January Market Commentary
The great (interest rate) debate
The first few weeks of 2022 have plenty of market strategists and economic forecasters alike calling for 2022 to be the year where “the great bubble finally bursts” and “everything unravels.” In January, I suppose, every year has the potential to be a disappointing year. However, keep in mind some of these same prognosticators were calling for nearly the exact same scenario to play out a dozen years ago. A January 2010 article written in The Wall Street Journal particularly caught my attention.
In the article, Jeremy Grantham was quoted as saying the S&P 500 index is worth “850 or so; thus, any advance from here will make it once again seriously overpriced.” The S&P 500 was trading below 1,100 at the time that article was written. Grantham went on to predict “seven lean years” with his firm’s capital market assumptions forecasting large-cap US stocks to deliver a real return of 1.3% annualized over that timeframe. As we now know, 2010 through 2021 provided remarkable U.S. stock market returns. The S&P 500 traded at levels nearing 4,800 toward the end of 2021. Had one viewed anything above 850 as “seriously overpriced”, that investor would have missed out on some of the best returns the U.S. stock market has ever seen.
This is not to disparage Mr. Grantham but to point out the fact that market pessimists are always present and bold predictions of meltdowns, unravelings and multi-year bear markets are nothing new. Big, bold claims get ratings and create notoriety and pessimism is especially alluring as it makes the pessimist sound smart. As Morgan Housel, the author of The Psychology of Money, puts it, “pessimism is intellectually seductive in a way optimism only wishes it could be. Tell someone that everything will be great and they’re likely to either shrug you off or offer a skeptical eye. Tell someone they’re in danger and you have their undivided attention. Hearing that the world is going to hell is more interesting than forecasting that things will gradually get better over time.”
The recent downturn in the market, the expectation of rising interest rates on the horizon and the highest inflation reading we’ve since the early 1980s has many investors questioning everything. Questioning things right now is actually not such an unreasonable thing to do. Low interest rates have been a (the?) key driving force behind the prolonged rise in financial assets, namely stocks and real estate, over the past decade plus. And the thinking is, if the primary driver no longer exists then financial assets must fall.
While interest rates are vitally important to stock market valuations, they are not the only major factor. Corporate earnings also have a significant impact on stock valuations. Further, market sentiment and investor psychology drive stock prices quite a bit as well. That said, let’s take a step back and examine interest rates in a bit more depth.
While the Federal Reserve will, in all likelihood, raise rates multiple times this year and next, that does not mean that interest rates will be high. In fact, historically speaking, they would still be quite low. As we stand now, nearly every rationale market participant considers current Fed policy to be ultra-accommodative or very easy. If the Fed Funds rate goes from 0.25% to 1.75% or 2.25% or even 2.75%, rates would still be accommodative and should allow for prolific economic activity and continued growth and expansion. The expectation that the Fed can keep the economy and financial assets forever increasing without interruption seems a bit naïve. However, investors’ negative reaction to the Fed saying they are going to increase rates incrementally over time seems to signal that the expectation was indeed that the Fed would keep rates near zero forever.
At one point, the Fed’s stated mandate was keeping prices stable and cultivating an economy that helped create full employment. Now it feels like investors expect a third mandate where the Fed is also charged with keeping real estate and stock markets buoyant by keeping interest rates artificially low despite there being a very strong economy. Hopefully the Fed is able to steer clear from this unspoken “third mandate.” While there may be some short-term pain, having a Fed free of the burden of keeping the securities markets on a never-ending upward trajectory would be better for the greater good.
Another reason why we believe the Fed will not be able to increase rates to a level that would significantly impair financial asset valuations is because of the amount of outstanding debt that the United States has. The U.S. national debt was estimated to be $28,400,000,000,000 toward the end of 2021. I know, all those zeroes make it difficult to comprehend. That number is $28.4 trillion. Yes, still difficult to fathom. Because of the sheer magnitude of this number, if borrowing costs were to rise to 5% or 6%, the interest burden that the U.S. would face would be overwhelming. Therefore, in our view, the Fed does have a bit of a conflict of interest that will prevent rates from increasing too much above 3%. This level of interest rates should help provide a bit of a floor on financial asset prices that is much more palatable than what many in the financial media are saying.
In summary, while interest rates may be rising and financial conditions may be tightening, they are not tight. While growth may be slowing, it is not slow. While valuations may be higher than average, they are not so high that investors should panic. While equity returns may not be what they were in 2019 through 2021, they should still be attractive relative to other asset classes. Stock returns will likely moderate in 2022.
Despite this likely moderation, there are still numerous reasons to be constructive on the equity markets. With a still easy stand from the Fed, corporate profit growth expected to be over 10% for the year and many areas of the market looking attractive, we view 2022 as having an encouraging framework for strong global equity returns.
Written by Charles Verruggio, Chief Investment Officer