Covid May Be Fading into the Rear View
With the surge of cases around the country from the Omicron variant, cases have skyrocketed. That frightened the markets briefly in December until two studies of South Africa and Great Britain showed that they had already passed the surge. The new variant is far more contagious and far less deadly. This is the natural progression of a virus. It mutates to survive. The Covid chart shows how deaths have not surged along with the cases. That is great news. We could be looking at our path to herd immunity as so many people will now have natural immunity combined with the vaccines. It doesn’t mean Covid will be gone, but rather very manageable into the future. Covid will likely be part of our annual flu season for a long time to come.
Federal Fiscal Support Subsides in 2022
As the pandemic fades, the extraordinary fiscal support by the federal government will come to an end. The last two years we have added $5.3 trillion to the economy. It is part of the reason for the inflation we will address later in this outlook. It is unclear if the additional “human infrastructure” bill will pass in this election year. Even if the bill were to pass its spending would be stretched out over 10 years, and it would not be as impactful as what occurred over the last two years. There is also a myriad of new taxes in the bill that would offset some of that fiscal impact. The economy is on solid footing and should weather the reduced fiscal support, but growth will likely be at a reduced rate going forward.
Unemployment Is Down and Wages Are Up
The labor market has seen huge improvement in 2021. Unemployment fell from 6.7% in December 2020 to 4.2% in November 2021. Wage growth has been rising at the fastest pace since the 1980’s. The shortage of labor is from a combination of lower legal immigration, fear from the pandemic, enhanced unemployment benefits and higher childcare costs. These conditions may persist for some time. The labor pressures should ease as the pandemic fades in 2022.
Inflation More Stubborn Than Transitory
Due to the massive increase in the monetary base and the fact the stimulus checks to millions of Americans - many of whom did not lose their job - increased the buying power and increased the cash flow of Americans on aggregate during the better part of the last two years. This increased consumer demand. We spent in different ways during the pandemic, but consumption was up. At the same time, supply has decreased throughout the supply chain due to mandates, policy differences between various states, worker shortages due to fear, childcare issues and illnesses. This has disrupted the supply chain which was designed over the last few decades to be a “just in time delivery” system. These supply chain issues will take months, at least, to fix. The inflation might ease in the second half of 2022, but it wouldn’t be too surprising if it persists for longer. Equities and real assets (infrastructure, real estate, commodities) are the best hedge against rising inflation.
Fighting the Fed
In response to the stubborn inflation the Fed has changed their rhetoric to become more hawkish and less dovish on interest rates. This is bringing us into a new regime. The shift is from quantitative easing and zero bound interest rates to something less dovish. What does that look like? That is an unknown variable for markets. How fast will they taper their asset purchase program? How fast will they raise rates and how will the capital markets respond. We think that initially the rate increases shouldn’t be too much for stocks to grind higher at least for a while. The 10-year treasury is hovering around 1.75% as I write this piece. A move into the low 2% - 2.25% range in 2022 is not out of the question. If rates move too high, too fast that could cause the stock market to reassess valuations and sell off.
Stock Prices Are Slightly Elevated
Stocks prices are currently elevated based on current forward P/E ratios. If earnings continue to come in strong for the S&P 500 companies, the multiple could continue to come down into a reasonable range as the market churns higher. We do expect earnings to continue to grow albeit at a slower pace. We will need to keep focused on the earnings multiple.
Growth vs Value
As we examine the valuations within the market, we can see that “value” is trading at a steep discount to “growth” and has been for half a decade. At some point the attractiveness of value stocks will take over. However, the timing of such a move is hard to get correct. When the tide will turn is unpredictable, so we want to remain exposed to this space. We might make tactical adjustments to overweight value if growth valuations get even further extended.
International vs Growth
International stocks continue to trade at multi-decade lows vs US stocks. These trends can last for a long period of time. We need to recognize that at some point these will become too attractive relative to overpriced US stocks. We must continue to remain invested to this asset class and look for an opportunity to tactically adjust more towards international stocks if the US continues to extend the forward P/E multiple.
When this shift begins it can last for a decade or more as has been the case in the US for the last 14 years. It generally follows the strength or weakness of the corresponding currencies.
In Summary
We expect positive equity returns in 2022, but increased volatility. Last year there was only 1 pull back of 5% during the year. The typical intra year decline is 14% per year on average. We should expect bigger corrections in 2022 especially given the shifting monetary policy from the Fed. Bonds will continue to be challenged by rising rates. We will seek the opportunity to rotate back out on the yield curve if rates rise to a level of that makes longer duration bonds attractive.
Broad asset class diversification remains the best way to control any concentrated risk.
The views stated are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.
The MSCI EAFE is designed to measure large and mid cap equity market performance of 21 developed markets, including three regions (Europe, Australasia, Far East) excluding the U.S. and Canada. The Index is market-capitalization weighted, covering 85% of the free float-adjusted market cap in each of the 21 countries.
The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 628 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.