At the close of business on Friday, global equities were mixed, with North American and Japanese equities declining while European equities and China saw modest increases as the US Federal Reserve hinted it might more aggressively remove stimulus.
The yield on the US 10-year Treasury note spiked to 1.79% from 1.50%, matching its 2021 high, as investors assessed the Fed’s more hawkish stance. The price of a barrel of West Texas Intermediate crude oil increased to $79.15 from $75.50 while volatility, as measured by the Cboe Volatility Index (VIX), rose to 19.6 from 17.7 on the week.
2021: The year in stocks
The S&P 500 Index rose 26.9% in 2021, marking the benchmark’s third straight positive year. The Dow and Nasdaq also notched three-year winning streaks, gaining 18.7% and 21.4% for the year, respectively. The S&P 500 notched 70 record closes this year, the second-highest annual tally behind 1995′s 77 closing highs, posting at least one new record close every month since November 2020. The longest span without a new high in 2021 was 33 trading days between record closes on 2 September and 21 October.
Energy and real estate were the best-performing sectors in the S&P 500 this year, surging over 40% each. Tech and financials also rose over 30%. The Canadian TSX rose 21.74%. The MSCI World Index rose 20.1%. The estimated year-over-year earnings growth rate for 2021 was 45.1% which marked the highest annual earnings growth rate for the index since it began tracking the metric in 2008. According to Bank of America’s Flow Show report, global equities attracted a record $949 billion of inflows in 2021, exceeding the cumulative inflow of the past two decades.
Stocks are poised to deliver positive returns in 2022, but likely not as much as they did in 2021, as earnings growth slows and the Fed tightens. Attempts by the Federal Reserve to tighten monetary policy might affect real rates, with an impact on the markets and the economy. Growth stocks could continue to outperform value if interest rates stay low. They have been leading the market since 2014.
I expect that the secular bull market that began in 2009 will continue, driven by demographics, low rates, and strong cash flows from the big growers.Your portfolio has largely been overweight in the US for much of the last decade. Since the brief-but-sharp 35% decline almost two years ago, US stocks have risen to record highs, thanks in part to the timely and massive fiscal and monetary policy response to COVID-19 and the resulting lockdowns. Now as 2022 begins, I expect the markets to mean-revert to trend-like growth, and for the Fed to take the first steps on the road back to a neutral monetary policy.
Most economic indicators suggest that the developed markets remain in the mid-phase of the business cycle, following the early recovery from the pandemic in the second quarter of 2021. There are hints of late cycle, but they are coming mostly from the tight labour market. For 2022, I expect stocks will perform much as they have in previous mature mid-cycle expansions by continuing to advance, but not as much as they did earlier in the cycle when the economy was just emerging from the COVID recession.
The reason for slower growth in stock prices is two-fold. First, earnings growth is likely peaking now, at the same time that the Fed begins to remove liquidity from the system. Earnings growth in 2021 was 45%. In 2022, earnings are expected to continue growing, but at a slower pace, with consensus estimates at 8%. During the earlier part of the recovery, stock valuations rose sharply, simply because price often bottoms before earnings. Since then, earnings have done the heavy lifting for this bull market. But like seasons in the year, we now enter that phase of the cycle where earnings growth slows to a more trend-like pace. That’s still a positive for stocks, especially against the backdrop of low interest rates.
The Fed, growth, and inflation
Just as it has for the past several years, the Fed will continue to play a big role in 2022, but for somewhat different reasons. After taking extraordinary measures to stimulate the recovery, the Fed is now looking to step back and end—or “taper” in Fed-speak—its bond purchases in anticipation of raising interest rates back to what it considers a neutral policy (2.5%). The Fed needs to normalize policy because its dual mandate of full employment and 2% average inflation has now either been met or exceeded.
As 2022 begins, unemployment has fallen back to where it was before the pandemic (and near what the Fed considers full employment), while inflation is well above 2%. Therefore, there is no longer any justification for the Fed to keep rates at 0% and buy $120 billion worth of bonds each month. In retrospect, the Fed probably should have normalized policy sooner. But given how big a role the Fed has played in adding liquidity to the markets, stepping back may not be as simple as it sounds.
The market’s current wobble is evidence of that. I think we will see more of that in 2022 (corrections within a bull market), as the market and the Fed dance between market expectations and Fed policy. My sense is that the Fed has some goodwill from the markets, which have accepted that the Fed will taper its asset purchases more quickly than had been expected. They really have the next couple of quarters to figure out how often and how high to raise rates. It’s plausible that by the time it needs to decide, the inflation fever may have broken.
In my view, 6% or 7% inflation will not persist. There’s a school of thought that inflation is currently high because a lot of companies double-ordered inventory during the last few months because of supply chain bottlenecks. That has made those bottlenecks worse, but if economic activity slows, companies may end up with excess inventory and inflation could slow. If that happens, the Fed could stay with its original plan to gradually raise rates over a few years, rather than being forced into tightening faster than the markets can withstand.
What to invest in for 2022?
While 2022 will probably be a positive year for stocks overall, it’s less clear how various types of stocks may perform. In 2021, growth stocks and value stocks took turns outperforming each other and that could continue in 2022. If interest rates stay low in 2022, growth stocks could well continue to dominate because value tends to be more of a play on inflation.
Interest rates matter a lot for how this will play out. For investors, there’s not much reason anymore to buy bonds for their yield (nominal or real), other than for their diversification benefits. The diversification effect or ability of bonds to protect against drawdowns in stocks remains proven.
Riding a secular bull?
As 2022 begins, I believe we’re still in the secular bull market we have been in since 2009. Everything that the market has done since that point has been consistent with how secular bull markets behave. The recovery has been fast and furious, and the market continues to behave like a secular bull market. If it continues to follow the pattern of past secular bull markets, the S&P 500 could reach 8,000 in the next five years. Twenty-one months ago that may have seemed pretty outlandish, but it’s been following the historical analogue of previous secular bull markets consistently. The further it continues to do that, the less outlandish that 8,000 is going to look.
In our client meetings this past week, I have recommended taking a more defensive position as we start 2022. Our firm has always driven to provide strong risk-adjusted returns and we fully expect that we will deliver the same in 2022.