- Global growth continues, albeit slower than 2021
- Inflation moderates, settling at a range of 3%-3.5%
- Monetary and fiscal policy less accommodative, yet still supportive of growth
- Muted fixed income returns as rates move modestly higher, led by Treasuries with shorter maturities
- Global earnings will moderate, but continue to drive equity gains
- Forward-looking asset allocation thinking, broader diversification including less-correlated assets, and staying fully invested will be more important than ever
It’s hard to believe we are nearly two years into the global pandemic, a crisis that has caused a tragic loss of life, the deepest recession since World War II, an unprecedented pace of recovery and a global transformation in the way we work and live. The COVID pandemic has been a balancing act on a global scale, with governments and central banks trying to gauge how much fiscal and monetary stimulus was needed to catapult economies out of the crisis, without igniting runaway inflation and other structural imbalances in the process.
The explosive demand of 2021 resulted in stronger-than-expected economic and earnings growth and another year of double-digit returns for U.S. equity markets. Inflationary pressures also grew as consumer demand overwhelmed supply. Supply chain bottlenecks were a global phenomenon, as was a chronic shortage of labor. By year-end, inflation had spiked and stayed elevated long enough to force the Federal Reserve to drop the word “transitory” from its comments on inflationary pressures and take a slightly more hawkish stance.
We think 2022 will be a turning point in the pandemic, as well as for growth and inflation, as policymakers wean economies and markets off fiscal and monetary stimulus. With the anticipated increase in vaccine manufacturing and the availability of new therapeutics, we are hopeful we are turning the corner from pandemic to endemic. Meanwhile, global economic growth, corporate earnings, and equity gains look set to moderate and transition to lower yet still positive levels, led once again by the United States. Inflationary pressures should ease, but settle at a slightly higher level than the recent past, allowing central banks to successfully navigate soft landings.
Yet with all that said, we are optimistic at this point in the cycle. While 2022’s turning points may cause more volatility, it should be a good year of growth and gains. Let’s look at what may lie ahead for the global economy, the markets and what it means for portfolio positioning.
Turning Point: Global Boom Slows to Above-Trend Growth
Our base case is that the global economy delivers above-trend growth in 2022, albeit not as strong as 2021. Our 2022 forecast for real U.S. GDP is 4.0%, compared to an estimated 5.6% in 2021, and 4.4% for the Eurozone, versus an expected 5.2% in 2021. The United States and Europe should continue to benefit from 2021’s fiscal and monetary support, positive wealth creation from rising equity markets, and continued solid consumer demand. Although China was first to rebound from the pandemic, its growth moderated in the past year, as evidenced by a slowdown in manufacturing and services activity (Exhibit 1). We expect this trend to persist in 2022. China’s GDP growth is likely to slow to around 4.3% from an estimated 8.2% in 2021, as it continues to clamp down on debt levels, tighten regulation in certain industries like technology, tutoring and gaming, and address wealth imbalances.
Exhibit 1: Growth Momentum Slows, Particularly in China
Jobs, Spending and Supply Chains: Keys to U.S. Growth
Key to growth in the United States will be further improvement in the job market, continued strong consumer spending and an easing of supply-chain bottlenecks to help moderate inflation. The United States has made substantial progress toward recouping the more than 22 million jobs lost during the height of the crisis. By November, the United States was 3.9 million jobs shy of reaching its pre-pandemic employment level. Importantly, the unemployment rate has been in a downward trend and sits at 4.2% as of November (Exhibit 2). Historically, the direction of the stock market is positively correlated with declining unemployment, so the unemployment rate is a positive data point as we look ahead to 2022.
Exhibit 2: Tight Job Market
Still, the United States has a labor shortage. The October Job Openings and Labor Turnover Survey report showed over 11 million job openings and the labor force participation rate remains below its pre-pandemic levels. COVID continues to make many hesitant to re-enter the workforce and has prompted a wave of resignations and early retirements as people reassess their careers and priorities. We believe some of these factors will start to wane in 2022, which should help to ease the labor shortage. Even so, we’ll continue to monitor the rise in average hourly wages, which has been mostly driven by the service sector, to see if that proves to be a more permanent driver of inflation.
The U.S. consumer – accounting for 70% of GDP – has also emerged from the crisis financially healthier, with less debt and more accumulated savings arising from government stimulus, forced savings and asset appreciation. Throughout 2021, consumer spending, as measured by retail sales, has been resilient. November’s reading came in softer-than-expected, up 0.3%, as shoppers reacted to rising inflation, supply shortages and potential delivery delays. Retail sales continue to look strong on a year-over-year basis, up 18.2% from November 2020 (Exhibit 3). We continue to believe that spending will remain strong, given the roughly $2.5 trillion consumers still have in excess savings as of the fourth quarter of 2021, according to Moody’s Analytics. Keeping prices from spiking and COVID from spreading are essential for consumer spending to expand beyond goods to services. Both factors caused consumer confidence to drop in November.
Exhibit 3: Consumers Remain Healthy but Watch Sentiment
Turning Point: Inflation and the Fed’s Pivot
Inflation, whether temporary or longer lasting, and what central banks do about it, will remain a pervading focus of markets. In the United States, the Fed tracks the Personal Consumption Expenditures (PCE) Price Index, excluding the volatile food and energy components, for its flexible 2% inflation target. The core PCE rose by 4.1% in October versus a year ago, as illustrated in Exhibit 4.
Exhibit 4: Elevated Inflation: Will it Persist?
Although inflation has persisted for longer than expected, we believe that a period of sustained higher inflation is unlikely. The combination of supply-chain disruptions easing, the price of oil declining from its recent high in October and the “base effect” of comparing prices to 2021’s elevated levels should allow inflation to moderate in 2022. Also, two powerful forces that have dampened inflation for the past 20 years are still in place: aging demographics across the world's largest economies, and technological disruptions. The pandemic has added a third inflation dampener: productivity growth, which is prevalent in industries such as retail, healthcare, manufacturing, and financial services. We expect inflation will settle at a new normal range of between 3%-3.5% by the end of 2022, slightly higher than it has been the past decade, yet still in a range that is supportive of growth.
Still, we acknowledge that a shift in government policy from emergency measures to long-term public investments could fuel inflation beyond 2022. Although the Build Back Better proposal is still being negotiated, there are independent estimates suggesting that it could cost trillions of dollars over 10 years if some of the temporary provisions, like childcare credits, become permanent. Additionally, there are real concerns that the shift to a lower carbon economy could be inflationary, as the oil industry invests in renewables rather than fossil fuels, which will still be needed during the transition phase. A supply shortage could lead to higher oil prices persistently above $100/barrel. It will be important to monitor these contributing factors moving forward.
At its December policy meeting, the Fed announced it would scale back purchases of Treasuries and mortgage-backed securities to $30 billion/month, putting it on track to end all asset purchases by early 2022. The Fed also increased its median forecast for raising rates to three times in 2022. If inflation continues at the same pace as in 2021, the Fed could increase the federal funds rate as soon as the spring. In our view, the Fed will likely increase its policy rate twice before the November mid-term congressional elections.
We will likely see some monetary policy divergence among global central banks, with some tightening to tackle inflation, while others – especially China – remaining accommodative to support growth. This shift in monetary policy carries two risks: Moving too aggressively to tighten monetary policy, only to discover that inflation was temporary all along, which could derail recoveries. On the other hand, waiting too long to find out price pressures are more persistent could prompt more aggressive tightening than first expected.
The bottom line is that while policy uncertainty and the likelihood of rate hikes may be a source of market volatility in 2022, we expect the transition from what has been extremely accommodative monetary policy to something slightly less accommodative will continue to support growth and financial markets.
Fixed Income Returns Remain Muted
At the start of 2021, we expected modestly higher interest rates and a steepening of the U.S. Treasury yield curve. While interest rates moved higher across the Treasury curve, the yield curve flattened by year-end, with the shorter maturities rising more than the longer maturities in anticipation of the Fed’s tapering. Meanwhile, the U.S. 10-year note has had its share of volatility, with yields rolling higher amid positive economic news and higher inflation and then lower when COVID cases spiked. As we approach year-end, it looks very unlikely the 10-year U.S. Treasury yield will close above its 1.75% high point reached earlier in the year.
In 2022, we expect Treasury yields to move modestly higher, led by short-term interest rates. The trend higher in long-term rates should be more muted as markets anticipate that the Fed will not allow inflation to become problematic. We forecast a 1.25%-2.25% range on the 10-year Treasury note yield in 2022, ending the year in a range of 2.00%-2.25%. There is a limit to how high long-term U.S. rates can go, as they remain tethered to negative/low global sovereign rates.
Exhibit 5: Yield Curve Flattening Amid Potential Taper Acceleration
We continue to favor credit markets, given that corporate profitability is solid and defaults remain low. Investment grade and high yield corporate bonds still offer relatively attractive yields over Treasuries. Investors, however, should expect less price appreciation going forward, given the recovery in spreads has largely already occurred. Although we are underweight emerging market debt within portfolios, the asset class offers an attractive source of yield and is expected to deliver modest single-digit returns in 2022, as countries further reopen.
For tax-sensitive investors, municipal bonds remain attractive even though the relative yield spread between AAA-rated municipal bonds and AAA-rated Treasuries is currently tight by historic standards (Exhibit 6). Despite fears that municipalities would face downgrades in the height of the pandemic, federal stimulus, taxes from online sales, and revenue from appreciated home prices has dramatically improved financial conditions for many states and localities. We expect municipal bonds to deliver modest returns, buoyed by continued strong demand and slightly higher supply. Diversification within fixed income and a bottom-up, research-driven analysis of individual securities will remain an important aspect of uncovering value.
Exhibit 6: Municipal Bond Yields as a Percentage of Treasuries
A Solid but Bumpier Ride for Equities
Global equities had yet another strong year in 2021, driven by robust earnings growth as consumer demand exploded. Companies were able to manage rising input costs and keep profit margins increasing by adopting new technologies and finding cost savings. We don’t expect 2021’s 50% year-over-year growth in global earnings to persist in 2022, largely because year-over-year comparisons will be somewhat more normalized, and economic growth will moderate.
BNY Mellon Wealth Management estimates an S&P operating earnings range of $210-$220 for 2022. This more modest earnings growth rate of 5%-10% should continue to drive equity returns higher. Our year-end target for the S&P 500 is around 4,900-5,100, up 5%-10% year-over-year from December 14’s close of 4,634. Earnings growth outside the United States is expected to improve, with Bloomberg’s consensus for year-over-year earnings growth in 2022 at 4.5% for developed international equities and 5% for emerging market equities. This is based on expectations for continued economic recovery outside the United States and a stable to slightly weaker U.S. dollar.
Price-to-earnings valuations are incredibly important, as they suggest how powerful a drawdown might be if markets were to correct. U.S. stock multiples remain elevated compared to historical averages. At the end of November, the S&P 500 P/E was at 21x based on consensus 12-month forward earnings, above the 10-year average of 16x. The question will be whether markets can maintain elevated multiples in the face of less accommodative monetary policy and modestly higher inflation. History shows that equities can do well in a higher inflationary backdrop. As illustrated in Exhibit 7, multiples have held up well when inflation has been in the 2%-4% range. It’s when price increases have risen above 6% that multiples have been negatively impacted. Thus, relative valuations, along with plentiful cash still sitting on the sidelines, explain why investors “bought the dips” whenever equity markets consolidated in 2021 (Exhibit 8).
Exhibit 7: Low Inflation Supportive of Current Valuations
Exhibit 8: Cash on the Sidelines
The largest peak-to-trough correction in 2021 was only 5%, as fears of Omicron unsettled markets at the end of November. This has left many investors wondering whether equity markets are in store for a more substantial correction in the near future. But underneath the broader market, many individual stocks have already suffered corrections, with a year-to-date average of 37% of stocks in the S&P 500 declining over 10% from their 52-week highs. We believe this is healthy as the market resets at a price investors are willing to pay. Still, stock markets have tended to correct (that is, decline 10% or more) every 12-16 months. If we look at data since 1987, the S&P 500 has delivered an average intra-year correction of 14%, yet the stock market has finished higher nearly 75% of the time. So, while a significant pullback is certainly possible, it doesn’t necessarily mean that we are approaching the end of this bull market. Strong market calendar years are often followed by good markets in the next calendar year. Exhibit 9 suggests that when the S&P 500 is above its 200-day moving average, forward returns are often favorable. While the kind of returns we’ve seen in the past three years may not be repeated in 2022, we still believe equity markets can deliver another solid year – especially if economies and earnings continue to grow, without inflation becoming a longer-lasting problem.
Exhibit 9: Consecutive Days Above 200-Day Moving Average
There is also the potential for leadership shifts in investment styles in 2022. Since the March 2020 lows, we have seen several rotations between growth and value styles. Growth stocks dominated at the onset of the pandemic in 2020, as companies were able to deliver growth even as overall economic activity was barely on the mend. As the economy began to reopen, the hardest hit cyclical and value stocks were rewarded. But, as you can see in Exhibit 10, this leadership between growth and value within large cap stocks changed hands several times in 2021. As the year has played out, we’ve seen sentiment shift from growth to value and back again, as investors weighed economic strength, interest rate changes and COVID concerns.
Although investors have benefited from exposure to a mix of growth and value styles in 2021, we may see value take the lead in 2022, if economic activity broadens and COVID becomes less of a factor. If this occurs, small cap stocks as well as non-U.S. indexes should benefit from their more cyclical tilt.
Exhibit 10: The Case for Style Diversification
Positioned for Mid-Cycle Bull Market
In our view, this economic cycle is not ending. We believe we are in the mid-cycle of the recovery, which brings slower economic and earnings growth compared with levels earlier in the cycle, slightly higher inflation and an unwinding of central banks’ accommodative policies. We believe these factors can still be positive for risk assets in the coming year, albeit with more modest expectations for returns.
We continue to have a small overweight to equities overall, favoring U.S. over foreign stocks. The bull market should continue to broaden as the global recovery extends to more economically sensitive parts of the economy. There is the potential to diversify equities further into those regions, across capitalizations, and sectors.
We have a small underweight to fixed income given today’s very low yields. But as we saw when news of the Omicron variant rattled markets, fixed income continues to play an important diversification role in portfolios. We remain underweight U.S. Treasuries and favor credit, including investment grade, high yield, and municipal bonds.
We also have a slight overweight to diversifiers (often called “alternatives”) to buffer against the expected volatility. Private equity and real estate can provide attractive sources of return and can benefit from an overall economic recovery. While returns from private equity and venture capital are not likely to continue the exceptional performance from the last 12-18 months, they are still expected to provide more attractive returns than public markets. For investors who have additional capital to put to work, but are hesitant to enter at market highs, we suggest customized hedging solutions that provide capped upside exposure, with some downside protection against volatility.
Exhibit 11: Asset Class Positioning: Investment Strategy Committee Recommendations
A Look Back and a Look Ahead
History doesn’t always repeat but it often rhymes. At the onset of COVID, we were, of course, reminded of the flu pandemic in 1918 and the decade of the 1920s that followed. That decade of the “Roaring 20s” saw economic growth driven by productivity and innovation and a strong bull market. But there are also similarities to the post-World War II period, in the 1950s, when the United States achieved growth unseen in other parts of the world, driven by government spending on the interstate highways and social programs, as consumer spending shifted into high gear. Of course, the inflation spikes resulting from the unprecedented amount of fiscal and monetary support during the pandemic have also prompted comparisons with the 1970s and its runaway inflation.
We think there are more similarities with the roaring 20s and the 1950s, than the 1970s. Like the 1920s, we believe we’ll see a boost in both productivity and innovation, and similar to the 1950s, there’s likely to be a rebuilding of the economy boosted by the Millennial generation forming households, and increased infrastructure spending. While there are also some similarities to the elevated inflation of the 1970s, there are factors that will continue to keep inflation under control, including technology, demographic trends, and productivity.
Looking beyond 2022, each year we produce forward looking capital market assumptions to project asset class returns, volatilities and correlations over the next decade. This year’s analysis incorporates our expectations for higher inflation, a moderating pace of growth and a transition away from extremely accommodative policy. These projections are important inputs to our strategic asset allocation framework which helps to guide portfolio allocations based on a combination of growth, yield and stability goals. In recent years, these assumptions have reflected a more challenging return environment for a traditional 60/40 portfolio of U.S. stocks and bonds. We’ve responded by incorporating a wider array of asset classes within portfolios, in order to achieve specific wealth goals for our clients. This has included diversifying fixed income holdings, expanding the mix of equities, and adding alternative asset classes, notably private investments.
To navigate anticipated shifts in market conditions, we act on shorter-term 12-18 month views to capitalize on relative opportunities and to mitigate risk. These more frequent tactical views proved critical during the height of the COVID-induced bear market, as we leaned into weakness recognizing the buying opportunity the crisis created.
While we expect 2022 to be a turning point in the recovery from the global pandemic, our overall outlook remains constructive. We believe the combination of timely asset allocation shifts, broad diversification, and the discipline to stay invested over the long term will be more important than ever. The world has been irrevocably changed by the crisis, but a commitment to these investment principles will allow us to help our clients navigate this new world and to help you continue to build and protect your wealth.