Market Update

The S&P 500 closed at a record high last week, rising 2.3% to 4725.79. The index is mere points away from setting an all-time high. It peaked at 4743.83 on November 22nd. The Dow rose 1.7% and the Nasdaq 3.2% on the week. A Santa Claus rally is widely expected. Santa Claus typically visits the stock market between 27 December and 4 January according to the Stock Trader’s Almanac. Given how the market adapts, don’t be surprised if the Santa Claus rally has already come and gone. Investors may have front-run the rally and received an early Christmas present in the process.

Regardless, the bull market has left many stocks around the world far behind. The SPDR S&P 500 ETF (SPY) is up 25.52% year-to-date. The Russell 2000 small-cap index is up a puny 12.34% in comparison. The Vanguard FTSE All-World ex-US ETF (VEU) returned 6.32% through Thursday. The iShares MSCI Emerging Markets ETF (EEM) lost 4.87% year-to-date. Bonds have also lost money for investors. The iShares Core US Aggregate Bond ETF (AGG) is down 1.63% year-to-date. High yield bonds are up 3.35% on the year but are trading at tight spreads to Treasuries. The ICE BofA US High Yield Index Option Adjusted Spread is only 3.12%. Investors are not being paid to take on the credit risk associated with the high yield market. The average spread is closer to 5.5% and can blow out to 10.0% or more during a recession.

The bottom line for 2021 is that U.S. large-cap stocks were once again the place to be. Diversified portfolios suffered for their diversification. Yet if history has taught us anything it is that last year’s losers will become winners while last year’s winners falter. U.S. large-cap stocks have returned 88.5% since the start of 2019. The index is trading at 21.5 times forward 12-month earnings, well above the 15.5x historical average and the 18x average of the last twenty years. Investors will benefit from diversifying away from U.S. large-cap growth stocks in the coming years. Norwood is overweight international and emerging markets. It is underweight bonds, particularly intermediate and long-term bonds. Norwood owns 24 stocks for its clients. All its holdings are trading at sharp discounts to the S&P 500. All but two of them have dividend yields significantly higher than the S&P 500’s 1.3% yield.

Economic Indicators

The Leading Economic Indicators index jumped to 1.1% in November from 0.9% the prior month. The index is up 4.6% over the past six months. The strong number indicates continued economic growth in the first half of 2022. Gross domestic product growth was revised to 2.3% for Q3, up from 2.1% initially. The Chicago Fed national activity index (CFNAI) was 0.37 down from 0.75 in October. A reading above 0 indicates the economy is growing faster than trend.

Income and spending increased, but real disposable income fell 0.2% in November and real consumer spending was flat. Core inflation was 4.7% and the PCE deflator was 5.7% year-over-year. Five-year inflation expectations in December were 2.9%. Consumer sentiment is still weak with a final University of Michigan consumer sentiment reading for December of 70.6. Consumer expectations are signaling a possible recession in 2022. Most other economic indicators are signaling continued growth.

Norwood Economics is forecasting 2% to 3% GDP growth for 2022. Inflation should subside to between 3% and 4% by year-end 2022. Inflation is more likely to continue lower in 2023 than not. A recession in 2023 is likely if the Federal Reserve follows through with three rate hikes in 2022 and another three in 2023. A heavily indebted economy will not survive six rate hikes in the next two years. Expect the Fed to hike two to three times in 2022 and then stop as the economy slows more quickly than expected.

Debt and Economic Growth

Dr. Lacy Hunt of Hoisington Investment Management writes a quarterly review and outlook. Hoisington is an institutional fixed income manager with over $6 billion under management. It focuses on long-term investment strategies that utilize only U.S. Treasury securities, according to its website. Dr. Hunt is an economist and regarded as an expert in his field.

I read Hoisington’s quarterly review and outlook. Dr. Hunt’s focus on the big picture is useful in understanding the likely path of the economy and interest rates. It is also useful in understanding the inflation outlook. Unfortunately, the quarterly review needs translating for most people. Here’s a short translation of his latest report.

The increase in debt over the last four decades has negatively impacted economic growth in the U.S., as shown by numerous scholarly studies (Hunt lists four in his article). The use of additional debt to stimulate economic growth is no longer effective. The law of diminishing returns is a basic concept in economic theory. It applies to the use of debt. Increasing indebtedness has led to a decline in real per capita GDP growth. The velocity of money peaked in 1997 (how often money changes hands). The growth in real per capita GDP began to decline in 2000 relative to its long-term growth trend.

U.S. real per capita GDP rose by 2.2% per annum from 1870 until 2000. Per capita GDP growth has averaged 1.1% per annum since then, a 50% decline. GDP per capita would be almost 26% higher had the growth rate not slowed. Excessive indebtedness acts as a tax on future growth and a drag on our standard of living.

Debt that produces an income stream capable of repaying principal and interest leads to higher GDP growth. Debt that creates insufficient income to repay interest and principal leads to slower and slower GDP growth. The slower the growth in real per capita GDP the less well off we are compared to what could have been.

The U.S. has had a supply shock that has caused the supply curve to shift inward. Prices rise when supply is constrained. A lower level of real GDP also occurs. The shortfall between actual GDP and potential GDP is deflationary. The deflationary gap is the result of demand destruction. Demand destruction occurs when prices initially rise. People paying more for goods and services can afford fewer goods and services. Reduced aggregate demand leads to cost-cutting by businesses, including layoffs. Demand destruction leads to falling prices as demand adjusts to the reduced supply.

In more formal terms, the demand curve shifts inward when money supply growth slows and the velocity of money falls. Money supply growth has decelerated the first three quarters of 2021. The velocity of money has continued to fall. The deceleration in money supply growth and velocity indicates that the inflation resulting from supply-side shocks will eventually reverse, writes Dr. Hunt.

Some economists worry about stagflation like the United States had in the ‘70s. Stagflation occurred in the ’70s because the Federal Reserve prior to Paul Volcker allowed the money supply to continue to grow rapidly despite the supply-side shocks. Today money supply growth is slowing. Math sums it up best: MV=PQ. The quantity of money times the velocity of money equals price times quantity. Money supply (M) growth is slowing, and velocity (V) is falling. Quantity (Q) is growing again which means price (P) must fall for MV=PQ or MV=GDP to hold true.

There are two main takeaways from Dr. Hunt's quarterly report. First, high inflation is temporary. Slowing money supply growth and falling velocity mean price increases will slow. Second, too much debt is reducing real per capita GDP growth. It will continue to do so unless the debt burden is reduced. Consequently, Dr. Hunt believes that the long-term downtrend in interest rates is still intact. Any rises in yields in 2022 will be temporary.



Regards,

Christopher R Norwood, CFA

Chief Market Strategist