2022 Market Outlook

2021 saw the extension of a healthy economic rebound from the recession of early 2020. While Covid-19 continued to have a global impact, its decreased virulence and highly effective vaccines allowed society to continue a trend toward normalcy. This trend, combined with the lagging effects of federal stimulus and continued low interest rates, looks to have driven well-above average GDP growth in 2021 of > 5.5%.

It’s no surprise, however, that following such a strong year, 2022 will be a little more challenging. January and February have already highlighted this fact through heightened market volatility. Russia’s invasion of Ukraine and the resulting humanitarian crisis have also shocked the market at the start of 2022. To learn more about our viewpoint and assessment of the conflict in Ukraine please refer to our most recent newsletter. A dangerous escalation from here would have broader impacts, of course, but we remain optimistic for an eventual resolution that does not engulf Europe. With that said, read on…

In this outlook we focus on three key themes which create a more demanding environment for investors. There remain many reasons to be optimistic on the outlook, but investor expectations should be anchored towards more normalized economic growth and the possibility for more historically average, e.g. less stratospheric, equity market returns.

1. Tightening Monetary Policy

The Federal Reserve has chosen to keep its policy (ultra short-term) interest rates remarkably low with the Fed Funds rate currently sitting at 0.25% despite increasing inflationary pressures. The latest reverse-course “tightening” guidance from the Fed has driven markets to anticipate a policy interest rate above 1% by the end of 2022. This in turn has already driven longer-term interest rates higher as well. We therefore see diverging impacts to both 1) economic growth and 2) asset returns in 2022 resulting from this tighter monetary policy.

In short, we believe the Fed could be successful in tightening its monetary policy without derailing the recovery. On March 2nd Chairman Powell stated that he supports an initial 0.25% bps rate hike this month and that he sees a good possibility for a “soft landing” scenario for the economy. He also stated that soft landings have occurred more often throughout history than is commonly understood and that he would like to see the balance sheet runoff occur “in the background”. We must be cognizant that this process is not academic. There is a possibility that the Fed overshoots and creates an unintended consequence of slowing down the economy too much. The recent market volatility is historically normal with respect to the Fed’s policy shift, and combined with high inflation, this shift poses risks to consumer confidence in the near-term.

It should be noted, however, that despite the present hand-wringing over rising rates we are lifting off of the floor of historically low rates, returning to what many would consider a ‘normal’ rate environment; see chart of Historical Interest Rates on the next page for context.

2. Slowing But Strong Economic Growth

We expect GDP growth to decelerate from the recent 5%+ levels, but to remain elevated and supportive of continued Fed policy rate increases. In the very near-term, high inflation and commodity prices will pressure consumer confidence and spending power, but the strong labor market, healthy consumer balance sheets, and pent-up travel demand could ultimately keep consumer spending elevated for the full year. Business capital spending has also been at highly elevated levels, driven by the need to restock depleted inventories and to keep up with consumer demand.

“High inflation and commodity prices will pressure consumer confidence and spending power, but the strong labor market, healthy consumer balance sheets and pent-up travel demand could ultimately keep consumer spending elevated for the full year”

While this spending does contribute to inflationary pressures in the near-term, it also provides a boost to productivity growth. Productivity growth will allow overall GDP growth to persist despite labor force shortages. In the very near-term, the Omicron variant has caused disruptions to consumer spending and payroll gains, but we view this as temporary, with further gains in employment, wages and GDP in the second half of 2022. Despite the extremes of COVID, the economy has demonstrated remarkable growth as seen in the chart on the following page:

3. Diverging Equity Market Returns

The difficulty that equity markets will face is rising interest rates. A major support to equity market returns in 2020 and 2021 were low interest rates from extremely loose monetary policy. Low interest rates and money supply growth led investors to reassess risk across a number of asset classes. Naturally, as interest rates rise and money supply growth declines, investors must re-think asset allocation and their approaches to valuing different types of securities. The market volatility and related increased risk sensitivity we’ve seen so far in early 2022 is a reflection of this dynamic.

We expect this market volatility to continue in 2022 as monetary policy continues to normalize via tightening. Our view of solid economic growth implies that company earnings growth can remain elevated, offsetting some of the valuation pressure from higher interest rates. But earnings growth will diverge across sectors. Many companies also had realized tremendous earnings tailwinds from stay-at-home dynamics, and this may taper going forward.

With valuation pressure from higher rates and diverging earnings outlooks among sectors and industries, individual stocks and stock sectors will reflect large divergent returns from each other. We think there are plenty of opportunities for equity investors to earn modestly positive returns in 2022 despite the record returns over the last two years. This may be influenced by the possibility of an awaited valuation adjustment/market correction after a multi-year show of exuberance in the markets.

Fixed Income Outlook

Naturally, rising interest rates do not bode well for fixed income returns in 2022. This is already reflected in the year-to-date negative returns of bonds.

“As interest rates move higher and bond prices fall, the fixed-income market could move to lower, move attractive valuation levels for dry powder investing or reinvesting.”

That being said, as interest rates move higher and bond prices fall, the fixed-income market could move to lower, more attractive valuation levels for dry powder investing or reinvesting. In other words, our economic and interest rate outlook implies challenged returns for fixed income in 2022, but once this bond valuation adjustment takes place, we view fixed income as becoming a better equity market/risk hedge than it has been in prior years. To date, both equity and fixed income returns are negative– not what has been the normal historical inverse correlation between the two. But for 2022 overall, we think the equity/bond correlation can normalize back to negative correlation, providing risk-reduction benefits for portfolios. 

To highlight this, if we are wrong on our assumptions, and inflation and Fed policy drive a weaker growth outlook, we believe longer-term interest rates can fall. Falling longer-term rates will support fixed income returns at a time when equity market returns would most likely be negative in a deteriorating earnings environment. This is why we are hedging ourselves by carefully maintaining both bonds, strategic alternatives and equities within portfolios, and not taking market “bets”.

A Word on Inflation

It would be disingenuous to dismiss today’s inflation as entirely transitory, but similarly we feel it would be incorrect to view all price increases as permanent. Some components are with us long-term, driven by higher wages and other factors. But we should be clear that some of the price increases we’ve all felt recently are clearly short-term supply chain driven (think the lumber drama a year ago), or even just plain opportunistic. As logistics issues resolve (and they will) the normal supply/demand equilibrium will be restored. Similarly, those companies taking advantage of inflation froth will find themselves competing with new market entrants that will steal market share and still be profitable at lower prices. Bottom line? Use caution interpreting this most recent spike in the CPI.

Asset Allocation Strategy

Putting this all together, our allocation recommendations for client portfolios follow a balanced approach in this new-Fed policy environment. While this may mean flat to slightly negative fixed income returns in a strong economic and rising rate environment, it still provides a level of risk reduction in a scenario of slower than anticipated growth, or equivalently, in a scenario where monetary policy tightening evolves more quickly than expected and results in lower stock markets.

If we see certain market segments become oversold (i.e., become attractively priced), we have the power to rebalance portfolios, strategically make select segment purchases at higher yields and lower prices by shifting the weightings of our stock, strategic alternative, and bond allocations for you. We are prepared for this situation, beneficially, and are following the markets and economic climate very closely at this time.

It is always worth considering lessons of the past, and the risks of letting short-term market stress drive long-term investment decisions, as seen in the accompanying chart regarding the value of staying invested.