2022 Market Outlook

January 1, 2022

With Stocks Facing Hurdles In ’02, Best To Follow The Earnings


John Bonnanzio

Let’s begin with the good news. No, the very good news.

In the early days of the pandemic (March 2020), drug companies quickly developed, tested and produced several vaccines to thwart Covid-19. By early 2021, they were initially rolled out slowly, then en masse. Today, a half-billion doses have been given and over 200 million people in the U.S., or 63% of its population, are considered fully vaccinated. Though there were still more Covid deaths in 2021 than the year before, hospitalization and death rates fell. That, coupled with huge federal Covid relief packages signed by presidents Trump and Biden set the stage for the country’s economic (and continuing market) recovery.

GDP grew about 5.7% last year versus -3.5% in 2020. According to a St. Louis Fed study, a quarter of that growth was attributable to trillions of dollars in federal spending (which increased the deficit). With such spending almost certain to slow, we’re now looking for the economy to expand about 4% this year.

Of course, these twin recoveries weren’t the entire story for 2021. In Washington and numerous U.S. cities, political and racial discord erupted into violence. Economic dislocation and hardship exacerbated public discontent even as individuals, businesses and governments developed better tools for living amid a pandemic. Not to be overlooked: two years of Covid have so far taken 817,000 U.S. lives and 5.4 million globally.

Too Much Of A Good Thing?

Apart from the federal government’s trillions in direct financial aid, loan guarantees, subsidies and even tax cuts, the Federal Reserve and Treasury Department stepped in with coordinated monetary and fiscal stimuli of their own. Their collective goal was to keep the economy afloat, and it worked. A repeat of 2020’s short-lived but painful recession had to be avoided. Unemployment peaked at 14.8% in April 2020. Since that time, joblessness has fallen to just 4.2%.

Of course, what’s now clear is that all this stimuli, coupled with a breakdown in the global supply chain, sowed the seeds of today’s inflation. While Jack weighs in on inflation in his pg. 1 Message, there’s no disputing that today’s 6.8% inflation creates a new set of problems. But is that enough to slow the economy and earnings in 2022? Can stocks continue to climb the wall of worry that they overcame last year? And, if so, will there be another change in market leadership by sector or market cap? And what about bonds?

Here’s our 2022 Market Outlook.

Stocks: Strong Tailwinds

Stocks again face consequential headwinds this year which may, in turn, lead to increased volatility.

The double-edged sword of low unemployment and inflation is that businesses must contend with a tight labor market. In addition to that putting upward pressure on wages, it’s simply hard to find people to work, which holds back growth. The pandemic has accelerated retirements while younger people appear averse to returning to the office.

Then there’s inflation. Higher labor costs would put upward pressure on CPI, as would any further increase in the cost of shelter. Granted, home-price growth has slowed recently, but higher mortgage interest rates may put ownership further out-of-reach for young families.

But there’s an upside to that, and it’s the wealth effect. When home values rise 30%, which they have in may places, it’s estimated that there’s a 5% rise in consumer spending. Similarly, a 30% rise in stocks increases spending by 1-2%.

Then there’s the supply chain problem. Yes, ports are starting to clear. But that improvement could slowly end with Omicron or yet another variant.

Those are the headwinds for stocks. The tailwinds may be more powerful: FactSet projects top-line sales growth for S&P 500 companies at 7.5% this year with earnings growth of 9.2%. While these are well below 2021 levels of 15.8% and 45.1%, respectively, that’s largely because of their comparison to 2020’s Covid-driven declines. A better context is this: the S&P 500’s earnings growth rate averaged 5.0% from 2011 to 2020. So 9.2% looks pretty good! And despite aforementioned headwinds, net profit margins are forecast to improve slightly this year to 12.8%, up from 12.6% in 2021.

2021: Covid versus Fundamentals

Mindful that there may be considerable market rotations as this year unfolds, there are presently several ways to play stocks this year.

For the more risk-tolerant, we continue to like large-cap growth generally, and tech in particular. Funds like Blue Chip Growth, Contrafund, and Select Technology in our Select Model, remain our top positions. But the ongoing economic recovery (coupled with some help from the Infrastructure bill) bodes well for economically sensitive cycles, too, where valuations aren’t quite as high. That means holding Select Environment and Alternative Energy in the Select Model, and the more value-oriented Equity-Income, Value, and Large Cap Value Enhanced in the other equity-oriented models. In other words, 2022 is a good year for diversification and risk mitigation!

As for stock funds in the conservative models, the mid-cap value Low-Priced Stock is riskier than the S&P 500. But relative to its benchmark, the small-cap Russell 2000, last year’s performance exceeded expectations: it outperformed by nearly 10 percentage points. As is often the case, superior risk-adjusted returns made it a good fit for several models.

High Yield

More highly correlated to stocks than to bonds, last year’s recovery helped shore up the balance sheets of indebted and leveraged firms. (Yes, they’re less risky than the latter and more volatile than the former.) But Capital & Income and High Income wound up serving our income-oriented models well, and we expect them to perform okay this year. Just okay? Frankly, there is less upside potential for this reason: the closely watched "fair value" gauge (the yield spread between high-yield bonds and 10-year Treasurys), once again narrowed last year, this time to 3.03%, down from 3.86% a year ago.

That’s well below its long-term average of about 550 basis points, making the asset class a little less attractive. On the other hand, should the yield curve further flatten in 2022 (with longer dated bond yields falling), their upside potential could improve.

International Opportunities?

For 2022, we’re not big fans of this asset class. Granted that could change. Moreover, our models have indirect foreign stock exposure, and in the case of Low-Priced, quite a bit. But our preference for now, as it was last year, is to stick close to home where our economy is strong, corporate earnings are stronger, and the investment opportunities remain largely unmatched.

Sector Picks

Needless-to-say, our top picks have made their way into the Select Model Portfolio. But there are other funds we like. One is Construction & Housing which stands to benefit from the wealth effect, strong demand for housing and still-low mortgage rates. The same case can be made for Consumer Discretionary (which we hold) and its subset Retailing. On the flip side, a brief word about a fund we rarely favor, Select Gold: it’s almost twice as risky as the market, yields nothing, and is a crapshoot with respect to its being a safe haven asset. Feel free to avoid it!

Bonds: Fed Holds The Keys

It’s pretty well accepted that the Fed has been slow to respond to rising inflation. Our concern now is that it doesn’t over-respond.

At its last confab, Chairman Powell telegraphed three rate hikes for this year and an accelerated end to its bond-buying program. Tightening the nation’s money supply will help to slow inflation. And it’s worth mentioning that countervailing forces could range from the controllable (higher federal spending) to the uncontrollable (unfavorable weather). Lest we forget, higher wheat and fuel prices last year were partly the result of drought and Hurricane Ida. But even as we expect inflation to ease to 5-6% (from nearly 7% today), income investors face another year of negative real yields.

The Bottom Line

With Omicron seemingly less calamitous health-wise, the economy strengthening, and corporate earnings growth solid, we’re optimistic that 2022 will provide a fourth straight year of stock gains — albeit far more modest.

 — John Bonnanzio