Market Outlook: Navigating the Challenges of 2022

The S&P 500 rallied 26.9% in 2021, thanks in large part to record earnings revisions, the strongest economic growth in decades, and unprecedented stimulus from the Federal Reserve.

However, those conditions will almost assuredly not be as market-friendly in 2022. Earnings growth is expected to slow to single digits, real GDP could fall below 4%, and the Fed is preparing the markets for a quicker taper and a tightening cycle.

2021: A Year of Unprecedented Growth

Not surprisingly, 2021 was a year of unprecedented economic growth. Stoked by massive global fiscal and monetary stimulus, along with a vaccine rollout that unleashed pent-up demand, the U.S. economy expanded 5.7% in 2021.

This marked the fastest pace since the early 1980s. The S&P 500 rose by more than 10% for a third consecutive year—an occurrence not seen since 2012-2014.

Key factors fueling this growth included:

• Expected Earnings Growth: Analysts anticipated a remarkable 65% growth in S&P 500 earnings.
• Upward Revisions: Consensus at the start of the year predicted 22.8% earnings growth, making it the biggest upward revision since data collection began in 1984.
• Mutual Fund Inflows: Record inflows into equity mutual funds and a resurgence in stock repurchases more than offset stock offerings.

However, the biggest factor of all was the strength of the mega caps, or the FAANG stocks (Facebook, Apple, Amazon, Nvidia, Google), plus Microsoft and Tesla. These companies account for nearly 30% of the S&P 500 index and were up 28% on a market-cap weighted basis.

In contrast, the remaining 493 stocks were net -2% on an absolute basis, overstating the general strength in equities.

When examining broader market performance, we observe:

• Small-Cap Growth Struggles: The equal-weighted Small-Cap Growth Equity Series fell 4.8%.
• Value vs. Growth: Value stocks outperformed growth among small-caps, with the Russell 2000 Value beating the Russell 2000 Growth by 25.4%. This marked the second-largest spread on record since 1979.

Overall, 2021 was indeed a year dominated by mega-cap stocks rather than a true reflection of broad-based equity strength.

2022: Risks and Challenges Ahead

Looking into 2022, the equity market outlook is fraught with risks, primarily due to the Fed’s actions. Additionally, persistent supply chain problems and higher inflation will likely remain entrenched in the near term.

Despite strong growth, the following challenges may present headwinds to equities throughout 2022:

• Maturing Economic Cycle: The economic cycle is nearing maturity, which could slow growth.
• Tighter Global Monetary Policy: Central banks are tightening their monetary policies.
• COVID-19 Concerns: The ongoing pandemic continues to introduce uncertainties.
• Rising Uncertainty: Increased uncertainty could weigh on investor sentiment.

The Fed is poised to start hiking short-term rates as soon as March. Historical data suggests that in the six months before and after the first Fed rate hike, the S&P 500 has typically risen an average of 9.3%. However, the speed of the rate hikes is crucial.

• Fast vs. Slow Cycles: The impact of rate hikes has been felt sooner during fast cycles (where the Fed raises rates at every meeting) compared to slow cycles (where the Fed waits at least one meeting in between).

A more restrictive Fed is a strong candidate for causing corrections or a shallow bear market. Furthermore, fiscal stimulus will be significantly smaller in 2022 than in 2021. The removal of stimulus during the first half of mid-term years is common. This trend explains why the S&P 500’s average post-war gain of 6% in mid-term years is the weakest of the four.

Expect Elevated Volatility

Uncertainty brings volatility, which is likely to remain elevated. We can expect corrections to be stiffer and more frequent than in recent years.

Absent a recession (which we currently do not anticipate), downside corrections are likely to be technical and structural in nature but short in duration, as unsettling as they may feel in the moment.

As always, we will continue to monitor the economic and investment landscape and make adjustments accordingly.

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