Abdur also joined TD Ameritrade Market On Close to deliver his market and investment outlook for 2022. In the interview, they discussed the durability of the U.S. economy and how markets will continue to do well despite recent global events and the effects of the anticipated interest rate hikes. Watch the interview‡.
Table of contents
Overview: Play it Again, Sam
We are not forecasting a Groundhog Day phenomenon, but 2022 will likely resemble 2021 in many ways. However, as investors emerge from 2021, their concerns that the market is bound for a significant correction are not entirely unfounded. The global economy is slowly recovering, largely due to the reduction of COVID restrictions, particularly in the U.S., where they appear to be in their final stages. Local, state, and federal governments are re-thinking their COVID response policies, and, while Omicron has surged, it is unlikely to significantly impact the global recovery. Rising inflation is likely to subdue gains in equities in 2022 particularly against the backdrop of record valuation. Additionally, we recognize that the U.S. Federal Reserve will need to balance the move toward a less accommodative monetary policy with a fiscal policy focused on economic expansion. It is likely the Fed will hike rates, thus pushing up global bond yields. However, the frequency and size of the hikes remain elusive as experts weigh how to locate inflation drivers and durability in conjunction with maintaining growth and employment, rather than sticking squarely to an inflation anchor.
We remain positive on global equities in 2022, foreseeing strong growth in corporate profits that should more than counteract equities’ earnings multiples.
In contrast, bond markets are likely to experience headwinds, with U.S. Treasuries expected to post losses on the year even though yield on the 10-year will struggle to exceed 2%. With real yields on inflation-protected bonds at an all-time low, this segment of the market will also fail to deliver the necessary returns to investors. The dollar is expected to retail favorably despite trading well above fair value, thanks to the relative strength of the U.S. economy.
There are two additional factors to note:
- Travel-related sectors are still performing at half their pre-pandemic levels.
- Supply disruptions are expected to decrease throughout the year with the easing of mobility restrictions in Asia.
Overall, we predict the following trends for 2022:
- The global economy will be reasonably strong.
- There will be growth across regions and sectors.
- Inflation will remain above the trend line.
Base case scenario: Partly sunny with a few scattered clouds
The rise in corporate profits supports continued global economic recovery. Even though we recognize headwinds in 2022, we remain positive that the global economy will continue to exhibit positive growth through the year.
COVID will continue to be an issue, however, the impact on global health care systems is likely to lessen in 2022. Resilience with respect to COVID measures in the U.S. and Eurozone, combined with wider vaccine compliance in Europe, the U.S. and the UK, will lead to a relaxing of COVID restrictions, thus enabling greater economic activity.
We remain confident the Fed’s bond purchasing program will taper off in the first quarter, in concert with a hike in the policy rate. In addition, we anticipate two additional hikes by year-end. We anticipate the long end of the curve will not go materially higher, thus constraining the Fed as it does not want to invert the curve. It is unlikely we will see strong coordination among central bankers with respect to the timing of changing their respective policy rates. However, we anticipate a staggered approach to rate increases, which is supportive of continued global economic growth. Labor and supply chain issues will continue to be a significant concern; however, these shortages are likely to lessen throughout the year. Monetary policy is expected to remain relatively accommodative, while fiscal policy will be focused on economic expansion.
On the political front, it is improbable that the Biden administration will pass substantial legislation as mid-term elections loom. A likely redistribution of Congressional seats will create a more challenging environment for President Biden to deliver on many of his campaign goals and promises. Additionally, the Russian invasion of Ukraine and its impact on crude and natural gas prices remains a concern.
Macro outlook: What comes next
During the past two years, the global economy has responded to the impact of the pandemic with strains on health care resources and global supply chains in several critical sectors. But it is apparent that with each new COVID variant, markets continued to show resilience. The redistribution of wealth through fiscal programs has given a glimmer of insight into the overall impact of global wealth inequality.
As these relief measures diminish, it is uncertain how markets and consumers will respond; unpredictability may well become the norm. By way of example, despite dire predictions, Omicron’s rapid spread did not cause the global economy to contract. Concerns over the capacity of health care systems around the world to adequately absorb COVID cases still looms, but the current variant is proving less crippling than its predecessors. In addition, global health systems are more prepared than they were for previous outbreaks. As a result, they are managing the Omicron surge well, and hospitalizations are lower this time around.
In addition to COVID, supply chain asymmetries have certainly exposed cracks in the broader economy. These issues are unlikely to abate until well into 2022. Inflation continues to be a leading concern, both in the U.S. and globally, with rates higher than we have observed in several decades. Consumers are seeing their purchasing power erode seemingly overnight.
We offer a few relevant observations:
- Many households have stockpiled additional savings, largely due to stimulus support, leading to an opportunity for greater spending.
- Many companies boast very strong balance sheets and liquidity.
- There is strong consumer demand for goods and services.
These three combined factors necessitate and foretell gradual expansion as businesses reinvest and ramp up to meet demand. One thing that should support and extend the economic expansion is the expectation that inventory levels will need to be rebuilt – possibly higher than previous levels to prevent the disruptions companies found themselves in during the past few years. Consequently, indicators predict a positive outlook for 2022.
Consumer spending appears tightly correlated to openings and closings due to pandemic restrictions. Consumers are eager for normalcy and a return to pre-pandemic spending habits as seen in many instances in 2020 as shutdowns ebbed and flowed. Economic data demonstrate that after restrictions were lifted, household demand rebounded rapidly.
Similarly, global labor markets have recovered relatively quickly since the start of the pandemic, although the labor shortage persists. In the U.S., the unemployment rate in November 2021 fell to 4.2%. This is largely due to labor shortages, which have become more systemic across many sectors. With a limited labor supply, employees are empowered to seek stable employment and higher wages. This fully supports the consumers’ willingness to spend more freely than expected; however, saving rates may remain elevated as consumers consider the possibility of another shock. Many households are equally likely to retain stronger balance sheets relative to pre-pandemic levels.
Regionally, Europe has a bit more ground to recover; output in 2022 could grow slightly stronger in the Eurozone and the UK relative to the U.S. Higher consumption in the U.S. is likely to be driven by higher household balance sheets compared to Europe and the UK. However, demand will likely translate into imports from Europe and the UK, leading to greater economic activity there.
An asymmetric impact on supply chain disruption will likely benefit Europe more than the U.S. This is likely due to the U.S.’s reliance on semiconductors via automotive and mechanical engineering, relative to Europe. We expect this to reverse in 2023, when the U.S. will surge ahead.
Positive demand growth in developing markets will benefit emerging market economies. Unfortunately, political instability in many countries will make this growth less uniform. In addition, tighter monetary policy in the U.S. will weigh on politically and economically unstable countries that are holding dollar-denominated debt.
In 2022, upward movements are expected to support corporate earnings and equity prices overall. An anticipated shift in monetary policy will likely disrupt markets and weigh heavily on interest rate-sensitive assets. We maintain a close watch on two risk factors:
- Pandemic swings
- Uncertainty related to the size and breadth of inflation throughout the broader economy.
If inflation remains deep and persistent, central bankers will have to pivot from current policy and course-correct earlier than anticipated. This will likely make markets more volatile.
Central banks: A balancing act
The widespread measures implemented by central bankers in response to the COVID-19 recession are expected to fade in 2022. As inflation gradually increased in the latter part of 2021, the U.S. Federal Reserve had already begun its monetary policy reversal. In March of 2022, we anticipate an end to bond purchasing and a gradual rise in key interest rates, which will extend into the fourth quarter. However, the scope and magnitude of subsequent rate hikes by the U.S. Federal Reserve remain uncertain. It is quite likely that the European Central Bank (ECB) will be out of sync with the U.S. Federal Reserve in its first interest rate steps due to less pronounced inflation pressure throughout the Eurozone. However, we do expect the ECB to step down its bond purchasing in a notable fashion. Given the high consumer demand, we contend that continued support is no longer necessary.
As central bankers deliberated in the last few weeks of 2021, it became quite apparent that 2022 would see a change in current monetary policies. Also evident was the lack of consensus among central bankers on whether to remain accommodative or become more restrictive. Both the ECB and the U.S. Federal Reserve kept their key policy interest rates unchanged while giving clear guidance around bond repurchasing efforts in 2022. However, as we move through 2022, the U.S. Federal Reserve will likely have to make adjustments. All in all, it remains clear that, globally, central bankers are keen on maintaining economic expansion as a high priority.
As anticipated, the U.S. Federal Reserve has adjusted its inflation forecasts for 2022 and 2023, which are expected to exceed the 2% target. The shift in expectations provides the backdrop for the Federal Reserve to adjust its monetary policy. This modified policy will likely result in continued balance sheet runoff and subsequent increases to the federal funds rate. This signals the Federal Reserve’s departure from its attention on labor markets and a pivot towards mitigating runaway inflation. Clearly, the Fed is balancing the trend toward more restrictive policies with the drive to encourage economic expansion.
While the Fed conducts this balancing act, other factors are at play. Supply chain disruptions and increasing consumer demand coupled with an increase in shelter, energy, and basic services will abate throughout 2022. However, globally, central banks have concluded inflation is expected to be broader and more persistent than originally anticipated. In addition to these concerns, the current elevated price levels will impact inflationary expectations. Moreover, high future inflationary expectations may negatively impact the environment for maximum employment. As the U.S. Federal Reserve manages its dual mandate of full employment versus price stability, it has become apparent that full employment is currently of secondary importance. For this reason, we anticipate the Fed will focus its energies on managing inflation in a way that avoids slowing down economic growth while pulling rates closer to its inflation anchor.
To that end, the Fed is likely to implement several strategies in this direction:
- Terminate the bond purchasing program.
- Seek to tighten in the first half of the year.
- Aim to set a key interest rate between 75 basis points and 1% by year-end using disciplined rate hikes. (Hikes are not expected to occur between meetings.)
- Remain data-focused, continuously monitoring the effects of rate hikes to encourage and sustain economic recovery.
Accordingly, we predict the Fed to end the bond-buying program in Q1 2022 and implement its first interest rate hike sometime thereafter.
Global equity markets: Changing tides
For several years, equity markets have benefited from record valuations, accommodative monetary policy, and favorable fiscal policy. We anticipate that in 2022, inflation will put pressure on earnings multiples. As a result of strong corporate balance sheets, liquidity, and healthy consumer demand, corporate profits are expected to remain durable. However, this year, we forecast that equity markets will underperform relative to 2021.
Advancing inflation is likely to force central banks to act and accelerate the pace of monetary tightening. This will lead to a modest slowing of economic growth and a reduction in equity prices. But on balance, we remain positive on equities and anticipate above-average economic growth. The impact of inflation in the U.S. relative to the Eurozone and UK will likely lead to reduced coordination around tightening measures. The U.S. is expected to raise its policy rate first.
COVID will remain a topic into 2022, however, with vaccine and treatment advances, normal consumer activity is expected to take hold. Pandemic-driven, pent-up consumer demand, strong consumer balance sheets, and higher wages will translate to greater corporate profits. However, labor scarcity may put pressure on payroll expenses.
Across equities, we expect value-oriented cyclical stocks to perform well in 2022. This should result from a continued relaxing of COVID protocols and an increase in bond yields. Overall, banking as a sector should benefit due to higher bond yields, which support higher net interest income and consequently, improve margins for banks. In addition, higher short-term rates also benefit most banks as floating rate loans reset more frequently than deposit rates. Labor shortages should be supportive of an increase in CAPEX borrowing to fund payroll cost. In addition, we remain positive on U.S. small caps due to attractive valuations.
Owing to strong consumer balance sheets and demand in the U.S., European exports will benefit, thus lifting European equities in the short term relative to their U.S. counterparts. However, this should result in an asymmetric impact throughout Europe. Growth expectations across the continent are certainly experiencing headwinds due to population declines and more restrictive immigration policies. Meanwhile, given its value tilt and weaker currency relative to the USD, the UK remains attractive.
The view on U.S. equities is less straightforward. Currently, U.S. equities look very expensive. Cyclically adjusted, price-to-earnings ratios are now twice the long-run average. In contrast, when considering projected returns, corporate earnings are expected to be strong in 2022, mainly driven by robust economic growth and healthy profit margins. However, we expect headwinds from changing tax regimes, increasing cost of capital financing, and expanding payroll expenses as a result of labor shortages.
In summary, we anticipate the U.S. Federal Reserve to enact:
- Tightening policies
- Balance sheet runoff
We also forecast that emerging markets’ outperformance will be strained relative to U.S. and/or developed markets. We remain cautious on emerging markets in the first half of 2022, but a rotation back into emerging markets in the latter half of the year is likely.
Fixed income: Road to nowhere
We expect another challenging year for fixed-income investors. With the onset of inflation, the 10-year break-even inflation rate recently hit a 15-year high of 2.6%.
Markets are quite efficient; as a result, they have started to price in the likelihood that central banks in the U.S., Eurozone, and UK are likely to raise their policy rate in 2022. As inflation has moved markedly above anticipated targets, global central banks have signaled both a gradual reduction in their bond buyback programs and an increase in rates. While central banks tighten, we anticipate the trend will be modulated in an attempt to minimize the impact of economic expansion. That said, central bankers are not likely to move so quickly as to significantly impact economic growth—which remains the priority. In addition, they will need to consider the consequences of higher borrowing costs across more fragile aspects of the economy. This careful balance of tightening policies, while nurturing economic growth, is incumbent upon all decision-makers in the global economic sphere.
In developed markets, corporate spreads remain excessively tight, leading us to believe that corporate credits will continue to struggle in the coming year. We continue to see opportunities in both the high-yield market and short-duration bonds.
We expect the yield curve will flatten into 2022, particularly in the U.S., where investors are finding inadequate compensation for longer-duration risk. To counter this, short-term bonds should allow sufficient buffer for investors against volatility from interest rate fluctuations without sacrificing much-needed yield.
Unfortunately, inflation-protected bonds are not likely to offer attractive gains for investors. We see inflation protection through the holding of real assets: infrastructure, natural resources and real estate.
Relative to U.S. bonds, Eurozone bonds are not preferred; we see no significant changes over the next 12 months relative to the previous. Emerging market debt continues to be attractive. These dollar-denominated issues offer shorter duration and are likely to benefit from higher commodity prices. However, they are exposed to U.S. rate hikes. From a currency perspective, we are still bullish on the US Dollar due to strong US growth and continued demand for USD as a reserve currency.
Real assets: Get ‘em while they’re hot
Given the headwinds around fixed-income instruments, we anticipate that alternative income sources are likely to continue to be important in 2022. Traditional government bonds and corporate bonds are likely to exhibit little return potential. Additionally, central bankers are apt to increase policy rates due to higher inflationary pressures. Prudent investors will favor alternatives such as private credit and opportunistic credit over highly-liquid, fixed-income securities. These investments offer significant return prospects and are expected to offer strong risk premiums without major credit risk.
Even in the face of an increase in policy rates, real estate and infrastructure continue to be solid income sources and sound, viable alternatives for many investors. Real estate and infrastructure offer inflation protection in the medium-term and long-term, mainly due to the contractual nature which allows for inflation-based price escalation. It remains crucial that investors incorporate diversification in these various sectors due to the utilization of leverage, which could be weighed down by an increase in rates, thus making mortgage refinancing more costly. Even with the increase in rates, we continue to believe that infrastructure and real estate remain relatively attractive.
The overarching theme in our 2022 forecast is balance. While it will resemble 2021 in many ways, there are some differences in 2022, particularly as we emerge more fully from the pandemic. Central bankers will be focused on the mission to encourage economic growth and combat inflation while recognizing a movement toward a tightening of policies. Corporate revenue, consumer demand, and real assets remain strong, labor shortages will persist, and fixed-income investments and equity markets are likely to underperform relative to 2021. We predict growth across regions and sectors, while inflation is likely to stay above the trend line, and overall, the global economy will be reasonably strong.
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