Market Perspective - Where We’ve Been and Where We’re Going: What to Watch in 2022
Market Perspective - Where We’ve Been and Where We’re Going: What to Watch in 2022
The books are closed on another strong year for U.S. equity markets as the COVID recovery, fueled by fiscal and monetary stimulus, continued. The S&P 500 Index reached new all-time highs 70 times in 2021. Meanwhile, international stocks underperformed on a relative basis.
Fixed income markets continued to struggle with low yields and low (or negative) returns.
COVID cases have risen sharply as Omicron emerged as the latest variant. Cases have generally been milder than prior variants, and markets have largely brushed off the latest wave.
Several macroeconomic risks emerged in 2021, including inflation concerns, rising energy prices, supply chain disruptions, and speculation in certain asset classes.
Geopolitical risks, including flashpoints in Russia and China, have re-entered the lexicon for investors as low probability but higher-risk concerns.
Central banks and governments around the world have flooded economies with liquidity, and low interest rates persist. These factors have further boosted the availability of capital. There are a variety of signs that this may be changing in 2022.
The clean slate of 2022 brings with it a host of opportunities as well as investor concerns. As always, we remain focused on creating diversified portfolios to provide investors with a favorable mix of assets for the long-term.
“We must respect the past, and mistrust the present, if we wish to provide for the safety of the future.” ~ Joseph Joubert
The combination of enormous global liquidity, increasing corporate earnings, strong balance sheets, COVID’s diminishing importance in consumer sentiment (compared to 2020), and a variety of other factors led to a continued rise in many asset prices around the world. The chart below shows the performance of the major global equity indices in 2021.
Fixed income returns have been poor with interest rates at or near historic lows, as shown in the chart below.
Summary of 2021
Looking back, 2021 was a year marked by a strong but somewhat narrow market advance. Of the major geographic regions, U.S. markets led the way. Under the surface, however, the U.S. exhibited more narrow leadership, concentrated once again on the largest mega-capitalization companies, which dominated performance. Meanwhile, smaller companies generally underperformed, despite some pockets of strength in smaller, value-focused companies. On the international side, developed world markets lagged the U.S., but remained positive. Despite strength in countries such as India and energy-producing nations such as Russia, emerging markets were the most challenged, as they were weighed down by regulatory concerns created by ever-changing Chinese government policies. The Chinese markets were the worst-performing of the major regions of the world due to these regulatory concerns. In fact, U.S. markets outperformed emerging markets by the largest margin since 1998. Furthering the discussion to other asset classes, fixed income markets remain challenged with historically low yields coupled with rising interest rates. The most commonly followed bond indices were generally negative on the year. The S&P 500 outperformed the Bloomberg Barclays Aggregate Bond Index by the widest margin since 1977 (source: Ned Davis Research).
Uncertainty remains elevated, as a host of important factors have the potential to steer economic and market direction in 2022. Below are some of the key questions to watch as the year progresses.
1. What are the main drivers of inflation going forward? If rates rise and/or inflation remains elevated, what strategies should we be focused on?
Elevated inflation currently poses one of the more significant risks to the ongoing economic recovery. As a reminder, inflation is a rise in prices and the accompanying weakening of purchasing power. This negatively impacts consumers’ ability to purchase goods and services. There are several main areas economists are focused on related to inflation:
Supply Chain: The highly disrupted global supply chain is in the process of healing. However, backlogs remain high, and inventory levels are struggling to rise to levels that could return the market to equilibrium. While uneven, some of this mismatch may continue to correct as the year progresses.
Labor Markets: Uncertainty remains high in labor markets. Large numbers of employees are switching jobs and wage inflation—a major concern for the Federal Reserve—is elevated. Anecdotal evidence of labor shortages are widespread, and wage inflation is showing up in the data (as shown below). Market participants will be closely watching for signs that the labor markets are normalizing over the course of 2022.
Elevated inflation is one of the top items to watch in 2022 because it often results in rising interest rates. Traditionally, rising interest rates benefit value-focused equity sectors, such as utilities, industrials, and financials. Growth sectors, such as technology and new media/communications, tend to underperform in a rising interest rate environment, as higher discount rates affect long-term valuations. Fixed income returns may also be challenged, particularly with longer duration, interest rate-sensitive bonds. Interest rate securities with shorter maturities and/or floating interest rates may outperform.
2. The Federal Reserve (the “Fed”) recently announced it would end its asset purchases. What happens when they raise interest rates?
Critical to the longer-term outlook is the role of central banks around the world. In many regions of the world, the U.S. included, policy appears to be shifting from an accommodative stance to a slow tightening process, in part to fight elevated inflation (with exceptions in some regions, such as China, which may be growing more accommodative). Central bank stimulus has been a powerful market force in recent years, as shown in the chart below. Higher growth companies tend to underperform in a rising rate environment, and interest rate-sensitive assets, such as banks and other value stocks, tend to outperform. While the market is currently anticipating a number of rate hikes in 2022, the pace, and size of those hikes will be closely watched.
3. How should we think about potential policy changes in Washington as Congress continues to negotiate over trillions more in stimulus and tax changes?
Over the last two years, trillions of dollars of fiscal stimulus have been poured into the economic engine to stimulate growth and help with the pandemic recovery. More may be on the way, as Congress continues to debate President Biden’s “Build Back Better” plan. The current debate in Washington centers around how to pay for this stimulus as well as the concern that more spending may actually accelerate inflation. This political wrangling becomes more difficult as the calendar slowly rolls toward the upcoming mid-term elections. Needless to say, investors will be closely watching for possible policy changes.
4. Since international equities have been underperforming for such a long time, why should investors maintain exposure to those stocks?
Another trend that has been firmly in place in recent years is the relative outperformance of U.S. stocks vs. the rest of the globe. Markets tend to move in cycles over time, and the current cycle of U.S. equity strength has persisted for some time. However, the opposite has also been true. In prior cycles, international stocks outperformed U.S. stocks for long periods of time, as shown in the chart below. In other words, these trends tend to be cyclical and extremely difficult to time.
International investing has also served as a diversifying force for long-term investors. For example, from 2001–2012, the S&P 500 Index rarely achieved new highs, excluding a total of 14 new highs that all occurred in 2007. During most of these years, international markets outperformed and thus served as a valuable source of diversification. Unfortunately, investors can’t know in advance when cycles will shift, and timing markets is virtually impossible. Therefore, it can be valuable to maintain diversifying exposure to international equities despite the ongoing lengthy period of U.S. outperformance.
5. Are valuations a concern after such a large market rally?
Valuations can be measured with a wide variety of metrics. One of the most commonly used data points is the price/earnings (“P/E”) multiple. During the recent market rally, while the numerator (price) has risen substantially, the denominator (earnings) has risen even more. In other words, the P/E multiple on the broad market has actually declined over the course of 2021. This does not mean that the market looks inexpensive. By most measures, the S&P 500 is above its historical average. However, it is not as expensive as many may think, as shown in the graph below. Investors will be closely watching the direction of future earnings. If earnings growth begins to slow and/or decline, markets may follow.
6. What if Russia invades Ukraine or China invades Taiwan?
Geopolitical events are rarely long-term market movers, however in the short and intermediate term, they can cause significant dislocations. In either of the above scenarios, there may be a need to reposition portfolios based on specific outcomes. But even the most significant geopolitical events (e.g., 9/11, the invasion of Iraq, etc.) have been nothing more than blips on the long-term charts. That said, these geopolitical concerns are on most investors’ watch list for 2022.
7. Are markets really this strong despite the headlines we keep hearing?
Markets have once again exhibited extremely narrow breadth, with a handful of mega-capitalization stocks (most of them technology-focused) leading the charge. This narrow concentration led to the top five S&P 500 contributors (Microsoft, Apple, Google, Nvidia, and Tesla) representing 32.6% of the total S&P 500 return for the year. Microsoft alone was just under 10% of the S&P 500’s performance in 2021. The top 25 S&P 500 contributors were over 55% of the total return (source: Goldman Sachs Global Investment Research, Factset). In summary, this suggests that below the surface of headline major index performance, the picture is less rosy for a large number of individual stocks.
8. What should we expect from markets in 2022?
Predicting and forecasting markets is a challenging exercise. It is rather surprising that despite the ongoing COVID-19 pandemic, markets have remained extremely resilient, forgoing the normal back-and-forth they typically experience. Much of this has to do with the ample amounts of liquidity in the capital markets. However, with central banks likely withdrawing liquidity in the coming months, investors are expecting increasing volatility. 2021 saw no meaningful pullbacks in the S&P 500, with minimal volatility from a historical perspective. As the chart below demonstrates, in most years, markets show meaningful declines intra-year, as represented by the red dots below. In other words, market volatility is a normal part of the investment process and can be expected going forward.
9. How is the rise in cases of COVID impacting the economy?
As scientists debate the severity, infection rate, and ongoing rise of cases globally of the Omicron variant, investors are focused on its economic impact. The holiday season sales appear to have ended strongly, with consumer behavior largely unaffected by the ongoing Omicron wave although closures in some sectors due to lack of staff have become a short-term issue. Retail sales were strong, with full December numbers expected to be reported on January 14. Even directly impacted areas such as travel continued to recover according to the latest TSA data (see graph below). While COVID remains at the forefront of media attention and investors are watching it closely, the economic impact has been modest in the most recent wave.
In summary, our team at BDO Wealth remains focused on the risks and opportunities that will define the year ahead. We would be happy to provide additional perspective on the key themes driving markets today. As always, please reach out to your BDO Wealth Advisor if you have any questions.
BDO Wealth Advisors, LLC is a Registered Investment Adviser dedicated to providing clients with unbiased, personal financial advice. Working in partnership with our clients, our wealth management team helps organize, enhance, manage, and preserve wealth through sound financial strategies. This information is provided by BDO Wealth Advisors for the personal use of our clients and friends. It should not be construed as personalized investment, tax, or legal advice. Information compiled from Ned Davis Research and additional third-parties. Please be sure to consult your CPA or attorney before taking any actions that may have tax consequences and contact BDO Wealth regarding any investment decisions. Every investment strategy has the potential for profit or loss.