Some days my mind wonders off on topics that really have nothing to do with the economy or the markets, for that matter. For example, have you ever wondered why birds sitting on power lines or telephone lines are all sitting in the same direction? I’m certain there are many reasons but one being when their ready to fly off together, they will have much less wind resistance when they fly into the wind. Or for that matter, watching a duck on the water, they look so peaceful and seemingly calm on the surface but below the surface their paddling furiously to move or resist water currents.
“Normal” is the last word any of us would use to describe the past couple of years. As we put 2021 behind us and stare into 2022, the bird on a wire and duck metaphor may be a quick way to characterize the economy and the equity markets. Going forward we will probably face more headwinds than we have seen in the past year, while being nimble and paddling hard to adjust to the market’s currents.
2022 Issues:
Next year could be a frustrating one for investors accustomed to a market that only goes up but there will be opportunities for those that approach markets carefully. In a recent Goldman Sachs Research report [1], their expectation is for 2022 to be broadly defined by more moderate expansion and normalizing monetary policy as the world navigates the next leg of an unusual pandemic recovery. A few of the key issues expected are supply chain issues and inflation. These two bugbears have captured the lion’s share of the news headlines and pundit discussions over the last few months. These are not likely to change and as economies and markets are facing a more complicated year ahead as they will have to contend with slowing global growth, rising inflation, and shifting monetary policies—and of course, the potential risks from the new omicron variant.
- Inflation. As the world moves past the peak of the reopening boost and gradually transitions from a highly unusual pandemic recovery to a more normal expansion, fiscal policy on the taxation topic is turning from a tailwind to a headwind and monetary policy is likely to adjust to a maturing economy with higher interest rates. During this transition, economic demand slows while supply rises, growth shifts from very rapid to merely solid, activity rebalances from goods to services and inflation moderates. After a decade of inflation below 2%, we believe inflation will shift to a higher level but won’t spiral out of control. It’s a reset, not a revolution.
- Supply Chain Issues. A combination of tightening financial conditions and decelerating growth is usually not a good thing for equities, especially when combined with some of the highest valuations on record. 2022 may not be a downturn primarily due to a fresh virus outbreak but also higher inflation because of tight goods supplies and excessive wage pressure. Although a significant part of the supply chain squeeze will abate over the next year, at present the stress on supply is substantial and inventories in semiconductors, durable goods and energy markets are very low. In such an environment, even a moderate production outage resulting from covid outbreaks, an energy demand spike related to a cold winter, or other short-term disruptions could have sizable economic effects.
Looking into 2022, it is going to be about midcycle challenges: better growth against lofty valuations, tightening interest rate policy and higher inflation than most investors are used to. So, we have mid-economic cycle conditions with late economic valuations.
A big component of successful investing is getting the narrative right and next year this will be no exception, begging the question: is the narrative changing? One might think so. A narrative of slower growth and higher interest rates will determine the market leadership and performance. Investors have benefited from a mostly smooth ride up but its important that they not be lulled into complacency. Therefore, as we move further into the mid-cycle environment and as interest rates come off historic lows, we would encourage investors to assume a more flexible and diversified approach, one made up of quality and dividend growth. The equity markets should remain buoyant but with much shallower gains through 2022, corresponding with rising bond yields.
In summary, 2021 was a year of rebound and recovery, and we expect that 2022, by contrast, will be a year of moderation—particularly when it comes to growth, inflation, and investment returns. So, despite a strong 2021 for equities, proceed with caution, expect a little more volatility, we are emphasizing “balance” and “patience.” You will need to be prepared but no need to panic, for despite the risks, we are optimistic about the outlook. Like the duck on the pond or the birds on a wire, navigating these currents and headwinds will be about finding an alignment of risk and balance. The investment environment is not nearly as rich with opportunity as it was a year ago, which means one must be more selective and fundamentals will matter.
[1] Goldman Sachs GS Macro Outlook 2022: the long road to higher rates.