Three Key Thoughts

1. Record Number of Records

2. The Fed vs Inflation

3. Global Recovery Without China?

Record Number of Records

Despite a myriad of potential worries, the US stock market climbed to new record highs 70 times in 2021. The old Wall Street saying about the market climbing a wall of worry seems like an understatement. There was a mountain of worries to climb! To list just a few, we had the Delta variant of COVID, the vaccine rollout, the botched pullout from Afghanistan, inflation reports at a 40-year high and Congress debating major new spending bills and large tax increases. Then we finished the year with the new Omicron variant threatening the reopening and inflation running even higher.

But the US market saw that corporate earnings were increasing quickly as demand stayed strong for goods of all kinds, even while supply was constrained. And it also expected that inflation will moderate in the new year and that the Federal Reserve will begin to withdraw its bond buying and begin to raise interest rates. To the surprise of many – but maybe not the market -- Congress failed to enact another big new social spending plan and the higher taxes to pay for it. Finally, the employment picture remained very strong, with unemployment dropping sharply and job openings plentiful. On the whole, the market judgment was that the economy and earnings are getting better, not worse, and that is what matters most.

2022 may be a bit more challenging, however, as the markets will likely need to digest somewhat higher interest rates and likely slower growth in the economy and corporate earnings. We expect wage pressures to begin to make a dent in corporate profit margins as workers continue to demand and receive substantially higher wages. The grocery worker strike that started this week in Denver is, we believe, one of many such actions we will see across the country this year.

In addition, the massive stimulus that the US government provided the economy over the last two years to offset the impact of COVID is largely going away. While some lip service is being paid to resurrecting the Biden Administration’s Build Back Better plan, it doesn’t seem likely to move forward in 2022, meaning the economy will have much less government stimulus applied to it.

The Fed vs Inflation

Into this interesting set of circumstances comes the US Federal Reserve with a dual mandate of price stability and full employment. They believe they have largely fulfilled their goal of full employment and the state of the labor market would certainly seem to bear that out. With unemployment at 3.9% and job openings in excess of 10 million, the only weakness is in labor force participation which, at 61.9% stands 1.5% below the prepandemic level.

But price stability is a long way from being where Fed would like it. After more than a decade of trying to boost inflation to a higher level and failing, the Fed is now facing inflation of 7% (the latest CPI reading) even while it is still carrying on its monthly bond buying and keeping interest rates near zero. The Fed has already announced that it intends to drop its bond buying relatively quickly in 2022 and expects to consider interest rate increases. But the Fed is also quite aware, as we pointed out above, that the massive government stimulus of the last two years is going away, just as the Fed reduces its stimulus. Whether the economy can withstand this withdrawal of both fiscal and monetary stimulus at the same time will be one of the key questions for markets to answer in 2022.

We expect the Fed to be more cautious than the inflation and employment data might imply because they would likely prefer inflation to run a bit “hotter” than in recent years over the possibility that they push the economy into recession.

Global Recovery Without China?

China continues to cling to its “COVID Zero” policy of harsh lockdowns and testing protocols at the first sign of any outbreak, regardless of how minor. Xi’an, a city of 13 million, has been locked down for more than two weeks now and other smaller cities are beginning to experience the same. Many companies are warning of production shortages if these shutdowns extend or expand. And Omicron has just reached China’s shores. Other countries have found that this variant spreads so quickly that lockdown efforts are largely useless to contain it. We think the next several weeks could be quite interesting as China tries to host the Olympics while keeping the virus at bay.

More importantly, however, is that much of the rest of the world is well along in dealing with the Omicron variant and some are predicting that this will ultimately spell the shift of COVID from deadly pandemic to more routine virus inconveniences. If that were to be true, we could see economies reopen much more broadly, igniting production that meets unfilled demand and reduces supply backlogs in many parts of the world economy. However, China’s participation in that recovery remains a key question as they still face major potential disruptions from Omicron if they stick with their current policies. It is impossible to tell how this will progress but if recent history is any guide, this will proceed quickly. It could well be a very interesting few months ahead of us!

Investment Implications

We remain optimistic that the reopening of the US and developed economies will continue, despite the recent setbacks from the Omicron variant of COVID. The reduction of both government and Fed stimulus this year will prove a challenge to continued growth in the economy, but we expect the Fed to be the buffer, letting inflation go on longer. The rest of Washington is likely on hold through the election so that is a net positive.

We are keeping asset allocations close to long term targets, with sufficient cash available to take advantage of short-term setbacks, which we expect more often than we saw in 2021.