We expect 2022 to be a very interesting year from a markets perspective, primarily because the Fed has the unenviable task of taming, what has turned out not to be, “transitory inflation.” Inflation, as measured by the consumer price index, came in at 7% in 2021 which is the highest recorded level since 1981. Massive fiscal stimulus and loose monetary policy have fueled the jarring rise in prices observable in the economy, with supply chain disruptions and tight labor markets adding to the inflationary outlook.
Now the Federal Reserve must manage the concurrent normalization of interest rates and its $9trillion balance sheet. How challenging and economically risky is this dual monetary shift from low rates and excess liquidity to a normalized yield curve and balance sheet? It is quite tricky with recession or stagflation and market dislocation hanging in the balance.
Perhaps the use of an aviation metaphor is appropriate since the Fed is aiming for a soft landing with the economy, particularly in a midterm election year. Unfortunately for the Fed, it appears that their Open Markets Committee is behind “the power curve” when “landing the plane” which can produce very hard landings in real life aviation and the economy.
The market is expecting 3 or 4 rate hikes during the year of 25 basis points each. However, adding 1% to short term rates during the year will still result in negative real interest rates (the nominal rate minus inflation), and even nominal interest rates will remain below the sum of GDP growth plus inflation which avoids the level of tightening which is needed to tame inflation.
To offset the accommodative nature of negative real rates or low nominal rates in a growing but inflationary economy, the Fed may need to dramatically withdraw liquidity through its balance sheet normalization or quantitative tightening. The Federal Reserve balance sheet grew from $4trillion in 2018 to $9trillion currently. Asset values and equity multiples have thrived from the massive increase in liquidity combined with low rates. As this combination reverses, equity market volatility is bound to increase as prices adjust to higher rates and less money for investment purposes.
Moderating corporate earnings add further color to this economic mural of rising rates, declining liquidity, higher prices, and tight labor. Operating margins are coming under pressure which is showing up in lower earnings growth for 4Q2021 and, more importantly, for 1Q2022 earnings forecasts.
A further change in market equilibrium is the shrinking “Fed Put” (i.e. the use of monetary policy and interest rates to protect equity markets from another financial crisis). Since the market crash of 2008, many market participants have relied upon the Fed to keep interest rates low or inject liquidity if equity markets declined sharply. Quantitative easing was a manifestation of the “Fed Put” and on other occasions the Fed halted interest rate increases if markets became too jittery.
The Federal Reserve will be under pressure to stay the course of raising rates and reducing liquidity to reign in inflation. It could easily feel like a forced diet or an undesired intervention to investors. For now, the market has priced in 4 rate hikes and feels good about it. However, as the Fed works with the US Treasury or banks to remove reserves from the system, credit markets should slowly tighten, and equity markets will take notice. For a little more spice, a Russian invasion of the Ukraine in the coming weeks would add geo-political risk to asset values.
However, there remain bright economic notes to point out. We should expect supply chains to discover new efficiencies which will benefit companies going forward. Also, additional fiscal spending and likely tax increases are probably on hold as the midterm elections draw near.
While the prudent asset allocation might seem like an overweight to cash in this macro-economic landscape, inflation remains a real incentive to stay invested and attempting to time the market is not sustainable, usually producing more pain than gain.
However, we do believe that a modest level of de-risking in moderate growth portfolios is appropriate going into 2022. For long investment horizons, thoughtful diversification across asset classes with an overweight to equities, real assets, and some exposure to liquid alternatives seems like a wise investment strategy, though one with expected notable bumps along the way this year.
We believe our risk based diversified asset allocations within an active/passive approach provide both the discipline and flexibility to adapt to market conditions over the duration of the investment cycle.