We first want to wish all our readers and clients a Happy New Year!
As we say goodbye to a tumultous 2021, we look forward and to 2022 and what it may have in store for investors. 2021 saw inflation run away to heights not seen for decades. The Fed completely under-estimated this and shifted gears stating it was going to get serious about tackling inflation by tapering its bond buying and raising interest rates in 2022. The markets are re-calibrating. How big an issue is "inflation" and how soon can it be brought under control? These are the key questions as they will influence how aggressive the Fed is with respect to raising interest rates.
The key determining factors with respect to taming inflation are:
a) Global Supply chains. Can global suppply chains check the supply/demand dis-equilibrium and bring supply chains closer to "just-In-time" demand. As this occurrs it will have a mitigating impact on the inflation metrics. How much remains to be seen.
b) Tapering. As the Fed reduces its bond buying. this too will have an impact on stemming inflation. Again, how much remains to be seen.
c) Interest rates. Historic low interest rates along with massive injections of liquidity have made risk-on assets the only option for Investors to achieve positive inflation-adjusted returns. Higher interest rates change the market equilibrium towards a more risk-off mentality.
At this point there are multiple scenarios for how markets could unfold in 2022. If global supply chains can calibrate towards supply/demand equilibrium sooner and this translates into reducing inflation metrics, the Fed may move more cautiously. The longer global supply chains cannot adjust to demand, the more aggressive the Fed will need to be to curb inflation.
The markets will be watching these metrics closely as they will heavily influence the Fed and the direction of equities and Treasuries. We see Omicron as less of a concern with respect to economic activity as early research shows it is less lethal (and can be treated relatively effectively) compared to prior COVID variants.
As we have discussed, there are different scenarios that can play out depending on how soon the "inflation boogeyman" is tamed or not. There are scenarios where they may not raise rates or may raise rates aggressively.
Inflation metrics are going to heavily influence the markets and the Fed in the first and second quarters. Be prepared for turbulence!