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December 31, 2021 — Market Insights
Market Review

Delta Gives Way to Omicron...

  • At the time of our last quarterly write-up, the wave of COVID-19 delta variant infections was fading, and the biggest market concern revolved around ongoing supply chain bottlenecks. Fast forward to the end of the year, the highly contagious omicron variant has spread like wildfire around the globe. Like delta, omicron serves as another reminder of the uncertainty involved with a global pandemic.
  • GDP grew at a 2.3% q/q annualized pace in 3Q21, underwhelming expectations that had been revised lower throughout the back half of the year. The delta variant was clearly a drag on consumption; however, supply chain bottlenecks, labor market constraints, inflation concerns, and the fading impact of Government stimulus were significant influences as well.
  • Headwinds persist as inflation remains elevated and it will take some time for shortages to abate. Confidence intervals remain wide, but currently 4Q GDP is expected to be 6.0%-6.5% q/q annualized while full year 2021 GDP is expected to be 5.5%-6.0%.

…And Shortages Temper Economic Recovery

  • Job growth has been lackluster, mostly missing expectations. Regardless, unemployment has ground down to 3.9%. Despite an unprecedented 10-11 million job openings over the past six months, labor force participation and total employment remain below pre-pandemic levels.
  • Earlier in the fall, consumer spending held up well as evidenced by month-over-month changes in retail sales of 0.7% and 1.8% in September and October respectively, but then November sales rose only 0.3% versus expectations of 0.8% with supply chain issues to blame.
  • Business activity continues to be strong; however, supply chain issues and labor shortages remain problematic. After hovering near the highest level in the past 20 years for most of 2021, the ISM Manufacturing PMI dipped to 58.7 in December from 61.1 in November. Meanwhile, the ISM Services PMI reading of 69.1 in November marked the highest point in the series’ history before falling back to a still-elevated 62 in December.

Fed Takes Action

  • As expected, the Fed kept rates unchanged at its November and December meetings, and started QE tapering in November. However, at its December meeting, after the highest inflation prints in nearly 40 years, the Fed decided to speed up its taper. The accelerated schedule will conclude in March, three months earlier than originally expected.
  • The market now expects three interest rate hikes in 2022, to begin soon after the taper is complete. Indeed, the most recent Summary of Economic Projections (SEP), released at the December meeting, now indicates that 17 of 18 FOMC members project at least two rate increases in 2022, with 12 of 18 members projecting at least three rate increases over the next year.
  • The debt ceiling was successfully increased by $2.5 trillion in mid-December, avoiding a Government default. Congress successfully passed the $1.2 trillion Infrastructure Investment & Jobs Act in November, while the $2.2 trillion Build Back Better Act stalled out in December and still needs Senate approval.

...As Inflation No Longer Transitory/h2>

  • Headline CPI increased by 6.8% y/y in November, the highest rate of inflation since 1982, while core CPI increased by 4.9% y/y, the highest since 1991. Similarly, headline PCE increased by 5.7% y/y in November and core PCE increased by 4.7% y/y, the highest readings since 1982 and 1983 respectively. On a month-over-month basis, all of these measures are near pandemic highs after briefly dipping lower during 3Q.
  • This reversal of monthly measures and the highest year-over-year inflation readings in ~40 years suggest that core inflation may be stickier than previously expected by the Fed. Indeed, in his Congressional testimony at the end of November, Fed Chair Powell stated, “it’s probably a good time to retire the word transitory,” and the reference was subsequently removed from the December FOMC statement.
  • Although the 5-year break-even inflation rate is elevated at almost 3%, the 5Y-5Y forward break-even inflation rate remains firmly anchored at 2.25%, suggesting that the market believes the Fed will act aggressively enough to keep inflation at bay.

Yield Curve Flattens on Rate Hike Expectations, Non-Treasury Sector Performance Muted

  • As the market re-priced inflation fundamentals and a hawkish monetary policy response, the yield curve reshaped considerably during the quarter. The 2-year Treasury yield increased by 45 bps (0.45%), reflecting expected rate increases, while the 10-year Treasury yield increased by only a couple of bps, such that 2s vs. 10s flattened by 43 bps. Over the year, the shape of the yield curve was remarkably unchanged (2s vs. 10s flatter by only 6 bps). Nominal Treasury yields moved higher but real yields were virtually unchanged, leaving break-even inflation wider for the year.
  • Most major fixed income spread sectors slightly underperformed like-duration Treasuries during the quarter, with the exception of high yield Corporates which outperformed. Within investment grade Corporates, longer bonds underperformed short/intermediate maturities, while A/BBB issuers modestly lagged the highest quality names.
  • Corporate spreads widened modestly across maturities during the quarter, roughly moving back to beginning of year levels, but remain historically tight overall. 2021 new issue supply was very strong, ~$1.5 trillion gross ($420 billion net). Expectations for 2022 are similar with current estimates ranging from $1.4-1.6 trillion gross/$525-650 billion net (BMO, JPM).
  • The Agency MBS sector gave way to rapidly developing Fed policy during the fourth quarter, generating negative excess returns versus like-duration Treasuries. Home prices charged higher by 18.4% y/y in October, marking 11 straight months of double digit year-over-year growth. Notably, however, the month-over-month growth rate slowed as the year progressed.
  • ABS also underperformed Treasuries in 4Q, as the Fed pivot put pressure on short spreads. At ~$270 billion, ABS new supply in 2021 was the highest on record; however, it was primarily the result of supply in 2020 getting pushed out (Citi). Averaging ABS new issue over the past two years gets ~$230 billion per year, which is in alignment with ABS new issue in the three years leading up to the pandemic. Consumer credit performance continues to be strong, despite the expiration of pandemic related assistance programs.
  • Consistent with other securitized sectors, CMBS underperformed during the quarter. The same cast of characters are to blame: shifting Fed policy and swap spread widening. CMBS conduit supply limped along at only $30 billion for the year, while Single-Asset/Single Borrower (SASB) supply exploded to $81 billion (BofA). While overall CMBS credit performance continues to improve, the omicron variant of COVID-19 is forcing yet another delay of an elusive “return to normal.”