What we know about the markets in 2022
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Hello, welcome and happy new year. We have managed to avoid the prediction game for the coming year because we are at least as bad at predictions as everyone else. But it’s the start of a new year, so we figured we could at least showcase what we think are the most important known and unknown to the market right now which is where we think we are, if not. where we are going.
Where are we at the start of 2022
Monetary conditions are set to tighten, at least until the market or the economy hits an iceberg; this will put pressure on asset prices. The Federal Reserve is reducing its bond purchases at a faster pace. It looks set to hike rates in the middle of the year (although its fundamental bet is still that inflation will turn out to be transient).
There are other key determinants of how much dollars are flowing, as Michael Howell of CrossBorder Capital (our favorite liquidity analyst) points out. There is the General Treasury Account – the government’s current account at the Fed – which is rebuilding after being almost wiped out last month. This means that the government takes cash out of the system (by issuing debt) and not delivering it (by spending). Another variable: the bulk of the Fed reverse repo program, under which it sells short-term debt securities to withdraw liquidity from the banking system, with the aim of preventing overnight rates from turning negative. If reduced, it could compensate for the taper and buildup of TGA. Meanwhile, the European Central Bank and the Central Bank of China are tightening and staying neutral, respectively.
All other things being equal, when there is less money or more expensive, asset prices face a headwind. People who think they have too much money try to get rid of it, driving up the price of other things.
Market prices tell investors that inflation will soon come down. If you’re betting on inflation or booming growth, great. But the market thinks you are wrong. Break-even points – measuring the spread between inflation-linked bonds and five-year vanilla bonds – show the thinking of the market. Expected inflation over five years is less than 3%:
That could change, of course. Maybe that’s changing right now; yields have risen across the yield curve over the past few days, and there appears to be a rotation towards cyclicals and current banks, which also suggests somewhat of an increase in inflation. And:
Supply chains remain knotted and we still don’t know when this will normalize. The New York Fed new gauge of global supply chain pressure clearly tells the story:
Some supply constraints are easing, but most are not. Analysts’ forecasts are fuzzy. Some expect a brutal 2022 while others believe the second half of the year may bring relief. Notably, even optimists do not expect a full return to normal in 2022, but rather a normalization in some sectors. Don’t get lulled into the headlines later this year saying sourcing conditions are improving. The extent of supply problems matters as much as their trajectory.
The riskiest equity assets are already in bearish territory. But junk credit spreads remain very tight. The long-term ARK Innovation ETF is as good an indicator as any other. It has plunged 27% since November. But bad credit wasted no time. The spreads to T-bills for CCC-rated bonds (Fed data) have remained below 7% (the very low end of the historical range) for almost a year:
The equity / debt contrast isn’t all that strange. Creditors are ahead of shareholders in a recovery from bankruptcy. And there are hardly any bankruptcies right now, anyway. Nonetheless, credit spreads are the fear indicator to watch over the coming year.
The market is very thin. US stocks, as we have pointed out, have been exceptional both in terms of performance and weight at the top. So much so that holding the S&P 500 last year would have almost tripled the average return of hedge funds. Even better if you only owned the best stocks – what we call the S&P 10:
Globally, the United States accounts for the lion’s share of equity gains. And just a few stocks represent the lion’s share of US earnings. As many market commentators have suggested, a thin market does not always point to a correction. But it’s still scary, if you ask us.
Especially since the main reason super-duper stocks rose was not earnings growth but multiple expansion. There has been some excitement in recent days about Apple tripling its value from its lows during the pandemic to become a $ 3 billion company. But most of the increase is due to a higher price-to-earnings ratio. Bloomberg data:
The relationship between the valuation of individual stocks and their future performance is also not determined. All the same – scary.
How important will Omicron be to the economy? We love Omicron’s optimistic outlook. As shown, for example, here, it goes as follows. Cases are increasing, but hospitalizations are not. The vast majority of vaccinees, and many of the unvaccinated, suffer from mild symptoms. The new pill (Paxlovid) should improve the chances of those who get very sick. So in the case of the United States, we could come out the other side of that in (say) a few months without widespread calamity and with a large majority of the country either triple vaxxed or resistant to infection, or both. . It could finally put handcuffs on the service economy and the labor market – and give asset prices a head start.
We can think of a million ways that this does not happen. But charts like this one, from the FT using UK data, mix hope and uncertainty:
Can China contain its real estate crisis? China’s economic growth is slowing as it hesitantly moves away from its investment-driven growth model. But the massive debt and overbuilding that results from this model remains. Can the authorities let the air out of the housing bubble without a financial crisis? So far, it seems they have. But the game is still in progress, and the final score is to be guessed. It could be 22’s biggest story, or none at all.
Will the Democrats put in more stimulus? Some are clinging to the hope that Joe Biden’s social policy bill, Build Back Better, could eventually pass, despite protests to the contrary from core Senator Joe Manchin. 2022 will be their last chance to pass major legislation before an expected rout midway through.
If Build Back Better fails, the pressure could intensify for Democrats to adopt executive order policy, such as massive student debt forgiveness – boost household balance sheets on the liabilities side. Pardon by Order in Council would surely be challenged in court, but the many question marks surrounding US policy could spill over into the markets.
Is Tina enough? This is the big one. Why shouldn’t stocks at historic highs, in terms of price and valuation, worry us? Because there is no alternative: earnings returns on stocks are always much higher than returns on fixed income securities. There are serious theoretical questions about this argument (shouldn’t low returns indicate lower economic growth, hence lower future earnings and lower stock prices today?), But its psychological power and its popularity are indisputable. Even if inflation doesn’t drive up interest rates, something else could upend Tina’s cult. A correction would follow. (Armstrong and Wu)
A good read
2022 is an election year. It will count for the markets. Right here, from Split Ticket, is a good analysis of the sharper edge of the Democratic / Republican divide – the divergent voting patterns of white Americans with and without college degrees.