Where Do We Go? Oh, Where Do We Go Now? (Part II)
The title to this week’s (and last week’s) update was stolen from lyrics to a popular song from a 1980’s rock band. Other things that are “rocky” include Mount Rushmore, movies about a determined boxer, an ice cream flavor and a one-word description of the stock market thus far in 2022. The highest inflation readings in 40 years coupled with disappointing retail sales numbers led to continued volatility and downward pressure over the past week. These data releases were not a complete surprise but they do point to some changes in the economy and come as a harbinger of what may lie ahead. Higher inflation, questions regarding the strength of the labor market, a possible slowdown in consumer spending and potential action from the Federal Reserve have led investors to be jittery. How long with this continue? What will the rest of the year bring? Continuing from where we left off last week, we want to offer the remainder of our predictions for what will happen with the markets and economy and the factors driving it.
Energy prices continue to face upward pressure. Oil prices have risen considerably as demand has again increased from the trough of when the pandemic began. We anticipate this to continue, but not to the extent they rose last year. Issues with domestic supply and the fact that OPEC countries benefit from higher prices so they have little incentive to increase output, coupled with increased demand will drive prices even higher. Global electricity demand is expected to grow sharply in coming years and despite the increase in renewable energy sources, fossil fuels continue to provide the majority of electrical power generation, especially in foreign countries. This leads to our next prediction….
Emerging Markets perform well, but probably not until the last half of the year. 2021 was a challenging year for emerging markets, especially in comparison to developed markets, but we think 2022 will be better. Many less-developed countries have felt an outsized effect from COVID and will likely continue to in the near term but eventually will rebound. Valuations in emerging markets are very attractive compared to developed markets and tremendous potential for growth from modernization and demographics remain. There are many factors which have the potential to impact this prediction so this is the one we are most likely to alter our view upon as we get further into the year. Other areas of the markets we are watching include ….
Small Caps outperforming Large Caps. Mega-cap stocks have driven the markets over the past two years as we have seen meteoric rises in many very large companies. This has led to inflated valuations for certain large cap names. Small caps have lagged the broader market the past few years yet fundamentals remain solid, making valuations of many small cap companies more reasonable. Similar to large caps, strong earnings and solid balance sheets are again in focus so performance will also be dependent upon quality of the individual names. As we mentioned last week, we expect market returns to be more modest this year so even if small caps do outperform large caps returns could be somewhat muted. This covers the stock market, but when it comes to bonds…..
The yield curve flattens. The yield curve is a line showing the difference in yields between bonds of differing maturities. Generally longer term interest rates are higher than short term rates, but when the difference between the two becomes less the curve is considered to be “flattening.” Conversely, if the difference is greater it is said to be “steepening.” The Federal Reserve is expected to tighten monetary policy by raising the Fed Funds rate to combat inflation so we anticipate other short-term rates to move higher as well. We also expect longer term rates to increase, but not as much as short-term rates, leading to a flattening of the yield curve. There is also a possibility the yield curve inverts, which occurs when short term rates are higher than long term rates. A flatter yield curve generally indicates slower economic growth. With yields expected to rise across the curve, this is not shaping up to be a good year for bonds. And lastly…
The mid-term elections will change the balance of power in Washington. Most mid-term elections see a wave of members of the opposite party from the presidential administration being elected. This year looks to be no different and may even result in higher turnover given the unpopularity of the current administration. There is a lot of time between now and the elections later this year so many things could occur, but even if the popularity of the current administration were to improve significantly the odds are there will still be a red wave with the power of Congress shifting from the Democrats to the Republicans. This would create gridlock, which is perceived as being positive for the markets, and increases the chances of the current administration becoming a lame duck. Since this balance of power is widely anticipated, it can also be assumed the current administration will try to push their legislative agenda through Congress in the coming months. If they are successful, this could include increased government spending and possibly higher tax rates.
Even though the calendar changes when we enter a new year, most things remain about the same or continue on the trajectory they were already on. This remains true for the markets and economy, however there do seem to be some shifts occurring which perhaps began a couple of months ago. This year is shaping up to be different than what we have experienced the past couple of years. The greatest threats to the market are not what has been mentioned above but rather what we do not anticipate; unexpected events could alter the course of the markets and therefore have an impact on our predictions. We will remain vigilant, as we always are, to market and economic events so we can best position portfolios for our clients.
We invite you to join us for our Lunch & Learn on January 24th when we will discuss our outlook for 2022 in greater detail. We hope your year has started well and you are optimistic for what lies ahead. Please contact us if you would like to discuss your individual situation.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
Office phone # (952) 460-3260