2021 was a better-than-average year on many fronts. Strong stock market returns with infrequent and short-lived pullbacks, economic growth, policy stimulus and inflation all ran hot while volatility was historically low. 2022 won’t be a carbon copy, as progressing Fed policy settings and economic trends are consistent with mid-cycle conditions, a backdrop that could produce more moderate growth and market performance. In 2021, the world returned closer to normal, but the pandemic and inflation continue to pose unique challenges as well as geopolitics.
Below are some of the highlights that defined the markets in 2021, along with potential implications for 2022.
1. Strong economic growth
Powered by massive fiscal and monetary stimulus, a vaccine rollout and pent-up consumer demand, U.S. GDP grew about 5.5% in 2021, the fastest pace since 1984. With the benefit of strong household consumption (70% of the economy), economic activity reclaimed its pre-pandemic peak. Household finances emerged from the crisis in better shape than they went into. Unemployment declined from 6.7% at the beginning of the year to 4.2% with now increasing signs of labor market tightness.
2022 implications – Growth will likely moderate from this year’s rapid pace to about 3%-4%, but this is still above the 2.2% average. Even though the stimulus will fade, further jobs gains will continue supporting incomes. A full return to normalcy, though difficult to time, is likely to unleash pent-up demand for multiple services.
2. Inflation made a comeback as strong demand met constrained supply
2021 has been the year of high prices and inflation surprises. The consumer price index (CPI) has topped 5% amid material and labor shortages, supply has struggled to keep pace with the rapid rebound in demand.
2022 implications – Inflation will be carefully followed by the markets as central banks gear up toward rate hikes to tame fast-rising prices. Supply chain bottlenecks and the shift back to services from goods should help inflation peak in the coming months and moderate from there.
3. Rising corporate earnings propelled stocks higher
2021 was the sixth-best year for U.S. equities since 1990 and is hovering near record highs. Behind this large market return has been the strong cyclical rebound in corporate earnings. Pricing power along with productivity improvements helped margins and profitability reach a record high. With strong economic and earnings growth, U.S. equities logged another year of outperformance versus the rest of the world.
2022 implications – The bull market moved from the early recovery phase to a mid-cycle phase. As it progresses further into this phase, the pace of earnings and market gains will likely slow. A still-strong demand backdrop will continue to support earnings, helping sustain the bull market. Valuations are unlikely to expand, and could moderate some, especially if central banks start hiking rates.
4. Pandemic waves triggered rotations in leadership
Since the beginning of the year, stocks have remained in a steady and mostly uninterrupted uptrend, with only one 5% pullback. Following the vaccine rollout and optimism around the economic reopening drove sizable gains in value stocks then growth stocks and vice versa.
2022 implications – The path of the virus will continue to shape the course of the economy, but each virus wave has had a smaller negative effect on the economy. In addition, governments are less willing to impose severe restrictions on activity. As the reopening continues next year, value investments should continue to benefit from above-trend economic growth and then we may see a return of the growth stocks. A balanced approach portfolio is probably the wisest.
5. Excess liquidity fueled potential excessive valuation
Since 2020, the Fed stimulus has helped maintain stability in the credit system by lowering borrowing costs for consumers and businesses. However, this excess liquidity may have caused some excess in valuations.
2022 implications – Real yields could be rising from near-record lows. The gradual removal of excess liquidity and rate hikes will likely spark bouts of volatility in the speculative segments of the market. As the bull market progresses, a focus on high-quality investments becomes more important.
6. Politics and geopolitics
In 2021, the US remains divided into irreconcilable political camps, in addition we have high political tensions with China and Russia. There is also a growing view that President Biden is out his depth and is losing momentum.
2022 implications – Politics can depend on fine margins and a few personalities. Political systems can tip out of control thanks to a few accidents, but it can equally easily restore equilibrium. The tense relationship between the US and China will be a big challenge. Overall, we will have to discern the noise from the real important events that can be really disruptive.
The year 2021 has seen rapid growth, above-average equity returns, and inflation. The economic outlook remains bright for 2022, but as markets begin adjusting to slower growth and tighter monetary conditions, volatility is likely to increase, and returns will likely moderate. Maintain realistic expectations for returns, build properly diversified portfolios in market leaders with a solid financial standing. With fundamentals remaining firmly in favorable territory, if we were to see a correction, it should be temporary and can be treated as a buying or rebalancing opportunity.