Inflation, Tapering and Healing

2021 will go down in history as a year that brought many changes to all of us.  Inflation was headline news throughout 2021 and will continue to be part of 2022 headlines.  The S&P 500 recorded its third consecutive year of double-digit returns, which has happened nine times since 1928.  According to a Reuters article, S&P 500 profits rose almost 50% in 2021. ¹  However, company profits are forecast to grow at a slower pace of 8.6% in 2022.  Interest rates have declined significantly since 2008 to record lows, helping corporations, consumers and investors enjoy one of the greatest bull markets in history.   Interest rates have declined to near 0% over the past four decades compared to 1981 rates at 15.84% on the 10-year Treasury.  This has all been fueled by government stimulus, easy monetary policy and the Federal Reserve bond buying to prop up the economy caused by a once in a lifetime pandemic.  Many experts, while supporting the actions by government stimuluses and the Federal Reserve, underestimated the timing of the recovery.  Keep in mind that none of us have ever experienced a pandemic and how the economy would respond. 

Inflation

Cause for the inflation we’ve seen since late 2020 is a bit more complex.  Factories shut down due to workers getting sick, worse yet dying, and vaccines were not yet available.  Shutdowns were intended to help ward off overwhelming hospitals with patients and buy time for vaccines to come to market.  The world could not produce the materials or staff up to produce the goods.  World governments injected money into their economies.  In the U.S. under normal conditions stimulus checks would have enhanced job growth as demand for goods would have been met by supply.  The equation was missing one main ingredient: workers.  What developed instead was a disconnect between Wall Street and Main Street.  The U.S. unemployment payments and stimulus checks meant people could pay their bills, but not everyone benefited from them.  

By mid-2020 consumers were tired of being locked up and many found they had excess cash for spending.  Products from toilet paper, hand sanitizer, flour to bikes were in short supply.  Inflation driven by a “nowhere to go” world changed to online buying on steroids.  By 2020 year-end, inflation, which had been non-existent in its pure form for decades, started showing up in housing, energy, and food as well as many other areas of our economy.  

The stay at home/work at home/learn at home economic recovery was well on its way in the first quarter of 2021.  Vaccines were available and people were ready to get out of jail after an entire year.  Life was beginning to look normal by the summer 2021, but something was still missing:  workers.  The stock market ignored the staggering inflation numbers in hopes that workers would return by Labor Day.  Labor Day came and went yet workers did not show up.  Many in the labor force were tired from longer working hours due to layoffs and illnesses.  Some retired earlier causing more labor shortages. While all this was going on, those who had money were back spending at a record pace propelling earnings and driving growth for many companies. 

This past year we heard the words “transitory inflation” which has taken on a different meaning from first thought.  We continue to see lingering inflation as a byproduct of the pandemic.  Even the brightest of minds cannot out smart a virus that still prevails.  What they clearly had correct was the pent-up demand for goods.  Factory shutdowns worldwide and reopening of economies has created supply chain bottlenecks as demand has outstripped supply. 

As quickly as inflation has risen due to global supply shortages it can reverse course the same way.  We are beginning to see production increasing and inventories returning to shelves despite continued labor shortages.  This could signal a reversal and drive prices down which in turn will drive down inflation.  

Inflation in 2022 will add volatility to the markets as the Federal Reserve begins to taper its bond buying along with increasing interest rates to slow the demand.  The data suggests that higher inflation and supply chain disruptions are heading to peak and will start to improve in 2022.  Federal Reserve chairperson Jerome Powell is optimistic that the supply-chain bottlenecks will ease this year and begin to bring inflation down.²   

Federal Reserve

The Federal Reserve (Fed) has played their hand on how they will counter inflation.  The federal government and the Fed have been winding down their bond buying program which has provided market stimulus since the pandemic’s start.  The Fed should complete its reduction (tapering) of buying bonds by mid-year.  This could provide some headwinds as the subsidies expire and in turn allow the Fed to begin raising interest rates.  The Fed will have to delicately balance reducing the stimulus while monitoring inflation before raising rates.  We will see how this plays out during the first half of 2022.  

Investors may have already priced in rising interest rates.  Since the Fed will be less accommodating with removing the ongoing stimulus, the markets may be volatile until we reach a point of stabilization. To counter the Fed moves, we have shortened maturities and continue to maintain higher quality bonds within the portfolio.  During 2021 we added to dividend paying companies by slightly increasing the exposure to offset some of the drag from bonds in the portfolios since bonds are unable to keep pace with inflation.  This may be a temporary tactical change as the bond market resets in the next few years.   During past inflationary times dividend stocks have performed well.  

Healing

World economies are no longer reeling from the pandemic; Data instead shows that they are healing much like the U.S.  Although we worry as to whether there will be another wave of the pandemic, we are learning how to adjust our lives and live.  According to Brad McMillan, Managing Principal, Chief Investment Officer of Commonwealth, prices in many categories have peaked and started to recede.³   Of course, this can change if we have newer variants, but economies are open, and more vaccines/boosters are in various stages of development. 

Although the pandemic changed the world both on the corporate side and our personal decisions in everyday life it has not changed the way we strategically construct portfolios.  The economy will be driven by fundamentals, not medical ones that we cannot control.  No matter the outcome we know that we are in a global recovery that is taking more time than most people anticipated.  We have not abandoned our diversified strategy nor should you.  We happen to be in a pronounced time where the virus is charting the course rather than fundamentals.  We will return to fundamentals when the virus is no longer the day’s topic.   

We look forward to a great 2022 and our conversations with you.  Please let us know if you have any questions or concerns.  Stay healthy and let’s look forward to a great 2022.  

_{IMPORTANT DISCLOSURES:  The opinions presented in this communication are subject to change without notice and no representation is made concerning actual future performance of the markets or economy.  Information obtained from sources is considered reliable but is not verified.  The research and other information provided herein speak only as of its date.  We have not undertaken and will not undertake any duty to update the research or information or otherwise advise you of changes in the research or information.  Performance information presented is not an indication of future results and index data is provided for market reference purposes only.  This is not an offer to buy or sell or the solicitation of an offer to buy or sell any security/instrument or to participate in any particular trading strategy.  This document is the property of Legacy Financial Advisors and is intended solely for the use of the Legacy client, individual, or entity to which is addressed.  This document may not be reproduced in any manner or re-distributed by any means to any person without the express consent of Legacy.  This material is for educational purposes only.  Mis-transmission is not intended to waive confidentiality or privilege.}

_{[1]   Reuters, Business January 12,2022: by Caroline Valetkevitch, “Investors ready for U.S. earnings as inflation worries run high”}

_{[2]  Wall Street Journal January 12, 2022}

_{[3] Commonwealth: Market and Economic Outlook}