Weekly Investment Update (01/14/2022)
This Week’s Highlights:
- U.S. inflation: Inflation hit its fastest pace in nearly four decades; Fed likely to hike in March and may surprise hawkishly in the coming months.
- Real interest rate increase: In the short term, increases in real interest rates should keep equity volatility high. Ultimately, the Fed is unlikely to take policy into restrictive territory, and we continue to favor equities over bonds from a longer-term perspective.
- Oil market: Supply-demand tightness in oil markets continues in 2022.
U.S. Inflation Hit Its Fastest Pace in Nearly Four Decades; Fed Now Likely to Hike in March and Potentially Surprise Hawkishly in Coming Months
The consumer price index (CPI) rose 7% in December from a year earlier, marking the third month inflation exceeded 6% given pandemic-related supply and demand imbalances as well as the lagged effects of monetary and fiscal stimulus continue to push prices higher. The core consumer price index, which excludes food and energy, rose 5.5.% on a year-over-year basis. Supply chain limitations and low inventories exerted upward price pressure on autos, both new and used, and holiday goods categories during December. We would expect increased production and improving semiconductor shortages to eventually ease these price pressures, though we are cognizant that this could take some time. There were also some indications of wage growth for lower-income workers passing through to restaurant and personal care services prices.
In our view, inflationary pressure will likely remain acute in the near term and above longer-term averages all year. We do expect some relief in the coming months, however, as the supply of goods rises and U.S. consumers’ demand for goods rotates from some sectors to others and to services from goods more generally.
December’s CPI release reinforced the probability that the Fed will move to begin interest rate hikes in March. Given the national focus on inflation and the concern that higher expectations will become imbedded, it is possible the Fed actually surprises hawkishly and delivers more hiking than is priced into the market in the coming few months. At the same time, we do not believe the Fed will take rates into restrictive territory in this hiking cycle, and the policy rate is likely to remain negative in real terms.
Volatility is likely to remain high as the market processes this shift, and real rates may continue increasing (see below), but we believe the economy is strong enough to weather a more hawkish Fed. A still-strong growth environment coupled with continued inflation pressures favors equities over bonds, in our view. Additionally, our portfolios have some cyclical exposure to materials, railroads, commodities, and banks that may benefit from a higher-inflation environment.
From a Short-Term Perspective, Increases in Real Interest Rates Will Keep Equity Market Volatility High
In times of increasing real interest rates, as we have seen since their November low, equity markets experience varying degrees of pressure depending upon how quickly interest rate markets are repricing. Using real interest rate and equity market data since 2006, an increase of 40bps (0.40%) or more in the 10-year U.S. real yield in a month’s time tends to lead to a 4% drop in equity markets, on average. At the time of writing, 10-year real yields have increased 38bps over the past two-and-a-half weeks and the S&P 500 stands roughly 3.5% off its all-time high.
The recent market volatility, which has stemmed mostly from Fed communications on interest rate hikes and balance sheet reduction within its December meeting minutes (and the variance around investors’ interpretation of the communications), is sure to pass once markets reach a clearing level — i.e., where investors broadly agree — for interest rate expectations.
Given our forecasts for ongoing above-trend growth and higher levels of inflation than seen over the past decade, we view any near-term drawdown in equity markets as an opportunity for clients to add to long-term exposure in portfolios, where possible.
Oil Market to See Continued Tightness as Supply-Demand Imbalance Continues
After strong gains in 2021, the price of WTI crude oil continues to rise in 2022, seeing a 10.30% return year-to-date given continued tightness in the oil markets. The supply-demand mismatch that led to higher oil prices in 2021 remains in place in 2022. In 2021, crude oil consumption rose on account of increasing economic activity and easing of pandemic-related restrictions, while production was restrained due to curtailments by OPEC+ members, investment restraint from U.S. oil producers, and other supply disruptions.
As U.S. oil producers pivoted to a strategy of providing dividends and buybacks to shareholders rather than maximizing output and exploration, there may be an underinvestment in supply to meet growing demand, which could continue to put upward pressure on oil prices. Meanwhile, regulatory and environmental pressures have put additional stress on the fossil fuel industry, possibly contributing to lower industry-wide investment.
Despite the relatively high short-term returns in 2021, when looking back over a longer three-year period, the S&P 500 Index strongly outperformed the energy sector. The S&P 500 returned 92% in the past three years while the energy sector posted relatively flat returns. Although the Bessemer All Equity portfolio increased its energy exposure last year, it currently remains underweight relative to the benchmark (3% vs. 4% for the benchmark). Bessemer internal equity portfolio managers generally find limited opportunities for long-term outperformance in the sector as energy companies tend to be lower quality with higher debt burdens. Energy stock performance often closely correlates with crude prices rather than growth drivers that are more within control of the companies’ management teams. Among the large energy companies, we have the largest exposure to Chevron given the portfolio teams’ assessment of its relative balance sheet strength.
— Bessemer Investment Team
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