Market & Economic Update – January 2022
January 10, 2022
By, Peter Mueller & Steve Taddie
The past 18 months was one for the record books as the US stock market climbed the proverbial wall of worry and produced another great year of returns for stock investors in 2021. The benchmark, Standard & Poors 500 (S&P 500), posted 70 record highs during the year, the most since 1954. Stock prices moved in advance of corporate earnings as investors focused on the healthy economic backdrop more than the short-term worries of the day or negative headline risk. Valuation in the stock market remains moderately expensive with current 2022 earnings for the S&P 500 estimated at $215 per share. Based on these estimates, the market currently trades at 21 to 22 times earnings which is still reasonable given the low interest rate environment, increased productivity, and accelerating earnings (4th quarter earnings are expected to increase 21% year over year, marking the 4th consecutive quarterly earnings growth north of 20%). However, we have seen elevated prices in many asset classes such as real estate, selected commodities, labor, and the prices for goods and services. As a result, we enter the new year with higher inflation indexes coupled with a wide range of forecasts regarding future market and economic activity.
The Federal Reserve (the Fed) and monetary (interest rate) policy have helped fuel the asset valuation boom over the past decade via low interest rates and its asset purchase program (adding liquidity to the financial markets and economy by buying assets in the marketplace and holding those assets on its balance sheet). As economic activity proves more durable and sustainable, stimuli from the Fed becomes less important and allows the Fed to remove this excess policy accommodation – which is precisely the transition period we are entering. The Fed has now begun “normalizing” monetary policy by reducing, or tapering, its asset purchase programs over the next 3 months, with the intention of raising the Fed Funds rate, then possibly reducing its asset holdings – all at a slightly faster pace than the market previously expected. This quickened pace is in reaction to inflationary pressures that have built up over the past year specifically due to supply chain constraints and labor shortages. Changes in interest rate policy are expected to begin shortly after the Fed finishes tapering its asset purchase program, which could be as early as their March meeting. The markets are further pricing in 3 potential interest rate hikes in 2022, that will possibly occur as the Fed begins to reduce its asset holdings.
A good way to frame this change, is that the economy is healthy enough to stand on its own two feet – absent of excess support from the Fed. This is a positive in the long-term, as it signifies an independent and normal economy not requiring government assistance or support. Furthermore, it signifies that we have reached full employment (we still need more people to re-enter the labor force) and it allows the Fed to begin to focus on reigning in some of the inflationary pressures thus preventing inflation from becoming too persistent or problematic over the long-term.
Entering this period of monetary policy change will undoubtedly create some turbulence in market prices (both bond and stock markets) as the market begins to assimilate inflation and interest rate expectations into current pricing. While volatility will pick-up during this period of adjustment, it should be temporary much like the turbulence we often experience while flying. We will eventually find some “smooth air” which should allow the market to refocus on fundamentals – positive corporate cash flow and earnings which should drive stock prices higher for the year. During these periods, it is important to stay focused on the quality of your investment holdings, your asset allocation, and thinking long-term into multiple years of investment time horizon versus the short-term or the worries of each day – should they be economic, geopolitical, etc.
Circling back to inflation worries, a key issue remains that the higher the inflation rate, the higher the rate of growth or income is needed to surpass inflation’s eroding effect on the purchasing power of savings. The warning lights of inflation in the US have been flashing for some time, with the Fed remaining steadfast in its desire to err on the side of too much inflation rather than on the side of economic contraction. This holds true for many developed economies as well. Typically, one of the last guests to the inflation party is wage rates. Historically, hourly wage gains in the US have not exceeded the cost of living by enough for workers to experience sustained higher standards of living, as for the last 40 years, central banks (e.g., the Fed) have squashed inflation at about the same time the supply/demand dynamics in the labor market began to favor workers. This time around, the Fed has been patient with inflation pressures, but is beginning to indicate more aggressive moves to reign in these pressures from becoming more permanent. Within wage inflation, some of the reported wage gains has included one-time hiring and/or retention bonuses which do not carry over to future percentage-based raises for hourly or salaried workers. In the end, a little wage inflation could help bolster the middle class, but to meaningfully increase their standard of living, wage inflation needs to be higher than cost of living inflation.
Domestically and globally, except for less developed economies, it has been hard to maintain desired, stable inflation levels, as many developed economies have undershot those levels for years. As we stated earlier in the year, for the Fed to obtain their goal of a long-term average core PCE price index of 2 percent, they would either need to modestly overshoot that number for a 6-to-8-year period, or overshoot more significantly for a shorter period. With the price index data reported to date, it looks like the Fed will reach their goal sooner rather than later.
In this past year, forecasts from top notch economic forecasters have shown wider dispersion than normal. One of the issues driving this has been a narrowing of the pool of responders to surveys covering things from labor and capital investment, to consumer and producer activity and price data. Smaller sample sizes in surveys leads to results with lower confidence levels, and differing opinions regarding the impact of Covid 19 and its variants on government, business and consumer behavior create a formula for wider disparity of economic performance and commensurate market forecasts. This will likely persist through the year and will lead to a wider range of forecasted possible outcomes. As noted earlier, maintaining a longer-term investment time horizon allows one to look past the short-term worries of each day.
All the Best,
Steve Taddie Peter Mueller
The discussions and opinions in this correspondence are for general information only and are not intended to provide investment advice. While taken from sources deemed to be accurate, HoyleCohen makes no representations about the accuracy of the information in the letter or its appropriateness for any given situation. HoyleCohen’s quarterly statements are provided as a convenience and we encourage clients to refer to custodian statements as well.
