Equity markets got off to quite the rocky start to begin the 2022 with the S&P 500 falling 5.26%, the NASDAQ losing 8.98%, the Dow Jones Industrial Average slumping 3.32%, the Russell 1000 Value “outperforming” by falling only 2.46% & the Russell 1000 Growth ending the month down 8.62%. January’s selloff marked the S&P 500’s worst monthly performance since March of 2020, when the onset of the COVID-19 pandemic caused the S&P 500 to fall 16.36%. Despite rebounding in the final two days of trading in January, both the NASDAQ & the Russell 1000 Growth ended the month of January in correction territory as the tech-heavy indices closed the month 13.85% & 11.61% below their 52-week highs, respectively. Additionally, the S&P 500 briefly dipped into correction territory towards the end of January when it closed 11.37% below its 52-week high on January 27th only to rally more than 4.5% in the final two days of trading to end the month only 6.71% below its 52-week high.
January Stonemark Market Commentary
January saw 10 out of the 11 S&P 500 sectors end the month in negative territory with Consumer Discretionary (-9.70% for the month of January) & Real Estate (-8.54% for the month of January) leading the markets lower. The only sector that ended the month in positive territory was Energy, which surged 18.97% to start 2022. The Financials sector was virtually flat to start the new year thanks in part to strong earnings results out of the big banks & the recent rally in interest rates, both of which we will cover in more detail later in this commentary.
The Fed, Interest Rates & Inflation Dominate January
After nearly 2 years of unprecedentedly low interest rates resulting from extremely accommodative monetary policy from the Federal Reserve (“the Fed”), the yield on 10-Year U.S. Treasuries has returned to its pre-pandemic levels, closing the month of January at 1.78%. The surge in Treasury yields to start off 2022 comes after the Fed announced at its December meeting that it would start raising interest rates & reducing the assets it holds on its balance sheet starting this year. At the Federal Open Market Committee’s (“FOMC”) January meeting, Federal Reserve Chairman, Jay Powell, reiterated the Fed’s upcoming monetary policy actions by recognizing that while COVID-19 uncertainties will remain for the foreseeable future, the labor market is improving & overall economic activity is continuing to strengthen. As a result, Powell & the FOMC agreed to maintain the Fed Funds rate at the current 0-0.25% target rate but also acknowledged that they expect that an “increase in this rate would soon be appropriate.” Looking at the graphics below, it is clear that not only do the markets expect several rate hikes in 2022 & the beginning of 2023, but the markets are expecting increasingly more rate hikes on a weekly basis.
Looking at Figure 1 above, just in the last month, the CME Group’s FedWatch Tool has started pricing in an additional 1-2 rate hikes by the end of 2022. As of January 6th, 2022, the FedWatch Tool was pricing in 3-4 interest rate hikes by the end of the year, which would bring the targeted Fed Funds rate to 0.75%-1.00% (3 rate hikes) or 1.00%-1.25% (4 rate hikes). However, as of February 4th the FedWatch Tool is now pricing in 4-5 interest rate hikes, which would bring the Fed Funds target rate to 1.00%-1.25% (4 rate hikes) or 1.25%-1.50% (5 rate hikes) by the end of 2022. That being said, it is important to remember that the CME Group’s FedWatch Tool is simply a snapshot of where traders, who are actively trading these Fed Funds futures contracts, expect rates to be come December & that these traders are buying & selling these contracts either for hedging or speculative purposes. As a result, these probabilities must be taken with a grain of salt as only the FOMC can actually set the targeted Fed Funds rate. Looking at Figure 2 above, we can clearly see that over the last 5 Fridays from December 31st through January 28th, there is growing expectations that by the end of 2022, the Fed will hike rates almost 5 times. In other words, as of December 31st, 2021, markets were pricing in just under 3 interest rate hikes by the end of the year & in just 4 weeks, markets are now pricing in just under 5 interest rate hikes by December 2022. Again, like the CME Groups FedWatch Tool, the data in Figure 2 must also be taken with a grain of salt as this data is simply how make interest rate hikes economists & market participants believe there will be.
While the graphics above by no means guarantee 3-5 interest rate hikes this year, if we needed more assurance aside from Powell explicitly stating that several rate hikes in 2022 are all but certain, recent economic data & the rally in Treasury yields that we have seen so far in 2022 support the idea that the Fed will raise interest rates several times in 2022. The graphic below shows the consumer price index (“CPI”) ex-food & energy on a year-over-year basis as well as the 10-Year U.S. Treasury yield & the midpoint of the targeted Fed Funds going back to 2000.
With inflation data coming in at levels significantly higher than anything we have seen over the last two decades; we do not have a historical reference to compare the current inflation environment to. However, the graphic above does show the correlation between inflation & interest rates. In other words, when inflation is on the rise, interest rates also tend to rise & vice versa. As we have discussed in the past, when interest rates are reduced, individuals & companies are able to borrow more money since the “cost” of borrowing money (a.k.a – the interest charged on these loans) is low. As a result of this increased borrowing, individuals & companies now have more money to spend on goods & services, which results in economic growth. While economic growth is almost always welcomed, it does produce the byproduct of increasing inflation. Because of the unprecedentedly low interest rates we have seen over the last two plus years, combined with the massive amounts of liquidity that the Fed & federal government have injected into the economy via asset purchases by the Fed & the government sending out stimulus checks to millions of Americans, we are now witnessing record levels of inflation. In order to combat surging inflation, the Fed has a few tools at its disposal; the use of which could send shockwaves through the markets. Before we go further, it is important to remember that Chairman Powell has assured markets that the FOMC will do its best to not surprise markets with its policy decisions & will give plenty of forewarning before implementing these policy changes.
The first tool that the Fed has its disposal is also the easiest one to implement & that is the setting of the targeted Fed Funds rate, which is the rate that commercial banks borrow & lend excess reserves to each other to meet overnight reserve requirements. Remember, the Fed sets the target Fed Funds rate while participants in the Treasury markets are the ones who are essentially determining the longer-dated interest rates. That being said, Treasury yields & the Fed Funds rate historically move in lockstep so with the anticipation that the Fed is going to start raising the Fed Funds rate as early as March, the yield on 10-Year U.S. Treasuries rose as much as 36 basis points (“bps”, 1 bp is equal to 0.01%) before coming down a bit & ending the month of January up 26 bps. With the Fed Funds rate currently sitting at a 0-0.25% targeted range & the typical rate adjustment being in increments of 25bps, a March rate hike, would bring the targeted range to 0.25-0.50%. However, some Wall Street professionals believe that the Fed is so far behind tackling this surging inflation that they could kick off the rate hiking cycle with a 50bps hike. But remember, Powell & the FOMC have assured the markets that they will do their best to not “shock” the markets & a 50bps would be a very unwelcomed shock to the markets. We believe that the Fed will hold true to their word & hike in 25bps increments but the question now is, how many 25bps hikes will we see this year? We believe that the Fed will hike interest rates 3-4 times in 2022, which would bring the Fed Funds targeted rate to 0.75%-1.00% (3 hikes) or 1.00%-1.25% (4 hikes). The graphic below shows how many hikes the large Wall Street banks believe we will see in 2022 & where they believe the Fed Funds rate will end the year at.
So, how does raising interest rates combat inflation? The simplest answer is that when interest rates are rising, individuals tend to increase the amount that they are saving because they are now earning a higher interest rate on those savings. As a result of increased savings, the amount of disposable income that individuals have to spend on goods & services decreases which results in a slowing of the economy & a decrease in inflation. The relationship between inflation & interest rates can also be explained using the Economics 101 principles of supply & demand. In other words, if the supply of goods & services is held at a constant level (remember this point) & demand increases (as a result of lower interest rates & increased borrowing as well as the stimulus checks), the price of those goods & services increases. On the other hand, when interest rates are on the rise & individuals are saving instead of spending, demand for goods & services will decline as will the prices of those goods & services. Looking at Figure 1 below, we start at what is referred to as the “equilibrium” price (P*) & quantity (Q*) of Good “X”, which is where the supply (S*) & demand (D*) intersect. Now, with increased borrowing at the extremely low interest rates that we have seen over the last two years, demand for Good “X” has increased (D* shifts to D2) & the new equilibrium price & quantity are now P2 & Q2, respectively. However, this was under the assumption that the supply of Good “X” was being held at a constant level, which is very much not the current case as just about every company’s management has mentioned “supplychain issues” or a “broken supplychain” on recent quarterly earnings calls, which brings us to Figure 2 below.
Given the ongoing supplychain issues, some companies are having a very difficult time procuring the input materials that are required to manufacture their final products & the input materials that they are able to obtain are most likely going to be more expensive than they were pre-pandemic. With that said, companies are producing a fraction of their products that they were pre-pandemic. As a result, companies now have fewer final products to sell (S* shifts to S2) & with the finished goods that they do have available, companies have to decide if they are going to absorb the increased cost required to obtain the input materials or pass those expenses onto the consumer in the form of raising prices. As a result of an increase in demand (D* shifts to D2) for Good “X” as well as a decrease in supply (S* shifts to S2) for Good “X”, our new equilibrium price & quantity are now P3 & Q3. Bear in mind, this is a very simplistic illustration of how supply & demand shift with lower interest rates & supplychain issues. The magnitude of the shifts in the supply & demand curves can be much larger or smaller depending on the industry & the goods being produced.
In order to illustrate the impact that increasing interest rates would have on the supply & demand curves, one would essentially go in reverse order of what was explained above. In other words, looking at Figure 1, S* & D2 would be your starting equilibrium supply & demand curves with equilibrium prices of P2 & Q2. When interest rates rise, individuals are saving more & demanding less of Good “X”, which shifts the demand curve from D2 to D*, resulting in a lower quantity demanded (Q*) at a lower price (P*).
In addition to setting the Fed Funds rate, the other tool that the Fed has at its disposal to combat inflation is what is referred to as open market operations (“OMOs”), which is the actual buying & selling of securities. At the height of the COVID-19 pandemic, the Fed was purchasing roughly $120 billion/month - $80 billion in Treasuries & $40 billion in mortgage-backed securities (“MBS”), which was held as an asset on the Fed’s balance sheet. As fixed income securities, both Treasuries & MBS’s mature & when they do, the owner of these securities are paid their final coupon payment as well as a lump sum principal payment (only for Treasuries. MBS’s do not pay a principal lump sum at maturity but rather the periodic payments are comprised of both principal & interest payments). As a result, when Treasuries held on the Fed’s balance sheet matured, the Fed would essentially use the proceeds of the maturing securities to buy more Treasuries. However, with economic data coming in strong (particularly the employment situation) & inflation surging to record levels, the Fed has gradually started to reduce the amount of Treasuries & MBS’s that it is purchasing every month. Remember, the Fed’s two mandates that they use to guide their monetary policy decisions are 1) maximum employment & 2) price stability. With the January’s unemployment number coming in at 4%, just above the 3.9% unemployment rate we saw in December, the labor market is very strong, a sentiment that Powell reiterated in his press conference following the Fed’s January 26th meeting. Furthermore, with inflation at record levels, Powell asserted that “the economy no longer needs sustained high levels of monetary policy support”. With the strong labor market & inflation boxes checked, Powell cleared the way for raising interest rates & phasing out the Fed’s monthly asset purchases. Here is what Powell said at his January 26th press conference, all but confirming that monetary policy change in on the not-so-distant horizon:
When asked about the markets should interpret the relationship between raising interest rates & reducing the Fed’s balance sheet, both of which would tighten monetary policy, Powell did acknowledge that because the “balance sheet is still a relatively new thing for the markets” that he views raising interest rates as the Fed’s primary tool to combat inflation. Because the Fed has used the setting of the Fed Funds rate as its primary tool to help navigate the economy through a multitude of macroeconomic “shocks”, there is significant historical evidence that the Fed has at its disposal to determine how the markets & economy will be impacted by a change in the Fed Funds rate.
With all of that said, we believe that the Fed will indeed start raising interest rates at the March meeting by 25bps to a targeted range of 0.25%-0.50% & will raise the Fed Funds targeted range by 25bps at every other meeting for the rest of the year, which would mean raising rates at the June, September & December meetings. If this is in fact the case, the Fed Funds targeted range would end the year at the 1.00%-1.25% level. Additionally, at the January 26th FOMC meeting, the Committee laid out what they called the “Principles for Reducing the Size of the Federal Reserve’s Balance Sheet”. The 2nd “principle” that was agreed upon said that “The Committee expects that reducing the size of the Federal Reserve’s balance sheet will commence after the process of increasing the target range for the Federal Funds rate has begun.” The Fed did not forecast how long after starting to raise the target range for the Fed Funds rate until they begin reducing their balance sheet, which does leave some uncertainty surrounding the use of this tool. One thing is certain though, the Fed is getting very close to reducing the extremely accommodative monetary policy that been supporting the markets & the economy for the last 2 years. Only time will tell how the markets & broader economy react to these changes, leaving investors to wonder if the Fed has made the right decisions.
4th Quarter Earnings Recap
With January coming to an end, the first month of 4th quarter earnings season is in the books with FactSet reporting that 56% of S&P 500 companies have reported their 4th quarter results as of the end of January. Of those companies who have reported, 76% of those are reporting a positive EPS surprise. The sectors that are seeing the largest percentage of the constituent companies beat their earnings estimates are the Industrials (87% beat), Information Technology (85% beat), Healthcare (83% beat) & Energy (82% beat) sectors while the Materials sector is the clear underperformer with just 44% of the companies beating earnings estimates.
While it is certainly nice to see 76% of companies who have reported beat their earnings estimates, it is important to remember that these are earnings for a quarter that has already taken place & that the equity markets, in theory, are forward-looking indicators & should reflect the future expectations for corporate earnings. With that in mind, one of the key elements that analysts look for when a company releases their earnings results is if the company is providing forward looking guidance & if they are, is that guidance positive or negative guidance relative to previous expectations. Recall back at the height of the COVID-19 pandemic in the 2nd half of 2020, many companies were faced with so many uncertainties that they could not accurately forecast future earnings & therefore companies were both withdrawing previously issued guidance as well as refusing to issue forward-looking guidance for the foreseeable future. Fast-forward to the present day & some companies are starting to retest the waters when it comes to issuing forward-looking guidance & so far, it has not been all that positive. Of the companies who have reported their 4th quarter 2021 earnings results, just 47 S&P 500 companies have issued 1st quarter 2022 EPS guidance with 34 of them issuing negative guidance & 13 issuing positive guidance.
With companies still citing supplychain constraints as a key issue that is impacting 4th quarter results as well as future guidance, we will continue to monitor the situation. Data out of the Marine Exchange of Southern California is indicating that relief on the supplychain front might be on the horizon as they report that the number of cargo ships waiting off of the Port of Los Angeles & the Port of Long Beach has fallen to below 80 – a number that we have not seen since last October. At its peak, there were 109 cargo ships waiting to dock at two of the busiest ports in the country.
With equity markets coming off of their worst monthly performance in almost two years, we will wait to see if the old Wall Street adage of “As Goes January, So Goes the Year” holds true for 2022. Going back to 1970, 22 out of those 52 years saw a negative January & of those 22, only 9 of those years saw negative annual returns averaging 16.40% drawdowns in the S&P 500.
Furthermore, the majority of those years that saw a negative January & a negative annual return corresponded with significant domestic & global macroeconomic issues, most notably the global economic slowdown in 2015, the ’08-’09 Global Financial Crisis & the “Dot-Com” bubble of 2000. While past performance does not guarantee future results, looking at the January we just had & the prospect of anywhere between 4-7 interest rate hikes out of the Fed, surging inflation & geopolitical uncertainties across the globe, it would be slightly irrational to not be a little nervous for what the rest of the year has in store for the markets & the economy. That being said, we do believe that there are certain sectors of the markets that will weather a potential downturn better than others & have been screening for names within these sectors that fit our investment criteria. Additionally, should we start to see signs that a significant economic & market downturn is on the horizon, we do have the ability to raise our cash levels or implement a hedging position. Finally, with the Fed expected to raise rates for the first time since the pandemic began & mid-term elections coming in November, as well as the unforeseen market moving catalysts that we can’t forecast, we believe that 2022 will have moments of elevated volatility. With that in mind, we will remain diligent in positioning our portfolios & keeping everyone apprised of what we are seeing in the markets & the economy in order to navigate what could be a volatile 2022 & beyond.
As always, please feel free to reach out with any questions or concerns.
Stay Safe & Stay Healthy!