We’re in a pretty interesting juncture in the markets. As we kick off the third year of the COVID-19 pandemic, the omicron variant is spreading across the country.
As of this writing, the Centers for Disease Control and Prevention reported there have been approximately 68.7 million cases of COVID-19, with the current seven-day average being approximately 783,922. That’s a significant increase from a seven-day average of roughly 416,357 at the start of January.
The rise of variants is among the trends that will impact the market this first quarter of 2022. Other trends we’ll cover in this article include potential changes in Federal Reserve policy, impact of behavior changes spurred by the pandemic, the rise of wages and inflation and geopolitical risk.
What’s the Fed Going to Do?
The biggest thing people are focused on now is what the Fed is going to do and how quickly it’s going to do it. We would expect the Fed to tighten up its policy to some degree.
Fed Chair Jerome Powell, who was nominated by President Donald Trump and recently renominated by President Joe Biden, had been criticized prior to the pandemic because the Fed raised rates and ultimately had to backtrack some of those increases.
As soon as Powell was nominated again, there was a fairly abrupt change in overall Fed policy, which was to start tapering its bond holding purchases more quickly. And while this in itself makes very little difference to the overall economy, its significance is that it moves up the date the Fed might raise interest rates.
Think of it like this: The economy has an interest rate that is somewhat sustainable, and it needs a certain degree of risk-taking and activity to generate enough economic growth to keep it working. When that economic activity gets too low, then the Fed lowers interest rates in order to speed up activity and incentivize people to continue to take risks.
The rates are lower than they were five to 20 years ago, having gradually gone down over that time period. So the question that we wrestle with is how much can the Fed raise interest rates before it slows the economy too much?
The Impact of Variants
We’re still dealing with variant after variant after variant. The fact that so many people are getting COVID-19 even though they’re vaccinated and boosted tells you that science has done some amazing stuff in the past two years, but it hasn’t eliminated every risk.
One interesting trend: Early in COVID and when Delta was the dominant variant, stocks that are less reliant on physical interaction were performing better than those that are more reliant on physical interaction. One of the questions we’ll get answers to in this first quarter is how much that will stick.
For example, during COVID, people have questioned where to exercise. During this time, we had a huge shift toward people buying their own equipment, rather than the service of a gym membership.
The question is, how many people will go back to gym memberships? And how many people can continue to buy exercise equipment. We’ve seen the stock of some at-home fitness business models that were expected to do really well fall quite a bit as concerns rise about their ability to continue to add people at premium price points.
Impact of Behavior Changes
Are we going to continue to use Zoom as much? Or are we going to continue to have groceries delivered? Probably. We’re also likely to lead more hybrid lives, meaning we’ll have more flexibility and days working from home than we’ve had in the past.
These behavior changes brought about by the pandemic might have an impact on other business models. For example, I am a huge plain M&Ms addict. There are many products with M&Ms at the grocery store – cookies, ice cream, yogurt with M&Ms – and when I go to the store, I’m going to buy them even though they aren’t on the list.
So companies and businesses that are relying on those impulse purchases are going to be affected. And so are those stores near the grocery store that rely on foot traffic. There are many economic models that will need adjustments, and the question is whether they can adjust quickly.
Wages and Inflation
Wages – disposable income – are up 5.8% year over year, but that’s effectively about the same as the inflation rates. So while people have gotten big raises, inflation has gone up so much that they’re really in the same position they were in before.
Both wages and inflation are going up quickly. The people who get hit hardest by inflation are those who are lower on the income scale who need to buy necessities, and as such they can’t adjust their purchase basket as much.
Simultaneously rising wages and inflation are putting pressure on the economy, which is why we’re seeing the Federal Reserve act. One of the issues we look at from the economy’s health overall is that inflation has gotten too high, and while we’re reaping the rewards, we’re starting to put inflationary pressure on the system. This ultimately becomes destabilizing, raising the risk levels and making it harder to invest. In the long run, inflation decreases the overall effectiveness of the economy.
Friction with China continues to be a concern. Our countries disagree with each other on a number of fronts. We have the relationship of producing goods, then shipping them to China for additional value add at somewhat lower wages, then transporting them to the U.S. for export. That’s the way the world works right now. As a result, some supply chains are getting threatened.
Another geopolitical area to focus on is what Europe is doing to improve its overall growth performance. The United States has been able to grow at a faster rate than Europe and be more innovative over a longer period of time. While that’s been good for U.S. companies, it’s been somewhat challenging for the world’s economy, as we haven’t gotten enough growth out of Europe.
As an investor, I’m looking for reforms in European markets as a potential opportunity to move assets overseas, which might allow them to better compete and offer better potential risk and reward than what we’ve seen relative to the United States.
During the pandemic, companies have performed well. For two years, our stock market has kept hitting new highs on a fairly regular basis. But we’ve started to see more churn within it, meaning some areas are doing well but others are underperforming.
After the initial decline in response to COVID, stocks rallied sharply while earnings declined. That pushed valuations higher. Even though earnings grew more than 50% this year, the strong stock market performance has kept valuations elevated.
We’ve seen above normal valuations – 21 times earnings. Not absurdly high, but definitely at a point where we would say we’re paying a bit of a premium valuation compared to historical returns. Lower interest rates should encourage us to pay a little bit more, because bonds are so much weaker and the cost of capital is lower. If rates move higher, the increased competition from bonds should put some pressure on valuations..
Many of these trends point to increasing uncertainty and we’ll likely have more volatile markets than we’ve seen and experienced during the pandemic. As such, it’s important to stay in touch with your financial advisors to ensure your risk allocation hasn’t moved just because of market movement and to make sure you’ve got the right amount of money saved for current needs so your risky assets have time they need to recover.