We hope this note finds you well and looking forward to a more positive 2022 after the challenges of the last two years. As 2020 and 2021 have been historic in their impact on society in general, we’d like to take a moment to review and offer a look forward toward what we think is ahead for the markets and economy.
While Central Banks globally have been unusually active in the last years, we think that 2022 will be especially consequential from a monetary policy standpoint as our U.S. Fed seeks to unwind the stimulus programs they implemented at the beginning of the Covid crisis. In order to look ahead, it is constructive to look back to gain context.
2020 – The Year of Covid – As far as the markets were concerned, 2020 was The Year of Covid. As we know, markets across the globe sold off heavily from late February to late March. “Uncertainty” was the word we’d use to characterize the first half of the year, but we also know, through the late spring and into the summer we witnessed an extraordinarily quick recovery in the markets. We’d suggest that this was driven in large part by speculation on a 2021 economic recovery, rather than the economic fundamentals that looked so poor at the time in 2020. Price/Earnings (p/e) multiples rose to relatively high levels, even though nobody seemed to have a very clear idea of what earnings/profits would look like in 2021. So, after the negative market volatility of the spring, speculation and multiple expansion was the defining trait for stocks in 2020.
2021 – The Year of Economic Recovery – Despite the fact that Covid was not eradicated, profits soared in 2021. Highly stimulative monetary policies had a lot to do with this. While analysts had very poor visibility of earnings early in the year, their initial conservative (or even cautious) estimates were steadily ratcheted up through the year, driving some stock prices ever higher. Certain sectors that had been deeply discounted in 2020 and earlier showed remarkable growth. The Energy sector led the way, but other names like Apple, Alphabet, and Tesla had very strong years. Again in 2021, performance was not particularly broad-based. Larger companies tended to accrue a substantial portion of the overall performance, with the S&P 500 leading other indices by a substantial margin. Beyond the S&P we saw lesser returns from small-cap, mid-cap and international stocks, and a negative annual return in the Barclay’s AGG Bond Index. We might attribute this to the fact that some stocks had been bid up in 2020 in anticipation of the recovery, so it was already priced in. As for bonds, the ongoing fiscal and monetary policy initiatives dominated markets.
2022 – The Year of The Central Bank – As we enter 2022, we enjoy a remarkably strong economy, one that is only being held back (primarily) by supply chain issues, access to goods, and labor. While Covid seems to be no less of an issue than it has been for some time, the economy is clearly moving ahead. Gross Domestic Product grew 5.7% in 2021 after a contraction in 2020. We think that the current economic momentum could carry us well into the future, absent any disruptive events.
However, we do think that our jolly bankers at the Fed could have a significant impact on markets (again) this year, though in a different fashion than was seen in prior years.
What will they do? – Just a few weeks into the New Year, the markets seem to have a somewhat different view of expected Fed actions for the year than was seen as recently as the end of December. With the recent jobs report coming in well above expectations, the suggestion that the Fed is behind the inflation curve has only strengthened. Recent commentary now has the bond market expecting more immediate action on increasing the lending rate and curtailing bond market purchases.
We now expect that we will see the first Fed Funds overnight rate hike in March, and it could be a larger hike than was expected just weeks ago. This, along with a reduction in the quantitative easing program (open market bond purchases by the Fed), seems likely to decelerate the pace of growth and inflation. Thus far in 2022, concerns about forward Fed policy have had a negative impact on risk asset prices. So, to the extent that the Fed either exceeds or fails to meet current market expectations for its moves, increased volatility could result.
Equity Markets – We expect an increase in volatility across equity markets this year. The above-mentioned Fed activity could drive a portion of that. In addition, while only about a third of S&P 500 companies have reported Q4 2021 earnings as of 1/28, this reporting season could add to volatility. So far, more companies that have reported are beating estimates than average, however, they are beating estimates by a smaller margin than average.
As earnings are the primary long-term driver of stock prices, this is a very important reporting season, as it comes off a period of exceptional growth for profits and is perhaps heading into a period of greater difficulty in sustaining those growth rates.
All in all, given the expectation that Covid will become less of a headwind to the economy, we anticipate that 2022 could be another positive year for earnings. Monetary policy and inflation are likely to present challenges, but if the Fed can navigate the challenge of returning to a more neutral stance, we would anticipate that the economy and markets would react positively. We expect equity market returns to come back to a more normal range of high single to low double-digits, while markets do experience increased volatility as described above. We also expect that performance will be more broad-based, as values in the small and mid-cap as well as international sectors may be recognized.
Bonds and Rates – As for bonds and interest rates, to the extent that the Fed curtails bond buying activities, we would anticipate a trend slightly higher in intermediate rates. This along with the expected hikes to the Fed’s overnight rate, lead us to expect an upward move across the yield curve. We think that by year-end we could see intermediate rates climb into the 2.25 – 2.50% range for the 10-year Treasury bond, assuming the Fed isn’t overly aggressive in increasing the overnight lending rate, which could damage the economy. Considering that we have generally maintained a relatively short average maturity in our bond allocations for the last year, we feel that we’re well poised to take advantage by gradually extending maturities into a higher rate environment.
Inflation – Inflation is clearly the topic of the day. We’ve witnessed a startling spike in inflation, and it seems to be the most pressing concern for consumers and investors. While the Fed has dropped the term “transient” in their discussion of inflation, we see no reason to view it as a permanent or oppressing challenge to the economy.
We expect a moderation from the 7.0% level reported for December 2021,  toward a rate of about 3.0 – 4.0% for 2022. For context, the Fed’s traditional inflation target is around 2.0%, and their current prediction for 2022 sits at 2.6%. We think these will be difficult levels to achieve in the foreseeable future, but we agree that the trend will be toward lower inflation in 2022. That said, predicting rates and inflation is difficult at best, and hazardous at worst. Accordingly, we are taking a measured approach to shifting our bond allocations.
As always, we continue to monitor the data and seek to make prudent and informed adjustments to our portfolios. If you have any questions about this, or any other financial issue, please feel free to contact your Atlas Wealth Management Advisor. We remain ready to assist you in your journey toward achieving your financial goals.