As of Jan. 18, 2022
The S&P 500® Index posted a nearly +29% total return in 2021. In two of the last three years, the Index has posted a return of over +25%. The availability of COVID-19 vaccines and strong reopening trends drove economic activity and thus corporate profitability higher throughout 2021. And though pandemic and inflation pressures remained ongoing issues for investors, the primary driver for higher stock prices was the above-trend growth most major developed economies experienced last year.
However, investors are quickly adjusting to the likelihood the Federal Reserve this year will raise interest rates, end its emergency bond-buying program in March and possibly start to reduce its nearly $9 trillion balance sheet.
As a result, U.S. stocks opened 2022 lower. In addition, high-growth stocks, including Technology, have seen a rough start to the new year. The surge higher in the 10-year U.S. Treasury yield has put pressure on high valuation companies, which typically are valued on future profitability. Higher interest rates erode the present value of those expected future profits, thus why high-growth companies have struggled at the start of the year.
That said, we believe investors should begin the year with a constructive view on growth and overall prospects for higher returns in 2022. However, economic and profit growth are likely to slow as the year wears on, and changes in monetary policy could create periods of greater volatility for risk assets, including stocks and bonds. As a result, returns could look more modest. And it may be harder to simply lean on high-level themes, as was possible in 2021, to generate portfolio returns in 2022.
Here are themes we believe investors should incorporate into their portfolio decisions for the new year.
- Overweight stocks, but be mindful of overall diversification properties. We believe investors should overweight stocks and underweight bonds as the Omicron variant eventually subsides and more of the world continues to move away from the pandemic. However, we believe the potential for outsized stock-price gains relative to history has diminished after several years of solid returns. Elevated valuations, a maturing business cycle and tighter monetary policies could create headwinds for assets during the year. We believe this is the time to evaluate risk tolerances, ensure proper diversification and temper expectations for future price appreciation.
- Interest rate risk is a growing threat to portfolios — alternative strategies could offer tactical opportunities. The potential for higher interest rates in 2022 could create crosscurrents for both stocks and bonds. To help reduce portfolio volatility, investors should consider a modest increase in exposure to alternative strategies over their longer-term strategic targets. Strategies that reduce equity volatility or hedge interest rate risk may offer a prudent way to manage through volatility and stay prepared for the unexpected. Examples could include absolute return and nontraditional bond fund strategies.
- The United States and Europe could continue to shine. Developed markets, including the U.S. and Europe, should continue to recover from the pandemic, allowing for above-trend economic growth and continued strong corporate profitability. Each region poses a unique set of risks and opportunities. While the U.S. offers more exposure to growth areas, it’s also more richly valued and sensitive to interest rates. Europe offers more concentrated exposure to reopening areas, like the Financials sector, but is more susceptible to pandemic pressures and slowing growth. However, we believe both regions provide a healthy mix of cyclical opportunities that should continue to benefit from a world emerging from the pandemic.
- Sector exposure can still guide portfolio allocations, though security selection could play a more prominent role in returns. We believe cyclical industries, such as Financials, could continue to perform well in 2022 — particularly against a rising rate backdrop. But easing supply chain pressures, improving economic activity and more pent-up demand being satisfied during the year should also provide tailwinds for Industrials, Energy and Consumer Discretionary sectors.
And while interest rate risk is a concern for the Information Technology sector, strong secular industry drivers provide growth opportunities against a normalizing economic backdrop. The Health Care sector may also offer an attractive balance between growth, safety and dividend yield at the start of the year and help diversify portfolios.
We believe high-quality companies with the ability to grow, navigate a still-challenging business environment and adapt to change quickly are likely to be rewarded with higher stock prices. Investors should place a stronger emphasis on underlying investment choices in 2022. Of course, a good dividend yield to help cushion some downside risk also doesn't hurt.
After such an intense period of returns for a range of assets (including stocks) since the depths of the pandemic, we believe investors should take a more prudent approach regarding risk and portfolio construction. In our view, the next step higher in the market is likely to be more discriminate across regions, companies and investments. And while our outlook for 2022 is generally favorable for higher stock prices, investors should expect the unexpected along the way, given moderating growth trends and potentially tighter monetary policies.
Data source for indices and sector graphs: Morningstar Direct, as of Jan. 10, 2022.
These examples are shown for illustrative purposes only and are not guaranteed. Past performance is not a guarantee of future results.