In our Q3 market commentary, we described the primary economic fears behind a lackluster and trendless market. Importantly, we said those fears would dissipate in the months ahead and push equities higher into the new year. Our forecast initially proved prescient, as concerns about the Federal Reserve and the delta variant waned. Then midway through the quarter, the omicron variant gained a foothold. The Fed, on the back of stubbornly high inflation, corrected course by increasing its pace of tapering and forecasting interest rate hikes in 2022.
A sharp sell-off ensued from mid-November to December, especially in cyclical and economically sensitive sectors and value stocks. After starting the quarter with a nearly 10 percent advance, the S&P 600 index (U.S. Small Caps) fell nearly 11 percent from their mid-November highs. Even more “virus” and “recession-proof” areas of the market, such as U.S. Large Cap growth stocks, experienced a pull-back — though it was a milder 4 percent decline. As we pushed through the holidays and the market digested news of omicron and the Fed’s policy pivot against a still-strong economy, cyclical and economically sensitive asset classes helped lead markets higher once again.
Earnings growth will moderate but prove to be enough for the stock market to climb higher.
Shifting leadership wasn’t a single-quarter storyline. The market experienced multiple twists and turns in sector leadership, as a recovering economy and easy money pulled one way while inflation and COVID-19 concerns pulled in another. Cyclical and economically sensitive sectors and value stocks took the lead when COVID-19 cases were on the decline and the “reopening trade” was in full swing but ceded leadership to “virus”-resistant sectors when COVID and inflationary fears reignited.
We think investors should expect to travel a similarly winding road in 2022. Despite current omicron health challenges, it’s likely this wave, like others, will peak and subside, probably sometime in Q1. Economic growth will remain strong, and fears about inflation and the Fed will once again cool from a boil to a simmer. Supply chains and the labor market are going to catch up, and that will essentially kill two birds with one stone (inflation and concern about the Fed moving too swiftly to fight it). Taken together, that’s a recipe for a market that will be pulled higher through the first half of 2022.
However, the second half of 2022 could prove challenging as investors attempt to pinpoint where we are in the current cycle, which could foster a turbulent market.
Our 2022 outlook in a nutshell
The past two years have been anything but normal. The period started with a large economic and market plunge in early 2020, followed by a robust recovery through year-end 2021. At long last, we believe 2022 will mark the beginning of a return to pre-COVID-19 conditions. We expect economic growth will remain strong and above intermediate- to long-term trends but don’t expect the torrid pace of growth set in 2021. Inflation, too, will hover above its historical trend but, notably, will pull back from today’s elevated levels. Monetary and fiscal policy will remain accommodative but pared back from the emergency measures implemented over the past two years. Lastly, earnings growth will moderate but prove to be enough for the stock market to climb higher. Cyclical and economically sensitive sectors and value stocks will stand to benefit most, particularly in the first half of 2022.
Strong economic growth, diminishing inflationary pressures
Let’s dig deeper into data supporting our outlook. The Conference Board Index of Leading Economic Indicators currently resides at a six-month annualized rate of 9.5 percent, which points to strong economic growth in the coming quarters. While COVID-19 surges remain a wild card, any resulting pull-back in the nearer term simply pushes growth further into the future — it’s not eliminated. U.S. consumers remain in terrific condition, and since the Great Recession they’ve reduced their debt-to-net-worth ratio from a peak of 24 percent in 2008 to 12 percent as of the last reading in 2021. What’s more, the cost of consumers’ diminished debt load relative to their monthly disposable income has fallen from 18 percent in 2008 to its most recent reading of 13.8 percent. Undoubtedly, fiscal and monetary policy have helped bolster household balance sheets, but job growth and pay increases have been picking up (and will continue to do so) where stimulus left off.
But there are challenges
That’s the good news. The bad news is that consumer spending in 2021 has pushed the gas pedal on inflation and kept it there. Many are wondering if we’re entering a new paradigm of sustained, heightened inflation circa the 1970s and ’80s.
We believe as we push through the beginning of 2022, both spending and inflation will moderate. Current inflation is being primarily driven by a domino effect of forces stemming from COVID-19 adaptations: An economy flooded with fiscal and monetary relief propelled a spending shift toward goods over services, which created labor shortages that pushed wages higher.
Before we comment on how each of these will likely subside in 2022, let us first make one brief comment on COVID-19. While predictions on the pandemic have been divergent and often wrong, a growing number of health officials are saying omicron may mark a tipping point that moves COVID-19 from a pandemic to something more endemic. Whether this proves to be correct or not, we continue to believe that each variant wave has impacted economic growth to a lesser degree than the prior wave.
Current inflation is being primarily driven by a domino effect of forces stemming from COVID-19 adaptations.
Now, back to inflation. Consumers in the virus-impacted economy of 2020 and 2021 changed their spending habits from services to goods. Real, inflation-adjusted spending on goods is up 15.3 percent from its pre-pandemic level versus the service sector (most of the U.S. economy), which remains 1.5 percent below its year-end 2019 level. This rather swift pivot to goods spending stressed supply chains, clogged U.S. shipping ports and ignited the current bout of inflationary pressures. Goods inflation is now up 8.5 percent year over year after more than a decade of flat prices. Drilling one level deeper, durable goods inflation is up 9.7 percent year over year. This is in sharp contrast to the past 25 years of deflation, when prices declined about 1.9 percent on average every year. We believe that spending on goods has been pulled forward, and consumers will shift back to spending on services, which will alleviate supply chain-induced inflationary pressures.
Whatever 2022 brings, we believe prudence, diligence and adherence to fundamental investment principles creates the best long-term outcomes.
Labor shortages have made it difficult to catch up with demand and pushed wages higher as companies aim to retain and attract workers. There’s good news on this front, but it also is an indication that the second half of 2022 could become a bit more difficult. Pandemic unemployment benefits, excess savings and COVID-19 difficulties have likely kept many potential workers on the sidelines. We believe that we will continue to see many of these workers return to the labor market. Nearly 10 million Americans stopped receiving pandemic unemployment benefits in September 2021. The good news is that there are currently more than 10.6 million job openings in the U.S. economy. As these individuals return to the labor market, it should help alleviate supply concerns and wage inflation.
However, this is where our second-half concerns creep in. Pre-pandemic, 63.4 percent of working-age Americans were participating in the labor market, either through employment or looking for jobs. The unemployment rate back then was 3.5 percent. This was a tightening labor market and indicative of an economy that was running out of economic slack and pushing toward the latter stages of a business cycle. Now, let’s take these 2019 numbers and compare them to today’s realities to estimate how much labor slack we have as we lurch back toward pre-pandemic economic conditions. Roughly 156 million Americans are currently employed, according to the U.S. Bureau of Labor Statistics. If we assume a return to 2019, the number of employed Americans would rise to approximately 160 million. This implies that we have an additional 4 million Americans to employ before we arrive at a tight labor market once again. While that may sound like a lot, keep in mind there are 10.6 million job openings, and we added more than 6.1 million in 2021.
In 2019, the economy was moving toward the end of a business cycle. While we had a deep recession in 2020, it was short-lived with an incredibly swift recovery. It is likely that in the second half of 2022 we will once again approach that latter stage of a business cycle, which could result in jittery markets as investors question how far along we are.
We believe as we push through the beginning of 2022, both spending and inflation will moderate.
Of course, the above narrative assumes all other factors remain equal. We think the economic cycle could last well beyond 2023, as productivity gains from technological advancement and business investment could bear fruit. An economy’s capacity is determined not only by how many people work but also by how efficient they are. If we push nearer to full employment, productivity and efficiency will improve and should conspire to keep the economy humming into 2024. We will be watching those numbers closely for evidence that our forecast is accurate.
Economic adaptations have created market oddities
Against rising inflationary pressures in 2021, interest rates rose but in a very measured manner. This has resulted in near-record levels on negative real interest rates, which has led investors to accept heightened levels of risk and push up valuations to extreme levels in many parts of markets. As 2021 ended, some of these oddities began to correct without causing broader market dislocations. Many of these oddities are confined to what we’ll call the “hopes, dreams, themes and memes” sector — for example, unprofitable tech stocks and stocks being driven higher by message board chatter. After a torrid rise in 2020 and early 2021, these stocks have fallen rather sharply. We believe this will continue in 2022 as real interest rates rise on the back of the Federal Reserve buying fewer Treasurys and eventually tightening monetary policy.
There are other market oddities that we believe will revert to their longer-term trend. Growth stocks, in general, trade near all-time high valuations relative to value stocks. The valuation gap between U.S. Large Cap stocks and U.S. Small Cap stocks has never been wider. The same gap exists between U.S. stocks and International stocks. Because of this vast divergence in relative valuations, investors may want to focus, or tilt, their portfolios to favor cheaper stocks or sectors with lower relative valuations. While this may sound obvious, in practice investors remain heavily focused on longer-term growth prospects versus cash flows and earnings today. We believe 2022 is the year economic and market oddities are smoothed out.
The final word: discipline, as always
We are now heading into year three of a pandemic, and COVID-19 remains a key variable as we navigate this ever-changing environment. In our 2020 outlook, the word COVID-19 didn’t appear once. Two months after publishing that outlook, COVID-19 became the only word that mattered to markets. Our 2020 outlook had already grown stale. However, as any rational investor does, we adapted our outlook based upon new information. However, our investment philosophy and process never changed.
This is a critical point. We always have a broad outlook regarding economic conditions and the trajectory of markets. That can change — and should — as conditions warrant. So, we build in wiggle room to allow for adjustments; the world is too dynamic to remain inflexible. However, nothing will alter our commitment to time-tested money management principles. We will not chase a fad, a new so-called paradigm or a shiny new asset class and deviate from what we believe wins the long-term game.
Whatever 2022 brings, we believe prudence, diligence and adherence to fundamental investment principles creates the best long-term outcomes. Investors can reflect the same philosophy by building a strategic, personalized financial plan with the help of an expert advisor. Your roadmap will get you to your destination. While figurative construction and traffic jams may require tweaks as your situation evolves, don’t fall prey to following the herd to the new flavor or fear of the day. Drastic deviations can result in lasting mistakes. A financial plan ensures you’ll be ready for whatever comes your way. Happy New Year, and cheers to a principled, long-term approach to building wealth.
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As the chief investment officer at Northwestern Mutual Wealth Management Company, I guide the investment philosophy for individual retail investors. In my more than 25 years of investment experience, I have navigated investors through booms and busts, from the tech bubble of the late 1990s to the financial crisis of 2008-2009. An innate sense of investigative curiosity coupled with a healthy dose of natural skepticism help guide my ability to maintain a steady hand in the short term while also preserving a focus on long-term investment plans and financial goals.