Commentary by Jerry Herman, CFA®

In 2021 the world returned to some level of normalcy and featured a recovering and generally strong economy. However, we continued to face ongoing challenges from the pandemic, supply chain disruptions, the highest inflation levels in decades, and generally sustained low interest rates. Overall investors benefitted from this combination – with equities strong and fixed-income weak. Fueled by massive fiscal and monetary stimulus, a vaccine rollout and pent-up consumer demand, U.S. GDP grew an estimated 5.5% in 2021, the fastest pace in more than a quarter century.        

Household finances emerged from the crisis and spending on big-ticket items surged. Unemployment declined from 6.7% at the beginning of the year to around 4% at year-end with increasing signs of labor market tightness.   The year featured high prices and inflation surprises. Through November, the consumer price index (CPI) topped 5% for seven straight months, with the November reading coming in at 6.8%, the highest in 40 years.    

Supported by a strong economic recovery and very accommodative monetary policy, the S&P 500 reached 70 record highs during the year, the most since 1996. The S&P 500 returned 26.89% in 2021, which followed gains of 18.4% in 2020, and 31.5% in 2019 - only the third time since 1926 that returns were greater than 18% for three straight years. The Dow was up 18.73%, and the Nasdaq was up 21.4%. While equity returns were strong, the picture was not so rosy for fixed-income, which recorded one of the worst years on record as interest income was more than offset by bond price declines.  

According to Blackrock, the world’s largest money manager, 2022 is expected to deliver global stock gains and bond losses for a second year – a first since data started in 1977. This unusual outcome is expected to play out as Central banks and bond yields are slower to respond to higher inflation than in the past. That should keep real, or inflation-adjusted, bond yields historically low and support equity valuations. It’s rare for global stock returns to be positive and bonds negative in any one calendar year let alone two years in a row.  

Several key themes should prevail in 2022: Central banks will be withdrawing some monetary support as the restart does not need stimulus. As a result there should be more moderate returns for equities. We expect the Fed to hike interest rates, but to remain more tolerant of inflation than it has been in the past. The Fed has achieved its inflation target, so the timing and pace of higher rates will depend on how it interprets its “broad and inclusive” employment mandate. So, inflation could very well settle in at levels higher than pre-Covid even as supply bottlenecks ease. New virus strains are expected to delay, but not derail, the restart thanks to effective vaccine campaigns and broadening natural immunity - less growth now should mean more later on. However, we are dealing with a confluence of events that have no historical parallels which increases the range of potential outcomes. This suggests trimming risk a bit. Since 1993 higher long-term rates have been historically good for stocks with average annual increases of 22%, while increases by the Fed have resulted in more muted average returns of 6.6%, which is below the historical average return.                

Regarding equity styles, we could see a shift toward value. Recently (end of October), the Price-to-Earnings ratio gap between growth and value was huge; 34x for growth vs.18x for value. Historically, when the variance is greater than 15x value tends to outperform growth over the next 3 years by about 17%.  So, investors are encouraged to review their equity style allocations.       

Bottom line: For 2022, there is a preference for equities in the inflationary backdrop of the strong restart; and in fact when equity returns are greater than 18% for three straight years they tend to follow up with a strong 4th year.  To help manage risk and maintain geographic diversity, it makes sense to lean into developed market (DM) stocks over the historically more volatile emerging markets (EM).

Yields (interest rates) are expected to gradually head higher but to stay historically low. Given the inflation outlook, inflation-linked bonds, partly as portfolio diversifiers; appear attractive. Strategically, there is a preference for equities over nominal government bonds and credit.    

With this backdrop, investors are encouraged to review their portfolios to insure allocations are aligned with goals, objectives, and risk tolerance.  Attention should also be given to sector, style, and geographic opportunities in equities and the size and role of fixed-income positions.