4Q, 2021: The Powell Pivot

Fourth Quarter 2021

December 31, 2021

By Mark Oelschlager, CFA

Our hometown Cleveland Cavaliers are the surprise team of the first half of the NBA season, posting one of the best records in the Eastern Conference despite being expected to be one of the worst teams in the league. The addition of a couple good players, improvement in others, and a team-first/unselfish style of play have led to the turnaround. A recent key injury may derail the Cavs’ season, but with Golden State on top in the West, it has felt like the good ole days, when the Cavs and Warriors faced each other four straight years in the Finals.

One of the fundamentals of basketball is that a player who has picked up his dribble can evade trouble by pivoting away from a defender. This works well - until a player is double-teamed and has nowhere to turn. With consumer prices rising at the fastest rate in nearly four decades, Federal Reserve Chairman Powell pivoted his stance on inflation and monetary policy in the fourth quarter. For much of the last two years, Powell has described the rise in inflation as “transitory,” but as it has persisted, it became clear that the adjective needed to be dropped, and it was. Finally concerned, the Federal Reserve (Fed) abruptly changed course, announcing a gradual tapering of its asset purchases and soon after declaring an acceleration of that timeline. The Fed now expects to end its asset purchases by the end of March and to implement three interest rate hikes by the end of 2022. All of this follows a not too long ago move away from its price stability mandate and its pronouncement that inflation at or above 2% is not only acceptable but perhaps desirable. Be careful what you wish for. The spike in inflation isn’t entirely the Fed’s fault (supply-chain disruptions have been a factor), but its policies have contributed.

Despite the imminent Fed tightening, stocks kept climbing, with the S&P 500 returning double-digits in the quarter. Growth led value, and small stocks lagged significantly. The move higher in stocks in the face of a more hawkish Fed is an interesting development. It’s always difficult to ascertain the forces affecting stock prices, but it may be the case that the tremendous liquidity that still exists in the economy – via the Fed’s loose policy and the enormous federal government stimulus – is overwhelming the typically-negative effects on asset prices of a tighter Fed and higher inflation. One market commentator stated earlier this year that the market’s pricing mechanism is broken. It’s dangerous to make a habit of thinking the market is wrong in how it is pricing certain assets, but he may have been onto something. A tidal wave of liquidity can do that.

While some time will pass before higher short-term interest rates are implemented and begin to affect the economy, it is important to remember that, recent exceptions notwithstanding, the market looks ahead. Waiting until the hikes occur to adjust the risk profile of a portfolio is too late. The Fed’s interest rate increases affect stocks in two major ways. First, they slow profit growth by raising borrowing costs. Second, they make alternative investment options (such as fixed income products) more attractive. Real interest rates (rates adjusted for inflation) are currently lower than what has been seen in several decades.

Given the worker shortage, labor costs have spiked, especially in the low-skill segment. With the concurrent rise in prices, fears of a wage-price spiral are prevalent. Currently, employment statistics look a lot like they do right before a recession. Is a recession around the corner? Hard to say. It might depend on how aggressive the Fed needs to be to rein in inflation. Extended tightening could turn the economy downward, though perhaps a return of people to the labor pool and an easing of supply bottlenecks will be enough to restore monetary balance. The yield curve is still upward sloping, which is a positive sign for future economic growth, though it has flattened significantly in the last few months. Our portfolio turnover is low, but the recent changes we have made could be characterized as marginally defensive.

A speculative fervor has remained in place in various segments of the market. Trading in options, which magnify the gains or losses in an underlying security, has skyrocketed this year, reaching the highest level ever. In fact, the average daily notional value of traded single-stock options exceeded that of regular stock trading in 2021. The combination of more money in people’s pockets, fewer opportunities to use it due to the pandemic, and the greater ease and free cost of trading options have all contributed to this trend. Interestingly though, many of the hot stocks of these options traders have come off the boil. “Meme” stocks, such as GameStop and AMC Entertainment, and various “disruptive” but unprofitable companies with allegedly bright futures took a hit in the last three months but remain at questionable levels, in our view.

President Biden signed into law a $1 trillion infrastructure bill but has failed so far to secure enough votes in Congress to pass his farther-reaching and more costly Build Back Better plan. Congress did manage to avoid a default on its debt by raising the debt limit by $2.5 trillion, which should be enough to pay its bills through the mid-term elections.

Mark Oelschlager, CFA Oelschlager Investments

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