This year has proven to be a profitable year to be invested in the stock market. All three major indexes — the S&P 500, the Dow Jones Industrial Average and the Nasdaq — all set records in 2021.
But let’s put things in perspective. As the economy is returning to full capacity, there are still many uncertainties.
First, the new coronavirus strain, the omicron variant, has thrown a wrench into the prospects of global economic recovery. Second, high inflation persists, and last, the moves the Federal Reserve will make on interest rates are yet to be determined. The main concern is how these uncertainties, coupled together, will affect the stock market in the future.
What is the environment we are headed into in 2022 and how can investors position themselves for strong stock market returns? Here’s what investors need to keep top of mind as they head into the new year:
— How higher interest rates will affect the stock market.
— Slowing economic growth in 2022.
— How to invest in stocks in 2022.
How Higher Interest Rates Will Affect the Stock Market
Fed Chairman Jerome Powell shared with Congress at the end of November that he suspects that inflation may stick around longer than anticipated. Markets are pricing in an approximately 80% chance that the Fed will start raising interest rates by the middle of 2022 and about an 87% chance of more than one rate hike by the end of the year, according to the CME FedWatch tool, using data as of Dec. 3, 2021. With inflation being an issue now, that puts pressure on the Fed to increase rates, but this decision ultimately depends on how strong the economic recovery will be as 2022 plays out.
The rise in interest rates is going to be a change for the markets. But it won’t necessarily hurt the appetite for investing in stocks. Rather, it could degrade the performance of some corners of the market, particularly growth stocks, which would favor value-oriented names, says James Ragan, director of wealth management research at D.A. Davidson in Seattle.
Higher interest rates are a headwind for growth-oriented equities, but not all stocks will respond the same way, says Don Calcagni, CIO at Mercer Advisors. Growth-oriented companies that have been trading at much higher valuations compared to their earnings should come under greater stress than lower-priced, discounted value stocks, like some in financials and energy, he says.
It’s also important to understand that while the Fed may move to raise interest rates in 2022 from their current near-zero levels, the COVID-19 picture could challenge that. That’s why Calcagni says there will likely be a “slow lift-off” into interest rates. “At the moment, it doesn’t appear that we are going to experience a rapid lift-off in interest rates, and that will give markets time to adjust.”
As the Fed hikes interest rates, it can be expected that the market will experience volatility, but overall, experts are optimistic about equities.
Slowing Economic Growth in 2022
The U.S. economy in 2021 was focused on economic recovery after the severe disruptions of 2020 and it recorded robust growth in much of the year. The first quarter of 2021 saw GDP growth of 6.4% on an annualized basis and second-quarter GDP grew even faster, at 6.7%. But the expansion in the first half of the year was followed by growth of just 2.1% in the third quarter. This drop was led by weaker consumer spending and supply chain bottlenecks.
The economic picture in 2021 was also roiled by an inflation surge. Some of the catalysts for inflation included supply chain disruptions, an emerging labor deficit and continued demand for goods and services — a combination that has put upward pressure on prices.
The fastest rate of economic recovery has likely already taken place, and while investors can expect continued economic growth in the U.S., it may not be at the same rate of growth as 2021. Many of these challenges present today will not go away in the short term, so investors need to be aware of these challenges to know how to navigate the markets.
Calcagni says investors will be faced with a triple threat in 2022. “The real theme for investors in 2022 is they need to balance the risks to growth, inflation and interest rates,” he says. While U.S. companies are expected to grow next year, they may not be at the same pace as 2021. That said, investors should extend themselves to investing in the global economy given greater economic growth estimates abroad. When we look at the economic growth forecasts, there will be more growth in economies outside of the U.S. Calcagni says there is greater economic growth potential in markets outside the U.S. coming out of the pandemic. “We are projecting greater economic growth in Europe and Southeast Asia and South Asia than we are in the United States,” he says.
How to Invest in Stocks in 2022
What does this mean for equities and where should investors be looking for opportunities? Experts say investors will want to look at durable businesses that maintain strong earnings and cash flows. These will be the companies that are best equipped for 2022’s particular risk factors.
“Investors should be looking at tilting their portfolio towards high profitability companies, companies that can expand their margins, that have high degrees of operating leverage, companies that can pass on price increases in their supply chains to their consumers,” Calcagni says.
Sectors that fit into this camp include financials, energy and health care. Investors should be looking at companies with these characteristics and, most important, make sure they have reasonable valuations. There are many ways to measure a stock’s valuation, but a basic one to look for is a relatively low price-earnings ratio.
With 2022’s hurdles in mind, an investing strategy for investors that will never go out of style and one that is important now more than ever before is diversification. It’s important for investors to diversify their portfolios to manage market risk and make sure they’re capturing growth from different areas of the market.
Since the size and market share of some of the largest U.S. companies have grown so much throughout the economic recovery, investors may want to consider diversifying beyond the S&P 500.
To manage the risk of being heavily invested in a select few companies, Calcagni says, investors should factor in companies with smaller to mid-size capitalizations. He points to Russell 1000 or Russell 3000 exchange-traded funds, which are index funds that follow the performance of the Russell indexes, which that include a mix of mid- and small-cap equities. Smaller companies tend to carry greater risk than large caps, but they can offer investors greater returns over time.
Another area of the market for investors to research is non-U.S. equities. While U.S. stocks have offered strong performance throughout the year, with the S&P 500 up more than 20% and U.S. equities outpacing non-U.S. equities for the past decade, experts say it’s time to add exposure to international stocks.
Investing in non-U.S. stocks today not only adds to portfolio diversification, but there are also opportunities to buy in at a discount. Given that valuations are high in the U.S. markets, it makes sense to invest outside of the U.S.
Calcagni says non-U.S. equities are more attractively valued and have greater economic growth potential. “Valuations in these markets are priced at a discount from anywhere from 20% to 30% relative to their U.S. equity counterparts,” he says.
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