The big sea change was in the credit and money markets. Most remarkably, the Fed pivoted towards raising interest rates thus ending 10 years of easy money policies by announcing they will stop all bond purchases by the end of Q1 2022. So far, the bond market has not responded with an expected sell off, but rather, has signaled that the Fed will lose its nerve and go back to easing.

It took something major to alter the course of the Fed and this came in the form of persistently high inflation readings. As you may recall, inflation, simply put, is too much money chasing too few assets. We experience the effect in the form of price increases for products and services, but it can also appear in more subtle ways such as a lowering of quality or quantity of goods for a given price. Inflation is always personal, therefore another way to look at it is through our budgets. Our clients have uniformly seen rises in their insurance, energy, groceries, and housing prices. These are important basic living expenses. The primary cause of this inflation is the massive increase in the money supply over the past two years—it has grown by 86%. This means there is almost twice as much money to purchase roughly the same number of services and potentially fewer goods because of supply chain shortages.

The silver lining is that monetary inflation, unlike other forms, also benefits investors because it raises asset prices. But this wealth creation is, to some extent, an illusion when we compare it to the increase in our budgets. If we deflate returns to various asset classes (economists call this making them real), then we see that those with a stash of cash locked in a 6.10% loss. Stock returns, while good at 5.20%, were in line with historical averages during less inflationary times and bonds preserved wealth. The important upshot of this is that no matter what the allocation, investors managed to more than make up for inflation, leaving those who remained in cash suffering a real loss. The lesson here is that the best defense against inflation is a well allocated portfolio.

Ideally, asset growth would be driven by increases in output or GDP—which currently has a growth rate of about 2%. The current gap between GDP and asset growth is unsustainable. The Fed is hoping to guide the equalization towards a soft landing as opposed to a shock.

This means that the most important question facing investors in 2022 is how long and to what extent will inflation grow and what will lead to its inevitable demise? The problem is that deflating the economy is inherently recessionary. Further downward economic pressure comes from the end of congressional stimulus, higher market volatility, and consumer savings eroded by inflation—and let's not forget that we are enduring added economic suppression from supply chain issues and a pandemic.

The Fed and central banks globally must tread a fine line between inflation and recession: reducing rising costs while maintaining growth in GDP. To me, this is a question of whether the Fed has both the willingness and the ability to raise interest rates to stave off inflation.

Historically, most recessions in the US have been sparked by actions at the Fed. In our time, failure would arise if markets and ultimately productivity—conditioned by more than a decade of easy money—collapse in the face of higher interest rates. This scenario would turn into stagflation if the interest-led decline in economic activity met persistent inflation. Many of us have memories of the '80s when the only cure for stagflation was interest rates above 20%, years of harmed livelihoods, and economic insecurity. This would lead to a decline in risk markets beyond the decline in bonds.

In recent years, however, the Fed has consistently lost its will to raise rates. Should this happen, risk markets will rally as the Fed resumes its role as the ultimate asset purchaser. The stock market—albeit unattractive at current levels—would be seen as the "best house in a bad neighborhood" and consequently rally. Placing 2021 stock market returns into context, you will see on the graph below that whenever the S&P 500 has risen more than 25% it has never gained more than that in the following year. The good news is that the year following those high growths have been positive 85% of the time, averaging a solid 11% return.

This outlook would become even more rosy if we witnessed a natural easing of inflationary pressures—perhaps through increased economic activity when supply shortages loosen. This is the most likely scenario in my opinion because the supply chain issue looks to be easing: massive capital has been directed towards blockages and the massive uptake in vaccinations means suppliers overseas might avoid future lockdown.

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