Key takeaways

• Most asset classes produced strong returns in 2021, though rising rates nicked high quality bond performance. 
• Next year’s outcome is likely to hinge on inflation and the Federal Reserve’s (Fed) response.   
• Investors are hoping that policymakers can strike a balance between slowing, but still above-trend growth and inflation.  

Investors are hoping for a return to normal in 2022

We’re likely to see more volatility in the coming year as markets navigate concerns about easy financial conditions against a backdrop of above-trend growth and inflation. Companies will have their work cut out as growth slows from heady levels and price pressures continue. 

After weaker-than-expected Q3 gross domestic product (GDP) growth, we anticipate a strong finish to the year and slower, but still above-trend, growth in 2022. An agonizingly slow normalization of the economy continues to present unique challenges to forecasters. New variants continue to pop up, and supply chains are still out of whack. Another year of higher-than-normal investment and stronger imports could ease the supply situation, but Omicron may slow this process. Consumer spending is likely to be robust as the continued overhang of unspent savings and investment gains propels growth next year. Even so, the handoff from public support to private employment isn’t complete. A lack of willing workers is a headwind, stemming from early retirements, lower immigration, and persistent pandemic effects. We believe the labor market will stabilize next year, but with tighter conditions than the pre-pandemic balance. So far, companies have been able to push through price increases to maintain margins, but resultant inflation has been higher and more persistent than expected. Consumers are frustrated that key financial goals like home ownership or a new car purchase feel more out of reach as wage increases fall short of inflation. We’re not too worried about a recession, but weaker consumer sentiment and a tight labor market are likely to continue to pressure policymakers and employers. 

Strong market performance reflected an explosive increase in earnings, expectations for robust economic growth and confidence that predicted rate hikes will be sufficient to keep a lid on inflation. Investors are also betting that companies can maintain margins even as growth slows and supply chain pressures and calls for higher wages persist.  While we saw several significant waves of new Covid variants, markets proved resilient as each subsequent episode had less of an impact. Estimates for economic growth have come down since June, but earnings have continued to surprise to the upside with Factset estimating earnings per share (EPS) growth at over 40% in 2021. Risk assets surged at the end of the quarter with the S&P 500 ending the year just off its record high, returning 28.7% for the year. Credit spreads were mixed in the quarter with high yield bonds tightening and higher quality bonds widening modestly. While corporate bonds outperformed treasuries for the year, high quality bonds produced a negative nominal total return in 2021, the first since 2013.¹

With markets awash in liquidity, there were a few warning signs. Bubbles and speculative bets emerged in meme stocks, crypto currencies, non-fungible tokens, and dry powder set aside for venture capital. Equity market breadth narrowed, and retail participation surged as investors chased returns. While credit spreads were tighter for the year, widening in Q4 meant spreads ended well off their mid-year tights. Saying that, in our view credit fundamentals appear good, and spreads remain tight in a historical context. With the strong finish to the year, high valuations dismiss the risks of rate hikes, mean reverting margins, labor bargaining power, and anti-trust action.    

Rates remain range-bound at very low levels despite considerable uncertainty around where inflation will normalize. Current expectations for 3-4 rate hikes are a benign scenario that won’t do much to tighten financial conditions. During the quarter, policymakers bowed to the market consensus that inflation is likely to remain higher than targeted. Investors took the news of a course correction in stride as the Federal Open Market Committee projected a faster taper of asset purchases and pulled forward guidance for rate hikes. The shift to a tighter stance is a global phenomenon, as a number of central banks raised rates. Despite the new bias, financial conditions remain extremely easy and projected hikes are modest in comparison. Market pricing now reflects an extended, but not out of control, breach of the Fed’s 2% stated inflation target. Investors believe that central bank actions will release enough steam for inflation to average under 3% over the next 5 years.   

Source: Securian Asset Management, Inc., Bloomberg. As of 1/4/2022. The data spans from 12/31/2010 through 12/31/2020.

Easy money denotes a condition in the money supply and monetary policy where the Fed allows cash to build up within the banking system. This lowers interest rates and makes it easier for banks and lenders to loan money to the population.

With rich valuations across asset classes, a Fed misstep resulting in a repricing of interest rates would be trouble. 

The big question on investors’ minds is whether buyers will continue to accept rates that don’t keep pace with inflation. As the pandemic wanes and labor and supply chain challenges resolve, we believe inflation is likely to fall in 2022. However, companies are still experiencing supply chain pressures, confidence in pricing power is growing, labor is making gains, and housing effects will lag. These challenges skew inflation risk to the upside in the coming year.   

Despite these risks, rates may remain subdued. High levels of debt, an aging population, disruptive technological change, and concentrated wealth remain powerful forces. The present comfort with long-term rates near 2% reflects a belief that these impulses will dominate. However, de-globalization and supply chain rationalization, pressure to address climate change and inequality, and depressed levels of immigration present more serious structural challenges. Other factors may exacerbate supply and demand imbalances. These include more fiscal/monetary policy coordination with an emphasis on direct cash support and policy tilts towards higher regulation and trust busting at a time when potential growth is slowing. These factors increase the risk that inflation could remain higher than desired for some time, creating both political and financial policy stress. 

The combination of monetary tightening, high valuations and an election cycle are likely to be a more volatile mix in the coming year. The battle between longer term disinflationary secular trends and declining potential growth versus the hotter mix of easy financial conditions, populist policies and the costs of climate mitigation is likely to be the story for some time. Like the Fed, we need to be data driven and alert to the possibility that the inflation and rates regimes could change.