Economic Monitor: A Balancing Act
BY: Mark Drachenberg
We made it – 2021 is now behind us, and 2022 has arrived! While last year certainly had its challenges (inflation, Covid variants, supply-chain issues), the markets took it all in stride and performed reasonably well ... at least, if you take a 30,000-foot view. This year promises more obstacles, as inflation continues to surge, the Fed shifts from easing to tightening, and Covid concerns remain as prevalent as ever.
There's a scene in the movie National Treasure: Book of Secrets, in which a group of treasure seekers is caught on a large platform balanced on a fulcrum, any movement threatening to send them to their doom. Similarly, investors need to be ready for a variety of circumstances that threaten to impact their returns.
In the movie, Nicolas Cage’s character ultimately figures out a way off the platform, and everyone's saved. Hopefully, by planning for the unexpected this year, investors can come out ahead, too. Let’s assess where we've come from and contemplate where we may be headed.
The end of 2021 played out in much the same way as the entire year did: with a good amount of volatility, and a nice gain to show for it. The only major index to decline during December was also the only one to post a loss for all of 2021: the Bloomberg U.S. Aggregate Bond Index. The loss there was 0.26% for the month and 1.54% for the year. On the flipside, all major equity indices posted strong gains for December, and all except the MSCI EAFE (international equities) had double-digit gains for 2021. (The EAFE posted a gain of 5.05% during December and an 8.78% gain for 2021.) The Dow Jones Industrial Average posted gains of 5.53% and 20.95% for December and 2021, respectively, while the S&P 500 posted gains of 4.48% and 28.71% for the same periods. The other equity indices all recorded similar gains. While the results are good, they are a bit misleading.
In recent years, the equity markets have been dominated by just a handful of stocks, and their contribution to both overall market capitalization and returns have been astonishing, exceeding those of the dot-com years circa 2000. For example, the top five, 10, and 50 stocks by market cap represent 26%, 34%, and 58% of the S&P 500 index, and most of these companies are tech-related, as 45% of the S&P 500 market cap is tech- or digital-driven. Of the overall U.S. market cap, the top five firms (Apple, Microsoft, Alphabet, Amazon, and Tesla) represent about 25% of the overall market cap, while the top 20 firms represent approximately 43%. Remember, this is not just of the S&P 500, but the whole U.S. stock market. Likewise, the top five contributors to overall U.S. stock market returns were Microsoft, Apple, Nvidia, Alphabet, and Tesla, and their returns made up just under 30% of overall U.S. stock market returns over the past 12 months. It is, therefore, easy to see that most other stocks posted very low or negative returns during this same time-period.
This domination by just a few stocks creates enormous risk for those heavily invested in either these companies themselves or the indices that hold concentrations in these stocks directly. For months, we've been talking about the possibility of a correction (loss of 10% or more), and it seems likely that an event of that magnitude could be coming in 2022. Though the economy is strong, earnings are expected to continue to grow, and consumers have continued to demand goods and services, even in the face of higher inflation, it may be prudent for investors to consider diversifying their portfolios, which may help them ride through the volatility that's likely to be present this year.
In some shape or form, the economy continues to be impacted by Covid. While many areas improved dramatically in 2021, the economic recovery that seemed so strong a year ago slowed as the year progressed, due to the Delta and Omicron variants. Let’s look at several economic indicators:
- Gross Domestic Product (GDP): The overall measure of the nation’s economy slowed during the year, as fears over new Covid-related restrictions took hold in the second half of 2021. Even so, GDP hit 5% for 2021. Expectations for 2022 vary greatly and will depend upon progress made against the virus, the Fed, economic policies from Washington, and more. Current estimates put the figure between 3.5% and 5%, with most around 4%. This is not surprising, as it was/is expected that the economy would eventually revert to pre-Covid levels of activity, resulting in GDP gains of 2% to 2.5% per year.
- Inflation: The talk heading into 2021 was that inflation would hit at some point, but that it would be transitory and not permanent. It appears that, to a degree, that prediction was wrong, or that the period of time considered “transitory” will be longer than expected. Supply-chain issues have certainly caused prices to rise and be stickier than originally thought, but that's only part of the issue. All the fiscal stimulus we've enjoyed over the past year-plus is now contributing to the higher prices we're paying, as there's too much money chasing too few things. Wage gains are also contributing to higher prices, as firms eventually look for ways to cover those costs. Finally, all that demand is, in turn, creating demand for natural resources and other supplies, which eventually gets passed along, too. Inflation hit 6.80% in November, although it is expected to soften a bit to 4% or so in 2022.
- Unemployment: The job picture is a mixed one. The unemployment rate has fallen to 4.2%, but the job participation rate is also much lower than it was prior to COVID. This means fewer people are looking for work. While government programs helped families cover expenses early on, those same programs have, to a degree, contributed to fewer workers being available. Many of those programs have either ended or will soon, which should translate to more workers looking for jobs. Covid has also caused many to consider early retirement, further reducing the number of workers available. Those in this category may come back at some point, if finances require them to do so or boredom hits. The unemployment rate likely won’t change much in 2022, as workers come back to the workforce and cover many of the open positions out there.
- Other: Taxes are perhaps the biggie here, as higher rates could hit both individuals and businesses, should potential new spending plans in Washington come to fruition. Taxes are a drag on economic activity, and certainly could hit corporate earnings in the new year. Should that happen, growth expectations for the equity markets would take a hit. Housing will remain strong, albeit less so than the last two years. Finally, auto sales should pick up as supply chains improve.
The Fed is in the crosshairs of just about every investor, economist, banker, and politician right now, as it tries to steer the economy through the issues described above. Inflation has absolutely caught the Fed’s eye, and it has indicated that it is going to speed up the tapering process it initiated in November, and likely will raise rates for the first time this year in March. It's doing its best to forecast its intentions, but it runs into the same problems the rest of us do, as it reacts to a very fluid situation. Should demand fall and inflation end up being transitory, it could get caught being too hawkish at the wrong time. The opposite is true as well, as being too dovish may cause inflation to stick around longer, only delaying, and perhaps enhancing, the pain felt when it does raise rates.
The consensus seems to be that the Fed will raise rates three times this year, but don’t be surprised if it stops at two. The reason for only two increases is that the Fed will likely turn somewhat more dovish due to new appointments to the Board and the fact that it is an election year. The Fed is not supposed to be swayed by political opinion, but in our politically divided society, one never knows what might happen. Even with the Fed raising rates two or three times, the real rate of interest (the nominal rate minus the rate of inflation) will likely still be negative at the end of the year. Normally, rising rates can be bad for stocks in the long run, but with real rates still that low, equities could post a solid year of gains.
Similar to 2021, there's potential for good things to happen in 2022, and for not-so-good things to happen. A mistake by the Fed is the prime potential negative issue, but higher taxes, Covid variants, inflation, and more threaten what otherwise should be a fairly strong economy. The uncertainty over these variables is causing uncertainty among economists and investment managers as to how portfolios should be managed.
I've read multiple forecasts and it seems like each one points to a different strategy as to how to invest … some say small caps, some large caps, some value, some international. Usually, there's some consensus, but not this year. Similar to National Treasure, it’ll be a balancing act as we look for a way past Covid and inflation. To that end, a balanced approach seems like the way to go in terms of asset allocation. That doesn’t necessarily mean a portfolio that's 50% equity and 50% fixed income/cash, but it does mean avoiding large bets in specific investments, at least until the economic picture becomes clearer. Utilizing hedged equity products also seems wise, given the prospect of some significant volatility on the horizon.
Being comfortable with your asset-allocation decision and staying the course will likely prove to be a winning strategy in 2022. To discuss your portfolio, your asset-allocation targets, or any other issue you may have, please reach out to me or call our Wealth Management department at (608) 826-3570. We look forward to speaking with you!