January 27, 2022

The beginning of any new year is typically a time of hopeful resolutions as we reflect and strive to improve upon the shortcomings of the prior year. Moreover, in the case of ringing in 2022, we were very much longing to see a general return to pre-pandemic norms. Unfortunately, the immediate start to this new year was already thrown a severe punch to this optimistic thinking by the new Omicron variant disrupting holiday gatherings, as well as business activity, and the stock market experiencing its worst correction since 2020. As frustrating and uncomfortable as this initial 2022 activity has been, we have a more sanguine longer-term view and feel that this is a correction in a bull market instead of the end of the economic cycle. We expect generally positive returns in the stock market this year and, more meaningfully, a global acceptance of COVID-19 as an endemic disease.

Since April of 2020, the stock market has delivered exceptional returns with surprisingly little volatility, as unprecedented amounts of global economic stimulus have driven significant demand for goods and services and supported consumers’ balance sheets. Along the way, we have witnessed a litany of asset-inflating activity including one of the strongest IPO markets in history, a surge in the popularity of SPACs, surging meme stocks such as Game Stop, the exceptional rise of Cathie Wood’s ARKK ETF, and steadily climbing cryptocurrency prices. For an extended period, many who chose to dabble (indeed, speculate) in these things were handsomely rewarded. However, many of these same areas of the markets changed course by the end of last year as the IPO market softened, SPACs struggled to attract capital, meme stocks fizzled, and both the ARKK ETF and Bitcoin fell more than 30% from their highs.

Importantly, the S&P 500 was relatively unphased by the air coming out of these overinflated parts of the market last year. But as the new year began, with Omicron cases and concerns rising and the Federal Reserve telegraphing plans to hike interest rates multiple times this year to combat inflation worries, volatility in the broader market picked up. Many high-valuation growth stocks recently experienced significant pullbacks and the top ten holdings in the S&P 500—which had been trading at significant valuation premiums to the remaining 490 stocks—also declined more than the broader index. 

Since 1950, the average calendar year S&P 500 correction has been 13.6%. Such pullbacks are particularly common at the beginning of any rate-hiking cycle when investors anticipate being able to earn higher risk-free rates of return and re-evaluate how much they are willing to pay for other risky assets. This time around, we not only have the likely beginning of an extended rate-hiking cycle, but we also have the highest inflation in 40 years, plus ongoing COVID-19 variants and escalating geopolitical tensions. However, corrections of 20% or more are usually caused by recessions and, outside of a “black swan” type of event, we don’t see any sign of a recession developing in the next 12-18 months.

Indeed, many forward-looking economic indicators, such as the Conference Board Leading Economic Index (LEI) and the Institute for Supply Management (ISM) surveys of the services and manufacturing businesses are at very elevated current levels relative to history, which suggests that economic activity will remain strong in the coming quarters. Furthermore, the job market is healthy with an estimated one and a half jobs open and available for every unemployed person. 

Even so, the overall pace of consumer spending on goods is apt to slow this year based on the significant buying activity that has already occurred over the last few years. The Omicron variant is also likely to negatively impact economic activity during the first quarter of this year as rising infections cause labor disruptions and yet another round of cancelled in-person events. However, as the year progresses, we expect spending on services—as well as travel and leisure activities—to meaningfully pick up as global attitudes toward the pandemic shift to more manageable and acceptable endemic status. Ongoing labor shortages could also support spending on capital goods and technology as companies strive to increase productivity. This should serve to not only alleviate consumer goods-related supply chain disruptions but support ongoing economic growth as well.

But what about inflation? There is a strong argument to be made that we are experiencing peak inflation here in the early part of 2022 and expect that some categories such as used cars—which contributed a noteworthy 1% of the 7% increase in CPI during December—will stop experiencing price increases as supply chain shortages ultimately correct themselves. Of course, some parts of the inflation basket—such as labor and rent—are less temporary and their increases could hold and offset some of the likely positive outcomes in other categories. Still, we expect the end-result to be a year where inflation moderates as the year goes on. Besides, many parts of corporate America benefit from mild inflation as companies have social permission to raise prices for the first time in many years. This is especially true in environments like the one we are in now where demand has remained strong even in the face of rising prices.

In the aggregate, we will continue to manage our client portfolios with an overweight to growth assets as we feel that stocks and commodities will generate a higher return than bonds this year. Even though the valuation of the broader equity market is somewhat above historical averages, we continue to see opportunity within several areas. International stocks continue to represent compelling opportunities with valuations that are three standard deviations below their usual discount to the U.S. markets. In a scenario where the global economy reopens, we think this part of the equity market could outperform. Similarly, more economically sensitive sectors in domestic markets—such as financials, industrials and energy—could continue to trade at attractive valuations relative to the broader market and should also benefit from above-average economic growth.

So, as others opine in the New Year about the changing landscape of the moment, our own reflection on the year to come is one of continued economic growth and a potential shift in global views of COVID-19 from pandemic to endemic. We look forward to discussing our views with you directly and wish you a happy and healthy 2022.