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.