The perilous market path ahead
Testing new highs or succumbing to Fed fear?
At the beginning of December, it looked like 2021 might be the year the Grinch would win, as fears surrounding the virus and central bank tightening caused investors to rethink the buy-the-dip mentality that had persisted for the past 18 months. But just as the negative tone seemed to take over the media and investor persona, markets turned higher and finished the year at, or near, all-time highs.
What remains to be seen is whether this was just a historically strong Santa rally or the start of another significant move higher. The last few weeks of December are never great market indicators, since they usually have very thin volume and don’t reflect a complete economic picture. This is not unlike how, when stepping back and looking at the index performance for 2021, many would think it was an easy year. This was far from the case.
In 2021, most active funds underperformed broader indexes. In general, the year will go down as one of the worst years for hedge funds, as many were never able to recover from the short attacks that took place from the Reddit crowd early in the year (AMC and GameStop ring a bell?).
On the positive side, 2021 saw the return to favour for the cyclicals. Crude oil and the energy commodities have been great examples of this change in sentiment. After the initial shocks from Omicron took oil down from over $80 to the low $60s, we have seen a strong rebound that recovered most of the losses, setting up for another test of new highs in the coming months.
Looking towards 2022, investors will have a lot to focus on, and many questions to be answered. Going forward, it probably won’t shock anyone to see Bitcoin back to new highs in the near term, but it may catch many off guard if it were to happen at the same time as gold was breaking out. The path of the U.S. dollar will go a long way to determining if this is the case.
As always, the most important factors in capital markets are the central banks. This year should be very different from last as central banks around the world should begin hiking rates and may be less focused on protecting the stock market. We may have seen the end of the “Fed Put” for this cycle. It is expected that the FOMC will announce its first-rate hike since late 2018 in March. And while every tightening cycle is different, they are usually not an easy time for markets, and can lead to higher levels of volatility as every central bank meeting has the potential for surprises.
The risk of central bank error
The biggest market risk is a central bank policy error, and messaging will continue to be extremely important. As the banks begin to remove stimulus while the virus remains, there will be a risk that the banks are eliminating stimulus at a time when its actually needed in many parts of the economy.
The argument contrary to that is they have left the stimulus on for too long. This can be seen in the dramatic increase in the price of goods and services globally. The hope is that these price increases really were just transitory, and once supply chains recover, prices will return to more normal levels; however, inflation could persist longer than expected and refuse to fade away.
To hedge inflation risk, the bull case for real assets returns. The commodities have responded to this fear and, as one of the top-performing sectors in 2021, are reminding investors of their place in portfolios.
Rising rates are usually not kind to high-multiple growth stocks, and we have seen this group come under pressure in the second half of the year. Comparisons between the current market and the market of 1999 and 2000 are starting to be made more frequently. History never repeats, but it often rhymes.
Concentration is another risk in the current market environment as mega-cap tech stocks dominate many indexes and ETFs. Their valuations are getting stretched – if they fail, it will be ugly for many investors. This group will have to be monitored closely for any signs of a shift in sentiment, and active management will get another chance to add value in the new year.
As central banks begin their attempt to normalize rates, we will have to see if it is safe for us to predict that the rest of the world will return to normal as well. It’s probably a fair bet to predict this will be a “new” type of normal. We should expect (1) an increase in volatility with opportunities for gains and (2) new sectors to lead in the new environment.
Broader indexes may return to more normal single-digit rates of change as multiple expansion will be harder to expect coming in with higher valuation levels. What remains are extreme levels of cash on the sidelines looking to be deployed, which should act as a buffer to prevent any dramatic selloffs. But, as always, expect the unexpected, and get ready for what could be an interesting year.
Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.
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