A Volatile Year Ahead?
by Craig MacKinlay
Moving into a new year, we all hope that the virus will run its course, allowing for the return to a normal environment. As this transition takes place, an open question is what are the implications for financial markets? Given the uniqueness of the environment, it is very difficult to use history as a guide to address current markets. In this month’s issue of Partner Talk, we will address the key factors that define today’s investment environment.
There are signs that we should anticipate a volatile year for asset markets. Both the stock market and the bond market have experienced large swings in value over the month of January. A real-time measure of expected market volatility is provided by the VIX volatility index published by the Chicago Board Options Exchange (CBOE). This index is a forward-looking measure of stock market volatility expressed on an annualized percentage basis. In January, the VIX has been above 30 percent on a number of days and averaged over 23 percent – a value substantially higher than the long run average of about 19 percent. Since volatility is persistent, more periods of high volatility should be expected as we move through 2022.
The possibility of a high rate of inflation is the greatest concern to many of us. The inflation rate for last year (2021) as measured by the Consumer Price Index came in at an annual rate of 7 percent. This annual rate causes concern since it is the highest inflation recorded since the middle of 1982 at the end of the period of runaway inflation in the late 1970’s. Because we need to look forward, the natural question is what rate of inflation should we expect in 2022? In recent years, the forecasts of economists have been generally closely clustered around a consensus forecast of about 2 percent. However, looking forward for the year 2022, things are different. There is an unusual amount of disagreement with respect to what lies ahead for the price level changes. Two schools of thought dominate forecasts.
One school of thought is that inflation has peaked and will settle back close to an annual rate of two percent later in 2022. Two prominent members of this school are Jerome Powell, the Chairman of the Federal Reserve, and Janet Yellen, the Treasury Secretary. For the past year, the Fed chair has labelled the observed increase in inflation as “transitory” and argued that a return to 2 percent is imminent. Only recently did he concede that inflation will not return to the Fed’s target level of 2 percent as quickly as he predicted and “retired” the use of the “transitory” descriptor. The Treasury Secretary continues to forecast a return of inflation to low levels but does concede that the continuance of the virus could be disruptive.
The second school of thought is that rate of inflation is persistent. This persistence will lead to inflation remaining above 5 percent for calendar year 2022. Two well-known economists who share this view are Larry Summers of Harvard and Jeremy Seigel of Wharton. A concern is that the combination of high demand stimulated by fiscal policy and supply-chain constraints invariably lead to increasing prices. The inflation induced by this supply – demand mismatch can’t be quickly curtailed.
What do these inflation concerns mean for financial markets? For fixed income allocations, higher inflation will put significant downward pressure on bond prices. This pressure will be greatest for longer maturity nominal bonds since it is the present value of further out nominal flows that are impacted the most by inflation. This downward pressure on bond prices can be reduced by holding shorter maturities and by holding bonds that are inflation protected. (For inflation protected securities, both the bond principal and coupon payments adjust based on inflation.) In contrast, the values of equities are empirically less sensitive to inflation. Because equities represent claims on real assets and the value of most real assets will increase with inflation, an equity allocation does represent a longer-term inflation hedge.
This differential impact of inflation on financial markets has already been observed in the past year. Inflation was significantly higher than expected in 2021. Partially reflecting the above-mentioned inflation impact, the value of bonds as measured by the Bloomberg Barclays US Aggregate Bond Index decreased by 1.54 percent. In contrast, the stock market was surprisingly strong with the value as measured by the S&P 500 Index increasing by 28.71 percent for the year.
Inflation is not the whole story. Its impact cannot be viewed in isolation. The growth rates of the economy and corporate earnings are also keys to financial market performance. In the past year, both growth rates were solid. Real economic growth as measured by GDP increased by 5.7 percent in 2021 according to the “advance” estimate released by the Bureau of Economic Analysis on January 27. In 2021, corporate earnings increased by more than 45 percent relative to 2020 according to FactSet. This earnings growth is impressive but must be interpreted cautiously since the 2020 earnings were greatly reduced as a result of the impact of the pandemic on the economy. However, what to expect this coming year is more important.
For the calendar year 2022, real GDP growth is expected to be between 3 and 4 percent. While this level of growth is modest relative to 2021, it is in line with the long run real growth of the U.S. economy which is approximately 3 percent. Corporate earnings are expected to grow at 9.5 percent in 2022. This level of growth is low relative to 2021, but solid by historical standards. Taken together, expected real economic growth and expected corporate earnings growth do not signal significant problems. However, an unexpected increase in COVID could derail economic growth and earnings.
The role of the Federal Reserve needs to be considered anytime one is forecasting future inflation. The Fed has a dual mandate – price stability and maximum sustainable employment. Price stability is currently represented as a target inflation rate of 2 percent. Maximum sustainable employment is interpreted as an unemployment rate of 4.1 percent. Since the employment mandate is currently met, the investment community is focused on action the Fed will take to reduce inflation. The Fed has signaled its intention to end its quantitative easing program and to raise the federal funds rate at least three times. The goal is to reduce inflation and at the same time not significantly dampen economic activity. This goal is difficult to accomplish. Increasing interest rates to reduce inflation can lead to a recession.
There are many factors to consider in today’s investment environment. At PMA, these factors are being directly incorporated into the investment policy. As warranted, adjustments are made to allocations to achieve our goal of delivering high risk-adjusted performance.