2022 has begun with some choppy seas. From January 1, 2022, to January 27, 2022, the S&P 500 dropped -9.2 percent to mark the first correction in our new year. Since that time, the market has recovered some ground, rising 3.4 percent through Thursday February 3rd to 4,477, down -6 percent on a year-to-date basis. While this is not a significant drop by historical standards, the volatility has reminded investors that risks are rising. Indeed, some areas of the market have sold-off harder, including major winners from the past two years such as the growth stocks of the Nasdaq 100, down -11.3 percent YTD, and Biotech, down -13.6 percent YTD. Everyone is asking, “Is a bigger storm coming?”
As we discussed in our 2022 outlook just a few weeks ago, risks are rising in the market, driven by the Federal Reserve’s pivot to an inflation fighting stance. In response to inflation, the Federal Reserve will be forced to stop their bond buying and raise interest rates to slow the economy to curb inflation. The risk of a policy error during this time is high. If the Federal Reserve raises rates too quickly or too high, there is a risk of tipping the economy into recession. Conversely, if the Federal Reserve raises rates to slowly, inflation could continue out of control.
Arguably, the Federal Reserve’s statements during January spooked investors, triggering the January drop. The Federal Reserve has not been helpful with their communications, refusing to commit to a path, or forecast how quickly they will raise rates, insisting instead that the interest rate changes will be driven by data as we progress through the year. This uncertainty will likely mean more choppy markets as investors try to guess what the Federal Reserve will do. The bond market appears to be anticipating a 1% Federal Funds rate by the end of the year, but there is still much uncertainty on Fed policy, and there it is likely that the Fed will periodically ‘spook’ investors who incorrectly guess the Fed’s next move.
On the other hand, it is notable that January’s stock market decline was not related to declines in earnings forecasts, but rather a drop from the high valuations that we have seen over the past year. Expected earnings rose during January, which implies that, at least for now, the overall economy remains strong and is expected to remain strong for 2022. As long as the stock market worry does not spill over into the underlying economic data, we are cautiously optimistic that January’s drop was not a sign of a major storm for 2022, but rather the choppy seas that we will see throughout the year.
We continue to believe that the portfolios are well positioned but will continue to monitor the markets as we enter this new inflation fighting phase of the business cycle.