Monthly Update

While the S&P 500 was little changed in November, lower by .8% and the NASDAQ saw a modest gain of .25%, other major markets were soft and the news flow was noteworthy[1]. Within the US, the small cap Russell 2000 was weaker by 4.3%[2]. Looking overseas, the STOXX Europe 600 index was down by 2.6%, the Nikkei was lower by 3.7%, the Kospi declined by 4.4%, while the Hang Seng fell by 7.5% to name a few in Asia[3].

Interest rates in the US went their separate ways, depending where on the yield curve you looked at. In other words, the yield curve flattened, whereas the spread between the 2 yr yield and the 10 yr yield narrowed to 88 basis points from 106 basis points at the end of October[4]. The spread between the 5 yr and 30 yr bond was 61 basis points at month end, from 75 basis points at the beginning[5]. The main reason, which I’ll get into further detail soon, was the early November FOMC meeting decision to start tapering asset purchases, and which was followed just weeks later, that maybe the pace they laid out wasn’t quick enough. The curve tends to flatten when the Fed tightens monetary policy. What we are finding, though, is that it is not just the Fed that is beginning to reverse Covid emergency policy, but many other central banks are as well.

We are thus entering a global shift in the flow of global liquidity, and the brakes are now being tapped with the higher inflation trends being the main catalyst for the pivot. We’ve talked a lot, not just this year but also last year, about the rising inflationary pressures. Fed Chair Jay Powell himself has finally realized this and has thrown in the towel on his ‘inflation is transitory’ belief, saying at a Congressional hearing on November 30th that he is retiring that word. The only question now is how persistent the inflation trends will be. We believe that, while some supply pain points will ease up in 2022, price pressures will continue into 2023 with now wage gains driving more price increases, as companies try to recapture profit margins.

The other thing that grabbed the world’s attention in November came the day after Thanksgiving (we hope yours was great by the way), when we heard of the Omicron Covid variant for the first time. While as of this writing we don’t know yet the actual data on how effective the existing vaccines are against it and how contagious it is, the early signs are the vaccines still provide a high level of protection.

Inflation and the Central Bank Response

Sustainable inflation is always two sided, where there has to be both a high level of demand that exceeds the ability of the supply side to deliver. Or another conventional way of saying it is too much money chasing too few goods. When you combine about $5 Trillion of government spending, which includes the CARES Act in the spring of 2020, combined with the December 2020 Trump spending bill and the nearly $2 Trillion spending package that Biden passed, with major supply disruptions and labor shortages, you have the inflation we are currently witnessing.

Because central banks are typically reluctant to take away the punch bowl and are much quicker in filling it up, many this year have been betting on inflation being just a temporary phenomenon, which is why policy hasn’t really changed much. In fact, most of the monetary tightening has instead taken place in emerging markets that have experience with inflation and don’t like negative real rates. With developed central banks, we did see the Bank of Canada end QE, the Reserve Bank of Australia put an end to its yield curve control policy because it became untenable with higher inflation, and the Reserve Bank of New Zealand and the Bank of Korea each raise interest rates.

On November 3rd, the FOMC laid out their plan to begin the trimming of their asset purchases at a pace of $15b per month, and thus, end the current bout of QE in June. Thereafter would be a debate on when to start increasing interest rates. It was only a few weeks later that a few Fed members hinted at speeding up their pace of tapering because of high inflation reads and that possibility was confirmed at the end of the month by Jay Powell himself. He said they will be discussing this growing likelihood at their December FOMC meeting. In response, the bond market has pulled forward the odds of Fed rate hikes to possibly as early as May 2022, on the assumption QE will end by April the latest. We are thus in the beginning stages of monetary tightening, which will be followed by the Bank of England and European Central Bank, along with others, and will most likely be a major factor in how markets and the economy perform in 2022.

In November, we saw the October consumer price index rise 6.2% y/o/y, the fastest rate of gain since 1990[6]. The European Commission released its November CPI and it came in at 4.9% y/o/y, the quickest since 2001 when the stat was first published. The CPI in the UK for October clocked in at up 4.2% y/o/y, the highest since 2011[7]. Pressures on the producer side are even more intense, as the supply challenges are a global phenomenon. We do think that these pace of gains will likely peak out in the first quarter of 2022, just based on tougher comparisons, but still believe that the inflation in the US specifically will settle out at a 3-4% rate. While this is off the peak, it is still a higher level than we are used to, if we are correct.

A key factor in how sustainable inflation will be is the pace at which wage increases take place. Because of a shortage of workers and increasingly an intense competition for them, employers are paying more and not just to lower paid leisure and hospitality workers. In the October personal income data from the Bureau of Labor Statistics seen in November, private sector wages and salaries rose at an almost 12% annualized pace over the past 6 months. This is great news for employees, especially in the face of rising inflation, but creates a challenge for employers if they can’t absorb this higher cost via faster productivity growth. Seen in the third quarter productivity report, unit labor costs are rising, and thus, companies will do their best to pass on higher labor costs to the rest of us, in order to regain profit margins.

Equities and Credit

Because of the new reality of monetary tightening and higher rates, the stock market has become more sensitive to valuations. This is due to a reduction in multiples of many high flying stocks because of price declines. The spread between growth and value still remains very wide, though, with the former way outperforming over the past few years. Maybe we’re on the cusp of some mean reversion where value makes a comeback, but we’ve seen false starts in the past.

There was some softness in the corporate credit markets in November, as credit spreads widened out and yields went higher. As part of the risk assessment of valuation and concerns with inflation, this makes sense as yields for high yield bonds were no longer ‘high.’ The yield on the Bloomberg high yield index went from 4.22% to 4.80% at month end, and that is a one year high[8]. Its spread to treasuries went to 337 basis points from 287 at the end of October[9]. The investment grade yields and credit spreads remain very low, but did rise in the month.

Omicron

As of this writing there is not much to say on the Omicron variant, as we await the results of the testing that vaccine producers are conducting. Optimistically, by mid-December we’ll know, but the early indications from those who have gotten infected and have been vaccinated resulted in mild symptoms. We are hopeful that this is just a natural progression in the life of this virus, but not something that will set us back, and that the vaccines and natural immunity will be highly effective defenses. That said, it remains uncertain how governments respond to this in terms of any lockdowns or travel restrictions. In November, Austria announced a full 3 week lockdown, but if there is one thing that should have been learned over the past 20 months, lockdowns don’t work in stopping Covid as it is still there when you reopen. Instead it has a dramatic impact on one’s economy that becomes harder and harder to recover from particularly for small businesses.

Conclusion

Life is never boring and we were reminded of that again in November. From an investing perspective, a tightening of monetary policy in response to inflation is the new dynamic we have to now maneuver through. It’s relatively easy (in retrospect of course) when easy money is flowing, but we have to reduce our return expectations when a spigot slows the pace.

Either way, whatever the outcome will be, it remains vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will continue to be a choppy time for the economy and markets. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and these markets.

[1] Bloomberg

[2] Bloomberg

[3] Bloomberg

[4] Bloomberg

[5] Bloomberg

[6] Bloomberg

[7] Bloomberg

[8] Bloomberg

[9] Bloomberg

Disclaimer

The opinions voiced in this material are for general information only, and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and changes in price.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets. The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.

Precious metal investing involves greater fluctuation and potential for losses. All investing involves risk including loss of principal.

Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index – while providing a real rate of return guaranteed by the U.S. Government.

Peter Boockvar is solely an investment advisor representative of Private Advisor Group, DBA Bleakley Financial Group and not affiliated with LPL Financial.

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Private Advisor Group, a registered investment advisor. Private Advisor Group and Bleakley Financial Group are separate entities from LPL Financial.

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[1] Bloomberg

[2] Bloomberg

[3] Bloomberg

[4] Bloomberg

[5] Bloomberg

[6] Bloomberg

[7] Bloomberg

[8] Bloomberg

[9] Bloomberg