January 2022

January Investment Summary

A small rally in the last few days of January turned a disastrous start to the year for major equity markets into merely a terrible start. Only the FTSE 100 offered positive returns as markets reeled from concerns over rising inflation, and the newly found desire by central banks to tame it. In addition, the rising tension surrounding Ukraine and the potential for a Russian invasion added to investor fears. Energy prices rose further as the strong global economy was clashing with energy supplies that are unable to match rising demand. Years of reduced capex spending in the energy sector has left the world (for the moment at least) facing steadily rising prices for energy and many other commodities.

Inflation has now reached levels that central banks can no longer ignore. They are being pressured by governments and the general populace to “do something”. The Federal Reserve at their latest meeting strongly hinted they would raise rates in March. They also signaled their readiness to shrink the balance sheet. The Bank of England at its latest meeting hiked rates again and stated they too would begin to shrink their balance sheet. Even the ECB suggested that they would be prepared to act if inflation stayed high. The financial markets were caught off guard and began to rapidly reprice their expectations for rate hikes with bond markets seeing a sharp rise in yields at the same time as equity prices fell. A very unpleasant combination for investors but one we may have to get used to for this year.

Central banks continue to forecast that inflation will fall in the second half of this year back towards their 2% target as supply chains normalise, goods demand begins to moderate (in favour of a return to greater consumption of services) and year-over-year base effects fall out of the calculations. But central banks are no better forecasters than the rest of us. It is not clear that inflation will fall as fast as they desire (hope). In January, the expectation was that the US labour market would see a decline in hiring due to the Omicron variant of Covid-19, instead we saw strong hiring and upward revisions to the previous two months. To top it off, wage gains showed their strongest rise yet with average hourly earnings growing at a 5.7% annual pace.

It is clear that central banks are in a difficult spot (much of their own making). They can no longer continue the exceptionally accommodative polices they have been running since the onset of the Covid-19 pandemic. How high do rates need to go for inflation to start to decline? How large will the reductions in their balance sheets need to be to aid in reducing inflation? There is no clear answer to these questions. Don’t get caught up in the “will the Federal Reserve hike 0.25% or 0.50% debate in March?” That may matter for a day or two in markets, but the bigger picture is how far will they have to go? They will tighten until they achieve some results. Tightening policy will result in slower growth, but it is not a simple or clear equation. One cannot say that hiking by 1.0%, for example, will reduce growth by 0.5%. We expect central banks will go slowly, but they will be persistent until they see inflation trending lower. This is a big change to the investment environment. We are losing the very powerful tailwind of super abundant liquidity that we have been enjoying for the past decade. Markets are already reacting to this, and central banks collectively have done very little. What happens if the liquidity tailwind turns to a headwind?

Be mindful of stocks with rich valuations and no earnings. Volatility is rising and liquidity is poor. Who would have thought that Meta (Facebook) could fall 25% in a single day? They were a $1 trillion dollar market cap stock that is very widely held and very profitable. The markets will notice the exit from super easy money.

Jeffrey Brummette

Chief Investment Strategist

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