Economic Flash: Volatility Makes a Comeback

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February 2022

US Economy: Stockpiling growth.

The US economy grew at a 6.9% annualized rate in Q4 2021, capping the most robust year since 1984. Roughly 70% of the uptick in Q4 growth (+4.9%) was a buildup in private sector inventories, with the rest from consumer spending and exports. Retail sales fell in Dec. (-1.9%), buffeted by rising prices and the ongoing pandemic.

US Stocks: Value shines.

US equities gave back a portion of last year’s tremendous gains, with investors nervous about valuations, rising rates and rapid inflation. With that backdrop, value-oriented energy and financials sectors held up quite a bit better than growthy tech and consumer discretionary sectors which may find that environment more challenging.

Foreign Stocks: Diversifiers.

International equities have struggled to diversify US equity risk over the last several years but that wasn’t the case in January. Both developed and emerging markets stocks outpaced their US counterparts on account of better valuations and fewer perceived headwinds from inflation and less accommodative central bank policies.

Fixed Income: Yields jump.

The yield on 10-year US Treasuries rose to nearly 1.8% (from 1.5%). Core inflation for 2021 was 5.8%, the fastest annual pace since 1982, and the Fed has strongly hinted that this March is when it will start to raise interest rates and end its monthly bond purchases. Futures markets are pricing in as many as five Fed rate hikes in 2022.

Real Assets: Oil leads.

While infrastructure assets held up relatively well compared to REITs and stocks in general, commodities were the star performers in Jan., as oil spiked on production shortages and concern over the Russia/Ukraine conflict. However, gold and precious metals prices fell on rising interest rates and a stronger US dollar.

Alternatives: Mixed results.

In a difficult month for most financial assets, returns on hedge funds were rather bond-like overall. Unsurprisingly, equity long/short and other stock-driven strategies that had topped returns during the Covid-19 recovery rally performed worse in Jan. (-3.4%) than relative value strategies (-1.2%), which are less sensitive to market movements.

Equities Total Return

U.S. Large Cap (5.2%) (1.6%) 23.3%
U.S. Small Cap (9.6%) (11.5%) (1.2%)
U.S. Growth (8.9%) (6.8%) 15.1%
U.S. Value (2.6%) (0.2%) 22.8%
Int’l Developed (4.8%) (4.6%) 7.0%
Emerging Markets (1.9%) (4.1%) (7.2%)

Fixed Income Total Return

U.S. Agg. Bond (2.2%) (2.1%) (3.0%)
TIPS (2.0%) (0.8%) 3.5%
U.S. High Yield (2.7%) (1.9%) 2.1%
Int’l Developed (2.2%) (3.4%) (10.4%)
Emerging Markets (0.3%) 0.5% (0.8%)
Intermediate Munis (2.5%) (2.1%) (2.5%)
Munis Broad Mkt (2.7%) (1.8%) (1.6%)

Non-Traditional Assets Total Return

Commodities 8.8% 4.4% 34.7%
REITs (7.9%) (0.1%) 30.2%
Infrastructure (1.0%) (0.1%) 13.1%
Hedge Funds
Absolute Return (1.0%) (1.0%) 1.3%
Overall HF Market (1.9%) (2.7.%) 1.9%
Managed Futures 1.2% (2.0%) 8.8%

Economic Indicators

JAN-21 OCT-21 JAN-20
Equity Volatility 24.8 16.3 33.1
Implied Inflation 2.5% 2.6% 2.1%
Gold Spot $/OZ $1797.2 $1783.4 $1847.7
Oil ($/BBL) $91.2 $84.4 $55.9
U.S. Dollar Index 116.1 114.2 111.9

Glossary of Indices

Our Take

As long-term investors we avoid market prognostications, but we do prepare for likely changes in economic and market regimes. In our January Flash Report and our Q1 Quarterly Commentary, we highlighted that one of the chief attributes of a new market regime was likely to be higher volatility amid unabated “pandemic-induced fog,” as the Federal Reserve walks a tight rope trying to contain inflation without harming economic growth. It’s no wonder that Wall Street forecasts for 2022 are all over the map.

While the markets have had a very choppy start to 2022 (S&P 500 was down 5% for all of January), it’s important to remember that market drops are not abnormal, especially after a very strong 2021 and a three-year return of 90% on the S&P 500 (2019-2021). Our focus is making sure each client is on track on attain their financial and life goals, and to do that we continue to rely on diversification strategies. To varying degrees in January, diversifiers such as fixed income, real assets and hedge funds in LNWM portfolios helped to mute equity volatility. While it may seem boring, diversification works.

Looking forward, volatility could very well be here to stay as labor force, supply chain and consumer spending factors all make elevated inflation “sticky.” At the same time, we are starting to see signs of weakness in the US economy. And this raises the odds of a major Fed policy error: If the Fed raises interest rates too soon or too fast in 2022 to fight inflation, economic growth could suffer and even decline. Consequently, all eyes remain on the Fed. While concerns in the latter part of 2021 were that the Fed might not do enough to counteract inflation, the worries are now that the Fed is going to do too much. Such is the life of a central banker.

What We’re Doing

Headed into 2022, portfolio rebalancing looked like it would be appropriate, and even if equity markets have done a little of their own rebalancing, trimming overweight equity positions in portfolios to their strategic targets remains a healthy exercise today. We continue to view real assets (commodities, infrastructure, real estate) as attractive due to compelling valuations and built-in protection from inflation, despite the 2021 runup.

Core fixed income and cash also remain powerful diversifiers, despite their low yields, and should continue to buffer equity market volatility. That said, with the last month a good example, bonds aren’t a perfect counterbalance to equity; other asset classes such as private capital and real assets should be tapped to meet income needs and long-term objectives when practical.

In that vein, we continue to source unique, often less-liquid alternative investments that variously can provide clients with: (1) improved risk-adjusted returns through a full market cycle; (2) enhanced income; and (3) potential for non-financial returns/impact.