Q4 Quarterly Commentary 2021
As we near the end of the fourth quarter of 2021, it also marks the end of Biden’s first full year in office. The fourth quarter under the Biden administration saw the economy continue to recover amidst a backdrop of increasing vaccination rates, consumer spending, supply chain constraints, and a resurgent Covid variant, Omicron. By early December, it was reported that U.S. inflation reached a 4% decade high in November. The 12-month change in the Consumer Price Index reached a high of 6.8%, levels we have not seen since the early 1980s.
$2.8 trillion in federal spending approved since December 2020 has produced the fastest recessionary rebound our generation has ever witnessed accompanied by a persistent rise in inflation that has even taken the Federal Reserve by surprise. Growth in U.S. government spending continues to be met by rising GDP growth such that the Total Public Debt to GDP ratio has broken through the 125% level set at the end of Q3 to a 2021 low of 122% in December.
Note in the chart below, we are coming off a high of 135% reached in April 2020.
The most recent FOMC 2-day policy meeting brought a change in their policy language that the Fed will ‘pivot’ and set plans to reduce bond purchases more quickly into 2022 setting the stage for a series of interest rate increases to begin as early as Spring 2022. Median Federal Funds Rate projections for 2023 have risen steadily since March of this year. The median rate for 2023 started a 0% in March of 2021, rising to .5% in June of 2021, to 1% in September 2021 to now 1.5% in December of 2021. Recall that it was just in March of 2021 that the Federal Reserve vowed to keep interest rates low through 2023.
The main observation of the fourth quarter has been continued supply chain disruptions, coupled with a rebound in the shift in consumer spending habits due to the resurgence of Covid in the form of the Delta variant here in the U.S. Recall that after posting a record-setting Institute of Supply Management Services Index read in May of 64.0, the services index had cooled to 61.7 in August. The expectation was at the time that as the vaccination rates continued to climb and the Delta variant abated, consumers would once again feel more comfortable getting out of the house for office visits, haircuts, and family gatherings.
In the Q3 report, we mentioned that in this environment, we felt the demand for services could climb even back to record highs and may go even higher. We forecasted this to be a catalyst for the YTD 2021 broadening out of the market expansion into value sectors and would be a theme that continues well into 2022.
Looking at the combined ISM Manufacturing and Services Index charts below, you can see that our forecasts were spot on as we are now seeing the shift in consumer spending habits fueling the services sector to a record high of 69.10 in November, broadening out of the market expansion into value sectors. We feel that this is a theme that will continue well into 2022.
As always, we will continue to monitor developments in consumer behavior well into 2022. As consumer spending continues to shift to the services sector, it could take further pressure off commodity prices and further the valuation contraction of cyclical stocks (see relative PE F12M chart below). Growth stocks would be the obvious beneficiary of any decline in commodity prices as this would be an indicator that inflation may be more moderate versus embedded at elevated levels for the longer term.
The decline in U.S. Covid Delta variant cases, along with the discovery of the Covid Omicron variant, brought neutral-to-bearish technical signals throughout the quarter. As a result, we maintained our cash position from the beginning of the quarter up to our November rebalance, and at which time we eliminated our holding in BIL.
Overall, we believe the continuation of a change in consumer spending habits from goods to services will continue to broaden the recovery through at least Q2 of 2022. We have extended our outlook on the broadening of the recovery through Q2 of 2022 largely due to the temporary shock we experienced from Omicron in Q4 2021. We expect the stock market to continue its upward momentum until U.S. economic growth expectations begin to taper or we begin seeing more evidence that the Federal Reserve is not able to bring persistent levels of high inflation to a ‘soft landing’. Any perceived reduction in the U.S. economic growth forecast will be met with a broader PE multiple contraction as economic models are revised downward to reflect slower growth expectations.
The largest risk facing the economy remains a policy misstep by the Federal Reserve in their anticipation of inflation. Another large risk is that consumers begin reducing consumption in response to high levels of longer-term inflation.
In our Q3 report, we acknowledged that to date, most investors and strategists were all in agreement with the Fed that inflation will be “transitory” in nature. At that time, we stated that while we still agree that current supply chain issues coupled with the reopening demand lend support for the transitory inflation argument, we remained vigilant of the fact that most Inflation Index Surprise charts continue to measure greater than +2 Standard Deviations away from the mean consensus forecasts for the latest reads on inflation.
In our Q2 report, we presented the 3 key metrics we are tracking to determine if inflation is embedding itself longer-term into the U.S. economy: Worker Compensation, Consumer Demand, and Inflationary Expectations.
- Worker Compensation – In Q4 the supply of workers remained constrained, and wages continued to rise. These pay increases are forcing businesses to pass higher costs along to consumers and are embedding inflation longer term.
- Consumer Demand remains strong in a U.S. economy that remains flush with liquidity. In Q4 2021 manufacturers and their suppliers once again struggled to meet booming demand amid unprecedented lengthening of supply chains and delivery delays leading to further price increases for raw materials and finished goods.
- In Q4 and beyond, inflationary expectations remain one of the most powerful inflationary forces because of their ability to become self-fulfilling. When workers, consumers and businesses believe that inflation will get worse, they will bid up prices and wages in anticipation of inflation thereby fueling the flames of inflation they were originally fearing!
As of Q4, 2021, we have short-term expectations for inflation stabilizing at record levels according to the latest University of Michigan survey. According to the survey, 1-year consumer inflation expectations in the United States decreasedfrom 4.9% percent in November of 2021, to 4.8% percent in December 2021. Recall from the Q3 report, these numbers are up from 4.7% in July and 4.6% in May and remain at record levels not seen since the China commodity boom of 2011 post-Great Recession. Long-term the 10-year breakeven inflation rate in the chart below shows the 10-year treasury to 10-year TIPS spread indicating elevated but more moderate inflation expectations on average over the next decade of 2.44% per year.
Looking into 2022, we expect that the Federal Reserve will wrap up their $120 billion per month asset purchasing program sometime in late Q1 or early Q2 setting the stage for a series of rate hikes to follow. We also expect that the Biden administration will attempt to reach a bipartisan agreement on some form of the original $3.5 trillion dollar infrastructure spending package. There is a good chance this watered-down legislation will pass both the House and Senate. We will continue to seek out risks and opportunities by continually reevaluating our stance on all monetary and fiscal policies, inflation, interest rates, corporate margins and earnings, labor force participation, supply chain, geopolitical/China, unemployment, and regional/national gauges of manufacturing and service level activities.
Published December 30, 2021
Joe Maas, CIO | CFA, CFP®, ChFC, CLU®, MSFS, CVA, ABAR, CM&AA, CCIM
David Stryzewski, CEO | CSA, NSSA
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