How to Adjust Your Portfolio for 2022
Equities are likely to provide solid returns in 2022 that fall short of the outsized gains of recent years but remain superior to the uninspiring returns likely from the bond market. Economic and earnings growth should continue to exceed pre-pandemic levels, though rising wages and interest rates will put pressure on corporate profit margins and valuation multiples.
COVID-19 and inflation are among the risks to the favorable market outlook. 2022 began with a surge in COVID-19, with more than 1 million new cases reported after the New Year’s holiday. The Omicron variant appears to be far more contagious than Delta but so far is causing fewer hospitalizations and milder symptoms for most of those infected.
Investor sentiment appears to reflect the belief that COVID-19 will never be completely eradicated and that we must “learn to live with COVID.” The positive economic news is that most countries have been reluctant to reinstate the restrictive measures employed during earlier stages of the pandemic. China’s “zero-COVID” policy is a notable exception. The emerging consensus is that Omicron will slow economic growth but not cause growth to stall. The widespread rollout of booster doses and availability of effective and safe antiviral drugs should limit Omicron’s impact on economic activity to the first half of 2022, and the pandemic will likely recede in importance in comparison to 2021.
Inflation in 2021 reached levels not seen in decades. The surge in inflation is attributable in part to factors that should slow or reverse course during 2022. Goods demand should decline from peak levels, easing supply chain challenges creating congestion at and around major U.S. ports. The pandemic created a spike in demand for goods such as home furnishings, computer equipment, and recreational goods that became necessities for a world in lockdown. That surge in demand is not likely to be repeated, even if the Omicron wave continues for longer than current expectations. New and used car prices have been major contributors to the inflation surge and should stabilize as semiconductor production increases to catch up with demand. Rising U.S. rig counts and increasing production from OPEC + make it likely that oil prices will not repeat the rapid rise that created strains for consumer finances last year. Wage pressures are important to monitor – the tight labor market is the most significant threat to the consensus outlook for inflation.
Federal Reserve policy will be influenced by the stickiness of near-term inflation pressures and changes in long-term inflation expectations. Market-implied inflation expectations signal that investors expect inflation to stabilize at rates slightly above pre-pandemic levels. De-globalization, aging demographics, and a continued downturn in immigration are among the factors likely to push long-term inflation above pre-pandemic levels. The market expects inflation to settle in the 2.5% to 3% range over the next couple of years; the Fed is likely to act more aggressively to raise rates if long-dated inflation expectations rise meaningfully above that range. A more aggressive rate hike cycle would increase the risk of a Fed-policy induced recession.
The Fed’s actions will also be influenced by the labor market, with the supply of labor a key factor that may cause the Fed to move sooner rather than later. The economy may not return to pre-pandemic levels of labor participation, as some of the workers who left the workforce to retire or care for the young or old may not be coming back. Net immigration is at the lowest levels since the 1980s, creating additional strains for labor markets. The Fed is now expected to raise rates in March, sooner than many analysts expected at the end of last year. The Fed may move fewer times in 2022 than is currently forecasted by market prices unless economic growth and inflation remain significantly above pre-pandemic levels.
Stocks remain more attractive than bonds, despite the abundant risks to the market outlook. Continued strength for the global economy and for corporate profits should help equities, with strong household balance sheets, accumulated savings, and rising wages providing a positive backdrop for consumer spending in 2022. Although tighter fiscal and monetary policy will have an impact in 2022, policy should not be restrictive enough to push the economy into recession.
The S&P 500 and NASDAQ indexes are now dominated by a small number of stocks that have been the big winners from technology-driven innovation and from changes in how we work, where we work, and the nature of how our economy works. Elevated valuations, potentially unrealistic growth expectations, and heightened antitrust scrutiny are risks that cloud the outlook for these market-leading stocks. In a market environment in which gains may be harder to come by, investors should build a well-balanced portfolio that includes but is not dominated by a small number of companies.
Selectivity is vital for those who invest in small company stocks. Although many of tomorrow’s market leaders will come from the ranks of today’s small companies, a far greater number of small companies will stagnate or shrink in value. There is particular risk among the many small cap technology and biotech companies that have high valuations and minimal near-term revenues, making them more vulnerable to rising interest rates that cause far-in-the future earnings to be discounted more steeply. Consequently, it may be appropriate to invest with fund managers who have experience distinguishing between winners and losers in this high-potential but high-risk segment of the market.
Valuations outside the U.S., particularly in emerging markets, are at extremely low levels relative to U.S. stocks. International stocks ended 2021 trading at more than a 30% discount to the valuations of U.S. stocks, a much wider valuation gap than is typically the case. Pure cheapness isn’t enough to create a rally in international stocks, as absent a meaningful catalyst, valuation differentials can persist for many years. There are multiple potential catalysts for the valuation gap to close in 2022. A Chinese economic recovery is one such catalyst. The latest economic releases suggest that China’s credit cycle has bottomed, which would help the growth and earnings outlook for the second half of 2022. Given the importance of Chinese growth to the rest of the world, a rebound in China would also help the more cyclical economies of Europe and Japan. A shift from dollar strength to dollar weakness would also help international markets.
A well-diversified allocation to bonds remains a necessary counterweight to equity risk. Short-term, high quality fixed income holdings will provide safety and liquidity but unfortunately not a lot of coupon income in a low-rate environment. Selective use of corporate and mortgage-backed bond holdings can provide incremental income relative to government bonds; investors in high tax brackets should also consider municipal bonds.
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This communication may include opinions and forward-looking statements. All statements other than statements of historical fact are opinions and/or forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the beliefs and expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such beliefs and expectations will prove to be correct.