2021 was an outstanding year for U.S. stocks. The S&P 500 rallied nearly 30% on low volatility by historical standards (there was not a single correction of 6% or more). Fiscal and monetary stimulus, combined with a rapidly reopening economy, helped propel the market higher. We enter 2022 with a much stronger economy than a year ago, albeit with higher inflation and continuing waves of COVID variants.
Inflation, and its subsequent impact on monetary policy and corporate earnings, is likely to continue to be the top story for markets in 2022. Several key factors impacting inflation in the year ahead include the following: Energy prices have a broad impact on prices across the entire economy, from direct costs on consumers (gasoline & utility bills) to indirect costs (higher fuel/shipping costs increasing the prices of goods). Going back to at least the 1970s, every period of inflation has had rising energy prices. Labor participation remains well below pre-COVID levels despite a low unemployment rate. Rising wages may encourage more to join the workforce but could also lead to broadening inflation. Supply chains continue to struggle to normalize. Semiconductor shortages continue to persist, leading to depressed auto production. New and used cars were a top contributor to inflation in 2021. Semiconductor capacity expansions coming online in 2022 will need to be significant to provide relief to a very tight auto market.
Waning fiscal and monetary stimulus, and higher inflation likely warrant a moderation of return expectations coming off a strong multi-year run for the market. However, this does not mean pessimism is appropriate for long-term investors. The combination of a strong U.S. consumer and robust investment in technology, equipment, and infrastructure is favorable for stocks. We continue to see three ways stocks can mitigate inflation and interest rate risks: 1) Focus on quality stocks with pricing power – the ability to pass on higher input costs to protect profit margins. 2) Avoid stocks with extreme valuations, which tend to lag value stocks when interest rates rise. 3) Emphasize dividend-paying stocks, especially those growing dividends consistently.
Federal Reserve actions and words may lead to higher stock and interest rate volatility in 2022. Past Fed tightening cycles created uncertainty about when each cycle would end. If inflation moderates sooner than expected, look for both stocks and interest rates to react favorably.
-Jared J. Ruxer, M.S.