The Fed's Balancing Act for 2022

The central bank will have to weigh economic growth against reducing inflation. Plus, there’s COVID.

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By Samuel Park, Director of Fundamental Research, Pacific Life Fund Advisors

Market Review

The fourth quarter saw a repeat of the third quarter as large-cap growth stocks continued their upward momentum. Falling interest rates helped the interest-rate-sensitive stocks, while the flattening yield curve dragged the financial sector. Emerging markets suffered from its exposure to Chinese stocks, which have been battered by that country’s housing-sector debt crisis.

Within fixed income, higher inflation expectations amid still-ample monetary support continued to push Treasury Inflation-Protection Securities (TIPS) to outperform the broader Bloomberg US Aggregate Bond Index. On the other hand, with the Federal Reserve keeping the fed funds rate anchored, short-term bonds lagged the broader fixed-income market.

Outlook

We head into the new year with lingering challenges such as inflation and resurging COVID-19 cases. The Fed finally abandoned the term “transitory” to describe inflationary conditions that have been more persistent than originally anticipated. In turn, the Fed is expected to reduce its bond holdings earlier and faster than initially planned. It should be noted that the Fed’s balance sheet stood at nearly $9 trillion in late 2021, which is up from $4 trillion before the pandemic.

The Fed also projects raising interest rates in 2022, with the market pricing in a hike during the first half of the year. While the Fed is expected to raise rates three times in 2022, future hikes will depend on how inflationary pressures develop and the economy shapes up. In terms of the economy, employment conditions continue to improve, leaving employers having to scramble to fill open positions, which could ultimately lead to increased wages. The unemployment rate has fallen sharply and sits close to pre-pandemic levels.

Among various factors that contributed to the rise in inflation, the global supply-chain strains received much attention. Strong demand for goods and port congestions led to a surge in ocean-freight rates, which contributed to the rise in prices. Although easing supply-chain bottlenecks could alleviate inflationary pressures, there are little signs of this happening anytime soon although we may have reached peak congestion.

Many supply chains are deeply interconnected, leaving suppliers vulnerable to interruptions around the globe. This means that policies such as China’s zero-COVID strategy, which relies on strict lockdowns, will have long-reaching effects for producers and retailers around the globe. The recent emergence of the Omicron variant further complicates efforts to reopen the global economy. Given that China’s Sinovac vaccination has been reported to offer limited protection against Omicron, the country may continue with its zero-COVID policy through much of 2022. These restrictions could potentially mean that inflation persists longer than many had anticipated unless Omicron quickly subsides and another variant doesn’t take its place.

Given China’s outsized role in the global supply chain, events related to that country can significantly impact the global economy. While global central banks such as the Fed is expected to tighten monetary policy in 2022, China’s central bank has taken action to boost liquidity to help cushion the downturn in its housing market. This has garnered much attention given that the property sector represents roughly a quarter of China’s GDP.

This divergence in monetary policy could heighten volatility in markets as both central banks delicately balance between maintaining economic growth and quenching inflationary pressures. China’s monetary policy impacts Asia since China’s growth affects trade and supply-chain channels. In turn, the Fed’s tightening policy also matters for Asia as it affects U.S. growth, which could curb Asian exports.

Much will depend on how the Fed and the People’s Bank of China (PBoC) address their respective policies as both central banks attempt to avoid policy mistakes. The PBoC is expected to continue selectively ease liquidity, which should mitigate risks of a slowdown in China (and Asia). Furthermore, the Fed’s gradual policy normalization could reflect stronger U.S. growth. This would be reflected in a steeper yield curve in the U.S.

The combination of rising inflation, a healthy economy and the Fed’s reduced bond purchases may lead to rising yields. This could potentially reverse the recent momentum that had growth outperforming value stocks. All of this will depend on how the normalization process develops throughout the new year.

Definitions

The Bloomberg US Aggregate Bond Index is composed of investment-grade U.S. government and corporate bonds, mortgage pass-through securities, and asset-backed securities and is commonly used to track the performance of U.S. investment-grade bonds.

Treasury Inflation-Protected Securities (TIPS) are a type of Treasury security issued by the U.S. government. TIPS are indexed to inflation in order to protect investors from a decline in the purchasing power of their money.

It is not possible to invest in an index.

About Principal Risks: There is no guarantee the Fund will achieve its investment goal. Asset allocation and diversification do not guarantee future results, ensure a profit or protect against loss. Although diversification among asset classes can help reduce volatility over the long term, this assumes that asset classes do not move in tandem and that positive returns in one or more asset classes will help offset negative returns in other asset classes. There is a risk that you could achieve better returns by investing in an individual fund or multiple funds representing a single asset class rather than using asset allocation. A fund-of-funds does not guarantee gains, may incur losses and/or experience volatility, particularly during periods of broad market declines, and is subject to its own expenses along with the expenses of the underlying funds. It is typically exposed to the same risks as the underlying funds in which it invests in proportion to their allocations.

This commentary represents the views of the portfolio managers at Pacific Life Fund Advisors LLC as of 12/31/21 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. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Sector names in this commentary are provided by the Fund’s portfolio managers and could be different if provided by a third party.

Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding investment products.

You should consider a fund’s investment goal, risks, charges and expenses carefully before investing. The prospectus and/or the applicable summary prospectus contain this and other information about the Fund and are available from your financial professional or PacificFunds.com. The prospectus and/or summary prospectus should be read carefully before investing.

Pacific Funds are distributed by Pacific Select Distributors, LLC (member of FINRA & SIPC), a subsidiary of Pacific Life Insurance Company (Newport Beach, CA), and are available through licensed third parties. Pacific Funds refers to Pacific Funds Series Trust.

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