In our post from last week, we noted that the rate of change for economic growth and inflation will likely slow in 2022. This tends to lead to lower interest rates and flatter curves, which in turn causes rate sensitive and higher-quality factors to outperform commodity and low-quality factors. A similar dynamic occurred in the fourth quarter of 2018 and continued into 2019. That time period could be informative when thinking about positioning for 2022.
Inflation had been accelerating from a very low level to start 2015 until the summer of 2018. The rate of change started to slow into the third quarter and then accelerated to the downside in the fourth quarter and did not get back to prior highs in 2019.
Source: FRED.
Economic growth bottomed to start 2016, then accelerated into the second quarter of 2018, started to slow in the third quarter, and then declined significantly in the fourth quarter and 2019.
Source: FRED.
This change in direction for growth and inflation had a strong impact on asset class returns and market prices.
In fixed income markets, 10-year U.S. Treasury rates increased from 2016 until October 2018 and then declined in November and throughout 2019.
Source: Koyfin.
The U.S. Treasury curve was also an important indicator that growth and inflation expectations were declining as they continued to flatten throughout 2017 and 2018 while the Federal Reserve was increasing short-term interest rates.
Source: Koyfin.
The market for future rates expectations also started to suggest the rate of change for economic growth and inflation was likely to slow in late 2018 as the level of future short-term rates stopped increasing and eventually started to decline even while the Federal Reserve was still increasing current short-term rates.
Source: NDR.
These signals will be important to watch as 2022 progresses. The 10-year U.S. Treasury rate has been increasing recently, similar to the move in August to early October 2018, but is still below pre-COVID levels. The yield curve has steepened recently but is still well below levels reached in early 2021. The market for future short-term interest rates has increased recently as the Federal Reserve reiterated their intention to increase short-term rates in 2022, but the curve remains very flat. This suggests investors do not expect rate increases to last for very long or go very high.
Source: Koyfin.
Source: NDR.
In the credit market, high-yield spreads tightened from 2016 into the third quarter of 2018, then began to widen in the fourth quarter, and remained above prior levels for most of 2019.
Source: Koyfin.
High-yield spreads still remain below levels that suggest a concern about a major decline in the rate of change for growth and inflation and will be an important signal to monitor in 2022.
Source: Koyfin.
In the equity markets, Technology, Industrials, Discretionary, and Financials led during the acceleration in the rate of change for economic growth and inflation (2016-Ocotber 2018), while Utilities, Staples, and REITs lagged.
Source: Koyfin.
As economic growth and inflation decelerated, industry performance flipped and Utilities, REITs, and Staples outperformed while Energy, Materials, Industrials, and Discretionary lagged.
Source: Koyfin.
In the last month, Energy and Financial performance has improved while Staples and Utilities have also outperformed and Technology and Discretionary have lagged. Industry leadership in 2022 will have important implications for the likely direction of growth and inflation.
Source: Koyfin.
Equity volatility can also be a helpful indicator of changes in investor expectations for economic growth and inflation. From 2016 until October 2018, equity volatility indexes remained under 20, outside of a brief spike in early 2018. Equity volatility started to accelerate in the fourth quarter of 2018 and remained above 20 for most of 2019.
Source: Koyfin.
Current volatility levels have been rising recently, with small cap and technology indexes higher than the S&P 500. The trend moving forward will be an important indicator for how investors are viewing the outlook for 2022.
Source: Koyfin.
The commodity markets are sensitive to rates of change in growth and inflation and the broad commodity index was up 38% from 2016-October 2018. The index declined 20% into the end of 2018 and did not return to prior levels in 2019.
Source: Koyfin.
The commodity index has rebounded in recent months but remains below the prior high, as breadth has weakened and most major commodities are below their prior highs.
Source: Koyfin.
The market signals continue to suggest that investor expectations for the rate of change in economic growth and inflation have likely peaked and will start to decelerate in 2022. This had important implications for asset class performance during a similar shift in late 2018 and a similar dynamic could develop in the coming months.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC