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2022 Investment Outlook: Fed Actions Likely to Dominate Headlines

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Thomas Lee, CFA

Co-President and Chief Investment Officer

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What surprises will 2022 hold for investors? Dive into the data with our experts and find out. 

As we head into the new year, investors are being inundated with forecasts for the year ahead. While interesting and, at times, entertaining, the value of any forecast is always questionable. As the old saying goes, “There are two types of market forecasters—those who don’t know, and those who don’t know they don’t know.” 

At Parametric, we don’t advocate a forward view. However, we regularly engage our clients in conversations about the market environment, including understanding the themes that may drive sentiment or risks that have a low probability but high impact if they were to occur. In that vein, we look forward to 2022, not with a forecast but with eyes wide open to potential risks and opportunities. Let’s start by highlighting some themes from 2021 that will likely carry over into the new year.

A Look back at 2021

Coming into the year, COVID-19 garnered the primary focus of the markets. The newly elected Biden administration quickly proposed and passed a $1.9 trillion American Rescue Plan. It’s worth noting that this plan followed on the heels of $2.9 trillion in COVID-19 relief bills signed into law in 2020. That is $4.8 trillion of fiscal stimulus in a $21 trillion economy, for those doing the math. Later in the year, the administration piled on top of that a bipartisan infrastructure bill that included $550 billion of new spending spread out over five years. All of this spending was paid for with borrowed funds. 

Domestic equity markets reacted favorably to a combination of stimulus money and vaccine rollouts that facilitated the first steps back to economic normalcy. International developed and emerging equity markets were more subdued, as they generally trailed the US in both categories. As summer transitioned into fall, supply-chain concerns, related labor-market shortages, and heightened demand driven by cash in consumers’ hands led to a 6.8% surge in year-over-year inflation. It was the fastest growth in inflation since June 1982. In November, the Fed announced it would begin an eight-month taper of its quantitative easing program. However, after being confronted with sharply rising inflation, Fed chair Jerome Powell indicated the tapering could be accelerated and completed in four months, giving the Fed the option to raise rates earlier in 2022 if necessary.

At the beginning of 2021, US-China relations were a concern for the market. Most investors believed that the incoming administration would soften the rhetoric on China and eventually lower existing trade tariffs. Rhetoric has declined, but tariffs remain in place. The announcement of the Chinese Communist Party’s common prosperity initiative coincided with the government’s crackdown on tech giants in an effort to curb their dominance. Private tutoring companies also caught the attention of regulators. Our equity strategists highlighted these events in a timely blog post in September. Unsurprisingly, Chinese equity investors reacted negatively to the crackdown. 

Adding to the uncertainty in the Chinese market, Evergrande, the second-largest property developer in China by sales, continued to teeter on the edge of default as it struggled to make timely interest payments on its debt. Experts have warned that a formal default by Evergrande could be China’s Lehman moment, as the firm has borrowed money from 171 domestic banks, 121 other financial lenders, and countless individuals who put down deposits on future construction. More broadly, the situation with Evergrande and other Chinese property developers indicates that China may be at the beginning of an extended slowdown in real estate. That outcome would negatively impact China’s overall growth, as real estate accounts for one-fourth of China’s GDP (that number is closer to 15% for the US).

Equity market returns
Equity market returns

Source: Refinitiv, 12/13/21. For illustrative purposes only. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index. Past performance is not indicative of future results. 

Looking ahead

The year ahead promises to have varied themes that will warrant investors’ attention and fuel the potential for several surprises that could come to dominate headlines. Most market participants expect that, after nearly two years and a tremendous cost of life, the COVID-19 pandemic will finally move into the background. The likely outcome is that vaccines will continue to prove effective and the pandemic becomes less prominent in 2022. A low-probability impactful event would be an evolution of a COVID-19 variant that negates the effectiveness of the vaccines and puts lockdowns back on the table. A reinstatement of lockdowns played out in Austria in November. That outcome on a broader scale would be a shock to global markets.

The Fed is likely to be the most dominant theme in the coming year. The market is currently anticipating the Fed to fully wind down all bond-purchase programs by the end of March and hike rates by 75 basis points (bps) before the end of 2022. However, Powell has stated that the Fed will be data driven. A continuation of the current elevated level of inflation would put pressure on the Fed to pursue a more restrictive monetary policy. Look for an update from the Parametric fixed income team in the weeks ahead to provide a more detailed outlook for fixed income.

Since the beginning of the global financial crises in the fall of 2008, interest rates in the US, and for much of the developed world, have remained at historically low, and in some cases negative, levels. Low interest rates have helped inflate asset prices by creating the illusion—some may argue the reality—of free money. How will the end of free money impact the markets? Will rising rates create a strong headwind for equity markets? Some speculate that a rising rate environment would result in a rotation in stocks by driving a return to fundamental valuation. In this scenario, higher interest rates put pressure on high-flying growth stocks while bringing long-forgotten value stocks, which have systematically underperformed for over a decade, back into favor. Investors who lack solid conviction on this point will want to make sure their equity holdings remain diverse with respect to well-defined factors and not concentrated as a result of recent market outcomes.

Growth of $100
growth of 100

Source: Refinitiv, 12/13/21. For illustrative purposes only. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index. Past performance is not indicative of future results. 

Taxes will be another prominent theme in the coming year. The US borrowed heavily to finance fiscal stimulus during the pandemic. Going forward, there will be pressure on political leaders to rein in fiscal deficits. For the Biden administration, this means additional spending initiatives considered in the Build Back Better legislation (which, as of this writing, was seen as unlikely to pass) will need to be paid for through increased taxes. The administration has proposed a blend of higher taxes on corporations and high earners. Our senior equity strategists provided a snapshot of the different tax proposals under consideration at the end of June. The team will be updating this analysis in the coming months if the legislation can still be salvaged. 

The situation in China will also remain on investors’ radar in the coming year. China currently represents nearly 19% of global GDP—second only to the US. An economic slowdown in China, resulting from continued regulatory uncertainty, a collapse in real estate prices, or both, would create a headwind for global growth. Because of the size of the Chinese market, investors should consider their overall level of investment in China and the composition of that investment. Our equity strategists noted this point in their recent blog post (referenced above). At the end of November, the MSCI China Index held a 27.4% weight in just three companies, and the index has 741 constituents. Investors can achieve better diversification.

The bottom line
If 2021 taught us anything, it’s that surprises and “black swan” events can easily alter the course of the global economy and, by extension, the investment world. As we face uncertainty over the future of Chinese markets, the evolution of COVID-19, and possible rate changes by the Fed, Parametric continues to emphasize holding diversified portfolios and rebalancing allocations. Such a strategy can help portfolios remain in alignment, offering the best protection against the unknown future.

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.