Back in July, we published our 2021 mid-year market review. Having hosted a virtual year-in-review seminar in January, the article highlighted how much changed in the first six months of 2021. An increasingly vaccinated population rediscovered a sense of normalcy. The optimists in all of us were ready to declare victory and move on, but emergence of the Delta and Omicron variants in the second half of the year were a humbling indication that we were not out of the woods yet.
In spite of the virus, we exit 2021 with a healthy, growing economy and equity markets hovering near all-time highs. We are optimistic for continued economic growth in 2022 and while the market experience is much less predictable in the short-term, we believe our disciplined approach to investment decision-making will serve our clients well in the year ahead.
Did He Say the Economy is Healthy?
While not impervious to risks including new and existing COVID-19 variants, geopolitical uncertainties and monetary and fiscal policy moves, to name a few, the U.S. economy is on solid footing. Interest rates are low, demand for labor is high, and consumers are spending at record levels. The U.S. economy likely expanded 5.6% last year after adjusting for higher-than-expected inflation and economists expect real GDP growth of approximately 4% in 2022.
Unprecedented monetary and fiscal policy actions in response to the pandemic enabled rapid economic recovery following the shortest recession on record. Now, nearly two years into the current expansion, fiscal policy is transitioning from emergency COVID relief to longer-term spending plans while full employment and elevated inflation are accelerating the path to tighter monetary policy.
Full Employment Amid Labor Market Imbalance
At the time of this writing, the U.S. unemployment rate stands at 4.2%, down from 6.7% in January and 14.8% in April 2020. We have to acknowledge and appreciate the unprecedented pace of the labor market recovery. Using historical average recovery rates, unemployment would still be 11.0% today and would not reach 4.2% until March 2028.
The economy has regained more than 18 million of the 22 million jobs lost in 2020. That means there are still about 4 million fewer employed people in the U.S. Meanwhile, there are about 4 million more job openings than there were prior to the pandemic. Lower labor force participation driven largely by retirements and childcare uncertainties help to explain the nearly 8 million unfilled jobs, which results in continued strong demand for labor and upward pressure on wages.
Consumers Spending Despite Dented Sentiment
The value of retail sales rose sharply in 2021, supported by government stimulus, elevated savings, and economic reopening enabled by the ongoing vaccine campaign. For perspective, the total value of retail sales in November was $639B. This represents an all-time high in absolute terms and is 21% higher than the $526B reported in February 2020 (pre-pandemic) and 18% higher than the $541B reported in November 2020 (11.1% higher after inflation).
Overall, consumer sentiment has not recovered from depressed 2020 levels as higher inflation and the potential economic impact of variants weigh on consumers. Interestingly, consumer behavior has actually contributed to inflationary pressure, as strong demand for goods is further taxing an already disrupted supply chain. COVID-willing, we would expect demand for goods to normalize somewhat in 2022 as consumer spending on services (i.e. leisure and hospitality) increases.
Elevated Inflation Decelerating in 2022
Inflation has been higher and more persistent than economists and market participants expected in 2021. The rapid labor market recovery and accommodative monetary and fiscal policy actions created a demand shock. This occurred concurrently with a variety of negative supply shocks as COVID-19 persisted. Looking at the specific drivers of inflation, we note that energy and transportation expenses have contributed significantly to the overall increase in consumer prices with energy costs up 34% and used cars and trucks up 31% year-over-year as of November. Importantly, prices in these categories tend to be more volatile and less sticky, while price increases in categories like wages and rents tend to have staying power. Wages have been moving higher, particularly among the lowest-earning quartile of workers, but overall wage growth has not departed from historical trends and, so far, increases in shelter costs have not either.
We believe the fourth quarter of 2021 may mark the peak inflation levels for this cycle and would anticipate lower, albeit still elevated, price increases in 2022. Our expectations consider historically tough comps from 2021, normalization of demand for consumer goods, ongoing improvements in supply chains and tighter monetary policies expected for 2022.
Monetary Policy – Tightening in 2022
After doubling the size of its balance sheet to nearly $9 trillion, the Fed began tapering asset purchases in November and moved to accelerate tapering in December with plans to conclude quantitative easing altogether in March or April. Starting the year, policymakers did not anticipate any interest rate increases until 2024. Now, Fed projections now call for three 0.25% increases in 2022 in response to higher than expected inflation and rapid improvement in the labor market.
Fed missteps, in policy or communication, are an inherent risk to financial markets. As it stands, Fed policy projections align closely investors’ expectations. While the narrative will likely evolve throughout the year, we believe the current trajectory of monetary policy will gradually rein in inflation without significant disruption to continued labor market recovery and economic growth.
Fiscal Policy – Build Back Later?
During 2021, fiscal policy focus transitioned from emergency COVID relief to longer-term spending plans and multi-year infrastructure initiatives. A $1 trillion ($550B in new spending over eight years) hard infrastructure bill passed in November. However, lawmakers have yet to reach agreement on a second piece of legislation, Biden’s Build Back Better proposal. The bill, which includes a variety of hotly debated soft infrastructure spending provisions and corresponding tax policy implications, passed the House in November, but Democrats’ hopes for a Senate vote before year-end did not materialize. Party leaders continued to discuss possible routes to revising the legislation and potentially bringing it back for a vote in January.
Speaking of votes, a total of 469 seats in the U.S. Congress (34 Senate seats and all 435 House seats) are up for election in November. Historically speaking, the party in the White House typically loses seats in midterm elections. Observers on both sides of the aisle expect the House to flip to a Republican majority given Democrats’ thin five-seat majority there. As for the Senate, six states (AZ, GA, NV, NC, PA, WI) are considered toss-ups, 3 currently held by Democrats and 3 currently held by Republicans, so control of the Senate is less certain. Either way, the outcome of 2022 midterm elections will have policy implications throughout the second half of the term for the Biden administration.
2021 – Market Experience
Returns in 2021 followed the path of the strong economic recovery. US stocks performed well, consistent with a remarkable earnings recovery resulting in 45-50% EPS growth for the S&P 500. Higher inflation and accelerated monetary tightening put a damper on fixed income returns, but they continued to play their role as diversifying assets.
Looking Forward – Capital Market Assumptions
As for the market experience going forward, we share our updated capital market assumptions below. These forecasts represent our expectations for average annualized returns for each asset class over the next ten years. Over the next decade, there will be years where returns exceed our expectations and years where returns trail our expectations. We believe short-term market-timing strategies are unlikely to improve long-term outcomes.
We continue to recommend most of our clients hold a full weight to global equities in accordance with their individualized risk profile, and we remain marginally more constructive on international equities. Concurrently, we are less constructive on the outlook in fixed income markets and believe an underweight position in favor of an allocation to diversifying strategies (alternative assets) remains prudent.
Despite an ever-changing landscape, our disciplined approach and long-term orientation serve us well as we endeavor to create comprehensive investment solutions that help our clients reach their financial goals. Investment decisions are made in alignment with our documented investment philosophy and always with the intention of serving our clients’ best interests. Happy New Year and thank you from everyone on the investment research team for allowing us to serve on your behalf.