By: Stash Graham
December positively closed the year. All three major indices finished with gains consistent with our partners’ accounts—the strong finish caps a good year for the firm’s investment positions. As discussed below, there is still much work to be done as we should enter a different period for financial assets. We saw a strong performance from the companies that fall in our pharmaceutical and utility baskets. Of note, Cigna Corporation’s share price grew by more than 16% for December. We will be providing an update on the insurer in our January Investor Report. Precious metal gold lagged for the month, and their price was up just under 1%.
While headlines might seem rosy, financial markets end the year in a challenging situation. Equities (the stock market) continue to trade at historically elevated levels with poor breadth; meanwhile, the traditional defensive hedge to equities, corporate and municipal bonds, are sitting in an equally large bubble with high yield bonds trading at just over 4.0% yield to worst. At these low yields, the riskiest bonds in the market cannot even offer a real (inflation-adjusted) positive return. What happens to bonds if interest rates start to rise like Blackstone’s Bryon Wien beliefs. The Vice-Chairman for the financial giant’s wealth management division thinks we will see four rate hikes and a 10-year U.S. Treasury that reaches 2.75%. This rise would put all bonds under immense pressure. Why invest in a risky bond making 4% per year when you can get the “risk-free” bond, backed by the U.S. Government, for 2.75% per year. The stock market continues to see more underlying losses than gains. On December 27th, the S&P 500 closed at a 52-week high; however, 334 companies trading on the New York Stock Exchange hit a one-year low. This is over double the number of companies trading at one-year highs! While headline figures indicate strength, this overwhelming underlying negativity has only occurred three other times in history — all of them in December 1999. Weighing these variables together makes our SPAC Arbitrage strategy more critical as a fixed-income alternative to protect from a broad market sell-off.
As we begin the calendar year of 2022, two key drivers will influence financial markets. First, how the Federal Reserve hiking cycle evolves given the hawkish shift on inflation. Second, the pace of Chinese policy easing in a politically-sensitive year heading into the 20th National Congress. Traditionally financial markets don’t crater immediately when the Fed starts to tighten. It would be an extraordinary (and unique) recession for us to have, starting from zero interest rates and full employment. Yet, if the Federal Reserve hikes the Fed Funds Rates quicker and higher than expected, all parts of financial markets could come under stress. China’s Central Economic Work Conference (CEWC) struck a more pro-growth and less hawkish tone. During the December conference, emphasis was put on “economic development” and “the macroeconomy,” in contrast to the focus on “deleveraging” in recent years. The change in demeanor makes sense as the country just entered an industrial recession. Historically during Xi Jinping’s regime, now is when the Chinese government provides aggressive monetary policy support to promote economic growth.
Our base case is that 2022 will be a year of slower GDP growth and moderating, yet material inflation, a significant shift from what investors have become accustomed to since the pandemic-induced recession of 2020. This mix of variables does not mean that the stock market will fall or a recession will ensue. A lot depends on what the Federal Reserve will do to interest rates. If the Federal Reserve can engineer a soft landing in its attempts to rein in inflation, we could see many similarities as 2004 compared to the late 1960s, 1970s, and 1999/2000. It has been a while since financial markets have experienced a hawkish Fed with a slowing economy.
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