As we continue to adapt to the new normal, what are the implications for the markets in 2022?
The pandemic is still with us, so people are adapting. But will the markets follow suit in 2022?
From Thrivent Asset Management, welcome to episode 21 of Advisor’s Market360™. A podcast for you, the driven financial advisor.
Our winter break is over and we’re back at it, bringing you the latest market and investment insights from the pros at Thrivent Asset Management.
In the last episode of 2021, we looked at the effects of the pandemic on macro and microeconomic levels. As we bravely head into 2022, the question before us now is how will people and the markets adapt to a pandemic that doesn’t seem to be going away?
The past two years have been a period of exceptional disruption, triggered by COVID-19 and its multiple variants. But eventually, disruptive events become less so as individuals, institutions, and society at large adapt their behaviors and expectations.
It appears that there is a growing perception that we are transitioning from a pandemic to an endemic. For those of you who didn’t study epidemiology in college, an endemic is a disease that is regularly found among particular people or in a certain area. In other words, we are most likely in a situation where Covid will eventually be viewed much like the seasonal flu.
So, looking through an endemic lens, what are the implications for the markets in 2022 as the disruptive dimensions of the pandemic become part of the ongoing environment?
For an answer to that question and many others, we turned to Steve Lowe, CFA, Chief Investment Strategist. He said that, from a macro perspective, there are three key factors impacting the U.S. economy:
The first is liquidity. There continues to be an enormous amount of liquidity in the economy in the form of checking deposits and currency that remains poised for spending or investment. That includes $3.4 trillion in checking deposits which is way up from $1 trillion at the start of the pandemic. This liquidity will continue to fuel overall demand. Another ample source of liquidity is the lending power of banks, which are flush with capital that can be loaned out at exceptionally low interest rates.
The second key factor for the economy is labor. The labor market is very strong, with payrolls and wages growing at a healthy rate. Meanwhile there is a record number of unfilled jobs – approximately 11 million – that employers are desperately trying to fill. Such a strong labor market will continue to be the most important factor in supporting the economy in the coming years.
And the third key factor is logistics. Supply chain issues have posed one of the greatest challenges facing the economy. The unusual and novel circumstances of the pandemic caused widespread chaos in the underappreciated logistics of supplying goods to consumers. Supply chains buckled under the joint pressures of surging demand and disrupted logistics from Covid-induced lockdowns and shortages in key components. Although there are some early indications that pressures in this area are easing, it will take more dedicated efforts to unsnarl logistical problems in the coordinated areas of shipping, rail, and trucking.
Now we’ll zoom in to the financial markets. Lowe shared with us another three key factors impacting the financial markets:
The first is the logistical challenges that are crimping supply and driving inflation. And when coupled with exceptional levels of liquidity-fueled demand, they have led to rising prices across the economy. Reported inflation is now running at about 6% annually, while many key goods and real estate prices are rising at double digit levels. The Federal Reserve, or Fed, is now attuned to this issue and will begin reducing the amount of liquidity it is providing to the economy. The most challenging factor in the outlook for the coming year is the uncertainty around the magnitude and persistency of inflation. While there are some preliminary signs that inflation may have peaked and will subside, other evidence suggests that there is a greater risk that inflation will remain stubbornly high, fueled by more persistent factors such as wages and rents.
The second key factor for financial markets is profits. Corporate profitability has been exceptionally strong, surpassing expectations throughout the pandemic. Remember however, profit expectations were low due to the unprecedented nature of the economic environment. Given that solid economic growth should continue this year, solid corporate profits should follow. But overall profit growth likely will decelerate after such robust growth in 2021.
And the third key factor is price/earnings – or P/E – multiples. Key valuation metrics such as the P/E ratio are quite elevated relative to historic levels. However, this widely scrutinized metric has been high for quite some time. Higher P/E valuations can be justified when interest rates are exceptionally low, especially now as bond yields provide little “competition” for investor dollars. P/E multiples can also be justified when growth is high. That being said, it’s difficult to expect market valuations, as measured by P/E multiples, to go even higher, particularly if interest rates continue their modest churn to higher levels while profit growth moderates. Valuations are more likely to remain stable to moderately lower, with markets driven primarily by earnings.
So, what is Lowe’s outlook for a post-pandemic 2022?
Let’s start with the market. 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. And 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 being so low.
Finally, the Fed is beginning to moderate its highly accommodative policy stance. The risk of volatility increases as the Fed slows its asset purchases and eventually increases rates. 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 Fed rate increases coming more rapidly than expected in response to high inflation.
Next up is the outlook for the 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.
And finally, what is outlook for equity markets in 2022? The U.S. stock market, as measured by the S&P 500, has generated average annual returns of approximately 16% since 2010, with only one negative year, 2018, where it dropped by 4.5%. 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.
That being said, there remains ample liquidity in the system to support the market, even at lofty valuations, as evidenced by the consistent buying that occurs with even modest weakness in the market. As always, 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, or EU, also faces many challenges, including recuring Covid lockdowns, a stifling regulatory environment, and the turmoil that has come from the United Kingdom’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 shadow 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 and 9. Additionally, and 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.
Of course, as 2022 unfolds, we will keep you up to date with market outlooks, sector analysis, Covid updates, and much more.
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Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. Learn more about us at thriventfunds.com and find other items of interest to you, the driven financial advisor. Bye for now.
All information and representations herein are as of January 6, 2022, unless otherwise noted.
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Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC, is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.