- Scott Poore, AIF, AWMA, APMA
Market Musings, 2022 Outlook Edition
Given the start to a new year, we're taking this opportunity to release our Market Outlook for 2022 in place of our normal Market Musings post.
Equity markets in the United States made new historic highs in 2021. Our expectations for 2022 are not as rosy. There are headwinds that markets will face in 2022 that we believe will pose some risks for equity investors. That’s not to say that equity exposure should be reduced per se, but shifting from over-priced sectors and into under-valued sectors would probably be wise.
2022 Market Expectations
Our process forces us to examine three main legs of the economic stool when it comes to equity prices—Fed Policy, Fiscal Policy, and Corporate Earnings. Below is a brief summary of the three and how it may affect our asset allocation decisions for 2022:
Fed Policy: Neutral-to-Negative The Fed recently shifted from dovish to hawkish. In mid-December, the Fed announced a faster pace to Tapering of bond purchases and 3 rate hikes to take place in 2022. This means that the easy money for equity markets is officially over and now fundamental analysis will play a
much larger role in asset allocation. A hawkish Fed policy will likely lead to volatility in bond markets and some softness in equity asset classes that are over-valued, namely Technology and “growth” stocks.
Corporate Earnings: Positive Analysts look for corporate earnings to grow in 2022, albeit at a slower pace. Earnings growth in 2021 finished in the high double-digits (+45%). This year, earnings are expected to grow in the high single digits *(9% FactSet estimate). The primary issue was expected to be higher corporate tax rates built into the Build Back Better bill. That appears to be off the table (for now). However, inflation paired with higher labor costs and higher interest rates will likely eat into corporate profits in 2022.
Fiscal Policy: Neutral The government is expected to spend a little less in 2021 as additional fiscal spending will be at somewhat of a standstill in 2022. There is not much need for additional pandemic relief in 2022 as each COVID variant seems to be less severe. Senator Manchin has essentially killed the Build Back Better bill, unless somehow he can be convinced to change his steadfast position on the legislation. Lastly, we are entering a mid-term election year where major legislation is less likely to be attempted.
With regard to Fixed Income, the hawkish stance by the Fed will affect bond yields and prices. If the Fed stays on course with 3 rate hikes in 2022, the change in bond yields will be higher between 1% and 1.5%. Should inflation increases prove higher than Fed projections in 2022, this could cause the Fed to pump the breaks even more. The long-term average for the Fed Funds Rate is **4.6%. At that level, the fed could increase rates 4 times and still be 300 basis points off the historical average. We believe short duration bonds and lower correlation to U.S. Treasuries are a good fixed income strategies to undertake in 2022.
On the international front, we believe that the U.S. dollar will continue its dominance among world currencies. With the prospects of less additional fiscal spending on the table in 2022, the U.S. dollar should hold up well versus other currencies. The dollar rose more than 6% versus a basket of the top 5 world currencies in 2021. If the dollar continues on this path, which we think it will, then both developed international equities and emerging market equities are likely to under-perform U.S. equities.
With this as a backdrop, below are our total return expectations for 2022 for the following markets and ending values for economic data:
Equities: S&P 500 Index for 2022 (+7-9%); International Developed (+4-6%); Emerging Markets (+2-4%)
Fixed Income: Treasuries (-2%); Credit/Corporates (-5%); High Yield (+1%)
Economic: GDP (3.5%); Unemployment (4.0%); Inflation (8.0%); Fed Funds (0.75%)
2022 Asset Allocation
The following are the weightings given to the various asset classes listed in comparison to our neutral long-term asset allocation methodology.
The asset allocation of your specific portfolio(s) should be determined by you and your financial advisor. No two client situations are exactly the same and your situation may require deviation from these suggested allocation recommendations.
Equities: within the equity sleeve we are slightly increasing our Large Cap exposure, as inflation and interest rates will affect Small and Mid-caps greater than Large Caps; Developed International equities have been moved to a neutral weighting in our portfolios, while Emerging Market equities are now under-weight in our portfolios due to the expected appreciation of the U.S. dollar.
Fixed Income: within the fixed income sleeve we are over-weighting short duration and nontraditional bonds over intermediate duration bonds as the Fed Funds Rate will increase in 2022; while we are over-weighting to nontraditional bonds, we are slightly reducing exposure to asset classes such as high yield and convertibles as both asset classes are highly appreciated and bond volatility is expected to increase.
Alternative Investments: within the alternative sleeve we are over-weighting to Market Neutral and Real Assets as markets should experience more volatility in 2022. The need for capital preservation appears to be more of a concern with the headwinds we’ve previously mentioned and the fact that it’s a mid-term election year, which brings its own form of volatility to equity markets. Real Assets will be over-weight in the Commodity space as inflation is expected to drive commodity prices higher; Real Estate could under-perform in 2022 as higher interest rates may force home buyers to the sidelines as mortgage rates are expected to rise.
With regard to headwinds facing investors in 2022, below is a summary of five potential issues that could impact both bond and equity prices:
Fed Policy Error: It was originally thought that the Fed would begin raising the Fed Funds Effective Rate by the middle of 2022. This idea has shifted recently as minutes from the December Fed meeting suggest that March could be the first rate hike since 2019. Since inflation has proven not to be as “transitory” as the Fed assured us, market prognosticators and economists fear the Fed may be behind the eight-ball in terms of battling inflation. Time will tell if this is the case.
Inflation: As previously mentioned, inflation poses a threat to markets in the form of consumer behavior and corporate profits. If inflation continues to rise, it will cause consumers to make difficult spending decisions on essentials, rather than discretionary items. Since the consumer is two-thirds of U.S. GDP, a slowdown in discretionary spending would eat into corporate profits and negatively affect equity prices.
Interest Rates: As interest rates rise, cheaper assets look a lot more attractive than expensive assets. Technology stocks with average Price-to-Earnings rations in the upper 20s look more expensive than Financial stocks with average P/E multiples in the mid-teens. In addition to equity prices, personal loans and mortgage origination could slow due to higher interest rate costs.
Shipping Crisis: We hashed out this issue multiple times in 2021, but the risks still remain. Until transportation & warehousing sees a substantial increase in labor, consumers will continue to battle higher costs and longer wait times for products.
Labor Shortage: Consumers have noticed the lack of available help in restaurants, grocery stores, and retail chains. Coupled with the noted shortage in transportation, means employees need to be added in key sectors for continued economic growth.
*Source: Factset (S&P 500 CY 2021 Earnings Preview: Largest YoY Earnings Growth Since 2010 (factset.com)
**Source: St. Louis Federal Reserve (Federal Funds Effective Rate (DFF) | FRED | St. Louis Fed (stlouisfed.org)
This report was prepared by Eudaimonia Asset Management, LLC and reflects the current opinion of the authors. It is based upon sources and data believed to accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
Eudaimonia Asset Management, LLC (“Eudaimonia Asset Management”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Eudaimonia Asset Management and its representatives are properly licensed or exempt from licensure.
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No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Market or economic projections are not a guarantee of actual outcomes.
All investments include a risk of loss that clients should be prepared to bear. The principal risks of Eudaimonia Asset Management strategies are disclosed in the publicly available Form ADV Part 2A.
Risks associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.
Although bonds generally present less short-term risk and volatility risk than stocks, bonds contain interest rate risks; the risk of issuer default; issuer credit risk; liquidity risk; and inflation risk.