The Catch '22 for 2022
This year will likely be a push and pull between inflation, the Fed and COVID.Download PDF
On Jan. 12, 2022, we sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on the markets in 2021, the Fed’s evolving policies, inflation expectations, and opportunities in fixed income.
With 2021 in the books, what are your takeaways from the markets’ performance in 2021?
Overall, the market performed very well. The S&P 500 Index, Russell 2000Value Index, and Russell 1000 Growth Index all ended 2021 up around 28%year-over-year. That’s phenomenal. International equities, measured by the MSCI World Index, were up 11%, but the MSCI Emerging Markets Index was down for the year. Generally speaking, U.S. markets crushed it.
When you move over to fixed income, the Bloomberg US Aggregate Bond Index had a disappointing year, down 1.5%. So, a bad year for bonds. Credit, however, was quite strong. High-yield ended the year up about 5.25%,and floating-rate loans ended the year up about 5.4%. In general, risk assets did well; the riskier you were, the better you did.
What’s the yield environment look like going into this year?
With the increase in the 10-year Treasury yield, the yield-to-worst of the domestic investment-grade markets is about 1.75%. Triple B investment-grade credit is near 2.5%. High-yield enters 2022 at 4.25% with double B high-yields sitting at 3.3%. That’s just a general reflection of where the U.S. yields sit. Floating-rate loans have a current yield of a little over 4%, and a yield of maturity of about 5.4%.
We still are in a pretty depressed yield environment, where high-yield is yielding only 4%. That should give you a barometer on how risky certain yields are.
How do you see markets in 2022 differing than in the past two years?
I think this year’s going to be a very interesting. When I reflect on March of 2020, we had a health crisis that led to an economic crisis that led to a liquidity crisis. And essentially, the Fed and fiscal policy generated a massive liquidity surge, and that really helped stem the liquidity crisis. When the vaccines arrived, they economy surged even more.
Between the vaccines and the liquidity injections, you had a very strong rally in risk assets. This year, liquidity is probably going to be transitioning to a tightening situation. Now the question is: To what extent will that lead to economic tightening? Something to keep an eye on.
What do you see happening with the Fed’s tapering program and potential interest-rate hikes?
It’s all speeding up rather quickly. Just three months ago, the base case was that tapering ends in June with a probable rate hike in the second half of the year. Now the base case is the Fed stops tapering at the end of the first quarter and a rate hike follows quickly.
Fed futures are pointing to a 70% chance of a hike by March, assuming tapering ends in March. Then 82% by May and 93% by June. Market’s forecasting with a high degree of certainty that there will be at least one rate hike by the end of second quarter.
What are you watching for with the Fed?
What has come on the table is quantitative tightening (QT). Though they are quickly reducing the amount of bonds they’re buying, the Fed is still technically in a quantitative-easing (QE) mode. But for how long? In recent months, it went from, “We’re going to ease off the gas” to “No, I think we’re going to start to pump the brakes, most likely in the second quarter of this year.” That is a meaningful adjustment in my mind.
Understand, the Fed’s balance sheet is about $9 trillion, and their pre-COVID balance sheet was $4 to $5 trillion. When they get to QT, the question will be at what rate will they reduce the balance sheet and what will be a normalized balance sheet?
Is the rise in inflation here to stay for a while?
I would say the root cause of the bulk of the inflation we’re seeing is money supply. Just to give you a sense of the money supply, it’s up 25% since the beginning of the pandemic in March of 2020. Even last year, money supply was up 9%. You have a massive amount of M2 (a measure of the money supply in the marketplace). And when all the numbers come in, the Consumer Price Index (CPI) is probably going to register an increase of about 7% for 2021. How much of that7% is from the increase in money supply versus supply-chain disruptions? That’s difficult to know, but I would say on the margin, if supply chains normalize, then that should knock off a few percentage points on the CPI.
The push and pull between inflation, interest rates and COVID seems like it could put 2022 in a Catch ’22 situation with each of those factors affecting the others. How do you see this playing out?
If we follow South African data on the spread of the Omicron variant in that country in late 2021, the U.S. should spike and start to reduce new Omicron cases within the next month or two. And hopefully by the end of February, we’re through the Omi wave. After that, you’re going to start to see the freeing up of supply chains. Inflation rates, hopefully, will start to pare down, but then you have the Fed at the same time saying, “Okay, if the Omicron wave is going to end, supply chains are going to start to free up and inflation will ease, but at the same time, we have to put on the brakes.” That’s the Catch ’22. Observing how the Fed navigates that, to me, is the story for ’22.
Has the pandemic permanently altered how we view supply chains?
I think that’s an interesting secular theme. What has the pandemic changed forever? Certainly, the five-day work week has been altered. Cities-to-suburbs living has been altered. Autos have been altered. And, to directly answer your question, manufacturing has been or will be altered.
I think there are a few things to assess. In longer-term business models, you have to assess the price of supply-chain risk versus the cost to onshore. The factors that go into that include technology, tariffs, labor and shipping costs. And I think one of the elements over the next 10years is going to be more disintermediation of sales. If you’re able to onshore manufacturing, the only link between the manufacturer and the end consumer can be a website for a lot of goods. In other words, the thinking is, “Let’s reduce our risk by manufacturing in the U.S., and then we can cut costs by going direct.” I think you’re just going to see a lot more of that over the next 10years.
2021 was a year of consistent opportunity with floating-rate loans. But now,2022 faces a vastly accelerated policy shift by the Fed. Where do you see opportunities in fixed-income?
We do have excess monetary supply and demand in the system, and I think Omi will soon fade. So, I think you’re going to have this big surge in GDP, growth and inflation over the next six to nine months, which still puts me in the camp of “stay away from the long end of the curve.” Corporate credit is strong, and default rates are going to be low. It’s still defensive against inflation, and you’re being compensated by a higher coupon from the corporate-credit sand point. That’s still the opportunity I see today, but we’ll see where the10-year Treasury goes as the year progresses. I may have a different view a few months out. I’ve had that same narrative on corporate credit for now a year, and I think it’s worked out from a fixed-income standpoint
Time for the lightning round. Short questions, short answers. Are you ready?
In one word, how would you describe holiday shopping in December?
What’s a key economic indicator to watch closely in ’22?
I don’t know if you’d call it economic, but watch the 10-year Treasury yield.
The number of interest rate hikes in ’22?
I’ve upped my previous prediction of one. I’m at now three.
What effect will tapering and potential rate hikes have on the economy in ’22?
On the economy? Not much. On the markets, TBD.
What would be Omicron’s impact on the economy in ’22?
For all of ’22, negligible. For the first quarter, marginal.
I’m breaking the lightning-round rules with a two-part question. More people than ever are quitting their jobs. First, why? Second, what effect will that have on the economy?
We are in a supply-demand imbalance. Quit rates are at record highs, temp agency revenues are surging, layoffs are at lows, and there are a lot of job openings. The employees now have the leverage.
What have been the effects? The employment cost index is up 5% to 6%. Hourly earnings are up 5%. Consumer net worth is at an all-time high, and that helps labor more selective in accepting jobs. All this leads to higher inflation.
Finally, thoughts on the death of the Blackberry?
Could you share a personal thought for the new year?
New Year’s resolutions can come and go. I think instead of focusing on a resolution, focus on being resolute—resolute to the purpose or principles or beliefs you have. Whatever it is this year, just be resolute.
Bloomberg US Aggregate Bond Index is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.
The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.
Floating-Rate Loans are represented by Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. senior secure credit (leveraged loan) market.
High-Yield represented by the Bloomberg Barclays U.S. Corporate High Yield Index and index components. The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market.
The MSCI Emerging Markets Index tracks the performance of equity stocks in selected emerging foreign markets.
The MSCI World Index is a broad global equity index that represents large and mid-cap equity performance across 23developed-markets countries.
The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-value ratios and higher forecasted growth values.
The Russell 2000 Value Index is a small-cap stock market index that makes up the smallest 2,000 stocks in the Russell 3000 Index.
The S&P 500 Index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.
Yield to maturity is the total rate of return that will have been earned by a bond when it makes all interest payments and repays the original principal.
Yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.
You cannot invest directly into an index.
Pacific Asset Management LLC is the sub-adviser for the Pacific Funds℠ Fixed Income Funds. The views in this commentary are as of Jan. 12, 2022 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Any performance data quoted represents past performance which does not guarantee future results. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.
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