The fourth quarter saw a repeat of the third quarter as large-cap growth stocks continued their upward momentum. Falling interest rates helped the interest-rate-sensitive stocks, while the flattening yield curve dragged the financial sector. Emerging markets suffered from exposure to Chinese stocks, which have been battered by that country’s housing-sector debt crisis.
Within fixed income, higher inflation expectations amid still-ample monetary support continued to push Treasury Inflation-Protected Securities (TIPS) to outperform the broader Bloomberg Barclays U.S. Aggregate Bond Index. On the other hand, with the Federal Reserve (Fed) keeping the fed funds rate anchored, short-term bonds lagged the broader fixed-income market.
We head into the new year with lingering challenges such as inflation and resurging COVID-19 cases. The Fed finally abandoned the term “transitory” to describe inflationary conditions that have been more persistent than originally anticipated. In turn, the Fed is expected to reduce its bond holdings earlier and faster than initially planned. It should be noted that the Fed’s balance sheet stood at nearly $9 trillion in late 2021, which is up from $4 trillion before the pandemic.
Source: FactSet as of 1/7/22
The Fed also projects raising interest rates in 2022, with the market pricing in a hike during the first half of the year. While the Fed is expected to raise rates three times in 2022, future hikes will depend on how inflationary pressures develop and the economy shapes up. In terms of the economy, employment conditions continue to improve, leaving employers scrambling to fill open positions, which could ultimately lead to increased wages. The unemployment rate has fallen sharply and sits close to pre-pandemic levels.
Source: FactSet as of 12/31/21
Among various factors that contributed to the rise in inflation, the global supply-chain strains received much attention. Strong demand for goods and port congestion led to a surge in ocean-freight rates, which contributed to the rise in prices. Although easing supply-chain bottlenecks could alleviate inflationary pressures, there are little signs of this happening anytime soon, even though we may have reached peak congestion.
Many supply chains are deeply interconnected, leaving suppliers vulnerable to interruptions around the globe. This means that policies such as China’s zero-COVID strategy, which relies on strict lockdowns, will have long-reaching effects for producers and retailers around the world. The recent emergence of the omicron variant further complicates efforts to reopen the global economy.
Given that China’s Sinovac vaccine has been reported to offer limited protection against omicron, the country may continue with its zero-COVID policy through much of 2022. These restrictions potentially could mean that inflation persists longer than many had anticipated unless omicron quickly subsides and another variant doesn’t take its place.
Given China’s outsized role in the global supply chain, events related to that country can significantly impact the global economy. While some central banks, such as the Fed, are expected to tighten monetary policy in 2022, China’s central bank has taken action to boost liquidity to help cushion the downturn in its housing market. This action has garnered much attention given that the property sector represents roughly a quarter of China’s gross domestic product (GDP).
This divergence in monetary policy could heighten volatility in markets as both the U.S. and China’s central banks delicately balance between maintaining economic growth and quenching inflationary pressures. China’s monetary policy impacts Asia because China’s growth affects trade and supply-chain channels. In turn, the Fed’s tightening policy also matters for Asia as it affects U.S. growth, which could curb Asian exports.
Much will depend on how the Fed and the People’s Bank of China (PBoC) address their respective policies as both central banks attempt to avoid policy mistakes. The PBoC is expected to continue to selectively ease liquidity, which should mitigate risks of a slowdown in China (and Asia). Furthermore, the Fed’s gradual policy normalization could reflect stronger U.S. growth, which would be reflected in a steeper yield curve in the U.S.
The combination of rising inflation, a healthy economy, and the Fed’s reduced bond purchases may lead to rising yields. This situation could potentially reverse the recent momentum that had growth outperforming value stocks. All of this will depend on how the normalization process develops throughout 2022.
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