Equity markets declined for the third week in a row while bonds moved higher (in price) as investors reacted to everything from turmoil in Washington D.C. to turmoil on the Russia/Ukraine border. 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 –5.1%, the S&P 500 Index lost –5.6%, and the NASDAQ also fell by –7.0%.  Last week’s negative returns added to the poor returns we have already had in 2022.  Year-to-date, the Dow Jones Industrial Average is down –5.6%, the S&P 500 Index down –7.7% and the NASDAQ down by –12.0%.  Investors, spooked by the volatility in the equity markets, moved to money to the relative stability of the bond market and as a result bond yields moved lower last week. The 10-Year U.S Treasury bond fell seven basis points to close the week at 1.75%. 

Equity markets seem poised to react more so to higher interest rates rather than corporate earnings. In 2021, we had a perfect storm of events that fueled the bull market for most of the year. We had fiscal stimulus in the form of trillions of dollars flooding the economy, monetary stimulus with the Federal Reserve keeping interest rates near zero and record-breaking corporate profits across many sectors. 2022 is going to be a transition year for both the markets and the economy as both are forced to adapt to higher interest rates and significantly less fiscal stimulus. Higher interest rates are a given as the Federal Reserve has clearly telegraphed their intentions to do so, and current futures markets are pricing in as many as 4 to 25 basis point rate hikes in the Fed Funds rate. Typically, in stable economic conditions, long-term rates move higher as well. We have already seen the 10-Year U.S. Treasury move higher by 23 basis points this year alone (see chart below from Bloomberg), and over 70 basis points higher than the low seen in 2021.   

Higher interest rates alone are not a recipe for poor returns in equity markets. In fact, in an article published over the weekend in Bloomberg, Truist Advisory Services reported that the S&P 500 Index averaged a +9% annually during the 12 rate-rising cycles since the 1950s (See chart below).     

One needs to understand why we are seeing higher rates already and why the Fed will continue this rate path well into 2023. Typically, the Fed reacts to economic growth, inflation, and employment in their calculations for rate movements. 2021 could see real GDP nearing 5% for the full year, unemployment is at 3.9% and inflation is running at 7% year-over-year. These figures tell us the economic recovery is far from over and corporate earnings, as a result, still have room to grow and improve. However, as we have said before, stocks never go up in a straight line from bottom left to upper right; in fact, the path is bumpy to say the least and we expect a similar path this time as well. Further, pull-backs in the equity markets are to be expected and are a normal part of functioning markets. (See the chart below from Valley National Financial Advisors and Clearnomics on annual returns and pullbacks).   

When volatility is high it is tougher to remain focused on a long-term strategy, but the fundamentals underlying the economy are solidly in place, businesses are sound, and the consumer is in strong financial shape. Mix in the employment situation and there is still reason to believe markets can move higher from here simply based on sound economic fundamentals. Volatility is the watchword for 2022 just like COVID was for 2020 & 2021. 

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.