When 2021 began, we all had hopes of putting COVID in the rear-view mirror. Clearly twelve months later, this has not happened. Nevertheless, we have much to be thankful for as we begin 2022–including increasingly resilient, adaptable economic and financial systems, widely available therapeutics to combat COVID, and another year of strong investment returns. Above all, we thank you, our dear clients, for entrusting us as your financial partner and ally throughout this bewildering and challenging period for our world as a whole.
We are happy to say that today, nearly two years since the onset of the pandemic, the US economy has broadly bounced back. Most of the jobs lost in 2020 were restored in 2021–albeit we are still dealing with labor shortages and a steep drop in the labor force participation rate (from 63.4% in January 2020 to 61.8% today). In aggregate, personal income is up and US household balance sheets are in tremendous shape. Corporate after-tax profits are at all time-highs, even as companies are investing in their businesses at the highest levels ever recorded. The fourth quarter data, when it is released in January, will likely show that 2021 had the fastest GDP growth since the 1980s.
On the surface, many aspects of everyday life appear “normal.” But this is not a “normal” business cycle. We have never shut down whole swaths of the economy by governmental decree before. We have never seen such a dramatic expansion of deficit spending without the catalyst of war. M2 money supply in the economy is up 38% since January 2020 while the Federal Reserve’s balance sheet has ballooned by 109% to $8.7 trillion. Weak links in global supply chains have been exposed–fueling rapidly rising prices wherever bottlenecks occurred. The problem of stimulus-stoked demand combined with COVID-restricted supplies, inventories and laborers has caused the largest inflation wave in at least three decades.
Heading into 2022, we are anticipating slower domestic GDP growth–perhaps 3.5% vs. a growth rate of over 5% in 2021. The US labor force is still 4 million employees smaller than it was before COVID, so we think strong job growth can continue. The Federal Reserve has stated that they do not plan to raise interest rates until the objective of “full employment” is met; however, this modestly lax position on rate hikes is subject to change depending on the trajectory and velocity of upcoming readings on inflation. To thread this needle, it is possible that the Federal Reserve may begin reducing the size of its balance sheet before implementing rate hikes.
It is indeed time for the Fed to end their COVID-era monetary stimulus measures. The disparity between the Fed Funds rate and consumer inflation (CPI) is at historic levels. Markets are already pricing-in three ¼ point (0.25%) rate hikes in 2022. Our expectation is that interest rates will rise in 2022–albeit slowly–and remain at relatively low levels compared to prior inflationary episodes.
The prospect of tighter monetary policy from the Federal Reserve always makes markets nervous… and nervous markets are less forgiving. Thankfully Fed Chair Jerome Powell has become a skilled curator of careful communication. He seems to recognize that a nimble Federal Reserve that is able and willing to start, stop, pick up the pace, or pause planned monetary measures would represent the lightest headwind to markets. This approach is poised to be tested as rate hikes are set to begin alongside the flattest yield curve in a generation (the difference between the two-year and ten-year yield is just 0.81 at the time of writing). Unless this changes, three rate hikes in 2022 might be enough to invert the yield curve–foreshadowing economic recession.
Thankfully there are still reasons to be optimistic about the future direction of asset prices. Most prominent is the abundance of liquidity in the financial system. Even as the Fed begins to normalize their monetary policy there is over $4.5 trillion in cash bank accounts and money market funds held by the public. Valuations on some assets do appear stretched by historical standards but have been supported by today’s historically low bond yields. In fact, investors are paying a very high price for safety today: the Price-to-Earnings ratio of a 10-year US Treasury bond yielding 1.6% is 62.5x (vs. 24.5x for the S&P 500).
To combat the eroding impact of inflation, individuals are incentivized to own assets, primarily real estate, commodities, and/or stocks. Historically, stocks have been the best returning asset class. Broadly speaking, stocks can withstand inflation because companies will raise prices, which translates into higher revenue and earnings. Earnings growth is the mother’s milk of higher stock prices, and earnings growth appears likely to continue in 2022, albeit at a slower pace than what we saw in 2021.
Despite our underlying optimism, we think it is best to strike a balance in portfolios. We are in favor of a barbell approach to portfolio management. On one side of the portfolio, we want to own innovative and disruptive companies with long runways for growth in emerging new industries. On the other side of your barbell portfolio, we look to own companies that will benefit from the ongoing cyclical economic recovery–like travel/hospitality, homebuilding, real estate, etc.
With the Federal Reserve inclined to tighten monetary policy in 2022, we are expecting periodic bouts of volatility. For this reason, we believe it is wise to hold a cushion of cash for all but our most aggressive clients’ accounts. Holding cash serves to dampen volatility and simultaneously to fund the opportunistic purchase of high-quality assets at attractive valuations.
As always, we thank you for your continued trust and confidence. We are wishing you peace and prosperity in 2022 and beyond. If you would like to discuss your portfolio(s), we welcome an opportunity to meet with you individually.
 Source: US Bureau of Economic Analysis. https://fred.stlouisfed.org/series/CIVPART
 Source: US Federa Reserve. https://www.federalreserve.gov/releases/z1/dataviz/z1/balance_sheet/table/
US Bureau of Economic Analysis. https://fred.stlouisfed.org/series/PINCOME
 Source: US Bureau of Economic Analysis. https://fred.stlouisfed.org/series/CP
 Source: https://fred.stlouisfed.org/series/M2SL; www.statista.com/statistics/1121448/fed-balance-sheet-timeline/