumer starts the year in excellent financial shape bolstered by strong increases in savings accounts and limited spending in 2021. Corporate balance sheets are also in excellent shape allowing firms to boost wages and hiring but supply chain disruptions and drastic increases in raw material costs pose dilemmas for corporate CEOs. Wall Street economists are modestly optimistic on 2022 with growth estimates for U.S. GDP averaging +3.0% which certainly provides a solid base that supports the continuation of the bull market. 

An issue to keep in perspective is inflation and whether current elevated inflation levels remain in place or prove to be transitory and temporary. The Fed has committed to focus on inflation and will take the relatively high inflation numbers seriously as they consider future monetary policy. Recall that the Fed operates under a dual mandate of price stability and full employment. We are clearly in the camp that the U.S. economy and corporate America will continue to recover as we move into the post-pandemic period. The omicron variant worries us, but its impact seems less so that previous strains. Overall, the economy and the markets are headed in the correct direction, but we are moving into a period where fiscal and monetary stimulus will be waning, and markets will take some time to digest that significant change.

by William Henderson, Vice President / Head of Investments
Equity markets began the year with a dose of volatility that was largely absent in 2021; with all three indexes selling off and U.S. Treasury yields rising leaving investors with few places to shelter from the storm. The Dow Jones Industrial Average lost a respectable –0.3%, the S&P 500 Index lost –1.8%, and the NASDAQ got walloped dropping –4.5%. All the news that was fit to print was bad for the markets and the headlines were dominated by the Fed and the release of the minutes from the December 2021 FOMC meeting. The minutes revealed a Fed not only willing to taper bond purchases and raise rates in 2022 but one also willing to begin some serious balance sheet management. This sent the yield on the benchmark 10-Year U.S Treasury higher by 40 basis points to 1.75%. The Fed’s attention to its balance sheet should not be considered shocking in our view as you look at how large balances have grown even since the Great Financial Crisis of 2008 and before the pandemic. (See the chart below from the Federal Reserve Bank of St. Louis.) 

Certainly, a Fed relying more heavily on balance-sheet reduction, which in turn removes liquidity from the market as the largest buyer of bonds slows its process, although this action alone may not be all bad for markets. With this action, the Fed could focus more on its balance sheet and less on rate hikes as a way of removing monetary stimulus. Lower short-term interest rates allow for a steeper yield curve (the measure of rates between short-term levels and long-term levels); which generally is good for financial firms and banks and therefore the overall economy.

Last week’s market moves were impactful, but this same movie played early last year, and Wall Street strategists prognosticated the great growth-to-value rotation in equity markets. Yet, by the end of the year, markets moved closer to parity and all three major indexes posted strong gains for the full year. Three times since the pandemic interest rates rose sharply in a brief time followed by a sell-off in growth stocks and the NASDAQ. (See the chart below from FactSet)  

Generally, the technology heavy NASDAQ sees higher rates as a headwind to upward performance. This is true because technology firms typically borrow more than established firms and therefore higher rates affect future performance, due to increased borrowing expenses. Besides the obvious relationship between rates and growth, this chart also shows that these selloffs tend to be brief and often create a window to buy technology and growth sectors at more reasonable prices.

2022 looks to be a year with more volatility and uncertainty than 2021. You will hear the phrase “All Eyes on the Fed” about 1,000 times this year as Wall Street tries to decipher the FOMC dot plots and tea leaves of Fed minutes and comments made by Chairman Jay Powell at his press conferences. It is understood that monetary policy whether in the form of higher rates, less bond purchases or balance sheet management must be adjusted to reflect recent strong inflation data and an unemployment level reaching 3.9%. Fiscal policy seems in flux as well, as President Biden’s Build Back Better plan flounders in Washington with each passing week. This leaves us with the consumer and the corporation to propel the economy alone. That’s not a bad picture when you consider both are very healthy with strong balance sheets, healthy cash positions and relatively low interest rates.  

This week we will get a good amount of economic data with inflation (CPI) coming out Wednesday, unemployment level on Thursday and retail sales and consumer confidence on Friday. “All Eyes on the Fed”?  We say all eyes on the consumer.