By: Andrew J. Willms, CWM, JD, LLM
President and CEO, The Milwaukee Company
If you are a client of The Milwaukee Company, you are a frequent reader of this newsletter (or you listen to my podcast, (which you can find here), you likely already know that I do not put a lot of faith in forecasts about where financial markets are heading.
But I do think it is still important for investors to incorporate reasonable forecasts on how the markets and the economy will perform over the next year and beyond when formulating their expectations for their portfolio. This is a useful exercise because it helps us frame our expectations, think through our assumptions, and spend time thinking critically about what could go right or wrong.
Investors (especially inexperienced ones) tend to place too much emphasis on the recent past when setting their expectations for the years to come. As a result, it is understandable if you assume stocks will continue to generate double digit returns in 2022 simply because that’s what happened in the recent past.
Over the last ten years, the S&P has generated an annual total return of 16%. U.S. growth stocks have done even better, generating a 19% annualized return. By comparison, the bond market’s total return of just under 3% over the last 10 years looks downright dismal.
There is no denying the stock market ended 2021 with a good deal of positive momentum, and there is an extensive body of research that supports the notion that momentum has a strong influence on near-term future performance. That said, it’s important to remember the often repeated caveat that “past performance may not be indicative of future results”.
No one has a crystal ball, but I am of the opinion that there is a significant risk of a material stock market pullback and rising interest rates in 2022. The reasons include:
- The Omicron Variant. Recent studies have found that the omicron mutation is over 4 times more contagious, and spreads 70 times faster in the human bronchus than either the delta variant or the original strain of the virus. It also appears that omicron can infect vaccinated persons far more readily than its predecessors. The good news is the vaccines that are currently available appear to provide strong protection against severe illness, and 85% of American adults have opted to get vaccinated. As a result, I do not expect we will once again see a nation-wide economic shut-down.
- Inflation. It seems abundantly clear that the Fed got it wrong when it said inflation was going to be transitory. In fact, it may well be one of the worst inflation calls the Federal Reserve has ever made. And, while stocks are often a good hedge against inflation, that’s not the case with “stagflation” (where inflation and a stagnant economy combine).
- Monetary Policy. I believe the unprecedented expansionary monetary and fiscal policies the U.S., and governments around the world, have adopted in response to the Covid-19 pandemic have been a major reason for the stock market’s recent surge. However, Fed Chair Jerome Powell’s recent pronouncements have made clear that the central bank will throttle back on its easy money policies, in an effort to slow rising consumer prices. Central banks around the globe already have, or will likely soon, follow suit.
- High Valuations. The exceptionally high stock prices relative to earnings and other fundamentals suggests that it would not take much for the equities market to reverse course.
Please note that the foregoing concerns do not necessarily equate to a prediction on my part that an extended bear market will take hold in 2022. But I do think investors who disregard the risks associated with elevated stock prices and increased inflationary pressures do so at considerable peril.
As far as the bond market is concerned, I think the odds favor interest rates rising, bringing the decades-old bond market rally to an end. More specifically, I expect the 10-year Treasury yield to rise above 2.0% by the end of 2022, and would not be surprised if rates rose considerably higher from there.
It is also important to note that interest rates have a history of doing the unexpected. And so, I disagree with those who have recommended abandoning bonds as a buffer to the stock market’s volatility. Rather, I feel it is wiser to maintain an allocation (perhaps reduced) to bonds, while emphasizing the short end of the yield curve for now.
Speaking of volatility, I also expect stock market volatility to increase in 2022. Therefore, it’s important for all investors to conduct an honest reassessment of their ability to tolerate market volatility. (You can find short quizzes for conducting such an assessment on The Milwaukee Company’s website.) If the stock market suffered a 20% drawdown, would you be tempted to reduce your exposure to stocks? If so, it may make a good deal of sense to do so before such a sell-off happens, while the equity market remains elevated.
If you would like to discuss any of the foregoing, or whether your portfolio is properly positioned for 2022 and beyond, please contact me. I would be most happy to meet with you, in person or via the internet.
Thank you for reading, and my very best wishes for a happy and prosperous 2022!