Why inflation and the U.S. policy response will be critical for markets in 2022

U.S. financial markets have been fairly fluid for investors this year, with the Federal Reserve’s easy money policies helping smooth out tough times during the pandemic.

During the last weeks of December, the S&P 500 SPX Index,
-1.03%
was up 23% over the year, while yields on US junk bonds with speculative grade JNK,
-0.05%
the odds were near historic lows around 4.5% . The large stock market rally made it easy to make links between soaring asset prices and the Fed’s bond buying program and Washington’s budget support.

But that is all about to change with Fed Chairman Jerome Powell now firmly focused on preventing the significantly higher cost of living from derailing the U.S. economy, and investors expecting that 2022 is the moment when the markets really become interesting.

“I think inflation is the variable for 2022 because that will be what drives policy,” Jim Caron, senior portfolio manager at Morgan Stanley Investment Management, said in a telephone interview on Friday. “The policy has boosted asset performance. ”

And with a policy somewhat of a wildcard in the months to come, especially as the government seeks to ease pricing pressures without crippling the economy, Caron said he was urging investors to keep money. money on hand to buy opportunities in what could be “a very volatile and choppy year.”

Inflation matters, so does growth

U.S. stocks fell to their worst weekly losses in three weeks on Friday, after the Fed on Wednesday presented more aggressive plans to end its massive bond-buying program and posted three interest rate hikes of benchmark next year.

See: Why the Fed’s hawkish measures to calm inflation are unlikely to cause a sudden liquidity drain from the markets

Over the next few months, investors will expect the US central bank to stage a soft landing for markets as it attempts to shift gears and tighten accommodative monetary policies to fight inflation to low levels. 1980s, but also to keep the economy going.

Like Europe, the United States may also need to balance its policies with potential economic setbacks as the coronavirus variants begin to lead to another surprising wave of winter COVID-19 infections and restrictions on activities. consumers and businesses.

Read: Unvaccinated Americans face ‘winter of serious illness and death,’ Biden warns, as omicron begins to spread in US

“If GDP growth disappoints and inflation remains high, it will be difficult for the Fed to raise rates by 75 basis points next year,” said James Ragan of DA Davidson, director of research in wealth management.

As Fed officials boosted GDP growth in 2022 forecast at 4% next year against 3.8% earlier, still above the historical trend, this is lower than the growth of 5.5% expected this year. “This kind of GDP growth should support Fed rate hikes and higher long-term rates,” Ragan said in a telephone interview. Even if, with the yield of the 10-year Treasury TMUBMUSD10Y,
1.407%
near 1.4%, Ragan said the bond market had expressed doubts about how much leeway the Fed might have to raise interest rates over the next 12 months.

“I think bond investors are still concerned about the long-term growth outlook and a little worried that three rate hikes are a bit too much,” he said.

For equities, Ragan is worried about high valuations and uncertainty about future corporate earnings, especially if inflation slows economic activity, consumers cut spending, or wage pressures translate into lower prices. corporate profits.

“It’s something to watch out for in early 2022,” he said.

‘Good thing to do

Stephen Philipson, Head of USB at US Bank,
-2.96%
The Fixed Income and Capital Markets Group said the “Fed’s more aggressive stance is the right thing to do to tackle stubborn inflation,” especially with so much liquidity flowing in the financial markets. during the pandemic.

Philipson said he also sees impending interest rate hikes as a likely catalyst for LQD-grade US companies,
+ 0.23%
refinance some $ 1.25 trillion in debt maturing 2023 and 2025, with coupons above 3%.

“There is a significant amount of debt that could be taken out to refinance,” he told MarketWatch. “We have called for a slight drop in supply for the year, but I think that with the adoption of a more aggressive approach by the Fed, this could accelerate the refinancing of future bonds over the next few years. . “

Read also: Corporate debt investors brace for tighter financial conditions in 2022

The Dow Jones Industrial Average DJIA,
-1.48%
ended a volatile week down 1.7%, while the S&P 500 ended down 1.9%. The Nasdaq Composite Index fell 3%, with the three posting the worst week of decline since November 26, according to Dow Jones Market Data.

Midweek, ahead of Friday’s Christmas Eve holiday, a new list of U.S. economic data, including the updated December Consumer Confidence Index and existing home sales on Wednesday. But it will be Thursday with a deluge that includes the first weekly jobless claims for the week of December 18, but also November updates on core inflation, personal income, consumer spending, orders for. durable goods and more.


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