By: Linda S. Parenti, CFA - Chief Investment Officer
In last month’s Market Insights my colleague, Ryan Johnson, pointed out that if we hit a new record closing high on the S&P 500 during the month of December, we will have seen new highs every month this year. That feat was accomplished on December 10 with the S&P 500 setting a new all-time closing high of 4712. The last time this happened was 2014. With 67 new record closing highs year-to-date, 2021 now ranks as the second-best in terms of the number of new highs for the index over the past 50 years. The number one year being 1995 when a total of 77 new highs were achieved in a single calendar year.
One of the main reasons for the stock market’s strength this year has to do with the earnings growth, which largely determines equity prices in the long term, and growth has been strong. With higher market values showing for their portfolios, one might think investors would be more enthusiastic. However, bullish sentiment among individual investors has been falling and remains well below historical averages. This can be seen in the recent rise in market volatility.
A main culprit for the rise in market volatility is uncertainty regarding inflation and the Federal Reserve’s monetary policy response. The answer to how long supply chain imbalances combined with strong consumer demand feed inflation is unknown. Inflation levels appear to be staying high longer than expected. In response, the Fed has announced an increase in the speed it will reduce its accommodative monthly bond purchases. Market participants expect this will be followed by the Fed starting a new cycle of rate hikes next year. However, rising short-term interest rates do not necessarily spell doom for the economy or equities.
The last rate hike cycle by the Federal Reserve ended in December 2018. Over that three-year period the Fed increased the Federal Funds Rate eight times. Over that same three-year period, the S&P 500 rose 25% in total return. It’s also helpful to note that short-term rates should not remain near zero indefinitely. The Fed needs to raise short term rates to give them the ability to adjust them lower again when the economy goes through its next down cycle. What does matter is how fast the Fed tightens monetary policy. History has shown that stocks perform better when the Fed raises rates slowly.
The start and pace of the next rate hike cycle will be determined by the level and direction of inflation readings in the months ahead. Even though we don’t know exactly how much longer inflation will stay at these alarmingly high levels, the consensus from economists and the Fed is for lower inflation next year and expectations it will continue trending lower into 2023. As I wrote in October, eventually supply catches up to demand and/or demand declines due to price resistance, but either way inflation recedes. We expect this leveling to play out as supplies increase and demand normalizes, hopefully allowing room for the Fed to take a measured approach with the upcoming rate hike cycle.
Linda S. Parenti, CFA
Chief Investment Strategist
RISKS AND IMPORTANT CONSIDERATIONS
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