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Market Update - January 2022

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Image: The Fed doesn't want to get on this horse. The horse is inflation and is not easily tamed.

  • Stocks rose and bonds fell during December as investors digested the end of heavy pandemic stimulus and the mildness of the Omicron Covid variant.
  • Headline inflation is running at more than 6% as labor, energy and most of the consumer's basket rise in price. The impact of future shelter inflation on consumers will probably add 3-5% to baseline inflation as we go into 2022. Food companies announced 20% price increases for January.
  • The stock market is responding positively to increased stimulus from the Fed as they hold their policy rate at zero. The difference between CPI and Fed Funds rates has never been this wide in the last 60 years.
  • The bond market remains stable as central banks and foreign governments remain bond buyers despite sharply rising inflation.

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Broad market performance

Table 1: Performance update

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Equities rose and bonds fell during the month of December as the Fed rolled out a weak response to rising inflation and economic growth continued to move along. Strength in US large cap stocks was pronounced as small caps, international and emerging markets all lagged. Large companies like Apple, Google and Tesla dominate the performance of the various markets and there are few global competitors. Bonds weakened slightly but remained remarkably resilient in the face of very strong inflation.

The Fed and Inflation Are All That Matter

Inflation is running hot and is still rising. The causes are now clear and not easily fixed. The pandemic shutdown hurt the global economy damaging supply networks and normal business operations. Governments provided stimulus money to cover the difference, but the delicate balance of supply and demand was disrupted. Demand rebounded strongly in 2020, but supplies of food, labor, cars, and imported goods did not keep up. Additionally, the Federal Reserve's program of financial repression, in place since 2009 to stimulate growth and inflation, created plenty of incentives to borrow and spend. The pandemic acted as a catalyst to unleash price pressures and behavioral changes that had been building for some time.


Looking into 2022, the progress of inflation and the Fed's response to it are all that matter to investors. Even another Covid shutdown may not change this dynamic. The Fed has admitted another government shutdown will aggravate supply chain problems and increase inflationary pressures. Many stimulus programs are winding down, which will ease the inflationary impulse, but at the same time residential and food price increases will be pushing up inflation in early 2022. Expect a few horrifying inflation readings in early 2022.


Looking over the last 60 years, the United States has never seen this mix of low bond yields and high inflation. These numbers are in different universes.


Figure 1: 21-year comparison of inflation, 10-yr yields, and Federal Funds rate

(Increase your screen magnification using ZOOM function to see better)

Negative Real Interest Rates = Stimulus

In economics, there is a concept called "real" interest rates or the difference between the market's interest rate and inflation. When inflation is higher than the corresponding interest rate, this is call "negative real yield" and is considered a powerful form of Federal Reserve monetary stimulus. It is usually only employed during recessions or time of war. In the chart below, I've depicted CPI minus Fed Funds to get a sense for how much inflationary stimulus the Fed is tolerating. At 6.73%, this rate of negative real yield is higher than at any time in the last 60 years. It even beats the 1970s!

Figure 2: US Consumer Price Index Minus Federal Funds Rate

Labor Market Problems

The labor market in particular has shown limited signs of healing since the pandemic. Ironically, the strength of the equity market has made early retirement possible for many workers in their 50's and 60's. Many client-facing workers are reluctant to return to work and vaccine policies are leading to layoffs. There are many anecdotes of labor shortages, especially in the service sector. Yet, the Fed keeps the stimulus going to improve labor market conditions. This is a paradox.

Figure 3: Labor Force Participation of Men and Women in the US

The Fed Is The Key

How the Fed responds to inflation is the key for understanding market performance in 2022. If the Fed panics and begins raising rates quickly, we may see incredible volatility in the bond and equity markets. If they raise rates slowly and allow inflation to expand, then corporate profits will soar and stocks will rise while bonds remain stable.


It is pretty clear that this is the Fed's game plan:


1) Get Jerome Powell renominated to remain FOMC Chairman.

2) Gradually reduce quantitative easing (yes, they are still doing QE).

3) Consider raising rates 3 times in 2021 to a whopping 0.75% with inflation at 6+%.

4) Hope the bond market remains stable and rates unchanged.

5) Hope the political pressure to fix inflation goes away.


In other words, tame inflation without slowing the economy or tightening financial conditions.

Inflation Narrative Changes

Speaking of political pressure, the narrative on inflation has become extremely interesting in the media. Here are some recent headlines from different publications calling for the Fed to raise rates and do something about lowering inflation.


Figure 4: Headlines on inflation December 2021

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It is pretty clear the public and politicians are pressuring the Fed to act on inflation. That means higher interest rates and quantitative tightening. Some research firms are expecting rates to increase much more rapidly than the market expects.


As I mentioned last month, the real question here is how long will the Fed wait to take care of inflation? The longer they wait, the higher rates may have to go, the deeper the economic contraction required to break the cycle. This was the existential question of the 1970s: Which is worse? Inflation or Unemployment. This is the dilemma currently facing Fed Chairman Jerome Powell.

Bond Market Stability

Despite the rapid rise in inflation, the bond market has remained very calm. This may be one reason why the Fed is moving slowly on raising interest rates. The bond market itself seem unconcerned about higher inflation. Many years ago, higher inflation drove down bond prices and yields higher. The bond market has not behaved this way since the early 1990s.


There are three reasons for this modern change in bond market behavior. 1) Central banks bought trillions of Treasury bonds to suppress yields and stimulate growth. Japan began in 1990; the US began in 2008. This behavior calms the bond market. 2) Our trade partners China, Japan, Germany, and Korea do not repatriate their trade profits and build up huge currency reserves in dollars that have to be parked somewhere. That somewhere is the bond market. 3) Regulatory changes since 2008 have forced banks to hold more Treasury bonds in their loan portfolios.


All three changes over time have created constant pressure in the bond markets that lowered rates and stabilized yields at low levels.

Figure 5: 30-year Comparison of Consumer Inflation and US 10-year yields

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Other Key Factors for 2022

It is impossible to consider every factor likely to affect a forecast. However, there are several key items besides the Fed we will be following in 2022:


1) Mid-term elections. The Democrats are likely to lose the House, maybe the Senate based on recent polling. Presidential cycle timing, inflation, and unpopular policies are working against the Democrats with the voters. This will have a big impact on impending tax legislation.


2) Government may shutdown again. If the government panics again and shuts down the economy, this will have negative impacts on employment and profits.


3) China and Russia may up the ante in the new Cold War. Tensions over Taiwan and Ukraine are not going away.


4) Supply shortages may turn into gluts. These are also known as inventory recessions and can happen without Fed intervention.


5) Major cyber-attack. Our open internet is vulnerable to attacks from our geopolitical enemies. So far, business interruptions have been sporadic and isolated.


6) Unknown unknowns. To quote former Donald Rumsfeld, there are risks we can't hedge or predict. In December 2019, who had even heard of the word Covid? Maybe we will clear up that alien spaceship question.


7) The Best-Case Scenario. Covid infections plunge, supply chains are unclogged, inflation plummets, the Fed only raises rates to 1%, prosperity spreads globally, Russia and China abandon hostile geopolitics, and peace spreads throughout the world. We can only hope.

Final Thoughts

The economy is strong, yet valuations are similar to the 2000 highs with the Fed about to raise interest rates. Historically, this implies a very choppy environment.



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Again, if you have any questions, please call me at 281-402-8284.


Sincerely,


Rob and Chris

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Robert J Lloyd, CFA®

President and Chief Investment Officer

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380


281-402-8284

Robert.Lloyd@lloydsintrepid.com

www.lloydsintrepid.com

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