The increase in volatility that’s been happening since Thanksgiving ended a stretch of relative calm for the markets, says Legal & General Investment Management America (LGIMA) in a recent report analyzing the fourth quarter of 2021.
Recent factors responsible for the swing in asset prices include the emergence of the highly transmissible COVID-19 Omicron variant and the Federal Reserve’s December decision to accelerate the pace of tapering and acknowledge that inflation may be more persistent than its previous forecasts indicated, the firm says.
LGIMA suggests that fixed-income investors still tend to believe conditions will eventually return to the way they were earlier in 2021. With core inflation ending the year at 5% and the gross domestic product (GDP) also averaging roughly 5% over the second half of 2021, the firm says, it is difficult to justify 10-year Treasury yields in the 1.5% to 1.75% range, unless both inflation and growth decline back to trend soon.
Though bottlenecks have lasted longer than initially expected, LGIMA says it believes inventories will eventually catch up as demand moderates, leading to reduced inflation for automobiles, microchips and other goods that have been subject to acute price pressure, the report says. Investors remain confident that Fed hikes will quickly bring inflation under control, though inflation concerns have shifted to the shelter and services component against a backdrop of rising home prices and tight labor markets.
“In our view, the market not only believes inflation will decline back to target but also that rate hikes will have an even greater impact on the economy than the Fed believes,” LGIMA says. “Said differently, markets are priced as if the pandemic will have little lasting impact. Deflationary forces will reassert themselves in the coming years, and, as in the previous cycle, we expect the Fed will find it unnecessary or unable to hike aggressively.”
The economy of 2022 looks very different than that of 2019, and, as a result, the possibility that both growth and inflation remain well-above their pre-pandemic trend throughout 2022 and beyond should not be discounted, LGIMA says. The year ahead is likely to require a higher emphasis on security selection as investors evaluate which investments offer sufficient premium to compensate for a more volatile world.
It is difficult to judge the impact of the Fed’s decision to accelerate the pace of tapering, as it came squarely during the surge in Omicron cases, the report says. Yet, LGIMA adds there is no doubt it contributed to the increase in interest rate volatility during the fourth quarter, which was the highest since the beginning of the pandemic.
Credit market volatility was sharply higher in the fourth quarter along with rates, the report says. After trading within a narrow range from April through the last week of November, investment-grade credit spreads wiped out all the spread tightening experienced during the year before recovering marginally by year end.
The high-yield market was more volatile, yet better performing, during the ending quarter of 2021. Furthermore, for much of 2021, full valuations were a barrier to adding credit risk across portfolios. However, the combination of volatile markets and a rush of year-end issuance provided a short window to add risk at more attractive levels, the report says. More than $63 billion of investment-grade corporate debt was issued in December, well above the $23 billion average over the past four years.
LGIMA estimates that an “average” pension plan with 60% global equity and 40% U.S. aggregate fixed income investments began 2021 with a funding ratio of approximately 82%. Funding ratios for the average plan closed out 2021 at the high-water mark for the year at just shy of 93%, with the main contributor to the increase being the strong performance of equity markets. Global equities climbed approximately 20%, while the S&P 500 rose almost 30% during 2021, says LGIMA.Pension plan sponsors and other institutional investors also likely benefited from an increase in plan discount rates. The firm estimates discount rates rose close to 45 basis points (bps) over the year, helping to lower liability valuations. As funding ratios improve, demand has also increased for custom fixed-income strategies to dampen funded status volatility and increase predictability for plan sponsors.