The market outlook
The U.S. economy should remain on a solid, but moderating growth path. Consumer spending is expected to remain strong, given the very healthy labor market and the significant levels of cash still sitting in bank accounts.
Government spending will be another source of strength given that recently enacted fiscal spending programs have not ramped up yet. Furthermore, although debt levels are high at the corporate and consumer level, they do not pose an imminent risk to the economy, especially with the cost to service debt so low.
Finally, the Fed is beginning to moderate its highly accommodative policy stance. As the Fed slows its asset purchases and eventually increases rates, the risk of volatility increases. In the past, markets have typically fared well up to first rate hike, with subsequent returns dependent on the pace of the hikes. A key risk in 2022 is a more rapid pace of Fed rate increases than expected in response to high inflation.
Fixed income market
Overall bond market performance in 2021 was flat to modestly negative. With inflation running high and bond yields at 1% to 4% across the credit quality spectrum, bond investors continue to lose the “purchasing power race.”
The Fed will be winding down its policy of large-scale bond buying, eliminating a major support from the market. We expect the current performance trend in the fixed income market to persist, with bond yields churning to gradually higher levels.
In short, bonds remain uncompelling, although they continue to provide an important diversifying element to an overall portfolio by providing some hedge against a serious equity market downturn. We continue to favor a short duration, curve flattening position while augmenting fixed income portfolios with alternative income assets such as leveraged loans and preferred stocks. For more risk-oriented portfolios, we would also include higher dividend-paying equities.
The U.S. stock market, as measured by the S&P 500®, has generated average annual returns of approximately 16% since 2010, with only a single negative year (-4.5%) in 2018. After such a long and strong stretch of exceptional performance, with earnings moderating and interest rates possibly rising, stock market return expectations should be meaningfully reduced relative to recent returns.
However, there remains ample liquidity in the system to support the market, even at lofty valuations, as evidenced by the constant buying that comes into the market on even modest weakness. However, investor emphasis should be on quality companies, regardless of size, that have solid business plans, durable profitability, and well-managed balance sheets.
International markets, especially emerging markets, will remain challenged. Durable economic growth still remains elusive in the developed world, especially in Europe. Part of the problem is the lack of vibrant, innovative companies in high growth industries. The European Union (EU) also faces many challenges, including recuring COVID lockdowns, a stifling regulatory environment and the turmoil that has come from the U.K.’s exit from the EU.
Emerging market performance remains tied to developments in China. The extraordinary crackdown by the Chinese government on the business sector will likely cast a long pall over that market. China is also dealing with its own significant real estate problem, which bears some similarities to the real estate problems that erupted in the U.S. during the Great Recession of 2008-09. Unfortunately, emerging markets outside of China are faced with multiple challenges, including inadequate vaccination programs, currency volatility, high debt levels, rising rates in response to inflation, and reliance on commodity-oriented industries.
For more on the markets, see: New dynamics added to market uncertainty in 2021, by Steve Lowe, CFA, Chief Investment Strategist