As our investment team looks ahead in 2022, we see an interesting mix of both tailwinds and headwinds affecting the overall investment environment. We believe that the prevailing environment favors a patient, long-term approach to investing.
On the positive side, U.S. economic growth should continue with strength. We expect S&P 500 earnings to remain healthy, which bodes well for U.S. stocks overall. While inflation will likely increase during the first half of the year, it should moderate later in 2022. Meanwhile, we believe that the biggest risk facing investors is a potential policy error on the part of the U.S. Federal Reserve (the Fed). In the current context, the most likely form of policy error would involve the Fed raising interest rates and removing stimulative support too quickly and aggressively. We also anticipate a higher likelihood of market corrections in 2022 due to rising rates, geopolitical risks, and other factors.
Here are five market themes we will be watching particularly closely in 2022.
Inflation, interest rates, and the risk of Fed policy error
We expect that ongoing supply chain issues and record amounts of cash on consumers’ balance sheets will continue to push inflation higher during the first half of the year. Certain sectors, including energy and industrials, are likely to see the strongest price increases due to higher demand.
The Fed has signaled that it will raise the federal funds target interest rate at least twice in 2022. As rates rise, the money supply is unlikely to increase as it did in 2021. Rising inflation should push the 10-year Treasury yield upward as investors sell long-term bonds to stop inflation from eating into the coupons investors earn on these fixed-rate securities.
Perhaps the biggest threat to the stock market, however, is a Fed policy error. In the present environment, this would happen if the Fed raises the fed funds rate too soon and too aggressively in an attempt to curb inflation. An error like this could damage U.S. and global economic growth as lending capital becomes more expensive. Conversely, it is also possible that the Fed could move too slowly to combat inflation, increasing the risk of a more protracted and pronounced period of rising prices. As you can see, the Fed faces a difficult balancing act.
While rates for mortgages and other forms of debt will likely increase in 2022, it is important to note that interest rates are starting their rise from historical lows. Even if the Fed hikes rates twice in 2022, which is the current consensus expectation, short-term interest rates would remain well below long-term averages. Consumers will likely try to get ahead of coming rate increases by taking advantage of low mortgage and other lending rates.
Strong but slower corporate earnings growth
We expect positive corporate earnings growth to continue in 2022. However, this year will likely see the peak of the growth cycle that has taken place since the recession caused by COVID-19 in early 2020.
While the earnings cycle remains positive, momentum within the cycle is likely to slow as 2022 progresses. After the Fed’s initial rate hikes, we should have more clarity regarding Fed policy. This could help growth stocks, but the magnitude of the interest rate hikes is yet to be seen. Assuming sound (not overzealous) interest rate hikes, we expect growth to continue to outperform value stocks over the near to medium term. After 2022, corporate earnings should moderate toward long-term averages.
Increasing odds of a market correction in 2022
While we expect U.S. equity markets to deliver reasonably strong returns in 2022, there is a higher likelihood of at least one 10% correction during the course of the year. Such a correction may happen during the second or third quarter as the Fed begins to raise interest rates. Still, it is important for investors to remember that corrections are nothing to fear. In fact, corrections typically are healthy for markets, as they help to push valuations back to more rational levels.
Although investors have gotten accustomed to shorter, less severe “COVID corrections” that are influenced by the news cycle, these types of corrections aren’t the historical norm. In a pre-COVID world, markets averaged about two to three corrections of 10% or more per year. In our opinion, the stock market is long overdue for a correction. We expect bigger, more structural drawdowns going forward as the market returns to more normal trading patterns.
Lingering effects of COVID-19
Fortunately, we seem to be approaching the end of the pandemic and nearing a point where COVID-19 becomes an endemic but non-lethal disease. While the Omicron variant is more transmissible than the Delta variant, it also is less damaging to the body, as indicated by relatively lower hospitalization and death rates. We believe that we will get past the major effects of the Omicron variant by the end of 2022.
While consumers who have adapted to the pandemic may not revert back to their pre-COVID behavior immediately, most economists believe that the U.S. is past the point of renewed shutdowns or other severe COVID-related economic effects. This improving outlook should serve as a tailwind in 2022.
Volatility may rise due to geopolitical risks and other factors
While the ongoing pandemic has dominated recent headlines, we believe that geopolitical risks are likely to become more prominent in 2022. After leading the world in recovering from the pandemic, China has slipped back into recession, prompting the People’s Bank of China to loosen its monetary policy to spur economic growth. Although any slowdown in China is concerning for global markets, we believe that China’s recession will be relatively short and shallow. From that perspective, we aren’t overly concerned that the slowdown in China will create a significant drag on economic growth elsewhere.
In central Asia, Russia’s ongoing military and diplomatic conflict with Ukraine may pose serious threats to international security if Russian president Vladimir Putin decides to escalate the military conflict in the region. While an all-out war seems unlikely at this time, it is worth remembering that Putin has not hesitated to take military action in eastern Ukraine and Crimea and that he has been generally unpredictable in the past. As of this writing, Putin’s ongoing brinkmanship with Ukraine, the U.S., and NATO remains a serious concern.
In the U.S., the midterm Congressional elections will likely add volatility to markets as investors try to predict which party will eventually control Congress. This uncertainty may lead to spikes in market volatility and potentially contribute to market corrections.
Investors should remember that over the long term, corporate earnings drive stock prices. In many respects, everything else is noise. Geopolitical issues often lead to uncertainty, but at the end of the day, earnings are the critical factor influencing long-term returns.
Stay patient and focus on the long term
As always, we believe investors should remain patient and take a long-term approach to their portfolios, regardless of the short- to medium-term issues affecting markets. At Leelyn Smith, we will stay committed to our core investment strategy. This includes investing in companies with competitive advantages—those that can withstand greater degrees of volatility. While Fed rate hikes and potential market corrections may present challenges for investors in 2022, we view these headwinds as opportunities to optimize our investment strategy and increase our holdings on a tactical basis.
If you have any questions about the themes driving markets in 2022 and how they affect your portfolio and overall financial plan, please don’t hesitate to reach out to us.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.