Last year we at Touchstone, adopted an optimistic, risk-on posture despite high valuations for stocks and bonds. Our thesis was based on expectations for accelerating economic and profits growth, as well as continued U.S. Federal Reserve Board (Fed) accommodation. Looking to 2022 we believe these economic and profit tailwinds will diminish, though still grow. Meanwhile valuations remain high for stocks and bonds. This backdrop suggests a less optimistic stance on risk assets, though we are not advocating a defensive posture. Currently we see inflation and the Fed’s response as the wild card for the markets in 2022, though at the time of this writing our knowledge of the COVID-19 Omicron variant is incomplete. We believe that the pace of inflation will begin to slow allowing the Fed to implement a moderate approach to policy tightening. But should the Fed shift toward a more aggressive timeline we will need to revisit our stance toward risk assets.
Economic Deceleration
We believe fading fiscal stimulus, a less accommodative Fed, and very tough comparisons will lead to slower growth, though growth nonetheless. The current consensus real Gross Domestic Product (GDP) growth estimate for the U.S. economy is 3.9%, which is well above the 2.5% average seen over the last cycle. We also note that the U.S. consumer remains financially strong and the labor market is tight with likely continued jobs growth and wage gains. The expected slowing in economic growth applies broadly to most countries around the globe, as the tide of monetary and fiscal liquidity recedes. There may be some significant exceptions such as Japan and Germany and some emerging markets like Russia that are benefiting from higher energy prices. Still, the overall trend is towards slower economic growth and less policy accommodation.
Inflation: Now Everything's $1.25
Dollar Tree, also known as Everything’s $1, announced that it will raise the price of most of its goods to $1.25 in 2022. Dollar Tree opened its first store in 1986 (under the name Only $1). So for 35 years it has been able to maintain that $1 price point. No longer. Over the last year we have put a lot of time and effort into researching, evaluating, and writing about inflation and what different scenarios might mean for the markets. And to what end? Those efforts almost seem fruitless as the markets didn’t seem to care.
Why do the markets not seem to care? We believe that the simple answer is that the markets are not convinced that we have moved to a persistent state of higher inflation. Near-term inflation, yes, but longer-term inflation is expected to move back down either naturally or due to monetary tightening (maybe both).
And for equities there is the perspective that there is no alternative (TINA). In a recent survey of strategists, Bloomberg asked how they are adjusting their asset allocations due to changing views on inflation. It was surprising that it didn’t really matter what inflation opinion the strategist had moved to (higher or lower), the answer was always the same. Overweight equities.
We think that TINA perspective is wrong. While inflation didn’t seem to matter to the markets in 2021 we believe, if it persists, it is likely to negatively impact stocks in 2022. It may not be so much inflation, but the Fed’s response to it that could hurt stocks. The Fed has basically established its near-term policy on the assumption that inflationary pressures will ease next year. But the Fed has also stated that it will adjust to a more aggressive stance if high rates of inflation persist. The recent trend in inflation has been moving down, but still remains well above the Fed’s target. We’ve said in the past that we don’t know what the Fed is going to do because the Fed doesn’t know what it is going to do. The Fed has been upfront about the lack of visibility and the unique elements surrounding this recovery. As long as the markets continue to discount a more dovish Fed, through high valuations, they remain vulnerable to policy shifts.
COVID-19: Do We Really Need to Talk About This?
Two years in and now many just want to push it out of their minds and pretend it is no longer an issue. It does appear that we are broadly winning the war, despite setbacks such as the COVID-19 Delta variant. Still each country is different and it appears likely that there will be more waves. Omicron looks likely to be next one. So far, the combination of vaccines, natural immunity, and better treatments have diminished the harm from more recent waves. Even in Germany where the case count is well above previous waves, the number of deaths is much lower (true for Austria as well). The German health minister warned that its citizens would either be “vaccinated, cured or dead” from COVID-19 by the end of winter given how rapidly the virus is spreading. That sounds grim, but it also points to an end. Here in the U.S., survey data suggests that 92% of the population have either been vaccinated or recovered from a prior infection.
There is still uncertainty surrounding COVID-19. It is possible that Omicron or some other mutation is a breakthrough variant that even those vaccinated or with a previous infection cannot evade. If this were to happen, we would need to adjust our outlook depending on the severity of the new strain. Even without a new variant, as long as lasting immunity is not fully reached globally it doesn’t appear that we can truly get back to normal. Instead we will enter a new normal, and that new normal is likely to differ by country and region. From a markets perspective, this adjustment to a new normal is likely to be made on a stock-by-stock basis as opposed to at the index level.
Domestic Equities: Can It Get Any Better?
2021 was a strong year for earnings growth. Double digit growth happened pretty much across the board: large, small, domestic, and international. And those earnings lifted the markets. This year will be different. Earnings Per Share (EPS) growth expectations are currently well below 10% generally across the board, though all are positive. Bottom up consensus EPS growth estimate for the S&P 500® is currently 7.7% for 2022. That does not seem like an unreasonable expectation, though in a historical perspective it is quite low. It also is a rate of growth that makes current valuations harder to justify. Last year we expected the S&P 500 would see Price-to-Earnings (P/E) multiple contraction, as is typical of mid cycle conditions. That did not happen, due mainly to large cap growth stocks. If we exclude the top 10 names in the S&P 500, P/E multiples did contract as did those for mid and small cap stock indexes. Mid and small cap stocks (as measured by the S&P indexes) saw much higher earnings growth than the S&P 500 in 2021, yet have underperformed to-date through November. We recognize that valuations are a poor predictor of short term performance, but note that relative valuations are at extremes (relative to large caps) and earnings growth expectations appear more reasonable. We continue to maintain a slight overweight bias toward mid and smaller cap stocks, though we recognize near-term monetary policy risks.
Whether it is small, mid or large we do think it is appropriate to lower our return expectations. Let’s be honest, we’ve grown accustomed to some very healthy stock returns. This year the S&P 500 has produced a total return of +26%, year-to-date through November, it was up 18% in 2020 and up 31% in 2019. We do not expect this pace of market returns to continue, but we do believe that the market can continue to rise modestly.
International Developed: Mixed
Earnings have been strong for the MSCI EAFE Index. At the start of this year 2021 EPS were expected to rise ~22%, and using current estimates it appears that EPS growth for 2021 will clock in closer to 54%. Even so, the MSCI EAFE Index lagged the S&P 500®. To-date the MSCI EAFE Index has produced a comparatively paltry return of just 10%. As such, the MSCI EAFE Index has gotten relatively cheaper than the S&P 500 today than it was a year ago. Unfortunately, looking forward, MSCI EAFE Index EPS are expected to slow considerably. Most of the EAFE countries have much greater exposure to trade and tourism than the U.S. This has made them more susceptible to supply chain woes and the pandemic. A quick resolution to the pandemic would favor EAFE markets, though we don’t anticipate it at this time. Through the S&P 500 companies, investors do get significant international exposure and we believe U.S. companies have growth advantages. The offset is relative valuations. Extending one’s time horizon out a few years, within the MSCI EAFE Index, Japan looks interesting given its sector mix and leading companies in factory automation, robotics, and semiconductors.
Emerging Markets: Headwinds Likely to Continue
Fundamentally, 2022 is likely to be another tough year for China unless the government decides to embark on a stimulus program (which is a distinct possibility). The slowing property sector is likely to restrain economic growth. We also believe China’s continued zero tolerance policy toward COVID-19 adds risk from potential lockdowns and a psychological negative impact on consumers. China’s regulatory pressure on some of the largest companies in China’s portion of the MSCI Emerging Markets Index also shows no sign of abatement. All of these factors are fundamental headwinds for GDP and earnings growth. It is important to note that these negatives have not gone unrecognized in the market, the MSCI China Index has underperformed the MSCI Emerging Markets ex China Index by 16% year-to-date through November.
Outside of China the emerging markets picture is mixed. A number of countries have begun raising interest rates to fight inflation. Many countries have low COVID-19 vaccination rates, or inferior vaccines, putting them at risk of future waves. Others look on track to do better include Russia that is benefiting from higher oil prices and some Asian nations that have weathered the pandemic better than others. Despite massive supply chain issues we are still not seeing many signs of de-globalization. Product sourcing in Emerging Markets (EM) will continue to be a solution to help lower costs for Developed Markets companies. Earnings were held back in 2021 due to COVID-19 Delta variant, so EM may be in a better position for growth in 2022. We continue to see opportunities within EM though we believe broad exposure is unjustified. Please read our white paper Emerging Markets: Is Past Prologue? We Don’t Think So for additional thoughts.
Fixed Income: Still Offers Downside Risk Mitigation Potential
The return potential for investment grade fixed income remains low and real yields have dropped to levels not seen since the 1970s. Still, we believe fixed income deserves to be a part of an asset allocation strategy as it can offer ballast and help manage equity risk. Within fixed income our outlook for continued economic recovery and higher than target inflation leads us to suggest slightly lower duration exposure relative to the benchmark. That said, a more hawkish move by the Fed would cause us to revisit our stance. We had previously been emphasizing taking on lower credit risk given the positive economic backdrop. While we still are attracted to the higher yields that can be had in below investment grade credit we believe it is important to recognize that improvements in credit conditions likely cannot get much better. We expect that going forward credit conditions will begin to normalize in the other direction. Credit spreads did widen late in November, though still remain narrow in a historical context.
We would consider maintaining a strategic weight in credit and advocate for an active approach that could potentially add alpha1 through issue and sector selection — something that may also be important in managing risk as well. Please look at our Fixed Income Monthly to learn more.
Concluding Thoughts
In 2022, we believe the tide of liquidity (from monetary and fiscal stimulus) will begin to recede reducing the rate of growth and some of the underlying support for risk assets. As such, 2022 will likely be very different from the explosive growth experienced in 2021. Looking forward, we see a number of events that could result in binary outcomes with great uncertainty as to which way they will transpire (inflation and the Fed, the pace of slowing, whether China will re-stimulate, and how the pandemic plays out). Yet asset prices (stocks and bonds) remain broadly elevated. We are taking off the risk-on posture we advocated at the start of 2021 and think a shift back toward strategic weights may be prudent. We do believe opportunities will develop over the course of 2022, which will lead to advantageous positioning changes. In the meantime, we think it is important to consider a selective and flexible approach within asset classes as we believe it should be more rewarding than a passive one.
The information provided represents Touchstone’s views and observations regarding past and current market conditions and investor behaviors. The information and statements provided herein are believed to be true and accurate. There can be no assurance however that the beliefs expressed herein will be consistent with future market conditions and investor behaviors.
1Alpha is a portion of a fund’s total return that is unique to that fund and independent of movements in the benchmark.
PCE Core: Personal consumption expenditures (PCE) prices excluding food and energy prices.
CPI: Consumer Price Index is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
The S&P 500® Index is a group of 500 widely held stocks and is commonly regarded to be representative of the large capitalization stock universe.
The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure developed market equity performance excluding the U.S. and Canada.
The MSCI China Index covers 85% of the free float market cap of the China Equity Universe across H-shares, A-shares, B-shares, Red-chips, P-chips and foreign listed shares.
The MSCI Emerging Markets ex China Index captures large and mid cap representation across 26 of the 27 Emerging Markets countries excluding China. With 678 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used to create indices or financial products. This report is not approved or produced by MSCI.
Investing in Equities is subject to market volatility and loss. International and Emerging Markets equities also carry the associated risks of economic and political instability, market liquidity, currency volatility and differences in accounting standards. The risks associated with investing in international markets are magnified in Emerging Markets. Fixed Income/Debt securities can lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. Performance data quoted represents past performance, which is no guarantee of future results.
Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.
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