Ever since the market bottomed in March 2020, the S&P 500 has more than doubled from its closing low and the economic recovery is now in full swing. Propelled by fiscal spending and the central banks’ dovish policies, economies around the world were boosted by a tailwind in 2021. Looking to 2022, the effects from the stimulus will likely continue to diminish and economies will continue to slow from high growth rates.
The global economy is expected to have grown at a 6% clip in 2021, up from a decline of 3.6% in 2020. Next year, growth will likely slow to around 4% globally. The U.S. Federal Reserve (the Fed) is forecasting 3.8% in U.S. gross domestic product (GDP) growth in 2022, down from its 5.9% projection for 2021, but still high relative to the prior expansion. This seems in line with many other economists’ forecasts. While growth is slowing to more sustainable levels, the Fed did raise the forecast for 2022 while lowering 2021. Supply-side constraints are delaying growth from this year to next year. The Eurozone could do better than the United States as it catches up in reopening, and China may lag developed countries next year. Latin America is expected to trail other regions in growth.
The Fed is likely to play a bigger role in markets as it attempts to normalize interest-rate policy. The Fed has already announced its plans to taper bond purchases. All this means is that they will curb its buying of longer-dated bonds and eventually halt those bond purchases. The Fed had been buying Treasury bonds with the intent to keep bond yields low, and this practice is called quantitative easing. The next step is for them to raise interest rates, but that could be tricky because that would slow economic growth and potentially hurt the labor market. If it doesn’t raise rates, inflation could run hot and cause problems for consumers as goods become more expensive. Both inflation and employment figures are already at 2016-2017 levels when the Fed started raising rates coming out of the financial crisis. If inflation heats up faster than expected, it may force the Fed’s hand to be more aggressive and this could catch investors by surprise.
Equity market valuations in U.S. large cap equities remain near their 15-year highs, which could add to volatility if the Fed has missteps and lets inflation run too hot for too long or acts too quickly. Technology stocks have done well and benefited from low yields more than other sectors. We see this when bond yields rise, and the technology sectors sells off. As consumers shift more toward services such as eating out or going on vacations, this will leave less room for spending on other products that lead us out of the recession during the pandemic. Smaller cap stocks and value stocks are more attractive on a relative basis even after adjusting for future growth prospects. Earnings are projected to be good next year, but earnings growth is expected to slow. Now may be a good time to think about rebalancing and including more international exposure as valuations are better and international markets have less technology exposure and have underperformed U.S. markets for many years.
Fixed income is a challenging area right now because bonds offer relatively low yields with growing interest rate risk. As the government issues longer-dated bonds to finance the nation’s increasing debt, the duration, or interest rate sensitivity, of major indexes is growing. Now may be a good time to review portfolios for duration and see how sensitive your portfolio is to interest rate movements. Bonds are one of the best buffers against equity volatility, so one should not ignore them. However, bond positioning is important as inflation heats up. The Fed could raise short-term rates or bond investors may start to require higher yields for investing in longer-dated bonds. As yields rise, bond prices fall. Corporate bonds offer more yield but seem adequately priced. Overall, diversification within bonds and maturities could make sense depending on individual goals.
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This report is created by Cetera Investment Management LLC. For more insights and information from the team, follow @CeteraIM on Twitter.
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