The new year has gotten off to a rocky start. During the fourth quarter, we communicated that we anticipated greater volatility in 2022 and today we have it in spades. U.S. inflation remains the culprit with year-over-year increases in the Consumer Price Index of 6.9% in November and 7.1% in December, the highest levels in over 30 years. In our view, the volatility we are experiencing is linked to expectations that interest rates will rise faster than previously expected. While our risk discipline has caused us to make several portfolio adjustments, today we remain constructive on stocks over the year as a whole. Our current view is the precipitous decline is a temporary overreaction, as markets acknowledge the path forward will be more challenging than investors previously expected.
So how did we get here? For right or wrong, the seeds were sown after the 2008 financial crisis when the Federal Reserve moved from referee to market participant. The most recent example being an injection of 4.5 trillion dollars of monetary stimulus into the financial system by the Fed over the past 1 ½ years, not including five fiscal stimulus packages totaling more than $5 trillion. With so much intervention, market extremes are now becoming more severe and Central Bankers are creating a whole host of unintended consequences - wealth inequalities reaching extremes, inflation hurting the middle class, the dollar being debased, and populism in politics putting democracies at risk.
Financial markets are going through their first material correction since March 2020 lows and although uncomfortable, corrections are a normal occurrence in markets when the Fed is not intervening. The NASDAQ has experienced declines of more than 20% off recent highs, and 60% of the S&P 500 stocks were also down more than 20%. Meanwhile an unusual phenomenon exists…just six stocks represent about 25% of the S&P 500 and about 40% of the NASDAQ, often outperforming virtually everything else.
The markets reacted negatively to the Federal Open Market Committee (FOMC) meeting, judging that the Fed has pivoted hawkish. The Fed now signals they are set to end quantitative easing (QE) asset purchases and begin raising interest rates, letting the Fed balance sheet start to decline as early as March. If this is done, the Fed’s tailwind for risk asset markets may turn into a formidable headwind.
However, if inflation turns out to be more ‘transitory’ as some economists believe, this may justify a less restrictive Fed, which would likely be surprisingly bullish for equity markets. As COVID-19 cases continue to decline, it should help unlock the world’s supply chain bottlenecks, lessen inflation pressures, and allow for a more accommodating Central Bankers.
Inflation itself isn’t necessarily bad for stocks and tends to be positively correlated to companies’ earnings growth, especially for more cyclical companies. But for now, we will have to deal with ‘policymaker uncertainty’, and as we know, financial markets typically hate uncertainty hence the expected volatility.
As of today, we maintain a modestly bullish outlook for risk assets. Absent a Fed policy mistake, we expect 2022 to bring average economic growth, inflation that should ease from recent decade highs, and modest market gains. Earnings growth should remain healthy, but rich valuations may present another headwind to select holdings.
KG active asset allocation strategies seek to provide “all-weather” market exposure by embedding active risk management during these difficult times. Although our strategies can experience downside volatility, our goal is to generate positive returns in up or down market environments over a full business cycle, and therefore recommend investors have time horizons of greater than 5 years. Going forward, asset selectivity will aid performance which has led to holding individual stock positions in our dynamic model and more traditional exchange traded funds (ETFs) in our less volatile strategic model.
Ultimately, I remain confident in the long-term outlook and am excited about new investment opportunities ahead for patient investors. As always, our team is grateful for the trust you’ve placed in us to manage your portfolio and financial plans. If you have any questions or would like to consider if the approach or plans we use are still appropriate for your new circumstances, please call or email anytime. We always look forward to hearing from you.
Eric W. Kendrick, CFP Partner