02.14.22

Geopolitics enter the fray as market volatility persists

The last week's market highlights:

  • Investors continue to digest higher inflation data, which has resulted in forecasts for the Federal Reserve to begin "rate liftoff" far sooner and faster than economists and analysts had anticipated a few months ago. Fed funds futures, which are used by traders to bet on the direction of interest rates, are now pricing in more than six Fed rate hikes averaging 25 basis points each in 2022, starting in March.
  • Last week, yields on 2- and 10-year U.S. Treasury notes rose to their highest levels since before the pandemic but retreated on Friday amid risk aversion as U.S. national security officials warned that Russia could soon take offensive action against Ukraine.
  • Equity markets were mixed. While the primarily large-cap S&P 500 Index fell 1.8% for the week, the more economically sensitive small cap Russell 2000 Index gained 1.4%. Overseas, Europe’s STOXX 600 rose 1.6% (in local currency terms).1
  • This week, investors will be looking to January U.S. retail sales data for evidence the consumer has stabilized after rough patches in November and December.

Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2022 Outlook:Opens 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:

"There is only one happiness in this life, to love and be loved." – George Sand

Inflation remains a vexing concern

Unfortunately, the U.S. inflation picture isn't getting any better.

January's headline inflation, as measured by the Consumer Price Index (CPI), jumped 7.5% over the past 12 months, while core CPI, which excludes energy and food prices, rose by 6%. These CPI measures hit their highest levels since 1982.2

On a month-over-month basis:

  • Energy and food prices were up by just under 1%, with the cost of food accelerating in both restaurants and grocery stores.3
  • Household furnishings and apparel were among the drivers of headline goods price inflation.
  • Core goods prices continued to rise at a rapid clip (+1.0%), but this may have been exacerbated by the Omicron variant.4
  • Although service price inflation (+0.4%) is still elevated, it isn't showing serious signs of breaking out.5
  • The cost of purchasing a used car rose again but at a slower pace (+1.5%) than in prior months. New car prices were flat after months of 1%+ increases even as semiconductors, a crucial component in building new autos, remain scarce due to supply chain bottlenecks.6

In our view, there's nothing in this data to (a) dissuade the Fed from raising rates at its March meeting or (b) convince the market that the Fed would err in doing so. In the wake of this hot inflation release, traders are now pricing in a greater than 50% chance of a 50 basis point (bp) rate hike to begin "rate liftoff," and more than six rate hikes for 2022 as a whole. That's a stark contrast from this past September, when half of voting Fed officials believed no hikes would be needed this year.

We think the Fed will start with a 25 bp move next month while clearly signaling it will tighten at every forthcoming meeting unless wages start to decelerate or inflation quickly begins to reverse course. Moreover, we expect inflation to retreat from its current 7.5% pace in the coming months — although the question of how low it ultimately settles is becoming less certain.

Against this challenging backdrop, what issues should investors focus on when positioning their portfolios? Back in December, when we released our 2022 Outlook, one of our major investment themes was to focus on "growth + inflation" investments rather than pure inflation hedges. At that time, year-over-year headline CPI was "only" 7%.7

Let's review the performance of some widely used inflation fighters.

  • TIPS have slipped. With inflation heating up to multi-year highs during the second quarter of 2021, investors flocked to U.S. Treasury Inflation Protected Securities (TIPS), one of a handful of fixed income segments to post a positive return (+6%) for last year as a whole. But TIPS have since given up some of those gains (-4.4% in 2022 to date).8 This decline reflects substantial outflows from the asset class, as many investors have concluded the Fed will tighten policy sufficiently, leading to lower inflation expectations.
  • Gold's gone sideways. Gold has long been considered a "store of value" because its limited supply amid strong demand reduces the risk of devaluation. Somewhat surprisingly, gold prices have stayed relatively flat this year despite rising real (i.e., after inflation) rates. Since gold doesn't pay a dividend or produce income, it tends to falter when real rates rise.

Some traditional inflation hedges have proved more resilient, including:

  • Commodities. Prices of agricultural commodities as well as industrial metals and energy have risen, and within global equity sectors, energy has been the standout performer in an environment of still-solid growth worldwide.
  • Direct real estate. Owners of office, industrial, retail and multi-family properties — all major sectors in this asset class — often hike rents in tandem with inflation. In our view, U.S. commercial real estate can perform well in a rising-rate environment, as the asset class should continue to represent a higher-yielding alternative to traditional fixed income investments.

On balance, we think portfolios should be able to weather the current uncertainty reasonably well as long as 1970s-style double-digit inflation doesn't return — and it's unlikely to, based on our outlook for prices to begin falling as supply chains open up further and labor costs decline with more workers returning to the labor force. Last year, in the face of decades-high levels of CPI inflation, a traditional portfolio of 60% U.S. stocks and 40% U.S. bonds returned over 15%.9 Past performance is no guarantee of future results, of course, but we believe investors will be better served by focusing not on blow-by-blow inflation headlines but rather on remaining broadly diversified and sticking to their long-term goals.

For small businesses, inflation's impact is getting bigger

It's not just consumers feeling the squeeze of rapidly rising prices. According to the National Federation of Independent Businesses (NFIB), 22% of small businesses reported inflation as their top concern in January — a 41-year peak.10 Inflation is especially worrisome for those operating on Main Street because they tend to operate with tighter profit margins and are particularly exposed to higher labor costs.

How widespread wage inflation is at the moment remains a question of some controversy. While January's job report showed average hourly earnings rising more for white-collar jobs, there's still good reason to think that the labor shortage — and resulting wage increases — is severe only for relatively few positions in service industries, including restaurants, hotels and nursing homes. Worker scarcity is, to some degree, a structural issue, the result of aging demographics and lower levels of immigration.

So what tactics are small businesses employing as prices continue to climb? In the real economy some are (1) raising prices (2) investing more in productivity-enhancing measures or (3) combining the two. Those large enough, with cash on hand and "shovel-ready" capital investment opportunities, are in a position to thrive in what should be (at least temporarily) a hot economic environment — regardless of how soon and quickly the Fed tightens. The rest, primarily small firms without such resources, may struggle.

 

Sources:

  1. Bloomberg
  2. Bureau of Labor Statistics (BLS)
  3. BLS
  4. BLS via Bloomberg
  5. BLS via Bloomberg
  6. BLS
  7. BLS via Haver
  8. Bloomberg
  9. FactSet, Bloomberg
  10. NFIB

This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.

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