Capital Markets Commentary: 2022 Market Outlook
By Joe Bell, CFA, CMT, CFP, Chief Investment Officer, and Amisha Kaus, Portfolio Manager • December 27, 2021
2021 was a year of transition for global capital markets. While countries have moved away from widespread economic shutdowns, 2021 brought the highest inflation we have experienced in decades, upward pressure on interest rates, supply chain challenges, and lackluster labor participation. Despite these challenges, equities recorded above-average gains with little volatility, while only certain pockets of the bond market were able to avoid negative returns.
AS WE TURN THE CORNER TO 2022, HERE ARE THE KEY THEMES FOR NEXT YEAR:
» Elevated equity market risk - Gains in 2022 may prove to be more challenging than in 2021, with elevated equity risk compared to the start of this year. While long-term uptrends are still in place for U.S. equities, we have seen a significant increase in the number of individual stocks that are in bear markets.
» Inflationary pressure should ease by the end of 2022 - We see early signs of improvement in the supply chain and labor market that may cause a reduction in inflation by the end of 2022.
» Federal Reserve stimulus timeline - We expect the Federal Reserve to finish tapering by the end of the first quarter of 2022, with the first increase in the Fed Funds rate to come before June 2022.
» Focus on tactical fixed income - Being tactical in fixed income will become even more important in 2022. With upward pressure on interest rates by the Fed, bond investors will need to tactically allocate to areas outside of traditional investment grade and U.S. Treasuries.
» COVID-19 likely to become an increasingly manageable risk – While predicting the future path of infection is not something we can predict, we enter the new year with multiple vaccines in place, more education on how the virus spreads, and knowledge of methods to manage the spread without widespread economic shutdowns.
ELEVATED EQUITY MARKET RISK
The S&P 500 reached a historic milestone in 2021, achieving its fastest start to a bull market since at least 1950, eclipsing the earlier record made just after the Great Financial Crisis. In just 354 trading days, the S&P 500 Index gained more than 100% off its March 2020 bottom.
Although the trend of U.S. equities is positive, there has been a lack of participation during the second half of 2021. As shown in Exhibit 1, the percentage of Russell 3000 stocks that are 20% or more below their 52-week high (a classic definition of a bear market) has been climbing and sits right around 50%. This weakness under the surface is a concern.
EXHIBIT 1: THE PERCENTAGE OF U.S. STOCKS IN BEAR MARKETS HAS BEEN INCREASING SINCE JULY
Source: S&P Capital IQ
Inflation-adjusted valuations have also reached an extreme level. The S&P 500’s real earnings yield (Earnings Yield – CPI (Consumer Price Index) YOY Growth Rate) is at its lowest level going back to 1957. In the past, we have argued that the high valuation of U.S. equities has been warranted due to below average inflation, record-low interest rates, and favorable corporate and investment tax rates. While inflation may begin to subside during the second half of 2022, the government spending and current tax rates that have been a tailwind for equities are likely to reverse course in the next few years.
EXHIBIT 2: THE S&P 500’S REAL EARNINGS YIELD HAS MOVED TO ITS LOWEST LEVEL SINCE AT LEAST 1953
Despite these concerns, the long-term trend is still positive and strong uptrends do not historically reverse easily. In fact, since 1950, when the S&P 500 gains more than 20%, the following year has been positive 84% of the time, with an average gain of 11.5%. Given the increased level of risk, tactically monitoring momentum will be especially important as we navigate 2022.
EXHIBIT 3: ANNUAL RETURNS OF >20% HAVE HISTORICALLY LED TO MORE UPSIDE THE FOLLOWING YEAR
INFLATIONARY PRESSURE SHOULD EASE BY THE END OF 2022
Inflation took center stage in 2021, with the US Personal Consumption Expenditure (PCE) Index growing at a 5.7% YOY growth in November, its highest level since the early 1980s. A combination of massive fiscal-stimulated consumer demand, global supply chain issues, and lackluster labor participation have all been contributors.
While international part shortages continuing to cause delays in completing customer orders, we have begun to see an improvement in the size of U.S. inventories compared to new orders since August. While average supplier delivery time is still elevated, this could be a sign that manufacturers are catching up with consumer demand.
EXHIBIT 4: INVENTORIES ARE CATCHING UP WITH NEW ORDERS, WHICH MAY IMPROVE SUPPLY CHAIN ISSUES
We are not likely to see the same level of consumer demand again in 2022. As shown in Exhibit 5, the massive consumer savings in the U.S. has sharply declined and is down to its pre-pandemic level.
EXHIBIT 5: SAVINGS HAS DECLINED TO PRE-PANDEMIC LEVELS
In addition, the record amount of fiscal stimulus that bolstered the balance sheets of Americans in 2021 will not be occurring in 2022. In Exhibit 6, the stark contrast between total US Personal Income and US Personal Income excluding Federal benefits shows that Americans received more income than they would have if there was no pandemic. U.S. Personal Income has since declined to a level consistent with its historical trend. With savings and income back to normal levels, we expect to see a decline in consumer demand and an improvement in the labor participation rate by the end of 2022.
EXHIBIT 6: INCOME HAS DECLINED WITH THE EXPIRATION OF MOST FEDERAL BENEFITS
WE EXPECT THE FED TO FINISH TAPERING BY THE END OF Q1 2022, WITH THE FIRST INCREASE IN THE FED FUNDS RATE TO COME BEFORE JUNE 2022
We expect the Federal Reserve to end their COVID-related monetary stimulus by March 2022, giving the committee more flexibility to raise federal funds rate during the second quarter of 2022. We expect the first fed funds rate increase shortly after the March FOMC meeting, followed by two more rate increases during 2022. This should bring the central bank’s lending rate to just under 1% by the end of 2022. We expect this monetary tightening cycle to continue well into 2024.
The Federal Reserve's dual-mandate includes both stable prices and maximum employment. The Federal Reserve’s preferred inflation measure, the Personal Consumption Expenditure (PCE) Core Index, which excludes food and energy prices, currently stands at 4.7%, well above their long-term target of 2%. Despite inflation running well above its target, a key factor in gauging the central bank’s aggressiveness in raising rates continues to be the labor market. The U.S. unemployment rate reached a high of 14.8% during the height of the pandemic last year and has since gradually declined to the current level of 4.2%. The U.S. central bank expects the unemployment rate to drop to 3.5% in 2022, which will also put more pressure on the committee to move rates higher next year.
EXHIBIT 7: FURTHER IMPROVEMENT IN THE LABOR MARKET SHOULD ALLOW THE FED TO BEGIN A TIGHTENING CYCLE
WITH INTEREST RATES FACING UPWARD PRESSURE FOR THE FIRST TIME IN YEARS, HAVING A TACTICAL APPROACH TO FIXED INCOME WILL BECOME EVEN MORE IMPORTANT FOR INVESTORS
This year’s rising rate environment has been difficult for fixed income sectors, with many asset classes experiencing negative returns. U.S. Treasury yields spiked along with inflation expectations at the beginning of the year as the economy reopened and fixed income sectors suffered a sharp drop in returns. The 2-year U.S. Treasury’s total return is -0.45% so far this year and will likely close the year with a negative return, marking its first annual loss in more than 30 years. Lower credit quality and shorter-duration bond sectors have outperformed the broad fixed income market during this period of rate uncertainty.
EXHIBIT 8: 2021 CREATED CHALLENGES FOR LONG-TERM INVESTMENT GRADE & TREASURY INVESTORS
Lower credit quality sectors like bank loans or high yield bonds provide higher income and better performance during the interest rate volatility. In fact, Meeder’s overweight position to the high yield sector during the first part of 2021 protected the portfolio from the widespread drawdown at the beginning of 2021.
While our portfolios reduced lower credit quality exposure during the fourth quarter due to higher volatility and credit spread widening, we believe that overall credit fundamentals for high yield bonds remain strong. Default rates and credit spreads for high yield bonds continue to remain at historic lows, while the balance sheets for lower credit quality companies have improved due to cheaper debt refinancing. We believe this scenario is favorable for tactical positioning in high yield bonds in 2022. Tactical positioning in lower credit quality sectors along with a tactical duration strategy can provide more opportunities to improve total return in the current rate environment.
COVID-19 LIKELY TO BECOME AN INCREASINGLY MANAGEABLE RISK
Almost two years into the pandemic, various strains of the COVID-19 virus have claimed more than five million lives and affected billions more. As shown on Exhibit 9, we are currently amid another rise in cases related to the omicron variant, the most since the rise in the delta variant during Q3 of 2021.
EXHIBIT 9: OMICRON VARIANT HAS CAUSED A RECENT SPIKE IN CASES IN THE U.S. AND E.U.
Source: Our World in Data
In early results, the current vaccines appear to have lower vaccine effectiveness compared to the delta infection but are still moderate to high at 70 to 75%. While we are in no way infectious disease experts, there are reasons to be hopeful that, as time passes, this risk should become
» Pandemics historically do not die and go away, but they do fade away. Whether it is the Spanish Flu from 1918, SARS in 2003, or MERS in 2012, eventually the combination of immunity from surviving an infection or receiving a vaccination lessen the spread and severity of the virus
» We have multiple vaccines widely available, with the ability to adjust as variations of the virus appear, like how we tackle the seasonal influenza each year.
» Countries have learned more about managing the spread of COVID-19 that was not known at the beginning of 2020, making the potential of another widespread economic lockdown a low possibility.
The views expressed herein are exclusively those of Meeder Investment Management, Inc., are not offered as investment advice, and should not be construed as a recommendation regarding the suitability of any investment product or strategy for an individual’s particular needs. Investment in securities entails risk, including loss of principal. Asset allocation and diversification do not assure a profit or protect against loss. There can be no assurance that any investment strategy will achieve its objectives, generate positive returns, or avoid losses.
Commentary offered for informational and educational purposes only. Opinions and forecasts regarding markets, securities, products, portfolios, or holdings are given as of the date provided and are subject to change at any time. No offer to sell, solicitation, or recommendation of any security or investment product is intended. Certain information and data has been supplied by unaffiliated third parties as indicated. Although Meeder believes the information is reliable, it cannot warrant the accuracy, timeliness or suitability of the information or materials offered by third parties.
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