2022: Volume 1
While certainly cliché we’ll say it anyway: where does the time go? As we sit here writing this in late 2021, it’s a crazy feeling to think about the calendar year 2022 being such a short time away. We do an exercise at the end of every year where we, within our internal departments, recap what happened and our goals for the next year. One of our primary accomplishments, at least in our opinion, was the increased investment-related communications to our clients. In total, we’ll have sent out 52 weekly market updates and 11 monthly videos. Additionally, we conducted one mid-year webinar and just did our virtual market insight event. Our communication and transparency are something we take pride in, and candidly, we have our clients to thank for that. Because of the feedback we’ve received over time, this is an area we’ve improved and plan on building up in the future.
With all of that said, we wanted to start a new tradition of an annual letter to our clients, written from the perspective of the Diversified Investment Committee. The end of the calendar year is a great time for us to reflect on where we’ve been, where we’re going, and what we’re thinking about. Since we know everyone is busy and is interested in the investment world to varying degrees, we included a high-level executive summary for those of you who would prefer that medium. For those of you who prefer more details, we hope you find our more thorough write-up valuable. As always, we encourage any feedback about what you liked and anything you would like to see moving forward. Enjoy!
- Despite the changes caused by the pandemic, it has been more of the same from a market standpoint. In 2021, risk assets such as equities continued to drive market returns. For the third calendar year in a row, global equity market returns were in double digits.
- Within equities, U.S. stocks outperformed international. Within the U.S., it was once again large companies leading the way.
- Even though rhetoric began to change towards the end of the year, the Federal Reserve remained accommodative throughout 2021. We saw interest rates remain at the floor and asset purchases remain unchanged for much of the year.
- On top of monetary stimulus from the Federal Reserve, the government was fiscally active with a stimulus package and the beginnings of infrastructure spending.
- One of the biggest surprises in 2021 was the resurgence of corporate earnings, which will end up growing by about 50% from 2020 to 2021. We expect continued growth around 5-10% in 2022.
- Bottlenecks in the global supply chain, along with incredible consumer demand for goods, drove prices up in the second half of 2021. Now inflation dominates news headlines and is at the center of the Federal Reserve decision-making process.
- We expect more of the same in 2022, with stocks poised to continue their strength. We expect the Federal Reserve to finish their tapering process in early to mid-2022, and one to two interest rate increases during the calendar year. We also do expect inflation to subside a bit as the year progresses.
- From an asset allocation perspective, we prefer risk assets (stocks) to stable assets (bonds), but that blend should primarily be driven by individual risk tolerance.
- Within stocks, we’re going to overweight domestic over international, and will remain balanced between growth-oriented sectors (technology & consumer discretionary) and value-oriented sectors (financials & industrials). We think small companies can benefit from continued economic strength and are tactically leaning towards the semiconductor industry.
- Within bonds, we’re leaning away from traditional core fixed income based on our expectations for rising rates and historically low spreads. We’ll still allocate to core fixed income (Treasury bonds, investment grade corporates, mortgage-backed securities) for stock market diversification purposes, but will actively lean to spread sectors such as high yield, bank loans, emerging debt, and preferred securities. While they come with slightly higher risk, we see them as having value, higher yield, and an economic backdrop that is supportive (low defaults).
2021: An Economic Recovery & More of the Same
The more things have changed, the more they’ve stayed the same. It is quite incredible that we sit here today, over 18 months into a global pandemic, living in a changed world. Many companies around the world are in a hybrid working environment, just trying to adapt to the new normal. Despite these changes, the global equity market just went through its third consecutive calendar year with double-digit returns.
Some of this can be attributed to the support of the U.S. government. From the fiscal side, multiple stimulus packages designed to support individuals, corporations, and municipalities, offered assistance during a time of uncertainty. Not long ago in November, Congress worked through one of the pieces to the large infrastructure push, which is clearly a main item for the Biden administration. On the monetary side, the Federal Reserve and Chairman Powell have been receiving plenty of headlines this year. At the start of the pandemic, they reduced short-term interest rates to the floor and have left them there ever since. On top of that, another round of asset purchases, to the tune of $1.4 trillion in 2021, was started to provide substantial liquidity in markets. In total, both fiscal and monetary policy have been very accommodative.
Make no mistake about it, the primary reason for this continued strength in equity markets comes down to corporate earnings. The rollout of effective vaccines unleashed pent-up consumer demand. The expectations from FactSet are for earnings growth of S&P 500 companies to land in the 40-50% growth range for 2021. While some of that growth is due to the comparison to depressed earnings in 2020, it is still remarkable how the economy has recovered from this perspective. The graphic below is a good visual depiction of U.S. large companies’ earnings over the last couple of decades and projections for the next few years.
With this barrage of consumer demand and issues amongst supply chains, investors now find themselves face with something that they haven’t seen in a while…inflation. It has been some time since inflation came to the forefront of economic concerns, but here we are. After several months of high price increases, the Federal Reserve now has to balance their policies to meet their long-term objectives. As a reminder, the Federal Reserve can move short-term interest rates and add/remove funds in markets in an effort to balance low inflation (2% per year target) and low unemployment. With unemployment now under 5%, the Fed must determine if this inflationary period is just transitory due to unusually high demand and pandemic-related supply chain issues or if its more long-term in nature. Because of this, it is not a surprise, and wasn’t a surprise to many, that they decided to reduce (taper) their asset purchases in November and then accelerated their reduction in December. Once this taper is finished, expectations are for interest rate increases to be back on the table.
The combination of improved economic growth expectations, rising inflation, and expected interest rate increases on the horizon were headwinds to long-term investment-grade bonds. One of the core tenants to bonds is that their prices are inversely related to interest rates, meaning as interest rates rise the price of the bond you hold, which is now less valuable, decreases. While traditional long-term bonds have faced some headwinds and are relatively expensive, other areas of the bond market have performed well. For example, spread sectors such as high yield, preferred securities, and bank loans all outperformed the aggregate bond market this year. They tend to perform well when economic conditions are strong and default rates are low. Those conditions held true in 2021.
It was a different story for international equities during the year. From a pandemic perspective, most international economies are behind the U.S. with regard to their recovery. This holds true in both Europe and in many emerging markets, as vaccine distribution has been very uneven globally. On top of that, Chinese regulators surprised markets with their regulatory reform in both technology and after-school tutoring industries, the latter of which had grown to an impressive size.
As we said at the beginning of this section, much of what we’ve seen this year has been more of the same. It has been risk assets, primarily stocks, that have been driving returns for investors. From an economic standpoint, incredible corporate earnings growth, improving labor markets, supply chain bottlenecks, and the Federal Reserve have been the areas of focus. Even though the Federal Reserve didn’t change interest rates or their asset purchase program (at least until very late in the year), expectations around their future policies certainly affected fixed income returns. Despite scary words being thrown around out there, such as inflation and rate hikes, markets behaved relatively well and are positioned for more of the same in 2022.
2022: Inflation & Interest Rates Leading the Charge
Turning our attention to 2022, what is the Investment Committee looking at and what are our expectations? While we’re not huge fans of making bold predictions, we do have plenty of thoughts around what we expect. These thoughts drive our positioning and recommendations from a portfolio asset allocation perspective.
- Risk-On Works Again: Its natural for investors to be cautious with equity markets given three consecutive double-digit calendar year returns and elevated valuations. Despite that, we’re here to say that we expect another solid economic backdrop that should be conducive to continued success with stocks. With corporate earnings growth around 50% in 2021, we do expect that figure to drop down to 5-10% growth in 2022. That is still very healthy earnings growth, which will be mostly due to the strength of consumer spending. With 70% of GDP driven by consumer spending, we have a hard time seeing the U.S. economy struggling in 2022. You can see from the graphic above that the consumer is the most important part to the economic machine.
- The Fed Acts, but Less than Expected:As we entered December, there were points in time when the market started pricing in an aggressive Federal Reserve for 2022. The expectations became that tapering could be finished by March and three separate 0.25% interest rate hikes occur during the year. We think those expectations are a bit overstated. It is pretty clear that the Fed will finish tapering somewhere between March and June, and then start raising rates in subsequent meetings. Our base expectation is that the Federal Reserve will want to be careful and get this right, as aggressively raising rates too early can put the economy at risk. To that end, we think one or two 0.25% interest rate increases are most likely for calendar year 2022.
- Inflation Fades, but Higher Prices than Pre-Pandemic: We’ve already begun to hear that supply chains are easing, mostly from auto manufacturers in their Q3 earnings calls. It is still going to take some time for supply chains to fully ease, but we’ve at least seen progress. We expect that inflation readings do begin to fade in the second half of 2022, driven by easing supply chains, shifting consumer demand (from goods to services), and a higher base effect (inflation is calculated year-over-year). During our 2021 Virtual Market Insight event, our guest speaker Jack referred to this idea that prices likely have received a one-time step up from their pre-pandemic levels. We agree and think that is a great way to view the current situation. If inflation does ease as we expect, it should make the likelihood of #2 occurring much higher.
- A Reduction in Covid-Related Economic Impact: With the development and production of effective vaccines, we’ve seen the impact of Covid, and new Covid strains, reduced over the last 18-21 months. We see this process continuing, and the likelihood of additional domestic lockdowns as remote.
- An Uneven Economic Recovery: What has become clear is the United States is further along in this new economic cycle than the rest of the world. With uneven distribution of vaccines and inconsistent fiscal support globally, many international developed and developing nations are still early in their recovery. While this could present opportunity down the line, we still view the U.S. as preferable for both equities and fixed income while much of Europe and Asia fight through restrictions.
Potential Tail Risks
It is imperative that investors understand potential “left-tail” risks for the economy and their portfolios. What we mean by this is what could happen, despite being very improbable from our perspective, that would negatively impact our 2022 expectations mentioned above. While we look at them as very unlikely and may not do anything to hedge them, this is the type of awareness that allows us to better prepare for different scenarios. So, what are the left-tail risks for 2022:
- A More-Deadly COVID Variant: Up to this point, the several variants to Covid-19 have not had an effect that forced local governments to shut things down again. While some have spread faster or had slightly higher/lower mortality rates, most have fallen in line with the original strain and have been contained by current vaccines. The potential concern is that a variant comes on the scene that is much more deadly and just as contagious, which would likely force the hand of local governments to go back into lockdowns. This is not something we expect, but this is the type of scenario that would affect economic conditions and market returns.
- The Federal Reserve Gets Things Wrong: If inflation doesn’t subside and the Federal Reserve allows it to run too far, we could see interest rates spike. On the other side, if inflation does reduce but the Fed got too aggressive with raising rates too fast, we could see that as a headwind to economic activity. The job of our central bank is a tough one, but they’ll need to be methodical and transparent. Otherwise, we could see markets react negatively to unexpected policy shifts during the year.
With all of this said, how are we positioning portfolios heading into 2022?
- Equity: As we’ve stated several times throughout this commentary, we’re still optimistic for equity markets going into 2022. We see an economic backdrop of strong global growth (slowing, but still strong), impressive corporate earnings, low interest rates, and a healthy consumer as tailwinds to stock prices. Geographically, we’re going to be overweight U.S. stocks relative to international stocks. While international stocks are cheaper, we see the economic backdrop just mentioned as better in the U.S. We’ll still maintain a smaller allocation to international developed and emerging equities for diversification and upside if those economies recover unexpectedly fast, but as an underweight within our equity portfolio. We do prefer growth equities in the international space, especially sectors such as technology, consumer discretionary, and health care. We’ll be maintaining a balanced approach with regards to growth and value domestically, as we see opportunity for both next year. We expect technology to remain an important part of the U.S. economy, but are looking to some traditional value sectors (financials and industrials) to perform well if economic activity remains strong. Specifically, we have a tactical lean towards the semiconductor industry and the financial sector. Lastly, we’ll continue to maintain our allocation to U.S. small cap as smaller companies should benefit from continued economic strength here in the U.S.
- Fixed Income: After decades of falling interest rates, bond investors are now faced with potentially rising rates and tight spreads (meaning investors aren’t being compensated very much to take credit risk within non-government bonds). We’re always looking to position our bond portfolio to accomplish two primary objectives, provide stock market diversification and to offer a decent rate of return with lower volatility. With the likelihood of interest rates rising over the next few years, we cannot own long-duration government bonds and expect to generate consistently positive returns. The graphic below from JPMorgan illustrates interest rates since 2000 and the projection over the next few years. We expect the economy to be strong and defaults low, which is an environment where spread sectors (high yield, bank loans, preferred securities) perform well. The challenge is that those sectors don’t offer as much diversification from equity market volatility, so we must be prudent in how we approach bond portfolios. As such, we’ll continue to be diversified in our allocation approach. Relative to the aggregate bond market, we’re going to be underweight government Treasury bonds as we just don’t see value in exposing our bond portfolio to that much interest rate risk at this time. To compliment our core of Treasury, mortgage-backed, and investment grade corporate bonds, we’re going to allocate to several of the plus sectors such as high yield corporates, bank loans, emerging markets debt, and preferred securities. These sectors offer better value at this time and higher yields. Additionally, a strong economic and rising rate environment should offer a better backdrop for these spread sectors.
In summary, 2021 was another year where risk assets performed well. We’ve seen economic activity and corporate earnings recover much faster than any of us thought back in March 2020. We expect much of the same going into 2022, with conditions that are conducive to stock market strength. With that said, there are plenty of unknowns heading into 2022 with rising inflation, potentially rising interest rates, elevated valuations, and the pesky pandemic.
We hope you enjoyed our first annual investment letter and welcome any feedback as to what you liked, disliked, or would like to see moving forward. We aim to be transparent on our opinions and thoughts and hope that was conveyed throughout this commentary. As always, thank you for the trust you put in the entire Diversified team. We wish you a Happy New Year and hope your 2022 gets off to a great start.
Diversified’s Investment Committee