by William Henderson, Chief Investment Officer
All major market indexes fell last week adding to an already poor start of the year in equity markets. Even a wild upward rally on Wednesday was not enough to thwart negative returns across the board. The Dow Jones Industrial Average fell -2.0%, the S&P 500 Index fell -2.9% and the NASDAQ lost -3.5%. Year-to-date returns have stayed well into negative territory for all three major market indexes. Year-to-date, the Dow Jones Industrial Average is down -8.9%, the S&P 500 Index is down -11.5% and the NASDAQ has moved into technical “Bear Market” territory being down -17.8%. The Russia / Ukraine war has taken a triple toll on the markets: pushing oil higher, further impacting overall inflation, and finally impacting U.S. Consumer Sentiment. Inflation fears and this week’s FOMC (Federal Open Market Committee) meeting, where markets are expecting the Fed to raise interest rates for the first time in three years, negatively impacted U.S. Treasury bonds leaving us with a very volatile week in fixed income markets. After finishing the previous week at 1.73%, the yield on the 10-Year U.S. Treasury bond jumped last week by 27 basis points to close at 2.00%. (See the chart below from the Federal Reserve Bank of St. Louis).  

The yield on the 10-Year U.S. Treasury is now well off the dramatic all-time low of 0.50% hit during the peak of the COVID-19 outbreak and is working its way back to pre-pandemic levels. However, even as market participants are seeing higher yields, remember that if fear and uncertainty exist investors will need the risk management provided by fixed income securities. 

As mentioned, inflation, as measured by the U.S. CPI (Consumer Price Index), for February 2022 came in at 7.9% versus 2021, a 40-year high. All sectors, led by higher energy prices, showed increases including food and rent. See the chart below from FactSet showing oil prices (WTI Crude – left scale) and Inflation (U.S. CPI – right scale) and their close correlation. 

Critically, understand that the inflation data is backward looking information from February 2022 and therefore has not even considered the recent run up in oil prices during the month of March. This gives us a lot more confidence around the Fed’s plan for higher interest rates soon. 

Another data point that has us worried was last week’s release of the March preliminary University of Michigan Consumer Sentiment Index (previously called Consumer Confidence Index), which came in lower than expected at 59.7, versus a Bloomberg estimate of 61.0. At that level, the measure of consumer sentiment is the lowest since 2011 and well off the highs hit at the beginning of 2021 when COVID-19 was waning, and the geopolitical climate was a lot calmer. Throw in significantly higher oil prices and you get a worried consumer. (See the chart below from YCharts and Valley National Financial Advisors showing U.S. Consumer Sentiment since April 2021). 

We always talk about the efficiency of the markets, and we believe this to be the case today as always. Last week’s wild ride in the markets saw a 650-point (+2%) swing in the Dow Jones Industrial Average on Tuesday based on rumors of positive comments from Russian leader Vladmir Putin and hints of a ceasefire. This upward move was quickly reversed when peace talks fell apart and instead Russian invasions efforts into Ukraine intensified. As we write this report, ceasefire whispers are again underway, and markets are rallying. The international pressure on Russia and by decree on Vladmir Putin are enormous. Aside from blocking monetary transactions on SWIFT, an oil embargo by the west and severe sanctions elsewhere, the U.S. Department of Justice announced an intense “hunt” for assets held in the U.S. belonging to Russian Oligarchs. Putin was desperate enough to ask China for military and economic aid for its Ukraine war. This action was met swiftly with rebuke from Washington strongly advising China against any assistance whatsoever with Russia. In fact, this week, Washington officials are scheduled to meet with Chinese counterparts in Rome to discuss the war.  

It is difficult to see any outcome for Russia that ends well. The only plausible endgame is for a negotiated solution between Ukraine and Russia that gives Putin something yet allows Ukraine to remain and independent state. Unfortunately, if the war drags on, uncertainty and fear will persist, and the markets will react accordingly. Beyond the humanitarian impact the war is having, prices of such commodities as oil, natural gas and palladium are skyrocketing and inflation is the result which further impacts consumers and eventually economic growth. Expect inflation to continue for longer but the Fed will be on the move this week and their new objective will be to combat inflation. This week’s FOMC meeting will be important for reasons beyond the expected 25 basis point rate hike. The markets will be watching for language around the pace of future hikes and the scope of balance sheet reduction. This may add some calm and clarity to the markets, but it could be overshadowed by any breakdown in peace talks or unwelcomed involvement from China.  

by William Henderson, Chief Investment Officer
While domestic resiliency was present last week with strong jobs and earnings numbers, volatility related to the war in Ukraine won the week over and all three major market indexes closed lower. The Dow Jones Industrial Average fell -1.3%, the S&P 500 Index also fell -1.3% and the NASDAQ fell by -2.8%. Year-to-date returns continue to be unfavorable across all sectors and indexes. Year-to-date, the Dow Jones Industrial Average is down -7.2%, the S&P 500 Index is down -8.9% and the NASDAQ is down -14.8%. As a result of the uncertainty, fear, and volatility the “risk-off” trade occurred in the bond market and the prices of U.S. Treasury bonds moved dramatically higher sending yields sharply lower. The yield on the 10-Year U.S. Treasury fell 23 basis points from last week to close the week at 1.74% – a stunning move considering the path the Fed has laid out this year for interest rates. What this move tells us is that the safety and liquidity of U.S. Treasury bonds currently trumps everything else, including the Fed’s well-telegraphed plan of raising short-term interest rates. 

The move in U.S. Treasury yields further “flattened” the yield curve. If the yield curve (the measure of 10-year yields minus two-year yields) is flattening, it indicates the yield spread between long-term and short-term bonds is decreasing. The yield curve is often a reliable indicator of economic and monetary policy conditions. The recent yield curve flattening is a result of two-year Treasury bond rates rising in anticipation of Fed policy rate hikes; while 10-year rates declined, due to the flight to safety trade resulting from increased concerns over the war in Ukraine. (See the chart below from the Federal Reserve Bank of St. Louis showing the 10s – 2s spread and the dramatic decline since mid-year 2021). 

While a downward movement in the 10s – 2s spread has historically preceded an impending recession, we do not believe this to be the case now due to the sound underlying fundamentals of the U.S. economy including strong continued employment gains and near-record profits by corporations. According to FactSet, with the recent fourth quarter 2021 earnings season concluding last week, companies in the S&P 500 recorded average earnings gains of 31% over the fourth quarter of 2020. With such solid underlying economic fundamentals, why are the markets exhibiting such volatility and negative returns year-to-date? Fear and uncertainty!  These are and will always be the worst thing for markets. When you cannot measure the risk, the risk-off trade prevails, and investors sell stocks and buy bonds. Additionally, the Ukraine war and resulting severe sanctions on Russia are impacting many commodity prices, further exacerbating already hot-running inflation. This reaction again may be more than necessary, while oil spikes occurring are understood as Russia is a large supplier of oil to the world, their impact on the global economy is much less than one would think. See the chart below from Haver Analytics and Goldman Sachs showing Russia’s contribution to the global economy and Russia’s production percent of important commodities.   

Presently, oil is the biggest shock to the market and the price of WTI Crude has spiked to $130/barrel. Oil, as we have stated many times, is a key component in many household and industrial goods way beyond refined fuels for planes, trains, and automobiles. Oil is used in clothing (nylon & polyester), plastics, agriculture (pesticides & fertilizers), tools and toys – frankly – it is everywhere and when the price of oil rises, inflation is the result. These events – global slowdown in activity due to sanctions on Russia and the resulting inflationary impacts – puts the Fed in a quandary. Fed Chairman Jay Powell must raise rates to combat inflation but now he also risks slowing the economy at a time when things are precarious as the Russia/Ukraine war evolves. And thus, we have the uncertainty that the markets hate. 

Western nations are united in sanctioning Russia for starting the war with Ukraine. China, a strategic and economic partner of Russia, has not officially condemned the incursion but has stated succinctly that “all sides exercise restraint and avoid escalation.” While not a stern rebuke like the west, it may be the best we can expect from China, who selfishly understands any global economic slowdown will directly hurt their pocketbook. The obvious question is which side yields first – Russia led by Vladimir Putin, a former KGB Officer or Ukraine led by Volodymyr Zelenskyy, a former TV actor and his western “allies.” Again – uncertainty, and again – volatility in the markets.    Balanced portfolios with risk management tools like bonds help in times like this. What helps best is a level head and a long-term outlook on investments.

by William Henderson, Chief Investment Officer
Market volatility prevailed last week as the Russia / Ukraine “crisis” spiraled into a full-scale invasion and war between the two countries. On a continent that has been free of international aggressions of this sort since WWII, Russia acted unilaterally and invaded Ukraine. International reaction was mostly unified with quick condemnation from all countries except China, who remained silent. Markets ended the week on a mixed note, but wild price swings of 500 and 1000 points (on the Dow Jones Industrial Average) were common all week. The Dow Jones Industrial Average fell -0.7%, the S&P 500 Index gained +0.1% and the NASDAQ lost -0.2%. Year-to-date returns remain well in negative territory for all three major indexes. Year-to-date, the Dow Jones Industrial Average is down -6.0%, the S&P 500 Index is down -7.8% and the NASDAQ is down -12.4%. Even bonds were not spared last week in the modest sell-off as the yield on the 10-Year U.S. Treasury rose five basis points week-over-week to end at 1.97%.

The Russian invasion has spiked market volatility, increased uncertainty around the pace of the global recovery from the pandemic and thankfully brought unilateral financial sanctions to Russia. Volatility results simply from the uncertainty surrounding the duration of the Russia / Ukraine war and the impacts it is having on commodity prices; as Russia is a significant producer of several major global commodities such as oil, wheat, and palladium (a critical rare earth used in catalytic converters). See the chart below from FactSet showing the recent spikes in prices of oil and wheat.  

Thankfully, the reaction from the global community to the Russian invasion has been dramatic and financial sanctions such as limiting access to SWIFT banking channels and freezing of $630 billion of foreign reserves have already had an impact. Russia has closed its stock market, and the Russian Central Bank raised short-term rates from 9.5% to 20% to defend the tumbling Ruble. Of course, the reaction by the Russian people was a run on banks and ATMs in a last dash effort to get hard currency before an expected crash. Beyond financial sanctions and hardship on Russians themselves the international community has been swift in condemning Vladmir Putin personally and supporting Ukraine as much as possible. Given Ukraine is not a NATO country but borders several including Poland and Romania actual military support will be precarious and certainly measured baring a full-scale global conflict. 

As mentioned, fear, uncertainty and volatility are never associated with good times in markets – in fact quite the opposite. However, historically, markets look past geopolitical events and move higher over extended periods of time; and that alone should be an investors’ focus. (See the chart below from Haverford Trust & Ibbottson. Associates showing major geopolitical events and the increase in $1 invested in Large Cap Equities).  

While the underlying strength in the U.S. economy and thereby the markets exist, the current global uncertainty will prevail and grab all headlines. Higher commodity prices, specifically oil, have the propensity to impact the recovery and ongoing growth in the economy. Whether sanctions will prevail, and Russia retreats or U.S. policy makers impact markets by releasing strategic petroleum reserves, opening the Keystone XL pipeline or allow fracking again, we shall have to see. Typically, sell-offs in markets are short-lived and offer buying opportunities for longer-term investors. This week Fed Chairman Jay Powell reports to Congress and we may hear comments around the pace of rate hikes and balance sheet reduction in 2022. That story is significantly more important than what we are hearing from our national news media. Lastly, on Friday we will get another reading on U.S. employment conditions as the February jobs data is released. 

by William Henderson, Chief Investment Officer
Gangbuster numbers in retail sales and existing home sales failed to move markets higher as the continued unrest in the Russia / Ukraine put a damper on the markets. President Biden spoke towards the end of the week and said, “he believed an invasion by Russia into Ukraine was imminent.” That is all the fragile markets needed to chalk up another losing week across all three major stock market indexes. The Dow Jones Industrial Average fell -1.9%, the S&P 500 Index lost -1.6% and the NASDAQ lost -1.8%. Weekly returns added to a poor year so far in 2022, and all three major indexes are sitting on negative year-to-date numbers. Year-to-date, the Dow Jones Industrial Average is down -6.0%, the S&P 500 Index is down -8.6% and the NASDAQ, which naturally tilts to growth stocks and is much more sensitive to interest rates moves, is down -13.3%. Fortunately, as we have said over and over, when risk assets sell off, investors flee to the safety of bonds. Treasury rates moved lower across the curve 1-5 basis points: while the 10-Year U.S. Treasury Bond remained unchanged at 1.92%. 

The geopolitical situation remains fragile, but markets have typically tended to look past lesser geopolitical crises, instead focusing on where there may be pockets of economic impact. For example, Russia remains one of the largest oil producers especially in the European region where it also supplies up to 40% of natural gas to the region. We’ve certainly seen an impact on oil as the price of a barrel of West Texas Intermediate (WTI) has increased over the past several months. See the chart below from FactSet of the price of WTI since February of 2021.   

Oil is a critical component of many things well beyond simple heating and gasoline and the impact of higher oil prices are felt everywhere. As recent as 2019, the United States was completely oil independent producing enough energy to supply our own needs. The current administration killed the Keystone XL and banned new fracking on day 1 of taking office.   

Beyond the Russia / Ukraine situation there were pockets of good news, as mentioned above. Sales of existing homes rose +6.7% in January from the prior month to a seasonally adjusted rate of 5.5 million units, according to the National Association of Realtors. The housing market remains extremely competitive even in the face of rising mortgage rates in recent months. Additionally, U.S. retail sales for the month of January came in well ahead of expectations at +3.8% vs estimates of +1.9%, despite continued noise around the omicron variant. Retail sales increased in online sales, furniture and autos. As mentioned last week, the consumer remains well positioned to fuel the great “second reopening” of the economy especially as we move into spring and summer travel season. 

A final piece of economic news released last week was the Fed minutes from the January FOMC meeting. The minutes provided some comfort to the markets as they did not seem overly hawkish (higher rates) and contained no material surprises.  Economists had been predicting a +0.50% rate hike at the March 15-16 meeting; but the minutes revealed a Fed willing to raise rates at a gradual and measured pace. Almost immediately, markets adjusted the probability of a +0.50% rate to less than 33% from 94% (see chart below from FactSet showing the change in rate expectations from February 10 to February 17). 

In our opinion, this is good news for the markets. Inflation is running at a level that warrants higher interest rates but interest rates also fuel the economy so it can be a slippery slope for the Fed – raise rates to combat inflation but don’t kill the economic growth we are seeing. We believe a series of +0.25% rate hikes in a gradual, measured, and transparent manner is the right recipe for the Fed to quell inflation but continue to allow economic expansion. We further expect a gradual flattening of the yield curve (curve showing interest rates over time from short-term Treasuries to long-term bonds) as short rates rise but pressure on longer-term bonds continues due to pension funds, foreign buyers and investors seeking bonds as a risk management tool in their portfolios. 

This week we get a few more economic indicators including Revised 4th Quarter GDP (prior +6.9%) and U.S. Initial Claims for Unemployment. It is a holiday-shortened week and headlines will be dominated by the situation with Russia / Ukraine, and less so by the sound foundation underlying the growing U.S. economy. 

by William Henderson, Chief Investment Officer
Another hot inflation reading last week sent markets tumbling across all major sectors and all major indexes. Couple that with continued unrest and saber rattling between Russia, Ukraine and NATO Allies and you have the perfect recipe for poor weekly returns. The Dow Jones Industrial Average fell -1.0%, the S&P 500 Index lost -1.8% and the NASDAQ lost -2.2%.  Poor weekly returns piled on to weak year-to-date returns and as a result all three major indexes remain well into negative territory for 2022. Year-to-date, the Dow Jones Industrial Average is down -4.3%, the S&P 500 Index is down -7.2% and the NASDAQ is down -11.8%. Fixed income, while weak for most of the year, provided a modicum of safety for risk averse investors. Thus far in 2022, fixed income has fared just as poorly as equities; however, global uncertainty always moves investors to safety. We saw that last week as bonds rallied ever so slightly. The 10-year U.S. Treasury Bond fell one basis point to end the weak at 1.92%. 

As mentioned, last Thursday the government reported that inflation rose at a 7.5% annual rate in January, the highest level since 1982. January’s report piled onto the December 2021 level of +7.0%, both of which are well above the Fed’s target inflation level of +2.0% annually. (See the chart below from the Federal Reserve Bank of St. Louis).   

Inflation certainly seems to be out of control and well past the Fed’s target level and many economists now believe the Fed and the FOMC (Federal Open Market Committee) are behind the eight ball with respect to rate hikes. While Fed Chairman Jay Powell has preached patience and a need for moderate rate hikes; futures markets are pricing in a 50-basis point rate hike at the March meeting, according to the CME FedWatch tool. It is important to view the above chart as a whole and look at past recessions, past spikes in inflation and then a resultant calming of inflation as interest rates rose and slowed inflation. While some believe the Fed is behind, it seems to us that the Fed has effectively created their desired inflation and now will deal with it as is their design and plan. The Fed will be monitoring market data and economic indicators between now and the March meeting and that information will determine the magnitude and pace of future rate hikes. 

As we have mentioned before, positive returns in equities are possible in years where interest rates are rising. Further, Goldman Sachs published a chart showing varying outcomes for 2022 looking at economic growth and interest rates. Certainly, the economy is slowing from the robust growth we saw immediately after the pandemic-related recession. It is still growing, just at a slowing pace.   

We have certainly seen rising interest rates this year, but as bond yields rise, their attractiveness, especially for pension funds increases as well and buyers eventually return pushing yields lower. One potential outcome for 2022, based on data since 1975, shows modest S&P 500 returns given a growing but decelerating economy and rising yields. (See chart above). 

The uncertainty around the Russia / Ukraine situation is real and markets hate uncertainty, as we know. Outcomes here are too risky to predict but it is widely expected that the issue will not result in a global calamity and cooler heads, somewhere, will prevail.   On a different note, Bank of America economist, Anna Zhou, reported last week that credit card spending showed a noticeable uptick (+20.2% vs same period in 2020) in the previous two weeks and that the huge increase was due to a surge in services-related spending. This should not be seen as surprising given the recent drop in COVID cases and resultant decreases in mandates by states, including New York, Illinois, and New Jersey. Once the consumer, with a $22 trillion war chest, is free to spend, especially in the travel and leisure sector, we will see continued strong economic growth. Spending coupled with strong employment and inflation absolutely gives the Fed reasons to raise short-term interest rates; and that is what the market has already priced in as we have seen with rises in the two-year (1.57%) and 10-year (1.92%) U.S. Treasury bonds. Watch for a “second reopening” of the economy as the consumer is freed to spend and pandemic fades. 

by William Henderson, Chief Investment Officer
While year-to-date returns remain in the negative column for all three major market indexes, last week produced a positive week for patient and persistent investors.  The Dow Jones Industrial Average rose +1.1%, the S&P 500 Index gained +1.6% and the NASDAQ, as the week’s bigger winner, gained +2.4%.  As stated, year-to-date returns remain negative with the Dow Jones Industrial Average down –3.4%, the S&P 500 Index down –5.5% and the NASDAQ down -9.8%.  Fixed income, as in Treasury Bonds, which normally provide investors relief when markets are selling off, have fared no better year-to-date.  Last week, the yield on the 10-year U.S Treasury bond rose by 15 basis points to close the week at 1.93%. 

Our thesis each week is one centered around long-term investing that focuses on macro themes and avoids the noise presented by headline grabbing news sound bites and other hyperbolic tape bombs.  We have focused on the solid fundamentals that backstop the U.S. economy including well capitalized and healthy banks, profitable and growing corporations and consumers that are sitting on $21.8 trillion (about $67,000 per person in the US) of cash with few “open” venues to spend their money. (See chart of M2 by the Federal Reserve Bank of St. Louis. M2 consists of savings deposits, balances in retail money market funds and small-denomination time deposits.)

These fundamental strengths in the U.S. economy have led to strong year over year GDP growth, near record low unemployment and near record levels on major stock market indexes.  We point this out to remind investors of the importance of the relationship between a growing economy and a rising stock market.  See the chart below from Valley National Financial Advisors and YCharts, which shows the S&P 500 Index with U.S. Total GDP from 1992 to the present.   

There is a clear correlation between GDP growth and the stock market, especially over extended periods of time.  This commitment to long-term investment has rewarded the patient investor who sees the impact of macro themes on the markets.  We have stated that pull-backs and market corrections happen all the time, and notably during bull markets.  These occurrences are common and normal in functioning markets.   So, while we have seen weak year-to-date returns on markets (-5.5% YTD on the S&P 500 Index) recall that the S&P 500 Index returned +26.9%, in 2021 and +16.3% in 2020 and has averaged +10.5% annually since its inception in 1926 (Investopedia).  Long-term results are what matters to investors, not short-term returns, or short-term thinking. 

Further, last Friday’s release of the latest monthly employment report sent another wave of good news.  In January, 467,000 new jobs were created, which far exceeded Wall Street economists’ expectations of +125,000.  The massive increase in new jobs was surprising especially given the headwinds that the omicron variant created.  Particularly encouraging was the relative strength of job growth in the leisure and hospitality sectors which remain below pre-pandemic levels.  Lastly, there was a sharp jump in the labor participation rate which moved to a post-pandemic high (see the chart below from FactSet and Edward Jones). 

The labor force participation rate indicates the percentage of all people of working age who are employed or are actively seeking work.  When factored in with the unemployment rate (currently at 4%), the participation rate offers perspective into the state of the economy, which we believe continues to exhibit strength and solid potential for greater growth well into 2023. 

Certainly, last week’s jobs report puts the Federal Reserve in a quandary about interest rates and the speed and size of pending rate hikes.  Everyone knows rate hikes by the Fed are coming in 2022 and into 2023.  We pointed out last week that the stock market commonly moves higher, even during rate hikes and especially as rate hikes are known and already factored into most investors’ plans for 2022.  We remain steadfast in our positive long-term outlook for the economy and the markets.  Committed investors should do the same. 

by William Henderson, Chief Investment Officer
In an oddly quiet end to a volatile week in the markets where we saw a 1,000-point swing in the Dow Jones Industrial Average in one day, each major market index closed the week in positive territory or up slightly. The Dow Jones Industrial Average rose +1.3%, the S&P 500 Index gained +0.8% and the NASDAQ was unchanged. Year-to-date, the returns tell a different story as the severe volatility has impacted each major index, especially the technology-heavy NASDAQ. Year-to-date, the Dow Jones Industrial Average is down –4.4%, the S&P 500 Index is down –6.9% and the NASDAQ is down by –12.0%. Even bonds, which investors flock to in times of great volatility and fear, moved lower in price as a result, and the 10-Year U.S Treasury bond rose by three basis points to close the week at 1.78%.  

As mentioned, volatility in the markets has spiked, unlike 2021 where volatility was quiet and subdued. (See the chart below of the VIX (Volatility Index) from YCharts and Valley National Financial Advisors.) The VIX, the Chicago Board of Options Exchange Index, is designed to reflect investors’ consensus view of the future expected stock market volatility.

While the VIX has spiked in recent moves, it is nowhere near the fear levels we saw in March 2020 as the pandemic settled onto Wall Street. Earlier in the week, all the market noise was about the Fed and Jay Powell’s press conference following the end of the two-day FOMC (Federal Open Market Committee) meeting on Wednesday. Once the meeting was over, Chairman Powell had assuaged concerns that the Fed would be reckless in adjusting monetary policy. Further, Powell acknowledged that recent indicators of economic activity and employment continue to strengthen but remain impacted by the recent sharp rise in COVID-19 cases. Further, while Powell pointed to inflation running well above his 2% target, supply and demand imbalances related to the pandemic remain in place and are responsible for inflationary pressures. Lastly, the minutes of the FOMC meeting repeated their previous statement, “that it will continue to reduce the pace of bond purchases and expects it will be soon appropriate to raise the target range for the federal funds rate.” 

As we mentioned last week, equity markets have historically performed well through interest rate tightening cycles, and we pointed out to a Bloomberg article stating that the S&P 500 Index had averaged +9% annually during the previous 12 tightening cycles going all the way back to 1950. Our view is that while we will have greater volatility (see VIX above) we still expect markets to be positive in the year ahead. While last week focused mostly on the Fed and the release of the FOMC meeting minutes, an important economic report went almost unnoticed. U.S. 4th Quarter GDP was released at +6.9%, well above Wall Street economists’ expectations of +5.5% and full year 2021 GDP came in at +5.7%, also above consensus estimates. (See the chart below from the Bureau of Economic Analysis and Bloomberg). 

The current economic expansion, which started mid-third-quarter 2020, while solidly underway, still has plenty of pent-up steam left. In fact, FactSet has corporate earnings growth topping 9% this year; and the economic expansion continuing well into 2023. Again, we agree here as we have pointed out the relative financial strength and health of the banks, corporations, and the consumer; each of which individually and jointly fuels the economy. There are a few things that we are keeping our eyes on for a potential shock to the markets including: tensions between Russia and Ukraine, continued outbreaks of new COVID-19 variants and even oil prices, which continue to grind higher, hitting $84.48/bbl. last week (see chart below from the Federal Reserve Bank of St. Louis).   

Oil prices are now higher than pre-pandemic levels when the U.S. was considered by many to be oil independent. Oil is critical for most economic activity from plastics to home heating oil to gasoline; so, increases in prices will have immediate and lasting effects on inflation. 

It is easier to get swooped up with the noise of the markets and Wall Street than to stay focused on what is in front of us: economic expansion, attentive monetary policy, and a healthy and wealthy consumer. 

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.

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.