Don’t Expect Big Returns From the Stock Market Next Year as Interest Rates Rise
For investors, this has been a year like no other. Stocks soared, bonds slumped, Bitcoin went bonkers—on the upside and down—and nonfungible tokens became a head-scratching asset class, after an NFT of a digital collage by an artist known as Beeple sold at auction for $69 million. By our math, that equates to 339 times the annual salary of the chairman of the Federal Reserve, which flooded the pandemic-plagued U.S. economy with trillions of dollars in stimulus over the past two years, inflating the price of numerous assets.
This past week, Fed Chairman Jerome Powell announced that the U.S. central bank will accelerate the taper of its stimulus spending in a bid to combat the highest inflation rates since 1982. Therein lies the first clue that 2022 is unlikely to resemble the year now drawing to a close. The Fed’s hawkish turn paves the way for an increase in interest rates—probably several—for the first time since 2018. Meanwhile, corporate earnings and economic growth are expected to decelerate next year. About the only constant: the persistence of Covid-19.
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All of this adds up to a forecast for diminished equity returns, negative returns on bonds, and increased volatility across asset classes. With the stock and bond markets both priced for perfection, equity investors will need to focus next year on quality companies that can control their own fate, irrespective of macroeconomic trends. Fixed-income investors might need to look beyond traditional bonds for decent yields, while investors in commodities and real estate could find attractive inflation hedges.
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Here’s a look at the economic and investment outlook for 2022, based on our conversations with economists and market strategists over the past few weeks.
The Economy
The Covid-induced recession of 2020 officially lasted just two months, but was one of the deepest economic contractions in history. The rebound has been just as dramatic, and should continue in 2022. At the same time, supply-chain pressures, labor shortages, and inflation all could persist. The fast-spreading Omicron variant of the coronavirus could restrain travel and leisure spending, but an increase in the vaccinated population should help society carry on.
“Consumer and capital spending will continue to drive the economy next year, but we’ll return to a more normal growth rate,” says Wall Street economist Ed Yardeni, president of Yardeni Research.
He sees U.S. gross domestic product increasing by 3.3% in 2022, down from this year’s expected growth rate of more than 5%.
““Consumer and capital spending will…drive the economy next year, but we’ll return to a more normal growth rate.”
— Economist Ed Yardeni
The key variable for investors in 2022 will be the path of inflation, and central banks’ response. Returns for many asset classes could depend not just on when, but also how forcefully the Fed and other central banks withdraw the stimulus unleashed in 2020.
Based on the consumer price index, U.S. inflation rose by 6.8%, year over year, in November. Most economists expect inflation to remain high in the first half of 2022, before easing as supply-chain issues are resolved. But the consensus is for inflation to settle around 3%, well above the Fed’s 2% target and the 1.5%-to-2% range seen during much of the decade preceding the Covid pandemic.
The Economy: Still Strong
Although forecasts vary, the U.S. economy could continue to grow at a decent pace in 2022, propelled by strong consumer demand. The Fed's favorite inflation measure looks likely to peak.
“Inflation is set up numerically to abate; we won’t get another rise in energy prices [on the order of this year’s increase],” says Diane Swonk, chief economist at Grant Thornton. Yet, inflation has become more “broad-based,” she notes, pointing to rising shelter costs and wages, in particular. “There is the risk of it becoming entrenched and producing a wage-price spiral,” she says.
Even after supply pressures ease, strong household balance sheets and a tight labor market are likely to keep consumer demand high, while giving workers leverage and pushing up wages. That should put a floor under inflation at about 3%, but price increases won’t be economically destructive. “This isn’t the type of inflation that kills growth,” says Jefferies’ chief financial economist, Aneta Markowska. “This isn’t a stagflationary scenario.”
The Fed is still injecting stimulus into an economy that hardly needs it, economists say. Based on the Fed’s latest announcement, its asset-buying program is on pace to end in March. The median forecast of policy committee members calls for three quarter-point rate hikes in 2022, followed by three more in 2023.
The bond market is pricing in a targeted federal-funds rate of 0.75%-1.00% by the end of next year, up from 0%-0.25% now. That’s not a high nominal level of interest rates, and they will remain negative after adjusting for inflation. But three increases would mark a meaningful shift that could be felt across financial and other markets.
Ultralow interest rates push investors to take more risks, moving from Treasuries into corporate credit, from bonds to stocks, and from defensive shares to more speculative ones. When rates begin to rise, investors typically reverse course.
Equities
The S&P 500 index has returned 26%, including dividends, this year, following an 18% return in 2020. Strategists forecast more-muted gains for next year, with year-end targets ranging from the mid-4000s to the low-5000 area, versus Thursday’s close of 4668. A target of 5100 implies a price increase of around 9%, before a dividend yield of about 1.3%.
Expect a tug of war between rising earnings and pressured price/earnings ratios, capping the market’s gains. S&P 500 earnings are on track to rise nearly 50% this year; the average Wall Street forecast calls for profit growth of about 9% in 2022. As interest rates rise, the present value of future earnings will fall.
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Stocks
Mike Wilson, Morgan Stanley’s chief investment officer and chief U.S. equity strategist, has an above-consensus earnings forecast for 2022, but he’s below consensus on valuation. He expects the S&P 500’s P/E ratio to contract to 18 by the end of ’22, in line with the five-year average and still in the top quintile for the past 30 years, but below the current multiple of roughly 21.
Stocks: A Mixed Picture
Market strategists see muted gains, if any, for the S&P 500 in 2022, as inflation persists, the Federal Reserve ends its asset-buying program, and interest rates rise.
“When the Fed goes from a $1.4 trillion annualized pace of asset purchases to zero in four months, that will absolutely have an impact on multiples,” he says. “That’s not the end of the world, but it does make the opportunity set narrower.”
Valuation pressure on the major stock indexes makes stock-picking all the more important. Companies that can control their own fate should be able to weather a macro storm best. Strong profit margins and pricing power will be key, and below-average valuations will provide a cushion if the broad market’s P/E contracts.
Wilson screened for companies that meet those criteria and are recommended by Morgan Stanley analysts. The list includes AbbVie (ticker: ABBV), Activision Blizzard (ATVI), Cisco Systems (CSCO), Comcast (CMCSA), Johnson & Johnson (JNJ), and Oracle (ORCL).
Wilson recommends a defensive tilt for 2022, and favors healthcare and real estate. Both sectors have relatively stable earnings and face less risk from the supply-chain issues and wage pressures afflicting some other sectors. Valuations below the market average and positive exposure to rising rates also make financials, especially banks, attractive for 2022, Wilson says.
Saira Malik, chief investment officer and head of global equities at Nuveen, expects valuations to hold fairly steady next year, but sees earnings growth slowing sharply and volatility increasing. “Multiples will start to contract when earnings become an issue,” she says. “We’ve already seen earnings growth peak, but we haven’t seen a peak in actual earnings.”
Malik also finds more to like under the market’s surface in 2022 than at the index level, and she sees better value beyond the S&P 500. She prefers companies with pricing power and cyclical exposure to an economy still growing at an above-average rate. She’s also looking outside the U.S., to other developed markets including Europe’s, which investors can track via the Vanguard FTSE Europe exchange-traded fund (VGK). Emerging markets sport cheaper valuations than the S&P 500, but China’s regulatory and economic issues makes them a less attractive bet.
Energy is Malik’s favorite sector for 2022. Energy-company shares have below-market multiples, and higher oil and gas prices should provide a tailwind as supply stays tight and demand increases. U.S. energy companies are increasingly focusing on returning cash to shareholders, rather than pursuing production growth, making them more attractive to a broader universe of investors.
ConocoPhillips (COP) is one of Malik’s picks, and also makes Wilson’s screen. Malik sees the Houston-based company lifting its dividends and stock buybacks, and is a fan of its management team. She applauds Conoco’s recent acquisitions, including Concho Resources and Royal Dutch Shell ’s (RDS.B) assets in the Permian Basin. Pioneer Natural Resources (PXD) is another energy pick for both Malik and Wilson.
Savita Subramanian, BofA Securities’ head of U.S. equity and quantitative strategy, is overweight healthcare for 2022, which she calls “the forgotten sector” because it has lagged behind the S&P 500 by eight percentage points since the start of 2020. That’s despite strong near-term fundamentals and an attractive long-term outlook, with aging demographics and innovations in medical robotics, new drug-development technologies, and advanced treatments expected to boost future sales.
Most healthcare companies fit the quality theme. Demand for their products doesn’t depend on economic cycles, and research-intensive businesses are hard for new entrants to disrupt. S&P 500 healthcare stocks are trading at a near-record discount, relative to the index, Subramanian says.
The Health Care Select Sector SPDR (XLV) includes a basket of S&P 500 stocks in the sector. Nuveen’s Malik also recommends Zimmer Biomet Holdings (ZBH), a maker of artificial knees, hips, and other medical devices. As elective procedures that were deferred during the Covid pandemic resume, Zimmer will benefit, she says. The stock trades for 15 times expected 2022 earnings.
For broad quality-factor exposure, there’s the iShares MSCI USA Quality Factor ETF (QUAL), says Gargi Chaudhuri, head of Americas investment strategy at BlackRock ’s iShares unit. That fund includes shares of large- and mid-cap U.S. companies with strong balance sheets, high returns on equity, and stable earnings. Chaudhuri also recommends more-concentrated industry bets via the iShares Semiconductor ETF (SOXX) and iShares U.S. Regional Banks ETF (IAT).
Banks are a popular call for 2022. Lower-than-average valuations and excess capital on industry balance sheets make for an attractive starting point. Plus, banks’ bread-and-butter business model of extending loans will benefit from higher interest rates. Subramanian also sees the potential for higher dividends and buybacks in the sector in 2022, offering investors “inflation-protected yield.”
Another Wilson screen for quality stocks levered to inflation yields many financials, including Charles Schwab (SCHW), U.S. Bancorp (USB), and PNC Financial Services Group (PNC).
Fixed Income
Persistent inflation and the beginning of the Fed’s next tightening cycle will reverberate through the fixed-income markets in 2022. The low yield on the 10-year Treasury note has been one of the more puzzling features of this year; it peaked at about 1.75% in March before falling back below 1.25% by the summer and 1.41% recently.
Fixed-income strategists see the 10-year yield climbing to about 2% next year—not a huge move but enough to drag down bond prices, which move inversely to yields.
Treasuries still play a role in a balanced portfolio, says Dan Ivascyn, group chief investment officer at Pimco. “We think high-quality bonds still provide protection against many negative economic scenarios, [although] less than they would have provided in the past,” he says. “We saw it recently with the onset of Omicron-related concerns; you had a big rally [in bonds].”
Andy McCormick, head of fixed income at T. Rowe Price , expects more volatility in 2022 as the Fed tapers its bond purchases and begins to raise interest rates. That should mean wider credit spreads—the difference between the yield on a corporate bond and a risk-free benchmark like Treasuries. He’d like to see spreads widen before adding more aggressively to his corporate bond holdings.
“Bonds do three things: protect principal, serve as a hedge against equities, and provide income,” says McCormick. “The third category is tested now, with negative real rates. But the other two still apply in times of stress.”
Fixed Income: Yielding to Reality
With inflation running hot, the Fed is expected to lift interest rates next year. That could put the 10-year Treasury yield at or above 2% for the first time since mid-2019.
Unlike traditional bonds, Treasury inflation-protected securities, or TIPS, see the value of their principal rise with inflation, protecting against nominal price increases in the economy. They pay a fixed rate of interest twice a year on that adjusted principal. When inflation is present, the interest payments increase.
TIPS have been in high demand in 2021: the iShares TIPS Bond ETF (TIP) has returned more than 4.5% this year, versus a 1.5% loss for the Bloomberg Barclays U.S. Aggregate Bond index. Chaudhuri recommends that ETF for 2022, along with the iShares 0-5 Year TIPS Bond ETF (STIP).
She also cites the iShares Floating Rate Bond ETF (FLOT), which includes a basket of bonds whose interest payments will rise as benchmark interest rates increase. As such, it provides some protection against the Fed’s policy shifts next year.
McCormick makes the case for income-generating assets with floating rates. Bank loans are one option, with generally low duration exposure. The T. Rowe Price Floating Rate fund (PRFRX) is active in that space, and the firm recently agreed to acquire $53 billion private credit manager Oak Hill Advisors.
Investors might need to look far beyond traditional bonds to generate attractive yields in 2022. Areas such as bank loans, private credit funds, and business development companies, or BDCs, plus strategies like covered call writing look promising. ETFs with exposure to these include SPDR Blackstone Senior Loan (SRLN), Virtus Private Credit Strategy (VPC), VanEck BDC Income (BIZD), and Global X Nasdaq 100 Covered Call (QYLD). All sport yields that dwarf those of most traditional bonds.
“The bottom line is that yields are low,” says Ivascyn. “So, to maintain the same type of income level you’ve grown accustomed to, you generally have to take on more risk. There are rarely free lunches in markets.”
Commodities
Commodities could be a good place to seek inflation protection in 2022. Jeff Currie, Goldman Sachs ’ global head of commodities research, says a commodities “supercycle” is in the early innings of a multiyear stretch. That’s not just pandemic-related: Years of underinvestment in global oil and gas projects will keep supply tight, relative to demand, for years to come.
Currie doesn’t expect the shift to renewables to begin to slow demand growth for fossil fuels until 2025, or to put pressure on prices until the early 2030s. And, industrial metals prices should boom as governments spend on decarbonization and infrastructure. He has 2022 targets of $12,000 per ton for copper and $3,250 for aluminum, implying plenty of upside for both. He sees U.S. crude oil around $80 a barrel at the end of next year, some 15% above the current level.
BlackRock’s Chaudhuri recommends having commodities in a diversified portfolio, and points to the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT). It includes a basket of futures tied to energy, metals, and agricultural commodities. When inflation is high and dollars lose value, commodities priced in the currency are worth more dollars.
That’s true for real assets broadly, too. Chaudhuri recommends exposure to infrastructure assets via the iShares U.S. Infrastructure ETF (IFRA), which could benefit from recently passed infrastructure legislation. She also likes real estate investment trusts, or REITs, via the iShares U.S. Real Estate ETF (IYR). Both funds provide dividend income and act as potential inflation hedges.
Bottom line: Even if 2022 brings more turmoil, there should be many places where investors can hide—and prosper.
