Who’s afraid of higher inflation? Apparently not the stock market

Brian Nick

The last week’s market highlights:

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

“You feel a little older in the morning. By noon, I feel about 55.” – Bob Dole

The Nuveen 2022 Outlook: Slower…but still pretty fast

If you’re looking to make sense of the always-shifting financial markets and economic landscape, Nuveen’s Global Investment Committee (GIC) can help. This committee brings together the most senior investors from across the firm’s platform of core and specialist capabilities, including all public and private markets.
A few months ago, the GIC noted that the peak for global growth, even in the world’s largest economies, was firmly in the rearview mirror. Central banks moved from being extremely accommodative to merely quite accommodative after helping stabilize financial markets. Meanwhile, with valuations across many asset classes having snapped back to their pre-pandemic levels, bargains were harder to find.
So what’s the GIC’s view heading into the new year?
For starters, the GIC strikes a few “slower” cautionary notes:
  • Most factors that fueled economic growth will fade in 2022, including unprecedented fiscal and monetary stimulus in the face of the COVID-19 crisis and a once-in-a-century global economic reopening.
  • Vaccinations and fiscal aid helped companies achieve historically high earnings growth in 2021. That should not be the case next year, when global earnings growth will slow from greater than 50% to a mid-single-digit increase.
  • Monetary policy managed to keep financial conditions loose throughout the recovery. However, central banks worldwide have already begun to wind down their liquidity provisions as they weigh when and whether to begin raising interest rates amid accelerating inflation (more on inflation in the next section).
But on the “still pretty fast” side of the ledger:
  • Household net worth hit new all-time peaks in 2021 thanks to higher savings levels and rising asset prices. The trillions of dollars now sitting in cash should fuel robust consumer spending growth well into 2022.
  • There are encouraging signs of reacceleration in China and other Asian economies after a recent series of lockdowns. As factories return to full production capacity across East and Southeast Asia, supply chain stresses should ease.
  • Unemployment rates continue to fall quickly in countries that are further along in their recoveries.
Overall, even if the U.S. economy won’t achieve, say, 6% growth in 2022, as it has this year, GDP could still expand between 3.5% and 4.5% — quite a bit faster than what the markets became accustomed to before 2020.
The GIC’s 2022 Outlook also introduces three broad asset allocation themes. (Of course, investors need to take into account their own unique circumstances, including their specific financial goals, investment time frame and tolerance for risk.)
  • Remain “risk-on.” The GIC expects global stocks to outperform global bonds in 2022, as they have done 10 times over the past 12 calendar years and appear poised to do again in 2021.3 (Equity performance is based on the MSCI All Country World Index, while bond returns are per the Bloomberg Global Aggregate Total Return Index.) Given the degree of underperformance by bonds, investors might infer that valuations would favor fixed income over equities. But thanks primarily to this year’s powerful corporate earnings rebound, equity valuations suggest stocks will maintain their dominance in 2022, led by cyclical (economically sensitive) shares. On another “risk on” note, as we’ve often stated in the past, we believe investors are best served by remaining fully invested, rather than holding large allocations to cash.

  • Stay calm in the face of further bouts of higher inflation or rising interest rates. In the GIC’s view, markets have mostly priced in the risks of higher consumer prices and a pickup in interest rates, and therefore shouldn’t be overly rattled if and when either occurs. Against that backdrop, the GIC is cautious on inflation hedges such as TIPS, which are likely to be expensive relative to whatever degree of protection they might provide. Instead, investors may benefit from holdings in credit sectors like preferred securities and floating-rate loans, which can thrive in environments of low-but-climbing rates and elevated inflation.

  • Structure portfolios for yield and income. Interest rates are low but likely to increase in the year ahead thanks to a strong U.S. economy. Although a rising rates scenario is not ideal for bond holders (when interest rates go up, bond prices go down), supply/demand dynamics for fixed income assets may well work in their favor. That’s because net new bond issuance is expected to be lower in several markets such as those for municipal and preferred securities, while demand should stay high, as it did in 2021. And as with any asset, when demand outstrips supply, the price of the asset rises. In the case of bonds, that price appreciation helps offset some of the negative price impact caused by higher rates.
So what investment characteristics might be desirable in the search for yield? Any or all of the following may be helpful.
  • Lower credit quality, as this tends to be accompanied by higher yields.
  • Shorter duration to help protect principal. (Duration measures how sensitive the price of a bond or other debt instrument is to a change in interest rates.) In general, the shorter the duration, the less a bond’s price will fall should rates rise.
  • Less liquidity, since assets that are “locked up” (i.e., not as readily tradable due to limited market size or other factors) often pay greater returns.
  • Economically sensitive credits, which can benefit from a continuing recovery.
Very few investments check all four boxes. But among the categories that fit well into the GIC’s outlook are preferred securities, high yield municipal bonds and floating-rate loans. In terms of lower liquidity, opportunities in private credit and – looking outside traditional bonds and loans – income-producing real assets may warrant consideration.

Hotter November inflation = faster Fed taper?

We’ve seen this plenty of times before in 2021: Consumers continue to buy way more “stuff” than they did before the pandemic, with supply often falling short of demand. The result? Hotter-than-forecast (and well-above-normal) inflation.
Last week, the government announced that year-over-year headline inflation, as measured by the Consumer Price Index (CPI), jumped from 6.2% in October to 6.8% in November — matching its highest level since June 1982.4 Meanwhile, core CPI, which strips out food and energy prices, accelerated from 4.6% to 4.9%.5
Rising energy costs have been the primary driver of inflation over the past 18 months, complemented by a significant surge in goods prices in the second and fourth quarters of 2020 and, more recently, a spike in food prices. (Last week, the New York Times reported the demise of the 99-cent slice of pizza and the dawn of the $1.50 version.)
There has been some good news The cost of fuel — natural gas and gasoline, specifically — has been falling in recent weeks, and supply chains seem to be doing a better job of meeting demand for goods. Consequently, November may be the last “big” headline inflation number markets will need to digest for some time.
Unlike the headline reading, however, core inflation may still be headed higher on a year-over-basis. That’s because low core inflation levels from December 2020 through February 2021 will be falling out of the 12-month calculation as we roll forward into the first few months of 2022.
Also front and center on the inflation front is the prospect of a potential wage-price spiral due to labor market tightness. Last week, though, we got some encouraging news. While job openings (per the JOLTS report) topped 11 million — close to an all-time high — the percentage of workers who quit their jobs declined, mostly because they found better paying work elsewhere.6
Inflation aside, let’s turn our attention to the last major economic event of 2021: this week’s Federal Reserve meeting. In September, Fed officials were split 50-50 on whether to tighten policy in 2022; then, last month, Chair Jerome Powell announced that the Fed was targeting an end to its $120 billion/month quantitative easing purchases by next June. This Wednesday, December 15, we’re expecting the Fed’s median forecast for raising rates next year to be higher, and its pace of tapering faster. Those changes will likely accompany upgraded forecasts for nominal GDP growth (real growth + inflation) in both 2021 and 2022.
Much of our optimism about the economy in 2022, as we described in the GIC Outlook section above, reflects our belief that inflation will likely die down as a major source of concern by the middle of the year, allowing the Fed to stay more patient before raising rates, or, at least before raising them significantly. Although we’re not alone in this view, it is a contrarian call for now, with the fed funds futures market pricing in closer to three hikes rather than two next year. [Fed funds futures are used by traders to bet on the direction of interest rates.)
  1. Bloomberg
  2. Bloomberg
  3. Bloomberg
  4. Bureau of Labor Statistics (BLS), BLS via Haver
  5. BLS via Haver
  6. BLS
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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