The Economy and Market from Here... at Hills Quarter 1 2022

The Economy and Market from Here... at Hills Quarter 1 2022

January 5, 2022

Tagged As: Wealth Management

Stock markets rallied to new highs in the fourth quarter of 2021 before ending the year only slightly lower. All of this despite increased uncertainty surrounding COVID-19 and the new Omicron variant, inflation, the Federal Reserve, and conflict in the Capitol. The economy—mainly corporate profits and consumer spending—has shown resilience, thus propelling markets upward. The S&P 500 gained 11.02% for the quarter and rose 28.68% for the year. International stocks—as measured by the MSCI EAFE—added a modest 2.74% in the fourth quarter and ended the year up 11.86%. The biggest surprise, given the increased inflation and the Federal Reserve beginning to taper, was the yield on the 10-year Treasury which barely budged during the quarter. In fact the yield fell slightly, from 1.53% on September 30 to 1.51, to end the year.

Markets were extremely volatile during the final month of the year. The Omicron variant’s emergence instigated big declines in global markets as investors braced for more restrictions. Declines were relieved somewhat by initial reports indicating this variant, though more transmissible, appears to be less likely to cause serious illness. This may not continue to be the case as hospitalizations climb, but early evidence would confirm that compared to previous waves Omicron may be less severe.

The prevalence of infections and varying ways in which countries are dealing with the pandemic continue to wreak havoc on supply chains, further exacerbating the situation and impacting global economies. More specifically, we have been observing slower economic growth yet higher inflation. The Federal Reserve Open Market Committee (FOMC), led by Chair Jerome Powell, admitted at a recent meeting that the current inflation experience may not be entirely transitory but may persist at higher levels for some time. As a result, the FOMC has begun to reduce bond purchases in the open market (the taper) and plans to raise short-term interest rates next year.

The economy, though growing more slowly than many expected, is still humming. Consumers are spending, unemployment continues to decline, and manufacturing capacity is increasing. Consumer spending during the holiday season eclipsed that of 2019 and is now above levels seen pre-pandemic. Corporate profits continue to surprise due to a combination of greater productivity from the utilization of new technologies adopted during the pandemic and their ability to easily pass on increasing input costs (inflation) to the consumer.

Looking Forward

The upcoming year will be a year of transition. Supply chain congestion and inflation are expected to be moderate in 2022. The FOMC is expected to end their bond purchases early in the second quarter and begin raising interest rates. This signals a transition from accommodative monetary policy to a more neutral policy. Consumers will likely transition their spending away from goods and to more services, helping ease the supply chain woes. Corporate profits will likely moderate as companies exhaust their productivity opportunities and higher wages come to bear. Investment in automation during the pandemic may limit how far wages can rise and this will be part of the calculus made by investors in the coming years.

Stock and bond markets ended 2021 at lofty levels, and it is hard to imagine that 2022 can provide the price increases for stocks that we saw in 2020 and 2021. That said, we still believe the relative opportunity between stocks and bonds favors stocks and will begin the year maintaining our overweight position to that asset class. Interest rates, both short and long term, are expected to rise and inflation will likely continue to be at the forefront of the conversation. With bonds at very low levels, this does not bode well for the asset class. Stocks are expected to generate modest returns over the next several years, but nonetheless, have historically provided better protection against inflation than bonds.

We do think that volatility is likely to remain elevated and there are certainly plenty of risks that could result in a short-term decline in stock prices. Will the FOMC tighten too aggressively? Will a future COVID variant increase global alarm thus leading to further restrictions? Will rising costs impact corporate profits more than expected leading to disappointing earnings reports? Will the debate over the debt ceiling–postponed for now–again draw the ire of investors? These are the known risks, and there are always the risks no one is thinking about. Because of this, we would not advocate abandoning a position in bonds unless your time horizon is very long and/or you are making regular contributions to an investment portfolio. That is the pool of funds that can provide for regular distributions during times of stock market stress. It can also be a source from which to make investments during market dislocations, turning the event into an opportunity that will pay dividends in the future when markets recover.

Thank you for allowing us to serve you, it is an honor we do not take for granted. All of us here at Hills want to wish you a very happy and prosperous 2022. If nothing else, it is likely to be exciting! As always, we are here to answer your questions and make sure your current asset allocation is still appropriate for your circumstances. If it has been a while since you have visited with us, please do not hesitate to call or email and set up a meeting with your Hills Bank Trust and Wealth Management Officer.

Some trust products and IRA contributions/balances are not a deposit, not FDIC insured by any federal government agency, not guaranteed by the bank and may go down in value.