By Tim Courtney, Chief Investment Officer
During the second half of 2020, we experienced a unique confluence of events: a quick recovery from a lockdown recession, stimulative fiscal policies and government spending, central bank aggressive asset purchases, a ballooning of money supply and record-low interest rates. Even though employment numbers remained poor and production levels hadn’t yet recovered, households took advantage of liquidity from savings and stimulus by refinancing mortgages and taking out low-cost debt on cars, stocks and more.1
In early 2021 it was clear the economy, markets and labor supply were in recovery but there was little change to very accommodative policies. Though it seemed to policymakers that this was the right call at the time, inflation levels we haven’t seen in decades have changed the calculations and the politics. Now the Federal Reserve is raising rates and slowly ending asset purchases.
As we’ve previously mentioned, interest rates act like gravity to the economy. When rates are low or approaching zero as they were in the 3rd quarter of 2020, consumers and businesses (and governments) are more lively and debt effects are light. The prices of many assets such as real estate, bonds and equities, which are at least partially determined by interest rates, become untethered and begin floating or, in some cases, soaring higher. And while the “zero-gravity” environment can be fun for a while, there are consequences.
The price of commodities, food and travel moved higher, joining real estate and stock prices.2 Supply chains are somewhat to blame for rising consumer prices but still, the Fed has made the decision to re-introduce some gravity, initially by 0.25%, with more increases expected throughout 2022.3
The market is feeling the effects. Volatility has increased and we have now experienced a market correction for the first time in two years.4 Ultimately, we believe this is normal and a healthy reaction to the fast growth we’ve experienced since March of 2020. Interest rates, which should have been moving higher earlier, have jumped in recent weeks.
One measure we are watching is a potential yield-curve inversion, which happens when short-term interest rates are higher than their long-term counterparts. Historically in the U.S., an inversion signals an upcoming recession.5 However, it can flash a false positive as we saw in 2018 and its use as a signal in international markets has been unreliable.6 We’ll be watching this as one indicator among many others.7
Overall, we think the market has been responding relatively well to interest rate hikes. While the odds of a recession have risen with inflation and rates higher amid a war, we believe it still remains very likely that 2022 will continue the positive economic and earnings growth we saw in 2021 but at lower levels. If you have any questions, please contact your Exencial advisor.
Sources:
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 9.9 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 3.4 trillion of this total. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
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