Headwinds in 2022
We have seen an increase in volatility as of late, which makes it a little more difficult to handicap our outlook for 2022. News of a new COVID-19 variant forced a significant selloff in the market in early December as some countries re-instituted lockdowns, and déjà vu to the spring of 2020 set in. This was coupled with a more hawkish tone from the Federal Reserve (Fed) as they retired the term “transitory” inflation and pointed to a possible acceleration in their tightening plans. The combined impact from these two events took the S&P 500 Index down over 5% very quickly, creating a significant spike in volatility. Given high valuation levels plus the degree of rampant speculation, it seemed that risk assets were ripe for a significant correction.
Markets, however, have rebounded quickly in the last week as South African doctors downplayed the severity of Omicron symptoms, and vaccine and testing companies indicated the ability to respond rapidly to the new variant. While it seems unlikely that we are headed back into a full lockdown mode, we could very well see the revival of mask requirements and social distancing over the coming months as more data is analyzed. Importantly, there is much we do not know about this mutated version of the virus— what we do know is that the virus will continue to mutate. COVID-19 should eventually become endemic, much as the Spanish Flu of 1918 evolved over time from a pandemic to the H1N1 flu we now deal with annually.
While it appears we may be finally getting ahead of the curve with fighting the virus, we may be behind the curve with battling inflation. In recent congressional testimony, the Fed’s Chairman Powell revised the prior view of inflation as transitory and indicated that the pace of tapering might be accelerated at the Federal Open Market Committee’s December meeting. As JP Morgan’s Chief Strategist points out, however, “Tapering is different from tightening, and the Fed’s desire to increase the pace of tapering seems linked to concerns about financial markets overheating. As such, tapering may conclude earlier than expected, but we struggle to see how the Fed will raise interest rates before late 2022/early 2023.” The market seems to have digested this anticipated pace, but will react adversely to any further upside surprises on the inflation front that accelerate that pace.
We are responding to this patch of volatility with a measured review of both asset allocation and our underlying holdings. The flat yield curve still makes fixed income the least attractive asset class and the allocation in your portfolio remains near historical lows. We have expanded on the credit side to bolster yield, while keeping duration short to reduce interest rate risk. In the equity markets, we continue to remain overweight relative to the benchmark. The challenge next year will be fighting the Fed taper, as well as lower earnings growth relative to the past several quarters. However, with economic fundamentals intact, corporate profits are still expected to expand in the high single digits.
Given its significant price discount to US stocks, we are also looking to increase our international equity exposure. Returns in both developed and emerging equities have lagged US stocks for the last five years, but in 2022, we could witness a reversal of that trend as global economies recover from tighter lockdowns and restrictions. We may slow-walk this change given potential Russian and Chinese aggression on the horizon, but the relative values are compelling. In addition, next year should favor both broad diversification and active management as many of the tailwinds of 2021 dissipate.
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