As 2021 came to a close I was reminded of how a lot of things in life happen slowly at first, and then descend upon us all at once. In 2021 we saw a broad-based equity rally, which is typical of a mid-cycle bull market when the economy is growing, and earnings are healthy. Markets rewarded technology-heavy growth stocks, which dominated at the onset of the pandemic. But it also liked so-called "value" stocks, especially large capitalization companies. While investment style leadership switched several times during 2021, we saw a steady move away from past growth stock favorites and toward high quality, cyclical value stocks that can benefit from a global reopening.
The change of gears from growth to value stocks is to be expected in a strong economy and when monetary policy begins to tighten. This shift became a full-blown rotation during the first week of 2022, when a rise in the 10-year Treasury yield put pressure on high valuation growth companies. Treasury yields shot up on revelations that the Federal Reserve took a more hawkish pivot at its December meeting than the market first thought. Almost overnight, the debate went from whether the Fed will raise rates two or three times this year, to whether it would be three or four. By the last week of January equity markets experienced their biggest bout of volatility since the pandemic-induced correction in March 2020.
This is the kind of volatility we’re going to be dealing with in 2022. Equities do have the potential to perform well during periods of rising rates, but the pace of tightening is now the key metric. If the Fed lifts rates faster than the market expects, or unwinds its balance sheet more quickly than anticipated, then it could trigger more volatility and exacerbate an expected slowing of the economy in the second half of 2022.
What’s key to remember in a year of volatility is that absent a recession, market pullbacks can sometimes be viewed as potential buying opportunities. Our 2022 outlook is for GDP growth to continue at a strong pace (albeit slower than 2021), at around 4%. We are forecasting inflation to come down from its 7% year-over-year increase in December, to end 2022 at around 3-3.5%. Earnings growth is likely to be slower than 2021 but still positive, and our forecast is for equity returns in the mid-single digits this year.
That said, we are no longer in a market where passive investing will reap double-digit returns. We have been prepared for volatility to increase across markets this year because rate hikes are coming, at a time when valuations are high and risk premiums are compressed. Our investment outlook for 2022 highlights investing themes for this phase of the mid-cycle bull market, which can be addressed by following three broad investment strategies: diversification, active management, and staying invested.
Diversification that goes well beyond a traditional mix of equity and fixed income in portfolios is a theme we’ve advocated for several years, given our longer-term expectations for more muted returns across asset classes. Yet it becomes an even more important driver of returns and a way to offset volatility as the punch bowl of excess liquidity gets pulled away. We are no longer in a market where a rising tide will lift all boats.
While we are constructive on growth and forecast modest equity returns in 2022, investment portfolios require more selective exposure across equities, broader fixed income diversification and the addition of diversifiers (also called “alternatives”) to help buffer volatility and hedge interest rate risk.
Diversification should include:
- A more nuanced application of investing styles. It will not be as simple as thinking of growth versus value or large-cap stocks versus small-cap. We saw in 2021, for example, that within the Russell 1000 – representing the largest 1000 companies by market capitalization in the U.S. – growth and value were in a dead heat, with growth only slightly outperforming value for the full year. But in the Russell 2000 index, the U.S. market’s main benchmark for small capitalization companies, value stocks significantly outperformed growth. We continue to believe that having exposure to all of these asset classes will serve investors well in 2022.
Exhibit 1: The Case for Style Diversification
- International and emerging markets. U.S. equities, with the S&P 500’s heavier exposure to growth sectors like technology, have outperformed other stock markets since the pandemic and should continue to deliver good returns, albeit in the mid-single digits. But there could also be opportunities outside the U.S. this year. Given Europe’s heavier tilt toward value stocks, there may be a case for not only maintaining but even increasing exposure to international developed markets in 2022. European stocks also trade at lower multiples than U.S. equities.
The recent returns of the MSCI Emerging Markets index have suffered from its heavy weighting to China, where equities have been hurt by more restrictive industry policies and a government clamp down on debt. While we continue to monitor China, we recommend active managers who can outperform by finding the most promising emerging markets opportunities.
- Private equity. We believe exposure to private equity and venture capital will be key drivers of outperformance within a well-diversified investment portfolio. Private equity's illiquidity offers protection against public market volatility, as well as historically better returns. While private equity returns may deliver less exceptional performance compared with the last 12-18 months, they are still expected to be more attractive than public markets.
- Diversifiers. Given that mid-cycle investing can be more volatile than earlier phases in the market cycle, having certain diversifiers in a portfolio can provide alpha, risk mitigation, and higher income. The diversifiers we like include absolute return strategies, which can do well in a rising rate environment; long-short equity hedges to buffer against expected volatility, and real estate, which should continue to benefit from still low rates and economic growth.
- Fixed Income: Our expectation for a modest rise in interest rates from today’s historically low levels creates a more challenging environment for bonds, which is why we advocate underweighting fixed income. But we don’t think fixed income should be eliminated altogether, because it still offers predictability of income and stability within an overall portfolio. However, broader diversification of fixed income strategies to include more credit for yield – like floating rate high yield loans and opportunistic funds – could help increase income and help buffer equity portfolios during bouts of volatility.
THE VALUE OF ACTIVE MANAGEMENT
Active management will prove critical in a year when Fed tightening incites higher market volatility. Just as we made the decision to lean into weakness at the start of the pandemic, the Investment Strategy Committee I chair will continue to make forward-looking decisions about what asset classes to overweight and underweight, based on where we see opportunities and risks ahead. For instance, you may see us take advantage of a further reopening of economies as Covid cases plateau, by tilting toward more cyclical sectors in developed markets.
Active management is also better in less efficient asset classes like small-cap stocks and emerging markets. And unlike ETFs, which have no cash reserves, active managers can lean into volatility and buy oversold stocks after selloffs. They can also choose what regions, sectors and industries to invest in, as well as identify companies that can thrive as macro and secular trends continue to shape economies and markets.
We are expecting earnings growth, rather than multiple expansion, to drive equity market returns this year. That means a research-driven bottom-up process is essential, to identify high quality companies with strong earnings and the pricing power to flourish in a higher inflationary environment. The more speculative areas of the market, where elevated multiples are not supported by earnings, will probably struggle.
Apart from the obvious benefits of compounding returns over the longer-term, there are many reasons why investors should resist the temptation to jump in and out of markets during bouts of volatility. One is the risk of missing the rebound after a pullback. Analysis of returns on the S&P 500 from the beginning of 2001 to the end of 2021 found that seven of the best 10 days occurred within two weeks of the 10 worst days.1
This is a year when investors will be rewarded by sticking to an investment plan and staying invested. Having a broadly diversified and actively managed portfolio is more important than ever to smooth the ride and find new sources of return. And knowing what sectors and companies are poised to benefit from market trends and rising rates can turn bouts of volatility into investment opportunities. We’ve monitored the steady shifts in the market’s personality in the past year, and we are prepared for the volatility that’s already descending on markets in 2022.