Period ending December 31, 2021
by Daniel Greulich, CFA, CFP®
Chief Investment Officer
The Tug-of-War Between Growth and Inflation: Which Will Win?
In every economic period there are a myriad of forces that pull the market in different directions. As we begin 2022 the most significant forces are corporate earnings growth, COVID-19, and inflation. While economic projections are at times inaccurate, the Federal Reserve Board (the Fed) is expecting 4% economic growth and Goldman Sachs is predicting 4.5% growth this year. Those are Real Return projections calculated as growth minus inflation. That kind of growth would be a significant pull in the right direction for market growth. Pulling the market back in the other direction is another spike in COVID-19 cases fueled by the Omicron variant and high inflation, which appears to be less transitory than originally forecasted. The Fed’s challenge this year will be finding the right prescription for raising interest rates. With the pull of growth to the positive side and the pull of a pandemic and persistent inflation towards the negative, GreenUp anticipates we will experience a year of modest stock market gains with increased volatility.
What Happened Last Year
2021 was a strong year in the market despite significant obstacles. The first half of the year saw the US stock market recording new highs and the international MSCI Index reaching levels not seen since before the Great Recession of 2008, pushed by the tailwinds of continued government spending, low interest rates, and optimism with the rollout of COVID vaccines. In the third quarter we saw performance negatively affected by a seemingly overpriced market, China’s totalitarian policies, and fear that the bankruptcy of Chinese real estate conglomerate Evergrande would trigger another global liquidity crisis akin to the Lehman Brothers bankruptcy in 2008. By the fourth quarter those fears took a back seat to concerns over high inflation and the start of another outbreak of COVID-19, counter-balanced by strong corporate earnings. Earnings growth may have peaked in the fourth quarter, as corporate earnings for 2021 culminated with an impressive 50.9% year-over-year growth rate. The final quarter’s earnings growth was fueled by excess liquidity due to continued low interest rates and an accommodative monetary policy, continued low unemployment, and high retail sales (18.2% year-over-year growth).
Large US stocks had a strong finish in the fourth quarter as the Dow and the NASDAQ rose 7.4% and 8.3% respectively, while the large cap S&P 500 Index gained 10.6%. Mid-cap stocks finished the quarter up 7.6%, while small caps rose just 1.9%. For the year of 2021, the S&P 500 Index led the US market with a 26.9% gain, followed by mid-caps, up 23.2%, and the NASDAQ, up 21.4%. The Dow added over 5700 points last year—a gain of 18.7%. Small caps lagged, finishing the year up 13.7%.
In international stocks, developed markets finished the year up 11.4% while emerging markets declined -3.6%. In 2021 commodities were mixed, with Gold pulling back -3.5% and Silver declining -11.6%. Copper jumped 26.8% while Oil was the big commodity winner surging 55.1% (Source: The Sherman Sheet).
GreenUp’s 2022 Outlook
The growth forecasts for 2022 are positive, however we anticipate increased volatility. The US Bureau of Economic Analysis’ Gross Domestic Product (GDP) estimate for the first quarter of 2022 is 4.0%. The corporate earnings environment will provide a significant advance forward, which we believe will be offset by the added risk of COVID-19 disruptions and high interest rates pulling back on the economy.
The Pull of the Pandemic
2021 ended in a similar fashion to 2020 with COVID-19 cases on the rise. Initial data suggests that the Omicron variant, while significantly more contagious, is less dangerous than the initial COVID-19 and Delta strains. Hopefully the virus is losing its potency and in the long-run we will not have to worry about continuous COVID outbreaks periodically slowing the economy. At the same time vaccines are becoming more accessible worldwide while Pfizer’s Paxlovid pill reduces hospitalization and death by 88%. COVID-19 has had not only a profound impact on society but has been a challenge for the global economy by disrupting the global supply chain, leading to high inflation. Vaccines and therapeutics will likely reduce the impact of the COVID-19 pandemic on society and the economy as the virus transitions from a pandemic to an endemic illness. Reducing the impact of COVID-19 should lead to fewer supply chain disruptions, lower inflation, and a healthier economy.
The Pull of Inflation
While the future shows promise, the pandemic currently continues to surprise researchers, policy makers, and society, and it is unknown how long the virus will continue to exacerbate supply chain challenges. High consumer demand mixed with a limited supply of goods has led to inflation not seen since the 1980s. The Fed is in a challenging position as it fights inflation. At the same time the Fed is planning interest rate increases, it must also unwind a balance sheet of $8.8 trillion. The Fed sets a target interest rate that banks pay to borrow money (known as the Federal Funds Rate), directly influencing short-term interest rates. The Fed has stated that it will raise interest rates in 2022, however it may increase rates too fast or not fast enough. While the Fed is the world’s premier research bank with access to a trove of economic data, at some point it is likely going to be wrong about inflation. If the Fed does not raise rates fast enough the economy could overheat. If the Fed raises rates too fast it could cause a recession. What will affect the market is not the Fed’s plans to raise short-term interest rates but rather how quickly the Fed raises rates and the market’s perception of its actions.
Another issue the Fed faces is how inflation is calculated. The inflation rates of the components that make up the core CPI (Consumer Price Index) can vary dramatically, as they do now. Since the United States is a large country, localized economies experience inflation differently, and even within those local economies different goods and services are inflating at different rates.
An improvement in the supply chain could significantly lower prices on items such as vehicles and other goods. We will not know for some time whether inflation is transitory or persistent.
At GreenUp we use inflation and interest rates as metrics to guide our portfolio management. One metric of interest is the yield curve for US Treasury Bonds or the “Yield Curve”, which is a measurement of the interest rate yield for US Treasuries at multiple different maturity dates. We actively watch the Yield Curve as a long-term metric for forecasting. Specifically, we focus on the relationship in interest rate yields between the 2-year and 10-year US Treasury Bonds. It is typical for the 10-year US Treasury Bond to have a higher interest rate yield than the 2-year US Treasury Bond. When this relationship reverses and the 2-year Treasury yield is greater than the 10-year Treasury yield (commonly referred to as a “yield curve inversion”) there likely are problems in the near-term. These cracks in the market are caused by the Fed raising rates too quickly and can indicate low prospects for growth in the future. On average a recession typically occurs within 9 to 12 months from when the Yield Curve becomes inverted. Another metric we monitor regularly at GreenUp for short-term market movement is the Options Adjusted Spread (the difference in interest rate yield between investment grade and high yield bonds) which indicates a deterioration in credit markets and may foreshadow a market downturn in the following weeks. Although the Yield Curve is flattening and the Options Adjusted Spread is narrowing, we are not in territory that would cause concern at this time.
What GreenUp Anticipates for the Market
As interest rates increase, we expect more volatility in the new year than in 2021. If we were to see a correction (a drop of at least 10%) this year we would see it as a buying opportunity to take advantage of lower prices. GreenUp does not anticipate a recession and we remain optimistic about strong corporate earnings continuing into 2022. A prolonged period of high inflation would be a drag on the economy, but GreenUp believes high inflation will ultimately subside and we will return to “normal inflation” which is part of a healthy and growing economy that we have not seen since the Great Recession of 2008. The decade that followed had little to no inflation, no wage growth, and historically low interest rates. Because we see the potential for a strong economy, GreenUp’s dynamic portfolios remain at 105% of risk relative to their benchmarks. A variable we are cognizant of is COVID-19’s ability to change the direction of the economic tug-of-war, so we continue to monitor market conditions.
Our economy has seen similar obstacles before with periods of high inflation that ultimately subsided. We have seen the Fed over and undershoot interest rates, and it will happen again. However, corporations are still making money. Since GreenUp anticipates higher volatility in 2022 the money you will need in the near-term should be liquid and safe. However, for your long-term investment dollars, GreenUp believes equities are your best investment option. Now is a good time to discuss your short and long-term cash needs with your GreenUp Wealth Advisor.
- As long as corporate earnings growth remains strong, earnings will advance the market forward. GreenUp anticipates a modest growth year in the stock market.
- COVID-19 remains a pull on the market, along with correlated high inflation.
- GreenUp expects increased volatility in 2022 as the Fed fights inflation by increasing interest rates and unwinds its $8.8 trillion balance sheet.
- Discuss your short and long-term cash needs with your GreenUp Wealth Advisor.
GreenUp Investment Models Update
Active Allocation Models (Capital Appreciation, Growth, Balanced, Capital Preservation) The risk budget remains at 105% versus the benchmarks. We are adding US Global Jets ETF (JETS) as a re-opening trade, and iShares S&P500 Value ETF (IVE) to diversify the portfolio and reduce risk. In fixed income we sold SPDR ICE Preferred Securities ETF (PSK) and replaced it with the Invesco Senior Loan ETF (BKLN) as we continue to prepare for a rising interest rate environment.
Large Cap Stock Model We are selling Magellan Midstream Partners L.P. (MMP), Enterprise Products Partners L.P. (EPD), Mastercard (MA), Ionis Pharmaceuticals (IONS), Fiserv (FISV), McKesson Corp (MCK), Anthem Inc. (ANTM), and CVS Health Corp (CVS). We are adding Booking Holdings (BKNG), CarMax (KMX), IQVIA Holdings (IQV), Roblox Corp (TBLX), Analog Devices (ADI), and eBay (EBAY).
Tactical Equity Model The SPDR Dow Jones Industrial Average ETF (DIA) replaces the iShares S&P Mid-Cap 400 Value ETF (IJJ)
Tactical Income Model In December we replaced iShares High Yield Corp Bond ETF (HYG) and iShares Investment Grade Corporate Bond ETF (LQD) with iShares 7-10 Year Treasury ETF (IEF). This quarter we are adding back HYG.
The performance of market indexes is discussed as indexes are generally well recognized as indicators or representations of the stock market or certain sectors. Market index performance does not normally reflect reinvestment of dividends or expenses, and you cannot typically invest in a market index.
GreenUp Wealth Management is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.