This year, it was hard to take enough risk in investment portfolios to keep up. But in 2022, we don’t see the highest-risk parts of the market leading and, instead, would look to trim risk into strength based on our economic outlook.
The U.S. Leading Economic Index suggests we’re not near a recession yet, but that peak economic growth may be behind us. We’ll see some modest spending with the passage of the $1 trillion bipartisan infrastructure bill, but it will be spread out over five years and won’t come close to competing with the fiscal bazooka of 2020/2021.
U.S. Leading Economic Index, YoY (%)
Source: FactSet, as of 10/31/21. Shaded areas indicate recessions. The Composite Index of Leading Indicators (LEI) is published monthly by The Conference Board and tracks 10 economic components whose changes tend to precede changes in the overall economy. It is not possible to invest directly in an index. YoY refers to year over year. Past performance does not guarantee future results.
In addition, global central banks are making a massive pivot, going from full speed ahead to pumping the breaks—which could result in a policy accident. The cycle is moving fast, and the U.S. Federal Reserve (Fed) responding with tightening may result in a shorter cycle than the last 10-year cycle. We’d be careful to not add significant cyclical risk to portfolios next year as monetary and fiscal stimulus may fade and growth decelerates.
The Fed is stuck between a rock and a hard place
While tapering in the first half of 2022 is a done deal, raising rates will be much more difficult. After the last three U.S. recessions, the yield curve between 2- and 10-year U.S. Treasuries widened to nearly 300 basis points (bps). Now we’re at about 100bps, which doesn’t leave much room for rate hikes; in fact, the Fed could invert the curve with just over four 0.25% hikes, with the 2-year Treasury yield near 0.65%. The more aggressive the Fed is in raising rates, the more likely to us that this will invert the curve, as the long end will reflect slowing growth expectations.
Overall, a slowing global growth backdrop and less stimulus suggest to us that next year isn’t likely to see the Treasury curve steepening of 2021. We believe the Fed needs to tighten slowly to tame inflation and provide a release valve for speculative activity, but not too tight as to crimp financial conditions and let the curve get away from them.
The hardest part about tapering may be getting past the tantrum
In the last tapering example of 2013, yields rose from the time of hinting of tapering to the start of tapering, but when tapering started to end 2013, yields counterintuitively fell. We’ve seen about a 30bps backup in yields since the Fed suggested tapering at the September meeting, up to a high of 1.68% in October. With tapering starting now, this is the moment of truth for Treasury yields.
In terms of portfolio positioning, we’re modestly underweight in duration, mostly as a function of our more positive view on corporate credit. We like BBB-rated and BB-rated corporates and bank loans targeting about 3% in yield. After what’s turning out to be a tough year for bonds this year, next year may not be as bad, and some roll down on the Treasury curve may be more beneficial.
Follow the profits
Global readings on Purchasing Managers’ Indexes show that the United States still has an economic edge, outpacing the eurozone and much of the rest of the world.¹ China’s role as the growth engine of the global economy is diminishing, as increased regulations and defaults within the highly leveraged property market cause major growing pains.
On the fundamental front, analyst estimates for earnings growth in the United States continue to accelerate, while they’re flatlining overseas. As stock prices follow earnings over time, this is a key reason for our preference for domestic equities. Within international markets, opportunities remain, but investors will need to be more selective in 2022. We’re favoring longer-term secular growth companies that have cyclical upside, found primarily in the technology, consumer discretionary, and industrials spaces.
The end of earnings nirvana
While earnings in the United States are outpacing the rest of the world, investors should note that it will likely get harder from here.² The last three quarters have seen record year-over-year earnings growth for the S&P 500 Index, showing that the U.S. equity earnings engine is still on. Looking forward, this quarter and next may be the end of peak earnings, as analyst estimates are showing a deceleration from here (Q4 2021 estimates are now at 21%, Q1 2022 at 6%, and Q2 2022 at 4%).³ The evidence points to a still strong but decelerating growth environment into 2022.
This means that identifying the relative winners and losers will become more challenging. In this environment, balancing the quality factor (great fundamentals) with the value factor (cyclical upside participation) across global equities makes sense. In our Market Intelligence outlook, U.S. mid caps represent our highest-conviction idea for offense in a portfolio as well as a potential hedge against higher inflation, which we expect to persist through the first quarter of next year.
1 Markit, World Bank, FactSet, as of 11/30/21. The Purchasing Managers’ Index (PMI) tracks the economic activity of the manufacturing sector. 2 FactSet, as of 11/30/21. 3 FactSet, as of 11/30/21.