The year 2021 was a mixed bag of innovation, value vs. growth debates, equity recalibrations, high supply side inflation (stagflation), structurally challenged employment data, new virus variants and projected rate hikes. Going into the end of the year, the highly transmissible Omicron variant is roiling markets, overshadowing the Federal Reserve’s (“Fed”) policy guidance of rate hike to rein in inflation.
As we discussed in “Capitalizing on Stagflation”, stagflation remains a tangible risk despite the “transitory inflation” naysayers and the misinterpreted employment data. Just last week, inflation reached an approximately 40-year high coupled with an unemployment rate that remains plagued by decreases in the labor force participation rate and increases in those “not in the labor force.” This dynamic unfolds into an ill-informed positive bias of a structural improvement to unemployment data (which we believe is worse than projected). Furthermore, gross domestic product (GDP) growth projections have been revised downward due to new economic headwinds caused by the Omicron variant. With these comparative catalysts at play, equities may continue to be volatile through the end of 2021 as the low volume holiday season magnifies market uncertainties.
Fixed income markets and commodity markets have also been impacted by the combination of new monetary guidance, Omicron variant and the holiday seasonality. Bond yields and oil prices both fell on December 20th, 2021, amid new worries that a rise in Omicron Covid-19 cases could stymy economic growth, adding inflationary pressures (counter to the Fed’s rate hike plan). This dynamic seems very similar to the December 2018 equity correction that was a result of bond yields decreasing as the markets perceived the economy to be slowing due to autos and homes losing momentum despite the Fed’s hawkish narrative to combat unemployment induced inflationary pressures.
With an eventful 2021 almost in the books, let’s look forward to what 2022 could bring across the investment lineup:
Inflation will likely remain elevated through the first half of the year as stagflation pressures persist, but if the Fed raises rates as planned and external catalysts do not weaken economic growth (countering monetary policy) inflation may moderately decrease throughout the end of 2022 to around 3.5%. However, this remains dependent on the impact of the Omicron variant (and any potential new variants) and if restrictions and accompanied lockdowns resurface, causing increased inflationary pressures in 2022. Additionally, we remain prepared for the Fed to taper but also expect the Fed to continue to inject money into the economy, but at a slower rate. Though debated, much slower economic growth and a steep negative market reaction to the new variant remains unlikely as vaccination rates and booster shots continue to increase, companies continue to maintain work from home regimes and other COVID related policies, and individuals’ desire for a return to social normalization intensifies. Even though an abrupt economic slowdown is unlikely, GDP growth could be lower than consensus estimates due to the uncertainty around Omicron and rising interest rates. Therefore, we forecast (based on Omicron uncertainty, rising rates, and social status quo recalibrations) that GDP will grow at approximately 3.7% in 2022. Adding to the hectic macro environment, revived COVID uncertainty could stifle services demand potentially containing GDP upside beyond 4%. Unemployment rates will likely continue to improve from early March 2020 highs, but supply-side inflation and Fed market intervention to control supply-side inflation could indirectly create structural employment inefficiencies and elevated unemployment rates (above consensus estimates). Furthermore, the US dollar will likely continue to increase (2021 saw the largest annual gain in six years) amid inflation and a more hawkish Fed. Nonetheless, domestically the largest challenges for next year remain the supply bottlenecks, a Fed policy misstep, structurally high unemployment, slowing economic growth, COVID uncertainty, and stubbornly high inflation.
Internationally, developed markets will likely continue to grow at marginally higher rates through June, eventually cooling off towards the latter part of 2022. More specifically, the eurozone will likely experience slightly higher GDP growth (mid 4%) supported by a flexible hawkish monetary policy, strict COVID restrictions (i.e., Great Britain and the Netherlands), and a more modest inflation rate (around 4.9%). Additionally, Japan is likely to remain a safe haven for international exposure amid higher domestic inflation. Emerging markets (led by China and Brazil) can experience sluggish growth amid structurally slower improvements, a higher USD and political crossroads. More specifically, China can experience much slower growth compared to the past 10 years (approximately 7.25%) as GDP is projected to grow at approximately 5.0% as their expansion slows, zero-tolerance policies around COVID-19 persists, and slower retail sales continue. Policy headwinds and high corporate debt may also provide additional headwinds to China’s growth. China remains in an economic crossroads between capital injections and productivity. Without sufficient productivity, China’s economic growth could remain below historical highs. On the other hand, Brazil (which recently entered into a recession) remains plagued by the upcoming presidential election, weaker international relations, slower projected GDP growth (2.01% projection), poor infrastructure, and high inflation (around 10%). Despite limited emerging market upside, some emerging market countries such as India and Russia may experience marginally higher growth rates with capital injections and oil and gas sector strength.
Collectively, international equities in major developed markets can provide some upside exposure amid hawkish domestic monetary policy and high inflation. Countries in the EU and Japan may lead the way in the first half of the year with above trend economic growth. Emerging markets remain a dynamic landscape with equities likely to experience bouts of volatility due to political and financial uncertainty (Brazil), slowing growth (China), and intensified COVID related issues (India). Therefore, we favor domestic equities over international equities.
Domestically, with economic growth likely to continue in the beginning of 2022 (though at a slower rate), US mid-cap equities, small cap value equities, opportunistic large cap equities, cyclicals, and domestic markets remain poised to benefit during the current macro environment in the near term. However, as society emerges from the past two years of economic shifts, markets will remain in a provincial crossroads in establishing a post-COVID normal economically, socially, and financially. Based on current behavioral trends and the quick adaptations to the economy, the individual’s choice architecture appears to have shifted, making way for disruptive technologies, innovation, and net-zero carbon transitions (as the economy recalibrates). Economic and individual status quo biases have been reshaped with the intent to accommodate a similar anomaly event. Even though large cap growth stocks benefitted the most from the forced changes of individual status quos, in 2022 large cap equities will likely enter volatile territory amid the rising rate environment. Large cap growth stocks remain most exposed to increasing rates potentially stunting their beginning of the year market performance. In the near-term, growth stocks could experience limited upside due to the combination of investors taking profits, overvaluations (S&P 500 P/E ratio remains at historically high levels), and slower economic growth priced into markets. As we enter the mid-cycle (the longest part of the business cycle) accompanied by a hawkish Fed, high supply-side inflation, and resurfacing COVID uncertainty, small-cap information technology, industrials, and materials sectors could provide some unconventional alpha opportunities. Though we remain bullish on US equities with a slightly lower conviction than last year, it is important to bring up historical trading patterns of equity markets. For instance, over the past three consecutive years, the S&P 500 Index has finished the year positive, a streak that has only happened 11 times since 1929. However, a four-year winning streak remains a far less statistically likely scenario. Therefore, strategic equity allocations remain pivotal to weather the current equity markets. In short, value may outperform growth in the beginning of the year due to rising rates, Omicron variant fears, and market renormalizations. However, growth will likely show some strength towards the end of the year as inflation is likely to stabilize and the innovation economy becomes steadfast in investor agendas. Thus, selective exposure to large cap companies can generate alpha, but collectively, the majority of large cap companies may experience stunted performance due to downward pressures from rising rates. Thus, we believe that investors should maintain exposures to domestic small cap value equities, mid cap equities, and opportunistic large cap equities. Overall, equities appear to be in the middle of the economic cycle with a few more years of modest growth potential. However, supply bottlenecks, labor shortages, and COVID uncertainty could lead to higher costs and potentially lower corporate profits. Thus, despite some chance of equity volatility, overvaluations, and slower growth, we believe that the S&P 500 Index is fairly valued at $4,950.
Fixed income markets remain at the mercy of the Fed. Interest rates are expected to move higher in 2022 (amid three forecasted rate hikes next year, three more in 2023 and two in 2024) as inflation remains at 40-year highs and the impacts of COVID-19 variants are expected to fizzle out towards the later part of next year. Our forecasts for the 10-year treasury and the 30-year treasury is that it will trend higher approaching pre-COVID levels. Despite interest rates moving higher, equity market pessimism may halt any excessive interest rate appreciation.
Even though rates will rise in 2022, historically low rates will likely continue to provide opportunities in alternative fixed income solutions. Corporate bond issuances remain at historical levels through the end of 2021 (after peaking in 2020) illustrating structural strength in corporate credit markets. Corporate issuances will likely remain on the upper bound due to relatively low rates compared to historical norms. With interest rates increasing, bank loans (floating rate debt), short duration corporate credit, non-agency RMBS, and convertible bonds remain key alternative fixed income asset classes that can weather increasing rates, stagflation, and COVID-related headwinds.
As illustrated in “’Don’t Fight the Fed’”, Walk the Other Way”, floating rate securities perform well during all rate environments but particularly perform best during rising rate environments versus other traditional fixed income sectors. Short-term corporate bonds also perform well during rising rate environments as interest rate risk is minimized on the shorter end of the yield curve. Intermediate and longer-dated maturity bonds remain exposed to price attrition as increasing interest rates lower the demand for fixed rate securities at a lower yield. Thus, portfolio exposure to short-term investment grade corporate bonds with attractive yield can be the sweet spot in mitigating public credit markets. Meanwhile, non-agency RMBS remain a unique diversifier with low equity correlations. This asset class has an opportunity bias, with higher principal paydowns than agency RMBS, lower interest rate sensitivity, robust cash flows, and structurally resilient credit metrics on the underlying mortgages. Additionally, active non-agency RMBS managers can utilize Agency Mortgage Interest Only Securities (IOs) to capitalize on rate hikes as the borrowers would prepay slower, extending the duration of mortgage pools, leading to increasing values of IOs. Collectively, alternative fixed income investments that are poised to mitigate a hawkish Fed and lingering COVID related down drafts in yield remain key to delivering alpha. Lastly, convertible bond portfolios, that are actively managed, can offer meaningful equity upside with a bond floor as a safeguard, weathering traditional equity market volatility and maintaining attractive risk-adjusted returns.
Amid inflationary pressures and rising rates, commodities can be a unique diversifying hedge to some of the macroeconomic headwinds. More specifically, gold and soft commodity exposures remain pivotal to accomplish investment outperformance and risk mitigating allocations. Gold continues to be a debated hedge to stagflation, but idealistically gold prices are driven by real rates. With real rates at historically negative levels due to inflationary pressures, gold’s 0% interest rate and haven connotations remain an attractive opportunity for investors. Additionally, soft commodities (such as: coffee, cocoa, soybeans, corn, sugar, wheat, fruit livestock and other agriculture products) will likely maintain demand thresholds as consumer staples remain relatively stable during times of inflation and rising rates. However, hard commodities and precious metals (expect gold) could underperform the overall market due to slower growth, down trending economic activity, and staggard macroeconomic uncertainty from COVID-19. Therefore, active commodity strategies that can strategically shift positions based on nimble economic dynamics will likely remain the winners during the current thematic environment.
All in all, 2022 appears to be the year that we find stabilization in a post-COVID economic system. Even though the risk of a new a more serious COVID-variant impeding growth remains, the repercussions of the current Omicron variant and a potential Omicron related fallout is low. The Fed’s nimbleness in increasing rates continues to be the most important driver for markets. Though supply-side inflation rests at 40-year highs, increasing interest rates in the midst of weaker growth priced into markets (due to the Omicron uncertainty) could continue to decrease yields despite a more hawkish Fed guidance, illustrating potential for equity volatility in the near-term. Thus, the most important dynamic to monitor going into the new year is the Fed’s adjustment to COVID variants and their derivative repercussions. If all unfolds as planned with the new variant’s risks subsiding and the Fed raising rates and tapering, inflation may persist until the later part of 2022, GDP growth will likely slow (but remain positive), and equity returns likely to stabilize. Furthermore, alternative fixed income remains at the top of our investment priority list as interest rate hedging, low equity correlations, and low duration solutions may provide attractive risk-adjusted returns throughout 2022. Despite near-term economic dynamics, in the long-term alternative funds that focus on the innovation economy remains the most attractive long-term investment vertical led by disruptive technologies, net-zero transitions, and healthcare solutions.