• High credit quality fixed income portfolios were challenged in 2021 by higher rates and elevated interest rate volatility, fueled by inflation worries and anticipation of the Fed’s response
  • Inflation remains the predominant economic theme to begin 2022, and Covid has once again proven to be a difficult risk to remove from growth and inflation forecasts
  • Recent data indicates supply chain disruptions and associated cost increases may be easing, but other sources of inflation from tight labor markets and a hot housing market present ongoing risks
  • The December 15 FOMC decision was more in line with what bond markets had been pricing for several weeks with regard to rate hikes and the pace of tapering; balance sheet normalization remains an outstanding question for investors

It was a challenging year for fixed income investors in 2021. Most of the investment grade universe posted negative returns for the year on an unhedged basis, and only certain sectors down the credit scale were able to generate positive returns in the face of higher interest rates (see Exhibit 1). At the root of the underperformance in 2021 was market speculation of changes in Fed policy, fueled by the predominant economic theme that persists into the New Year – inflation. With Jerome Powell and his colleagues at the FOMC stand poised to combat rising consumer prices in 2022, most street outlooks forecast less-than-rosy predictions for fixed income performance over the next 12 months as well, although, as always, those opinions rely on many assumptions of the unknown.

We were also reminded once again in December that Covid has (unfortunately) not been eradicated, and beyond the public health impact, it can still affect economic growth and inflation forecasts. The virus rocketed back to the top of mainstream news headlines via the rapid spread of the omicron variant, but the ultimate economic impact is still unknown. If cases are more moderate, it could have more limited influence on consumer demand while negatively impacting supply chain flows further. The latter would potentially add more fuel to inflation pressures globally.

Despite Covid and other risks, the U.S. economy continues to do well. While not at the torrid pace of the last six quarters, real GDP growth is expected to remain above long-term trends in the first half of 2022 before slowing in Q3 and Q4, according to Bloomberg economist surveys (median forecast). Exhibit 2 provides a visual illustration of the recent growth trend relative to current forecasts and the long-run average. The decline in growth expectations as the year progresses coincides with a fading of the economic benefits of the fiscal stimulus of 2020 and early 2021, as well as less Fed accommodation via asset purchases and forecasted rate hikes. If the Fed were to have to act more aggressively than currently anticipated to rein in inflation, growth expectations would likely contract further.

On a positive note, purchasing managers surveys (PMI) indicated that manufacturing activity in Europe and Asia expanded more than expected in December despite omicron worries, and those surveys also indicated that supply-chain problems and associated input cost increases eased a bit to end the year. If supply chain pressures continue to ease, the bigger question mark on the inflation front is labor market tightness and additional wage growth. The latter is considered a “stickier” source of inflation that could keep CPI and PCE elevated above the Fed’s target even if supply chain pressures ease. Additionally, rising home prices (including rents) have bolstered consumer prices in recent months and could continue to do so in 2022 if the housing market remains hot.

On that note, housing affordability, as measured by a ratio of monthly housing costs to monthly median income, is at its worst levels since the Great Financial Crisis. Exhibit 3 uses a chart from a recent J.P. Morgan commentary highlighting the fact that while affordability is declining, it’s still below levels experienced in the 1990s and also below periods in the late 1980s and 2007 that preceded declines in home prices. Higher mortgage rates in 2022 could obviously worsen affordability as well.

Fed Remains Center Stage

The Fed finally discarded the “transitory” characterization of inflation risks at the December FOMC meeting, and financial markets now brace for monetary policy tightening via rate hikes at some point in 2022, perhaps as early as March or June. The pace of asset purchase tapering was doubled to $30 billion per month, as expected, and the Summary of Economic Projections were updated to show 3 rate hikes in 2022 according to the median participant forecast. The latter moved the Fed in line with what the bond market had been pricing in for several weeks, which is largely why there wasn’t much of a reaction in the Treasury market to the decision.

The biggest unanswered question related to monetary policy at this point, particularly for financial markets, is what the Fed does with the size of its balance sheet, most notably its securities portfolio which has grown to more than $8 trillion. Tapering does not reduce, or normalize, the Fed’s balance sheet; it only slows the growth of the portfolio. In the prior cycle, the Fed continued to reinvest principal from the portfolio for approximately three years after tapering was completed before it allowed the portfolio to pay down. Chair Powell was asked about normalization at the December 15 press conference, and he indicated that it would be a topic of discussion in future meetings. Our base case assumption is that normalization does not begin in 2022, but if the Fed felt it was still well behind the inflation curve despite tapering and rate hikes, that would be the next lever to pull. Doing so, all else equal, would be expected to negatively impact fixed income valuations via spread widening and increased interest rate volatility.

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