Now that 2022 is already in full swing we’ll jump right in with a quick review of the year that has gone past, followed by a look at how the year ahead might be shaping up.
Of course, we can’t tell the future, and you shouldn’t trust anyone who claims they can, but we can at least construct an idea of where the wind might be blowing.
The Year Behind Us
U.S. markets performed impressively in 2021, notching multiple record closes throughout the year. Of course, businesses were coming off the first year of the pandemic, in which corporate earnings for the most part had been significantly suppressed.
The return to functional work created a lot of upward momentum in stock prices, thanks to accompanying earnings growth. That growth in earnings created liquidity for many businesses, which allowed a lot of companies to buy back their own stock.
At the same time, the government put a lot of liquidity into the country in the form of stimulus funding, which gave many people enough excess cash to start putting it to work. Some people lost jobs or were furloughed, while others were able to continue to work remotely.
Either way, many people ended up having more cash than they needed, not only because of the stimulus but also because they really didn’t have the ability to spend the money on things like entertainment or travel.
Many allocated their unexpected largess into the markets, which of course helped increase prices.
Here we saw interesting choices being made, such as investing in GameStop and cryptocurrency, which were more risky approaches to investing than many people take with money they’re attempting to keep for the long term.
Often, when people have free and/or unexpected cash available, they’re more likely to take risks that they wouldn’t with money that was carefully saved and painstakingly accumulated.
We’ve heard this higher-risk approach to investing being called YOLO (You Only Live Once) investing. Call it what you will, it drove up the markets for unusual and speculative investments, like NFTs (non-fungible tokens), in addition to more traditional equities.
Despite these positive market trends, the markets did start to struggle towards the end of the year. In some cases, the struggle started as early as November, and as we have seen, continued into January.
The Year Ahead
The common theme, both this year and last year, is that the covid-19 pandemic is having less and less of an impact on global growth. While cases continue, vaccinations and variations in the virus have reduced some of the severity and the deaths that were causing lockdowns around the world.
As we look forward into the year ahead, continued vaccinations, new therapeutics like the Pfizer pill, less severe strains, and of course our ability, as humans, to adapt to almost anything, is allowing us to move forward economically, despite a once-in-a-century pandemic.
Inflation continues to be top of mind for most of us. The increase has been enormous, growing at the fastest pace in 40 years.
The global supply chain disruptions and bottlenecks that we discussed in October have carried forward into this year.
The Fed, at one point, referred to the inflation that we’re seeing as “transitory”, and it’s interesting that we’ve since seen that word being retired from their statements. It may be that even though the rate of inflation is expected to come down, “transitory” may not be the right description.
It’s unlikely that we’ll see prices returning to where they used to be before this run up on costs – reducing prices isn’t a common business sustainability practice. Costs are going up on everything across the board, including energy, food, goods and services.
Much of this has to do with the actual availability of the products we’re trying to purchase – which causes us to point back at those bottlenecks and supply chain issues.
You’re likely seeing this in your daily experience, just as we have. During a call with my mother recently, we spoke about the new flooring she had been wanting to get for her home. She’d been waiting for prices to come down, but after waiting so long, she’s starting to think that maybe … they won’t.
The glimmer of hope for mom, and the rest of us, is that usually at some point supply will overshoot demand. Bottlenecks will decrease, ships will start making their way more efficiently into ports, and trucks will start moving those goods more seamlessly across the country.
As supply increases, demand will start to fill, since people will now have the goods they had been waiting for. We may not see the nominal prices of goods start to fall, but we may start to see deals and sales as that demand decreases and retailers find themselves with more supply than they need.
The biggest hurdle is improving the supply chain. Just getting goods into some of our largest ports in California has been tough since a change in environmental regulations that has impacted truckers.
The majority of the long-haul trucks that deliver goods across the country aren’t able to meet the new requirements. This leaves only a small handful of trucks to take goods from the ports to the state border, where they are met by non-compliant trucks waiting for the hand off to make the trip across the rest of the country.
Just writing about this level of inefficiency makes me cringe.
On a more positive note, as efficiency improves, we should see a corresponding improvement in the supply chain, the availability of goods, and ultimately inflation should be significantly impacted by that change.
In spite of these challenges, the economy remains strong. When economies experience periods of strength like this one, global banks start to consider downshifting the amount of liquidity they’re putting into markets.
Generally, as strength increases, we see governments moving toward tightening, using interest rate hikes to help cool the rate of growth – which then also cools the rate of inflation.
Of course, interest rate hikes end up influencing market returns.
Generally, the markets tend to rally ahead of an interest rate hike, and then after the first hike in a series, we see a little softness. It’s possible that we’ve already seen that softness in January, as the market is anticipating this change.
The markets continue to adjust as new information arises, and our biggest question now is not whether interest rate hikes are coming but how fast they’re going to come.
At the same time hikes are being contemplated, we’re seeing the government easing back on liquidity. This potentially creates a double whammy, by removing liquidity from two different directions.
Again, the speed of rate hikes will make a significant difference to how the market reacts.
In the past, when we had rapid hikes of half a percent at a time, this faster tightening cycle had a much more negative impact on the markets than slower and lower hikes. In slower tightening cycles, markets have actually performed well. What remains to be seen is which approach they’ll choose to take.
Interest rate hikes will of course have an impact on bond prices, as longer term bonds tend to do poorly when interest rates are on their way up. Big growth companies, like those on the NASDAQ, will be seriously impacted by the reduced liquidity that they’ll experience as interest rates rise and put pressure on borrowing.
As the Fed reduces liquidity, there will be far less cash sloshing around, and people will be making less risky choices with their investments. Of course, valuations have gotten very high in the past year, and in some cases price growth has outpaced earnings.
All of these factors tell us that there’s real potential for increased volatility in the markets, especially through the first half of the year.
Going into the third quarter, we have midterm elections. Uncertainty always makes the market a bit nervous, and we may see some investors sitting on the sidelines, waiting for an outcome before deploying capital.
Short term volatility doesn’t always mean negative returns, however. We’ll be watching our base scenarios carefully, looking for the very real possibility of opportunity veiled in those downward swings.