The last week’s market highlights:
- Last week was another tumultuous one for markets. The yield on the bellwether 10-year U.S. Treasury note ended the week about where it started despite some pronounced daily moves, and the S&P 500 Index declined 0.30% for the week.1 The index has now lost 2.2% in January.2 Although the fourth-quarter earnings season kicked off, bringing hopes for another quarter of stellar corporate profits, investors focused on current conditions, including the impact of tighter monetary policy and COVID-related economic weakness.
- That weakness was reflected in negative and below-forecast readings for industrial production (-0.1%) and retail sales (-1.9%, a 20-month low). Meanwhile, consumers expressed their unease about COVID and higher inflation, with the University of Michigan (preliminary) sentiment report for January falling to its second-worst level in a decade.3
- In his Senate confirmation hearing, Federal Reserve Chair Jay Powell reiterated the Fed’s commitment to controlling inflation. This led investors to price in a higher likelihood of three or more interest-rate hikes in 2022.
- This week, we’ll get a healthy dose of data on the U.S. housing market for December and January, as well as reports on the U.K. labor market for December. The latter could be an important bellwether for how Omicron has affected job searches and hiring in other economies where cases spiked later.
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2022 OutlookOpens in a new window:
U.S. economy: Slower growth and inflation compared to 2021, but still pretty fast.
Global economy: Showing signs of heating up thanks to accelerating vaccination rates.
Policy watch: No more stimulus, but the Fed isn’t likely to raise rates too quickly.
Fixed income: Expect further challenges for rate-sensitive assets; consider assuming more credit risk.
Equities: Our cyclical tilt includes U.S. small caps and non-U.S. developed market shares.
Asset allocation: Although valuations appear relatively full across many segments, we’re leaning toward risk-on positioning.
Quote of the week:
“The time is always right to do what is right.” – Martin Luther King, Jr.
Inflation rears its ugly head — again
To the economists who downplayed the risk of inflation, 2021 was a year to forget.
Last week, the government reported that headline inflation, as measured by the Consumer Price Index (CPI), soared 7% in 2021, the highest year-over-year increase since 1982. Core CPI, which excludes energy and food prices, rose by 5.5%, another multi-decades peak.4
Month-over-month headline CPI increased 0.5% in December, down from 0.8% in November and 0.9% in October, but still well above its long-term average.5 Looking under the hood, we identified some of the usual suspects: Durable goods (+1.2%), were outsized drivers of higher prices, and within that category, the cost of used cars climbed +3.5%.6 Services inflation remained relatively tame at 0.3%, and shelter inflation edged up +0.4%.7 Because energy costs declined moderately, core CPI was up a bit more (+0.6%) in December, in line with its rise over the prior two months.8
In reviewing 2021, we can conclude that inflation owed much to the unleashing of pent-up demand (fueled in large part by multiple fiscal stimulus measures in the first half of the year) being met by scarce supply (thanks to supply-chain bottlenecks). For example, people wanted to buy new cars but were often unable to because of the ongoing shortage of semiconductor chips, a necessary component in automobile production. So they turned to buying used vehicles, whose prices soared a remarkable 37% last year.9 The months of highest inflation occurred in the second quarter of last year, but the fourth quarter was punctuated by inarguably elevated inflation that captured not only global supply-chain disruptions but rising labor costs due to a worker shortage.
Of course, consumers haven’t been the only ones worried about rapidly rising prices — so, too, have Federal Reserve Chair Jerome Powell and his colleagues. And with CPI hitting 7%, markets haven’t been surprised that the Fed is considering a series of rate hikes sooner rather than later. But what has been surprising was the Fed’s sudden shift in tone, from the “all is well because inflation is transitory” talk of September 2021 to the “actually, inflation is a severe risk” message Powell delivered in his confirmation hearing last week. What drove the Fed’s abrupt change of heart?
- Supply chain issues aren’t improving fast enough.
- Durable goods prices continue to rise when the Fed likely expected them to be declining by now.
- A scarcity of workers, as the unemployment rate has dropped quickly and steeply, and the recovery in labor force participation has been disappointing.
The Fed is also fretting about an elevated inflation mentality settling into the economy, affecting consumers, workers and bottom lines. Goods are still becoming more expensive, and sharply higher wages in some areas of the economy are pressuring profit margins and are likely being passed on to customers in the form of higher prices. Indeed, we may be seeing a bit of this wage phenomenon in December’s inflation data. Price increases at restaurants and personal care stores, where jobs tend to be labor-intensive and offer relatively low pay, accelerated in the fourth quarter, as employer efforts to lure new staff by offering bigger paychecks were met with indifference, despite the expiration of enhanced unemployment benefits in September.
Our view coming into 2022 was that the Fed could and would wait longer to see where inflation will settle before raising rates. But it now appears to be taking inflation risks far more seriously, with a rate hike in March now a strong possibility. Markets have gotten the message, as well — fed funds futures contracts are pricing in between three and four hikes this year, up from less than one when the Fed met last September. (Fed futures contracts are used by traders to bet on the direction of interest rates.)
What are markets thinking?
In our view, whether the Fed tightens only once or as many as four times in 2022 shouldn’t dramatically affect the economy in the near term. U.S. GDP growth forecasts are hovering around 5%-6% for the fourth quarter of 2021 and between 3% and 4% for each of the first two quarters of 2022 — still above the economy’s long-term trend.10
The Omicron variant remains a wild card, though we doubt its impact will last more than a quarter or two in the U.S., as states have thus far refused to reorder lockdowns. But other countries that compel strict mitigation measures could suffer economically in the first quarter.
Against this backdrop, equity markets have experienced an abrupt rotation in leadership, from defensive and higher-growth stocks to cyclical and value names, both of which tend to outperform when the economy runs hotter than expected and rates are rising. For example, energy stocks are off to a roaring start, fueled by rising oil prices, while the financials sector is benefiting from the spike in longer-term Treasury yields, which help determine the rates of interest banks and other lenders can charge on loans.11 In addition, eurozone stocks have recently outperformed their U.S. counterparts because financials make up a greater proportion of European equity markets.12 We believe this trend can continue based on our forecast for further increases in long-term yields by year-end.
In fixed-income markets, it’s common during periods of interest-rate volatility for spreads on credit sectors such as high-yield and investment-grade bonds to widen versus U.S. Treasuries. (Spreads measure the difference in yield between U.S. Treasuries and other fixed-income segments. The wider the spread, the more compensation investors are demanding for holding riskier debt.) However, spreads have generally held firm in 2022 so far, signaling an overall calm in the bond market. This relative stability in spreads has prevailed even though the bellwether 10-year U.S. Treasury yield began the year at 1.52%, jumped to 1.78% on January 10, and then dipped to 1.70% just three days later. It closed the week at 1.78%.13