It’s time for our 2022 outlook, but let’s look back at what transpired last year before we do that.
In the Rear-view Mirror
Despite the continuing pandemic and global jitters about everything from climate change to inflation, the economy kept rolling in 2021. When 4th quarter data comes out in January, it will reflect that 2021 had the fastest (albeit erratic) GDP growth and the highest inflation since the 1980s. Given the continuing COVID saga, it turned out to be a pretty remarkable year for investment markets and client portfolios – the third year in a row where most asset class returns exceeded their long-term averages. We credit this good news to a few dynamics:
Continued progress in the battle against COVID
We’ve continued to state throughout 2021, the evolution of COVID will likely result in a world where we learn to live with it rather than eradicate it. Vaccines, boosters, and effective treatments to prevent hospitalization and death are where we find ourselves today. Yes – cases of the new variant are spiking again – particularly among the unvaccinated. Early data suggests the Omicron variant may be far more virulent but less severe than prior variants. If you’re a history buff, you’ll note that this is a similar pattern that emerged from the Spanish Flu of 1918. It never really went away – it evolved into the regular seasonal flu. Will Covid follow suit? Time will tell.
Companies did what they do
Whether the challenges faced are economical, governmental, or medical, companies (at least in a capitalist society) find a way to make money for their shareholders. Despite COVID fits and starts, supply chain disruptions, and D.C. gridlock, American companies are closing the books on 2021 with record earnings, improved profit margins, and more cash on the books than ever before. And since the investment markets reflect how people feel about future economic prospects, their stock prices followed suit.
Fed Policy: Steady as she goes
During the depths of COVID, the Fed flooded the market with liquidity by buying bonds – not just government bonds, but corporate bonds too. The result was an economy awash in cheap money. As the economy stabilized, Fed attention turned to watching inflation for signs of life. While there was plenty of conversation about when to taper back on bond-buying and when to ratchet up interest rates, 2021 was not the year for it, and the Fed made that clear. Markets love certainty and hate uncertainty and respond accordingly. (See our thoughts on 2022 Fed expectations later in this commentary.)
Political gridlock paid dividends
In January of 2021, the new President proposed a bold plan full of government spending and tax increases for companies and the wealthy. You’ll recall we advised everyone to sit tight and refrain from making any decisions because they were merely proposals. We also opined we wouldn’t likely see any legislation passed until at least summer, as the sausage-making in Washington moves typically at glacial speed. Other than the passage of a watered-down infrastructure bill in November, a closely divided Congress could not formulate any meaningful legislation involving proposed tax increases or much of the additional spending plans. With 2022 being a mid-term election year, we suspect many legislators will be turning their attention to re-election efforts.
Looking Out the Windshield: 2022 Outlook
If book recommendations were based on investor sentiment, the New York Times bestseller list would be topped by Charles Dicken’s Great Expectations. Markets have enjoyed three consecutive years of above-average stock market returns, fueling expectations among investors that 2022 will be more of the same. Our response would be, “Don’t count on it.”
The fate of the economy
Early estimates indicate that 2021 will likely print a real (inflation-adjusted) GDP growth number between 5 and 7 percent, marking one of the fastest on record. Setting inflation aside for a minute means our economy grew between 10 and 13 percent compared to 2020. For comparison, we experienced annual growth in the 4 percent range over the decade before COVID. The question is: will we continue to grow at this pace this year or see a return to something more normal? We think the reasonable expectation is a return to a more normal growth rate in the 4 percent range.
The most significant risk to continued growth is another round of economic shutdowns in the face of public health. While some countries have demonstrated a willingness to reimpose lockdowns, we don’t think there is an appetite for that here at home.
The end of tapering and interest rates lift-off
Back in March of 2020, when COVID hit our shores, the Federal Reserve, whose job is to foster stable growth of our economy, pulled out all the tools in their toolbox. First, they dropped interest rates to near zero, and then they embarked on a bond-buying campaign. These actions attempted to create demand in the financial markets and stimulate the economy throughout the pandemic.
When you increase demand and reduce borrowing costs, stock values typically increase—one reason the stock market had such a good year. But with an economy growing like ours is now, it’s time to put these tools back in their toolbox.
The Fed’s bond-buying campaign will likely conclude in March, and the consensus is building that they will begin raising interest rates in May or June. Odds are leaning toward two, maybe three increases this year.
If lowering interest rates stimulates stock prices, what do you think happens when rates go up? If your answer is stocks will go down, you’d be partially correct. Whether stock prices decline because of rising interest rates boils down to how much those rates increase. The stock market seems to be accepting the prospect of three increases this year (the Fed usually increases rates in 0.25% increments, so that means they would go from 0 to 0.75% by the end of the year). If that is what plays out, we wouldn’t expect much impact on the markets. However, if the Fed were to increase rates four or more times, or increase them in larger increments, say 0.5%, that could cause some heartburn. The last time this happened was in December of 2018.
Oh great, more politics
We have another round of mid-term elections in November, if you didn’t know. We inevitably get the same question around every election season, “should I do something different with my portfolio in the face of the election?” Our answer remains the same – NO, your portfolio doesn’t care about politics. Two things determine the outcome of your portfolio: corporate profit growth and interest rates. Actually, there is a third more important influencer: your behavior. Let’s focus on these three and leave politics alone.
Bringing it all together: what should you expect for 2022?
We are watching two things with intensity: corporate earnings growth and Federal Reserve policy decisions. In our opinion, these two factors will determine financial market outcomes. If corporate earnings continue to come in better than expected, stocks should continue to climb. But by how much? Be patient. We are getting there. If interest rates continue to rise, the value of bonds already in the market (and in your portfolio) will face a headwind. We expect bond assets to break even this year.
Even though we expect stocks prices to continue climbing this year, the U.S. stock market just completed three years of double-digit annual returns. That has only occurred five times in the last eighty years. At the beginning of last year, we told you that a 3-peat was very rare, and four years in a row is even rarer (although it has happened). We’d be happy if stocks earned between 6 and 9 percent this year.
If stocks earn between 6 and 9, and bonds are flat, then a balanced portfolio split equally between them should earn between 3 and 5 percent. More growth-focused investors would earn a little more, while more conservative investors should expect less. As is the case with investing, nothing is guaranteed – and we aren’t making any guarantees. These are just our guestimations based on current events.
If we do get a 4-peat we won’t be upset.