Investor Outlook for 2022
There are several potentially disruptive forces (not including the ongoing global pandemic) which may subject financial markets to sharp volatility swings in the coming year. Accordingly, our key investment themes for 2022 will be the tightening of US monetary policy, surging inflation and an expected slowing of corporate earnings growth. In the weeks leading up to the recently completed December FOMC meeting, our biggest concern was that the Federal Reserve would risk a policy mistake and not pull forward its timeline for a tapering or reduction of asset purchases and for raising its benchmark interest rate. The Fed may have come through on both counts. The Fed had been buying $120 billion each month of US Treasury securities and mortgage-backed securities before it began tapering (reducing) those purchases in November. The FOMC December announcement reduces the rate of monthly purchases further, with a target month for $0 purchases now moved up to March 2022. It is widely assumed that the end of tapering will usher in the first of possibly three hikes in the Fed’s benchmark interest rate (each hike assumed to be 0.25%) during 2022. This shift in policy is the latest sign of how an acceleration and broadening of inflationary pressures, coupled with an unusually tight labor market, has reshaped the Fed’s economic outlook and policy planning. What does this policy shift mean for investors? We favor the stance that the speed of rate hikes has far more influence on share prices than the timing of the first Fed rate hike. History tells us that in periods of slow rate hikes the S&P 500 gains on average 10.5% in the first year after the first hike compared to a gain of just 1.6% in the first year of a fast-tightening cycle.
In November inflation surged to 6.8%, the fastest rate recorded since 1982. This latest move higher continued a trend started in April 2021. Inflation has long been a disruptor of bull markets. Mild inflation (at or near the Fed target of 2%) is an indicator of a healthy, growing economy that is functioning in line with long term trends. (From a historical perspective, the highest real S&P 500 investment returns have been seen when inflation is generally in the range of 2% to 3%.) High inflation, particularly if it is persistent, presents another set of challenges both to the economy and stock market. At the earliest signs of higher inflation last spring, Fed Chairman Powell described the change as “transitory”. At the December FOMC meeting he said “there is a real risk now that inflation may be more persistent and that the risk of inflation becoming more entrenched has increased.” In our opinion, the current high inflation was not caused primarily by easy Fed policy in response to the pandemic in 2020, rather it has many other causes including soaring consumer demand, supply chain bottlenecks, government stimulus (CARES), computer chip shortages and a revolution within the American workplace. We must acknowledge that even with a more typical economic recovery there was a good chance we would experience higher than normal inflation. Furthermore, it is likely that inflation would start to ease (even without the recent Fed policy shift) as the pace of economic growth slows in mid to late 2022.
Inflation is viewed as a negative for the stock market because it starts a chain reaction of increased borrowing and input costs (materials and labor), a subsequent lowering of expectations for earnings growth and the resultant downward pressure on stock prices. In times of economic recovery, rising prices and interest rates tend to eat into the bottom lines of growth companies which makes investors less willing to wait for future profits. A rotation from growth stocks to more value-oriented stocks may already be underway. History suggests that stock prices react far more negatively when the economy is contracting or in a recession than when inflation occurs during a period of expansion or recovery. During contractions, revenues and earnings are already declining without inflationary concerns. During periods of expansion, earnings are stronger and the economy should be able to better withstand some higher “transitory” or even “persistent” inflation.