Q1 2022 Market in Focus: Uncertainty Remains as Pandemic Enters Its Third Year

Take the Good With the Bad

Considerable uncertainty remains as we approach the third year of the worldwide COVID-19 pandemic. The pandemic has taken a toll on people's personal lives and continues to disrupt our daily routines. It has shifted the global economy, undermined economic activity, and left lingering marks on trade and social development.

Each time the virus mutates, a new wave of infections requires an updated and renewed response. The Omicron variant, which appears more contagious than Delta and other variants, is the latest to fuel concerns and shift our behaviors.

Fortunately for the economy, not all news is grim. The global economy has transitioned to a ‘New Normal’ during the COVID-19 era, marked by abrupt changes, sudden shifts, and notable recovery. Even while dealing with the adverse impact of the pandemic, the world economy is healing, and the economic output in most countries is at or above pre-pandemic levels.

Despite the turmoil, 2021 was a year of unprecedented growth. The global economy expanded nearly 6% in 2021, the fastest pace since (at least) 1980. In the U.S., this growth was fueled by massive fiscal and monetary stimulus and the vaccine-powered recovery, especially in the second half of the year. Emerging markets have been more constrained with respect to fiscal policy, while developed markets in Europe and Asia, and even China, have been reluctant to go as far as the U.S. has, and as a result, recoveries in these countries lag the U.S.

We have witnessed increased economic activity due to adaptation when people are less mobile. Over the last year:

• Real Gross Domestic Product (GDP) ¹ grew 6.3% and 6.7% in the first two quarters of 2021, respectively.
• The initial estimate for growth in the third quarter was 2%, placing GDP +4.9% above its level a year earlier and +1.4% above its previous peak.
• Real GDP increased at an annual rate of 2.3% in the third quarter of 2021.

What to Expect in 2022

In 2022, based on the survey of professional forecasters, growth is expected to moderate at 4.4%, which is still above the long-term average rate of 3.5%. Even with strong economic growth, there are still future risks and unknowns: the evolution of more variants of COVID-19, supply chain bottlenecks, and persistent labor shortages.

Among the most concerning headlines is inflation, as it has the potential to become a more serious problem over time. The surge has been caused by income growth which soared to record levels earlier in the pandemic. There’s also been a shift in demand from services to goods.

More recently, income growth has cooled off, and consumer demand has started to shift back toward services. Inflation pressure should lessen if the world continues to make progress in the battle against COVID-19 and supply chain constraints loosens.

Inflation Rising Above 5 Year Average

Fed Policy

At the onset of the virus in early 2020, there was a significant possibility of a financial market meltdown that could have been worse than the Great Recession of 2008. The Federal Reserve’s actions—including buying bonds and keeping interest rates ultra-low—have been commendable.

As the pandemic eases and the U.S. economy gets its strength back, these additional supports will likely no longer be needed. However, with inflation still rising, the timing of removing the Fed’s monetary policy support is causing concerns in the financial market.

• If the Fed hikes too early when inflation rises, it risks an unnecessary slowing of the economy later in 2022 or early 2023.
• On the other hand, if the Fed hikes rates too late, it risks allowing inflationary pressures to worsen, resulting in more and frequent rate hikes down the road.
• Also, if the Fed starts to taper down its bond-buying program too rapidly, it could convulse the financial markets.

Lingering Thanksgiving Indigestion – Expect More Volatility

The uncertainty with the pandemic has brought volatility in stock markets. Equity markets have been churning ever since the news of the Omicron variant broke on Nov. 26. The Standard & Poor’s 500 Index (S&P 500) fell 2.2% that day, and the Dow Jones Industrial Index lost 905 points (2.53%) in its worst post-Thanksgiving indigestion since 1931.

The global market is expected to experience more volatility in 2022 as the economy still grapples with the risk of more COVID variants, and a large portion of the world remains unvaccinated. The concerns – lingering inflation, the timing of Fed’s policy actions, supply chain issues and the continued shortage in labor supply – could add to the volatility.

Hanging Clouds Over Equity Valuation

According to Reuters estimate, U.S. corporate profits surged to a record level of growth at 9.2% in the second quarter of 2021 after a 5.1% increase in the first quarter. The jump in profits was despite businesses facing increased costs from higher inflation, labor shortage and supply-chain crisis. Many argue the U.S. stock market is overvalued, given the three-consecutive years of double-digit returns, which happened nine times before, since 1928. Equity market valuation is stretched, often because of very high allocation to stocks in a portfolio and long-term overbought ² prices. At the end of 2021, the S&P 500 traded at about 21 times forward 12-month earnings estimate, down from 22 times at the end of 2020. Historically, the S&P has traded 16.3 times ³. Uncertainties cloud the earning picture in 2022 over the renewed surge of COVID-19 variants, e.g., Omicron, which may restrict economic activities and adversely impact consumer demand.

The Path to ‘New Normal’

Since the post-great recession environment in 2008, the global economy has seen low real economic growth, disinflation, poor capital spending and weak productivity growth. Central banks, regulators, and policymakers were forced to take extraordinary measures in 2008 after the financial crisis.

Over the past decade, major central banks have bought trillions of dollars of bonds as life support for the economies. Global sovereign debt has ballooned, especially in the developed markets. U.S. equity investors have seen tremendous gains as the S&P 500 rose 529% from March 9, 2009, through Feb. 19, 2020.

As the pandemic began in March 2020, economic activity worldwide came to a screeching halt, and the panic triggered by the economic consequences and uncertainty led to a stock market crash. Between Feb. 20 and March 23, 2020, the S&P 500 lost 34%. Since then, the market recovered 119% through the end of 2021. In addition to fiscal and monetary support, this quick recovery was fueled by the hope and excitement that the pandemic might soon be behind us as vaccines are distributed, and the world would start to roll again.

While economic growth is still expected to be high in 2022, there could be a natural slowdown in the coming months, without another rebound related to reopening and monetary stimulus waves. The supply chain issues may take some time to normalize. 2022 will be a critical year and may normalize with lower return for the equity market with higher volatility and a tormented fixed income market. This normalization will be paved on the macroeconomic path to reach higher-than-expected growth, which comes with increased inflationary pressure. Still, it would lead to greater capital spending in innovation, resulting in higher productivity. These trends suggest that investors need patience and should consider maintaining a balanced allocation in their portfolios.

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Footnotes:
¹The monetary value of all finished goods and services in the United States on an inflation-adjusted basis.
²Overbought is a term used when a security is believed to be trading at a level above its intrinsic or fair value.
³Based on the average forward Price-to-Earnings (P/E) ratio in the last 22 years ending December 31, 2021 based on FactSet data since January, 2000. Forward P/E ratio is price divided by the consensus analyst estimates of earnings for the next 12 months.

The material and opinions provided in this post are meant for general illustration and/or informational purposes only and should not be construed as investment, tax, or legal advice for any individual. Although the information has been gathered from sources believed to be reliable, each reader must decide whether it is valid and applicable to his/her own unique circumstances. To determine which investment(s) may be appropriate for you, consult your financial adviser prior to investing. Diversification does not protect an investor from market risk and does not ensure a profit. Any economic forecasts made in this commentary are merely opinion, and any referenced performance data is historical. As a result, neither is a guarantee of future results, as all investments involve risk. All referenced indices are not managed and may not be invested into directly.

Some information has been obtained from sources we believe to be reliable. OneDigital Investment Advisors makes no representation as to the accuracy or validity of this information. Investment advice is offered through OneDigital Investment Advisors, an SEC-registered investment adviser and wholly owned subsidiary of OneDigital.