In what was generally a strong year for the economy and for equity markets, the last six weeks of 2021 were dominated by the emergence of another COVID variant – this time Omicron. The shortened trading session on Friday after Thanksgiving is usually a positive day for stocks. In 2021, thanks to news of Omicron, this was not the case. A week later, Federal Reserve Chairman Powell further roiled markets with remarks that inflation might not be as transitory as previously thought. The combination of an exceptionally contagious new variant and a more hawkish Fed took a toll on stocks – particularly those with already expensive valuations. At year-end the average stock in the S&P 500 had declined much more than the major averages since the Omicron discovery.
In December we learned that, while much more transmissible than Delta, Omicron seems to create fewer severe complications for healthy and/or vaccinated individuals who become infected. This is good news for the economy because the likelihood of another widescale shutdown due to Omicron is greatly diminished. It does not however, put Chairman Powell’s comments regarding persistent inflation back in the box, which has left markets with plenty to worry about through the holidays and into the New Year. Usually the “easy” trade is not what works, but it seems to be working in the short term. On days when Treasury yields go up, growth-oriented stocks (most notably large-cap tech stocks) decline. The math makes sense because future earnings are discounted back at higher rates, which makes them worth less in the present. The tug-of-war in markets currently is how long this trade persists.
Our baseline belief remains that the Fed has been behind the curve and that rates should have been normalized (i.e. not held at housing crisis levels) long ago. The snapback from COVID and resulting supply chain dislocations/inflation merely magnified the disconnect between rates and the strength in the economy. That’s not to say we disagree with the Fed’s strategy to err on the side of accommodation rather than constraint, but we also believe that the economy could easily handle several rates hikes from the Fed. Jamie Dimon, CEO of J.P. Morgan Chase, said earlier in the week that he would be surprised if there were “just four” interest rate hikes in 2022. He also pointed out that U.S. consumer balance sheets are in exceptional shape, and he’s forecasting “the best growth we’ve ever had this year.” All of which suggests that that the economy can withstand a tightening cycle.
None of this is to say that valuations can’t continue to be pressured as more hikes are priced-in by markets – especially for companies that are highly levered or not yet profitable. However, the other side of that coin is corporate profits, which should be strong and growing if the Fed is working to cool things off. We think the “easy” trade won’t work for much longer, and many of the quality stocks that have been out of favor recently can perform well in 2022.
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