Stuck in a Tightening Middle

The December jobs report signaled a tightening labor market and rising wage inflation, making it more likely the Fed will raise its overnight rate sooner rather than later, possibly in March. The stock market is reacting in early January, selling stocks and bonds against rising rates, and then bouncing back as if in disbelief. Going into 2022, we will ride out a drop in stocks if it occurs, rebalance as makes sense, and buy bonds as yields rise.

Regardless of how 2022 goes, we are coming off a big year. The S&P 500 gained 28.8%, including dividends, and reached 70 new highs during the year. This comes after twelve years of strong performance following the -37% drop of 2008 during the financial crisis:

2021     28.83%

2020     18.38% from a -35% drop

2019     31.74%

2018     -4.41%

2017     21.94%

2016     11.93%

2015       1.31%

2014     13.81%

2013     32.43%

2012     15.88%

2011       2.07%

2010     14.87% 

2009     27.11% from a -48% drop

2008     -37.22%

Depending on how you cut the tape, that’s an 11% annual growth rate including the 2008 crash, +16% from 2009, and +17.4% over the last six years from 2016—almost double the long-term historical rate of +9.4% from 1871, and enough that the past decade ranks with the 1950s and 1990s as among the strongest markets ever.

Markets operate in continuous time. Investing doesn’t have the beginning, middle, and end that Aristotle ascribed to a well-told story. Your money on the other hand, does—the beginning is when you buy an investment, the middle is when it begs you to leave it alone to grow, and the end is when you sell it and realize a profit or a loss.

Very rarely does the beginning, middle, and end of an investment correspond to a calendar year. Performance very much depends on when you start and stop the tape. Still, 2021 was a remarkable year in the market, following several strong market years.

Gains in 2021 were broad, with 88% of the S&P in the green, but much of recent performance has come from the eight big tech companies that make up 27% of the index. When they do well, the index does well, but the downside risk from this concentration is significant.

And we aren’t out of the woods yet. Since 2008 we’ve had two crashes greater than -35% followed by periods of multi-trillion-dollar stimulus and zero interest rate regimes to spur recovery from system threatening crises. We’re still weaning off the fiscal and monetary stimulus that shocked the economy back to life over the past 20 months. In the process, inflation has risen to a 39-year high, and has become the capital ‘I’ in the risk trio of insurrection, infection, and inflation. 

While the trio is still a significant ongoing risk to economic stability and the markets, our old nemesis inflation is front and center in the 2022 spotlight.

The shape of the coming year will be formed in the credit markets with the other ‘I’-player, interest rates. The Fed’s cheap money has pumped up all manner of asset values, from homes and crypto assets to EVs and the stock market. The Fed has redoubled the wind-down of its money-printing bond-buying stimulus so it can begin inflation fighting by raising its short-term rate maybe as soon as March, potentially followed by one or two or more 0.25% raises by year end.

What makes this a compelling drama is that we are still in the middle. It is uncertain whether the Fed moves will be too little or too much, too soon or too late. There is repricing risk on all sides. The market may fall even as prices continue to rise, or prices may stabilize but growth falters. Regardless, we will not be at the end of this yet.