Quarterly Update: February 2022

Highlights:

  • Despite downward revisions to 2021 growth estimates, real GDP has recovered to pre-pandemic levels and appears on track to return to the 20-year growth trend that preceded COVID-19.   
  • Despite service sector industries still struggling to reopen fully, corporate earnings are expected to reach all-time highs for 2022. 
  • Consumer spending drove GDP growth in 2021, but could begin to moderate as fiscal stimulus fades. 
  • Unemployment rates hovered around 4% by year-end (“full employment”). However, relatively low workforce participation has resulted in significant labor shortages in many industries.  
  • Inflation remains a primary concern with the headline CPI at 7%. This is due to a combination of factors, including unprecedented stimulus, supply shortages, and surging consumption. Although expected to recede from these levels, year-end projections are still well above the long-term average. 
  • Essentially reversing its previous position, the Fed has taken a hard hawkish stance in order to combat inflation and now projects as many as three rate hikes in 2022. 
  • Fiscal stimulus continues to fade, with very little opportunity for new spending on the horizon.  
  • Domestic equity markets cruised in 2021, while international equities remained hindered by COVID-related headwinds. 
  • Fixed income investing has been challenging this year as easy monetary policy coupled with a recession has kept Treasury yields low, with the 10-year finishing 2021 at 1.51% and the Bloomberg U.S. Aggregate Bond Index down -1.67% for the year.  

 

 

Monetary Policy

A rapidly improving labor market and persistent inflationary pressure has pushed the Federal Reserve to finally adopt a more hawkish stance as we enter 2022. In its December minutes, the Fed made clear that while the Delta variant had slowed economic progress, the labor market recovery has been robust and it now believes inflation to be stickier than previously expected.  As such, the Fed accelerated its pace of tapering by $30 billion per month, implying an end to its bond market support as early as March of 2022.ii This decision presumably clears the way for increases to the federal funds rate, with its dot plot forecast indicating three to four 25 basis point rate hikes in each of the next two years. iii 

 

The Fed’s abrupt change of strategy should not be minimized as it implies recognition that the current inflationary environment is more than just a temporary blip on the economic radar. Moving forward, wage inflation will be of particular importance to global central banks, as this has historically been one of the primary drivers of long-term inflation. While there is some optimism that inflation will moderate throughout 2022, year-end estimates are still high enough to erode nominal investment returns and drag on economic sentiment. Far from “transitory,” inflation will likely loom as a challenge throughout much of the year. vii 

 

Fiscal Policy

$5.3 trillion of unprecedented fiscal stimulus passed throughout the pandemic (both by the previous and current administrations) has proven to be a powerful accelerant for the economic recovery. The most recent $1.9 trillion package, passed in March 2021, is still working itself through the system and will likely continue supporting the economy through the end of 2022. However, the loose spending practices of 2020 may finally be coming to an end, now that economies have reopened and labor shortages have induced wage inflation. Concerns over inflation appear to have tightened the clamps on the stimulus faucet (for now). Despite successful passage of a $1.2 trillion “traditional” infrastructure bill in 4Q21, the current Administration’s ambitious “soft” infrastructure proposal of an additional $2 trillion seems to be dead in the water, primarily due to opposition within its own party. While it is anticipated that the overall economy will be stronger in 2022 than in either of the previous two years, it will most likely achieve this without meaningful fiscal support. ii 

 

Inflation

After holding relatively stable at 2% for the past 25 years, inflation soared in 2021 to levels not seen since 1982. iv Thanks to the collision of unprecedented monetary stimulus, surging consumer demand, and rampant supply shortages, inflation continued to ascend rapidly through 4Q21, with a year-end headline CPI of 7.0% (core inflation of 5.5%).vi While a portion of the increase is still being attributed to unique economic conditions, such as the severe supply chain disruptions caused by the pandemic and economic shutdowns; higher inflation is expected to linger and remain well above 2% for the remainder of the expansion. ii For its part, the Federal Reserve appears to have finally acknowledged as much, no longer referring to inflation as a “transitory” phenomenon. iii 

Despite the obvious inflationary trend, it does seem that some of the factors could ease throughout 2022. For example, oil prices doubled between 3Q20 and 3Q21, but have since retreated 17% from their peak. iv Additionally, there is some evidence that supply bottlenecks are beginning to open up, which could help resolve the current mismatch between supply and demand. However, persistent wage increases due to labor shortages threaten to continue driving prices higher, as does the rapid increase in housing costs, over the near-term. Assuming that supply-chain improvements continue, it’s possible we begin to see inflation recede throughout 2022, potentially finishing the year at around 3.5%. iv While this would certainly be good news, it’s important to recognize that even this level would far exceed the 2% target established by the Fed. 

 

GDP Analysis

During the first half of 2021, economic output rebounded sharply thanks largely to a combination of reopening economies, increased COVID immunity (due to vaccines and antibodies), and businesses learning to adapt to a “new normal” way of conducting operations. Quarterly GDP growth for the first two quarters were 6.3% and 6.7%, respectively, while year-over-year GDP growth at the end of June was 12.2%. i  However, in third quarter we saw the recovery slow down a bit, due largely to acute supply-chain issues and the impact of the Delta variant, as quarterly GDP growth declined to just 2.3% (4.9% year-over-year) by the end of September. ii 

After slowing down in the fall, and despite the emergence of a new variant (Omicron) in November, growth reaccelerated at the end of 2021 and is expected to continue to remain strong as companies rebuild their inventories. Although annual GDP data for 2021 will likely take a few months to confirm, expectations are that real output will exceed its pre-pandemic growth trajectory, implying a full recovery is on the horizon. Looking ahead, a shortage of workers, inflation concerns, and steep declines in both monetary and fiscal stimulus are expected to slow economic growth to its long-term trend of roughly 2% per year. ii 

 

Corporate Earnings

Earnings have recovered substantially since the big declines in 2020, achieving all-time highs in 2021.i This trend primarily reflects record profits within some of the most important sectors of the U.S. equity market, including technology and health care, which thrived during the pandemic. More generally, earnings have been bolstered by powerful consumer demand and higher productivity thanks to cost reductions related to more virtual work environments.ii However, corporate earnings began to subdue in the second half of the year, as profits for 3Q21 grew by only 3.4%, versus 10.5% in the previous quarter.iii  

Going forward, earnings growth is expected to be tempered by slower overall economic growth, higher wages, rising interest rates, and potentially higher corporate taxes.iv Additionally, while managing to finally resume somewhat normalized business operations in 2021, service sector industries continue to be plagued by the effects of new COVID variants. While still performing much stronger than a year ago, a “two steps forward one step back” trend may be on the horizon for restaurants, hospitality, and travel industries until the pandemic substantially subsides.  

 

Consumer

Consumer spending had a blowout year in 2021, posting double-digit growth in the first half of the year, and driving overall GDP growth far above its long-run potential.v While inflation concerns have accelerated, consumer confidence has fared relatively well on the backs of improving labor markets and rising wages. Hourly wages for November increased 0.6% from the previous month, beating expectations.vi  

Retail sales in the 4Q21 were up 2.1% versus the third quarter and 17.1% year over year. While areas like online shopping, sporting goods stores, and gas stations have seen above-trend growth since COVID began; service and hospitality sectors, like restaurants & bars weren’t back to pre-COVID levels until late spring 2021, and the winter rise in COVID cases is bringing volatility to these industries once again.  

Consumer spending is likely to remain strong in 2022, although expected to moderate somewhat from 2021 levels. Rising wages, jobs, and inflation will all be tailwinds, while falling savings, and the waning of the temporary boosts from stimulus and other government benefits will be headwinds. 

 

Equity Markets

Despite some investor trepidation in mid-November due to surging COVID cases, the S&P 500 exhibited robust 4th quarter gains of 11% and finished the year up 28.7%, just below all-time highs. Quarterly gains were strong across eight of the eleven primary economic sectors, with Real Estate (17.5%), Information Technology (16.7%), and Materials (15.2%) leading the way. iii For the year, the big winners were Energy (54.6%), Real Estate (42.5%), Financials (35%), and Technology (34.5%).i Small cap stocks underperformed large caps, with the Russell 2000 index up 14.8% in 2021. This was primarily due to concerns around inflation and additional COVID outbreaks. Generally speaking, small-caps aren’t as well equipped to weather the storm as large-caps. 

Despite robust returns for domestic equities, international stocks did not fare as well in 2021. While still in the green overall, the MSCI All Country World Index, ex US finished up only 7.8% on the year, while EM markets actually posted negative returns for the year, down -2.5%.viii Diverging market trends for international equities can largely be attributed to the different ways that nations around the world were impacted by the surging Delta variant. Some implemented stricter safety protocols than the U.S., restricting travel and forcing more of their regional businesses to reduce output. Furthermore, access to vaccines and treatments greatly varied across countries. This is particularly true of emerging market nations, many of whom are completely dependent on developed nations for these resources. While international equities still remain more vulnerable to future COVID outbreaks, they also currently provide a more favorable value proposition to us than domestic stocks. 

Following back-to-back years of robust returns and record highs for equity markets, hawkish monetary policy and elevated levels of inflation are expected to provide significant headwinds in 2022. In particular, high inflation and rising interest rates tend to be more problematic for growth stocks, whose valuations are largely based on projections tied to the cost of borrowing. While still susceptible to the same obstacles, we believe Value stocks appear to be relatively more affordable than Growth stocks, heading into 2022. 

 

Fixed Income Markets

Fixed income investing has been challenging over the last year, as easy monetary policy coupled with a recession has kept Treasury yields low. The 10-year Treasury finished the year at 1.51%. i  Liquidity facilities established by the Fed to protect parts of the bond market have compressed spreads, while low foreign yields and a temporary lull in Treasuries all appear to be suppressing long-term rates. As such, fixed income investments struggled in 2021, as evidenced by the Bloomberg U.S. Agg Index -1.5% return for the year. Conversely, High-yield bonds and Leveraged Loans, which often follow the trajectory of equities, performed much better finishing the year up 5.4% and 5.2%, respectively. Not surprisingly, Treasury Inflation Protected Securities (TIPS) proved the best-performing fixed income category, up 6.0% in 2021.viii 

Moving forward, the Federal Reserve, and its decisions related to rate increases, will be a key driver for fixed income markets. While it is likely the bond market’s initial response to these actions could be somewhat disruptive in the short-term, a “normalization” of monetary policy might be perceived as a bullish indicator to investors, and would ultimately provide more income potential in the long-run. Regardless, it seems apparent that interest rates will resume their ascension in 2022 against the backdrop of rising inflation, falling unemployment, faster growth, and a less accommodative Fed. ii 

 

Outlook

The global economy is expected to continue improving in 2022, with much of the world better off than it was 6-12 months ago. Potential new COVID variants introduce some near-term uncertainty, although unlikely to derail the overall recovery. Supply-chain issues and rising inflation continue to be chief concerns. Though inflation is expected to moderate from high levels, pressures may prove more persistent than expected. A return to normalization policies by central banks, including aggressive rate hikes by the Fed, will aim to mitigate these price increases, but are likely to create bouts of volatility in the market.  

In this context, we encourage individuals to view markets from the perspective of investors rather than traders. We recommend avoiding market timing approaches, as high inflation rates essentially guarantee meaningful value deterioration for holding large cash positions. For moderate and conservative investors, we recommend considering de-risking your portfolio and building in some defensive and inflation-resistant investments. As always, we strongly encourage you to connect with a fiduciary advisor to revisit asset allocations, liquidity needs, and risk tolerance to ensure your current investment strategy is in line with your overall financial goals and objectives. 

 

 

 

Andrew Mescon, MBA

VP of Strategy

Kristofer Gray, CFP®, CRPS, C(k)P®, MPA Principal
Sarah Archer

Chief Investment Officer

 

 

Sources:  

 

i. https://covid.cdc.gov/covid-data-tracker/#cases_casesper100klast7days

ii. https://www.worldometers.info/coronavirus/

iii. https://www.cnbc.com/2020/12/16/fed-decision-december-2020-fed-commits-to-keep-buying-bonds-until-the-economy-gets-back-to-full-employment.html

iv. J.P. Morgan – Economic and Market Update 1Q21 (12/31/20) 

v. J.P. Morgan – Guide to the Markets 1Q21 

vi. FS Investments – 10 for ’21 (11/30/20) 

vii. Goldman Sachs – Market Pulse Special Edition: 10 for 21 (12/2020) 

viii. Capital Group – Outlook January 2021 

ix. https://www.bls.gov/news.release/pdf/empsit.pdf

 

Disclosure: Past performance is not indicative of future results. The opinions expressed are those of the Integrity Financial Corporation (“Integrity”) and should not be taken as financial advice or a recommendation to buy or sell any security. Integrity is a registered investment adviser. Registration does not imply a certain level of skill or training.  Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Past performance is not indicative of future results. Investing involves the risk of loss of principal. Investors should ensure that they obtain all current available information before making any investment.  Indices cited in the information above are intended to support the opinions expressed and are shown as general examples of market trends. It is not possible to invest directly in an index and the volatility of the index may vary from that of an investor’s actual account. Note that index performance shown does not take into account management fees, and is not intended to be indicative of future results. Additional information about our investment strategies, risks, fees, and objectives can be found in Integrity’s Form ADV Part 2.  The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. There is no guarantee of the future performance of any Integrity Financial portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. 

The MSCI ACWI is a free float-adjusted market capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI Index consists of 49 country indices comprising 23 developed markets, including Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States; and 25 emerging markets, including Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Russia, Qatar, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates. 

The S&P 500 Index is the Standard & Poor’s Composite Index and is widely regarded as a single gauge of large cap U.S. equities. It is market cap weighted and includes 500 leading companies, capturing approximately 80% coverage of available market capitalization. 

The Bloomberg US Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States.