Inflation Will Define the Next Market Battleground in 2022
Despite the Fed’s accelerating tapering plan, inflation is here to stay and will become a key economic indicator next year.
Inflation is no longer transitory. With the monthly core inflation rate running above 4 percent for half a year, investors have come to believe that it will pose an acute challenge in 2022, despite the recent tapering announcement from the central bank.
Last week, the Federal Reserve implied that its ultra-easy policy in response to the pandemic is coming to an end. Instead, it would reduce bond purchases and start implementing tightening policies to address rising inflation, which is running at a year-over-year rate of 9.4 percent, according to a recent report by BCA Research, a sister company of Institutional Investor.
The current inflationary environment is a result of two significant changes to the Fed’s policies, according to BCA. One is the Fed’s decision to shift away from premature tightening, which meant that it would now wait for inflation to emerge before implementing contractionary policies. The second is the Fed’s plan to target a flexible average inflation instead of a purely forward-looking inflation rate, which implies that “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time,” according to its “Statement on Longer-Run Goals and Monetary Policy Strategy” in August 2020.
BCA predicts that the Fed will begin to raise rates in June 2022 at a pace of 25 basis points each quarter. But with tougher financial conditions — usually foreseen by indices such as the manufacturing PMI and the Goldman Sachs Financial Conditions Index — it might slow the pace of tightening. “Financial conditions are incredibly easy at present,” the report said. “But it is conceivable that risky assets will sell off on fears of Fed rate hikes, and a large enough sell-off would cause the Fed to pause.”
A high inflation rate accompanied by the Fed’s tightening policy will likely result in more volatile investment portfolios and lead to a “tolerable” year instead of another “great” one like 2021, according to Erik Knutzen, multi-asset chief at the investment management firm Neuberger Berman. “The S&P 500 Index cannot go up 20 percent a year indefinitely,” he wrote in a weekly note.
Neuberger Berman predicted that risky assets would tend to outperform the less risky ones in 2022, and said that “any downside in equity multiples or high-yield bond prices caused by rising real rates is likely to be more than offset by earnings growth and carry, respectively.”
“We think that investor response to tapering could teach us a lot about the likely path of markets through the rest of this cycle,” Knutzen added. He noted that the Bank of England and the European Central Bank quickly joined the league of hawkish central banks, and that the market reaction to their announcements has been mixed. “On the day of the Fed meeting itself, Treasuries and the dollar barely moved, and equities rallied,” he wrote. The next day, “Treasuries maintained their bid, but growth and tech stocks were down again, dragging the S&P 500 Index with them.”
The conclusion, Knutzen said, is that inflation is among a few key factors that “will define the battlefield for markets in 2022,” regardless of the Fed’s pace of monetary tightening. “Asset allocation is likely to be a tougher fight next year than it was this year,” he added.