As we look into 2022, the page appears to be turning from pandemic to inflation and policy, with a likely resulting surge in market volatility.

The past year was extraordinary in terms of the economic and societal turbulence provided by COVID-19 and the successive Delta and Omicron variants, coupled with a sharp upward turn in inflation. However, it was also remarkable for the strength of many risk assets, buoyed by a recovery in earnings and continued easy financial conditions despite the seeming promise of eventual central bank tightening.

After a 29% annual return by the S&P 500 in 2021 following two previous strong years, can stock market investors expect a repeat performance? To us that would seem unlikely even in an environment of more ordinary dynamics. But in the context of pandemic recovery, lingering supply chain stagnation and a hawkish turn by central banks, we see a more likely progression toward volatile, modest return prospects and shifts in market leadership.

We believe that 2022 may be a time when value investing may gain further traction over growth, given value’s leverage to the expanding economy and the relative vulnerability of higher-priced growth names to rising interest rates. Moreover, we see this as a period to emphasize dividend income where it aligns with individual goals, as healthy fundamental conditions can support payouts even if share prices grow wobbly. More importantly, the current environment may provide a good opportunity to look at asset allocations to ensure that they line up with strategic goals after a three-year period of strong market returns and a significant change in potential underlying macro dynamics.

On Solid Footing

As we move into 2022, much of the global economy is in solid shape as demand continues to recover from the pandemic and supply chains are gradually restored. The International Monetary Fund forecasts 4.4% growth for the global economy this year, along with 4.0% for the U.S.—down from 2021’s torrid 5.6%, but well above the long-term average of 3.1% since 1947.1 After some pullback, leading economic data has rebounded, suggesting that the U.S. is still in the early to middle “boom” phase of the economic expansion. Spendable household and corporate liquid assets are $4.2 trillion above where they would be given pre-pandemic growth trends, corporate capex growth is close to its highest level in 15 years, and financial conditions are nearly the easiest on record. Meanwhile, with COVID-related worker shortages, employment growth remains reasonably strong and wage growth has been accelerating, supporting consumption. Overall corporate fundamentals are reassuring, with S&P 500 company consensus earnings expected to grow about 8.3% this year2 and the default rate for U.S. high yield issuers holding at a paltry 1%.3

U.S. Growth Extends Its ‘Boom’ Phase

Conference Board U.S. Leading Economic Index, Six-Month Change

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Source: Conference Board, LEI as of December 31, 2021. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Within this constructive backdrop, we believe the coronavirus is taking more of a backseat in terms of investment concerns. Despite the recent surge in cases, Omicron symptoms generally appear less severe than for previous variants, while vaccines and antivirals have been largely effective in preventing or treating serious illness. Although some areas have seen increased restrictions, major lockdowns like those of 2020 appear unlikely. Instead, higher inflation and interest rates, coupled with uncertainty about resulting action from central banks, are taking center stage.

Policy Push

Until recently, policymakers were surprisingly slow to react to inflation, but heady late-2021 numbers, including a 6.8% CPI figure in December, have spurred them to become more active. In Europe, Norway and the U.K., central banks have raised rates, while the European Central Bank nearly doubled its estimate for eurozone inflation in 2022, to 3.2%, and announced that it would taper some bond purchases (even while maintaining others). Even the Bank of Japan followed suit, signaling an end to its corporate bond and commercial paper purchases this quarter.

In the U.S., the Federal Reserve accelerated the pace of its anticipated tapering, committing to end all bond purchases in the next few months. Moreover, its meeting minutes and forecasts now suggest that there will be three rate hikes in 2022, the first as early as March—a dramatic change in tone from just a few months ago. This compares with the market consensus of four rate hikes in 2022. The Fed has also revised up its 4Q 2022 inflation outlook from 2.2% to 2.6%—well above its 2% average target.

In general, the consensus remains that 2021 inflation trends are probably not sustainable, as supply chain disruptions ease, stimulus impacts fade, and labor demand and supply become better aligned. However, a key question is to what level inflation settles and how long it may remain there. Regardless, the challenge for central banks could be significant: They haven’t seen this kind of inflationary pressure in decades, and current policymakers are more used to encouraging inflation than trying to tamp it down. Moreover, today’s inflationary forces are in many ways supply-driven (supply chain snafus, reduced energy production, etc.) rather than demand-driven, so it is not clear how much leverage central banks have to address them without harming growth. Finally, some forces behind inflation may be more structural—e.g., changes in China, permanent reorientation of supply changes and expenses tied to fighting climate change—which may simply become part of the “cost of business.”

How Much Could Inflation Ease This Year?

Consensus Inflation Forecasts

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Source: Bloomberg, as of January 19, 2022. The PCE, or Personal Consumption Expenditures index, is the Fed’s preferred measure of inflation. Core PCE excludes food and energy. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Market Cross-Currents and Investor Strategy

Historically, we have seen rising rates be a common headwind for financial assets, reducing the future value of corporate earnings and subjecting bonds to pricing pressure, not to mention increasing the capital costs to businesses. Uncertainty about central bank policy and inflation may contribute to volatility and the compensation for risk required by investors for their capital.

More Volatility Ahead?

CBOE S&P 500 Volatility Index (VIX)

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Source: FactSet, as of January 6, 2022. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Still, our constructive view of economic fundamentals translates into a moderately positive take on stocks and to a lesser degree corporate bonds and other non-Treasuries. Bottom line: we think a tightening cycle and economic growth can coexist.

Within equities, value appears more attractive than growth for the buffer it may offer against downside risk and its typically lower interest-rate sensitivity. So far, many large-cap growth stocks been resilient in the face of potentially tighter monetary conditions, but more leveraged segments have seen weakness. Importantly, we see appeal in equity income names, which tend to benefit from lower interest-rate sensitivity and may provide steady, growing dividends even if pressure builds on equity valuations.

Stepping back, the current expansion seems likely to support the more cyclical non-U.S. economies and markets, just as it could help more cyclical sectors domestically. The strengthening U.S. dollar in recent months has been a major factor preventing non-U.S. outperformance, but there may be signs of an end to that momentum: European and U.S. inflation forecasts are now fairly aligned and, particularly with further federal stimulus now in doubt, there is greater potential for developed non-U.S. economies to raise their share of global GDP growth. In contrast, prospects for emerging markets are a bit more difficult, given sensitivity to interest rates, exposure to slowing growth in China and more struggles in dealing with the pandemic.

A Weaker Dollar Could Favor Non-U.S. Markets

The Plot Thickens Chart 4 

Source: FactSet, as of January 6, 2022. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Within fixed income, we favor a general tilt toward corporate credit, albeit with some caution as the likelihood of a low default rate is accompanied by the potential for volatility. It follows that performance this year may be due more to coupon-clipping than appreciation, although tactical trading on dips may provide a source of return potential. As in equities, lower interest-rate sensitivity, or shorter duration, appears a priority. And we believe it may be useful to seek additional return opportunities from liquidity risk rather than interest-rate risk, pointing to the merits of loans and private debt, which offer floating rates and also the potential to support robust demand for private equity and mergers and acquisitions.

With equity and bond valuations stretched and at risk from rising rates, we see appeal in alternative investments that can potentially offer uncorrelated returns, excess returns generated away from the volatility of the public markets, mitigation of traditional asset class volatility, or returns derived from volatility itself. Hedged strategies, with a particular focus on market-neutral and uncorrelated approaches, may make sense for some investors, while commodities may provide value as a portfolio diversifier and can help hedge against further inflation surprises. Private markets also remain appealing, partly because of their lower volatility than public counterparts and the relative appeal of their valuations. Moreover, private equity managers tend to have more ways to improve operations and margins than public equity managers, and are therefore less reliant on multiple expansion for potential returns.

Changing the Story Line

Although we anticipate a period of more sustained volatility, we would caution investors to avoid overreacting to potential market swings in the months ahead. A degree of risk is almost always necessary, and the downside of cash and short-term instruments can be a lack of potential return in the face of more elevated inflation. Keeping portfolios in line with long-term goals can allow investors to maintain exposure to potential opportunities while avoiding the near-term tinkering that can be detrimental to long-term results. Core equity exposure is important, but there may be appeal in holdings geared to specific investment themes such as climate, technology connectivity or health care innovation. In fixed income, broadening exposure to an array of public and private sectors may help improve yield and return potential. More generally, an openness to moving beyond “home country bias” may prove useful as more value opportunities are evident abroad.

As 2022 continues to unfold, with fundamental and technical issues driving markets overall, we believe investors will have a degree of control over how that broader story specifically affects them, through asset allocation and sound planning. Indeed, the plotline may, over time, be very different from individual to individual depending on approach and consideration paid to specific goals in light of market realities.