By David Schassler
Portfolio Manager and Head of Quantitative Investment Solutions
Van Eck Associates Corporation
Goodbye 2021! Welcome 2022! Last year marked another period of easy money that fueled yet another year of outsized gains. The S&P 500® Index returned +28.7%! Investors should be pleased with that outcome, but not surprised. The average return of the S&P 500 Index over the past 10 years was 17.2%. Over that period, there was only one down year and eight out of the ten years delivered double-digit returns.
Sadly, all this good financial fortune has come at a cost—and that cost is high inflation (currently 7%). It turns out that we cannot print and borrow infinite amounts of money and have no negative consequence: Who would have thought? Since 2020, the U.S. money supply (M2) has increased by 40% and U.S. government debt has increased by 28%, according to data from Bloomberg.
The U.S. Federal Reserve (Fed), politicians, consumers and, as a result, the markets, are now laser-focused on inflation. The Fed has finally acknowledged that we have an inflation problem. That’s the good news. The bad news is that the options to control inflation are limited due to the excessive debt and fragility of the economy.
This is an ugly way to start off 2022. There is a huge shift underway in the markets. Inflation is high and rising, growth is high and falling and interest rates are low and rising. A different playbook will likely be needed to successfully navigate the decade ahead.
Here are our three market calls for 2022:
- Inflation beneficiaries, specifically real assets, should lead the markets higher as traditional companies struggle to maintain and grow profit margins in a high inflation regime. The chart below demonstrates the performance of traditional assets (stocks and bonds) relative to real assets (commodities and gold) during the high inflation of the 1970s and mid-2000s. During high inflation, real assets prosper and traditional assets have historically suffered.
Historical Periods of High Inflation
The real asset that is likely best positioned to perform is gold. The chart below demonstrates real yields. Real yields are currently at their lowest rate (most negative) ever.
Real Yields 1954-2021 (Three Month Treasury Note Yields Minus CPI)
Historically, negative real yields are associated with exceptional returns for gold. The chart below demonstrates the annualized return for gold at different levels of real interest rates.
Gold Annualized Return Based on Real Interest Rate Level
Investors with a higher risk appetite should consider investing in gold equities. These companies offer a unique opportunity to perform given their capital discipline and attractive valuations.
- We believe value stocks will outperform growth stocks. Growth stocks are longer-duration assets than value stocks. This is because value stocks, with lower price-to-earnings ratios, return capital back to investors faster than growth stocks. Future returns are discounted much more heavily in a world of high inflation. The trailing 12-month P/E ratios, as of December 31, were 39.59% for the Russell 1000 Growth Index and 19.81% for the Russell 1000 Value Index.
This chart demonstrates how extreme both the magnitude and duration of outperformance of growth has been. This should quicken the velocity of the reversal.
Spread Between Russell 1000 Growth & Value
Source: Bloomberg. Represents the difference in total return between the two indices over rolling three year windows.
- We expect volatility will be elevated. We are gearing up to witness a good old fashioned fistfight between the Fed and inflation. Will either side back down? If inflation doesn’t subside to the 2% target on its own, which we do not believe that it will, and if the Fed follows through on its pledge to fight inflation (and that’s a big “if” given the current debt levels), then we should expect a bumpy ride ahead.
Fed Chair Jerome Powell anticipates gradually raising interest rates over the course of the year, ending asset purchases in March and allowing the balance sheet to run off. Deeply negative real rates at this point in the inflation cycle suggests that the Fed anticipates the supply side to do most of the inflation fighting.
But don’t panic! High volatility often creates the best opportunities. See market calls 1) and 2) above to help you navigate.
Our top pick to fight inflation is the VanEck Inflation Allocation ETF (ticker: RAAX) for three reasons:
- It is an actively managed ETF that provides exposure to the key inflation-fighting real assets;
- It dynamically adjusts to different inflation regimes; and
- RAAX is currently performing as an excellent inflation hedge.
We hope that you have found this letter helpful and invite you to tune in again next month as we provide further insights across the financial markets.
Originally published by VanEck on January 21, 2022.
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CPI – U.S. CPI Urban Consumers YoY NSA Index measures U.S. consumer prices (CPI) as a measure of prices paid by consumers for a market basket of consumer goods and services. The yearly (or monthly) growth rates represent the inflation rate.
The S&P U.S. Treasury Bill 0-3 Month Index (USGG3M) is designed to measure the performance of U.S. Treasury bills maturing in 0 to 3 months.
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