We appear to be in a state of excesses and extremes almost two years after the start of the COVID-19 pandemic and the severe but brief recession it sparked—market liquidity brought on by government stimulus, sizable household savings, high inflation, tight labor markets—not to mention the numerous new market highs and extremely low inflation-adjusted, or natural, interest rates.
In most cases, 2022 will be a pivotal year when the imbalances caused by the epidemic start to settle, and the business cycle returns to normal.
Many investors could believe that “normalization” entails a return to “more of the same,” i.e., the secular stagnation of the previous cycle. Passive indexes produced astronomical returns during the post-Global Financial Crisis period, which was marked by low real economic growth, disinflation, low capital investment, and sluggish productivity development.
Investors might be forgottten and forgiven for thinking they could revert to the effective portfolio strategies of the past, anchored to U.S. mega-capitalization growth companies that predominate passive indices, given today’s near-record cost multiples on double-digit profit forecasts for the S&P 500 Index. However, we believe that strategy to be unduly complacent. We predict that the economic and financial climate in 2022 will be reflationary, with more significant economic growth, more inflation, and finally, higher accurate interest rates—in other words, a warmer and shorter business cycle.
Four trends that might contribute to higher-than-expected growth and inflation, as well as increased capital investment and higher productivity, are as follows:
Innovation:Digital innovation was required of service companies during pandemic-related shutdowns. This has sparked unprecedented public and private market activity—from fintech and cryptocurrencies to driverless cars and artificial intelligence—investment and a boom in start-ups.
Deglobalization:Before the epidemic, companies thought about localizing their supply chains due to the U.S.-China trade dispute. This trend toward local sourcing has gained steam due to today’s inflation-driving supply imbalances and inventory shortages, as well as the growing sensitivity around cybersecurity, public health, geopolitics, and evolving regulatory frameworks in China.
Decarbonization: The epidemic and accompanying business closures resulted in decreased use of fossil fuels and carbon emissions and increased pressure against investment in such energy sources. This fact is putting further pressure on prices and may keep inflation at current levels.
Changes in the U.S. labor market:Employees may continue to seek innovative ways to change jobs or demand more excellent salaries due to a labor shortage brought on by worries about workplace safety and early retirements. This can therefore have an impact on profit margins.
These patterns imply that investors should prepare themselves for economic development that is abundant rather than scarce. Higher nominal and actual interest rates and a steepening of Treasury yield curves are projected to result from increased growth and inflation, with price/earnings multiples contracting in rate-sensitive industries.
The numerous “technology takers”—companies anticipated to spur higher tech adoption—rather than the few technology makers—should thus be the main emphasis when retooling investment portfolios for 2022.
Additionally, when the Fed ends its policy of providing support that raises all boats, the passive S&P 500 Index will likely remain volatile and rangebound. So instead, put your attention on security selection to find probable winners. More balanced allocations—between U.S.-based assets and those from other countries, between growth- and value-style equities, between cyclical and defensives, between mega-caps and small- and mid-caps, and between active management and passive exposures—will be critical to all of this. Finally, investors may seek to increase their exposure to tangible assets and absolute-return hedge funds while decreasing their allocations to specific fixed-income securities.
