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Market Insights

December 13, 2021

Looking Back to Look Ahead: An Objective Assessment and Four Key Questions for 2022

“…For time and the world do not stand still. Change is the law of life. And those who look only to the past or the present are certain to miss the future.” – John F. Kennedy, Address in the Assembly Hall at the Paulskirche in Frankfurt, June 25, 1963

Executive Summary

  • Glenmede’s 2021 themes still resonate with the new administration’s policies, the vaccine-induced recovery and a shift in investor attention toward inflation and rates.
  • The bottom line of those themes — that 2021 would provide a positive backdrop for markets despite lingering concerns — also proved quite accurate.
  • The coming year’s market performance will likely rest on answers to four key questions about the stage of the expansion, inflation, government policy and market valuations.
  • This time, however, the bottom line is more nuanced, with a positive economic and profit backdrop offset in part by growing headwinds and premium valuations.
  • Increased selectivity by investors appears justified by the relative attractiveness of investments such as real estate and smaller capitalization stocks.

It is that time of year when Wall Street strategists publish their outlooks for the coming year, with their specific forecasts for GDP growth and the returns for individual asset classes, including large cap stocks, small cap stocks, international equities, bonds and so on. Glenmede has a similar internal capability for modeling such projections but recognizes the limited accuracy and usefulness of such near-term projections. Instead, we focus our end-of-year efforts on understanding the backdrop and driving factors behind the path forward for the economy and markets. Such an approach prepares us for the year and helps us think ahead and focus monitoring efforts.

Looking back to look ahead

In 2021, this backdrop, from our perspective, centered on a new U.S. administration and associated policies, the transition of the COVID-19 pandemic from a year-end surge to a vaccine-induced recovery and eventually to a shift in the market’s attention on the “next” economic and market environment, which would be less worried about downside and more focused on inflation, rates and the return to work. This set of themes and drivers helped us correctly identify the supportive backdrop for 2021 and focused our attention first on fiscal policy and COVID-19 vaccination trends and, later in the year, on inflation and Federal Reserve (Fed) policy shifts. It also led us to search for and favor cheaper, economically sensitive investments that would continue to feel the lift of the improving backdrop.

Exhibit 1: A focus on 2021 themes and drivers is paying off

These statements reflect Glenmede’s opinions or projections, which may change after the date of publication. Actual future developments may differ materially from the opinions and projections noted above.

Nearly two years after the peak concerns of the COVID-19 outbreak, following rounds of fiscal and monetary stimulus and a faster-than-expected payoff from mRNA vaccine research, the economy, profits and markets have rebounded materially. Investors are now faced with a market whose performance will depend largely on the answers to four key questions, as outlined below, and what those answers should ultimately mean for investors.

Exhibit 2: A glance at the key questions for 2022

Question 1: Where are we in the pandemic recovery?

There are two aspects to this question: 1) whether the rebound from the pandemic is complete and 2) if the rebound has gone so far as to catapult the economy into the late stage of an economic cycle and introduce the risk of another recession. Our answer to both aspects is no. As shown in Exhibit 3, the economy has rebounded materially, but like past recoveries and the expansions that followed, has not yet improved enough to reach its longer-term potential. This leads us to view the current environment mostly through the lens of the midcycle of an ongoing expansion. There is room for improvement, although it is likely to be slower than the initial stages of the economic rebound. Because there is room for improvement, the midcycle of an expansion is, by definition, not overheated and is unlikely to enter a recession from the weight of its own excess activity. Put more simply, the rubber band has not yet been stretched enough for us to be concerned.

Exhibit 3: The overall economy still has room to return to potential

Source: Glenmede, Congressional Budget Office; Data through 12/2/2021
Data shown are estimates of potential real gross domestic product (GDP) for the U.S. economy via the Congressional Budget Office in blue and actual U.S. real GDP in green.

An exogenous force could, however, cause some economic difficulty. In the final month of 2021, the economy faces such a potential threat in the form of the COVID-19 omicron variant. So far, however, initial information suggests that while this variant is more contagious and may be able to spread to some vaccinated individuals, cases in vaccinated individuals do not appear to be more severe than those associated with the delta variant. Of course, this development bears close monitoring as this preliminary information needs to be confirmed by more robust analysis.

Question 2: Will above-average inflation persist into 2022?

Inflation has been a top concern for investors through much of 2021 and is unlikely to fade into the background in 2022. However, investors need to modify their thought process around inflation from one of debating transitory versus nontransitory to instead understanding what parts of the current inflation are likely to be fleeting and which are likely to be more persistent. Exhibit 4 attempts to do this, taking current inflation on the far left, breaking it down into longer-term inflation expectations (2.5%), base effects (1.2%) and excess (1.5%). Base effects, by definition, are transitory in nature and should fade away as 2022 begins. Excess inflation, on the other hand, is likely to be somewhat persistent since supply chain disruptions may get better but are unlikely to be fully resolved in 2022.

Exhibit 4: Inflation: Some is transitory, some is not

Source: Glenmede, Blue Chip Economic Indicators; Data through 11/30/2021
Data shown are various historical and projected figures for the U.S. headline consumer price index (CPI), which measures the change in the price of a basket of goods and services consumed by U.S. households. “2021e” and “2022e” are Glenmede and consensus expectations, respectively, broken down into long-term expected trend rate inflation, base effects and excess factors due to labor shortages and supply-chain disruptions. “2-year Avg” is the average of year-end inflation for 2020 and expected year-end inflation for 2021. “Exp. 10-year (Market)” is derived via market-based inflation expectations, which includes breakeven inflation rates on 10-year Treasury Inflation Protected Securities (TIPS) and 10-year inflation swap rates. “Exp. 10-year (Survey)” includes all the market-based inflation expectation components, alongside survey-based expectations via the Fed’s Livingston survey. Past results may not be indicative of future results. Actual results may differ materially from projections.

As a result, inflation for 2022 will likely land in the range of 3-4%, above the Fed’s preferred level and longer-term expectation of 2.5%. It is important to note that the longer-term expectation of 2.5% is both more subdued than the current levels that are ringing the alarm bells and meaningfully above the near 1.5% levels seen over much of the past decade. This higher inflation is a regime change but is unlikely to be a repeat of the much-feared inflation surge of the 1970s.

Question 3: What should we expect from policymakers?

Both fiscal and monetary policy are likely to provide headwinds in 2022. Independent of the passage of the reconciliation bill, given its 10-year implementation timeline and the tax revenue offsets, fiscal spending in 2022 is likely going to experience a significant decline from the level of the past two years. Similarly, as shown in Exhibit 5, the Fed is already embarking on its own removal of accommodation.

Exhibit 5: The Fed has begun the tapering process

Source: Glenmede, Federal Reserve; Estimates as of 11/30/2021
Data shown is a general representation of the Federal Reserve’s purchases of U.S. Treasury bonds in blue and agency mortgage-backed securities in green. Solid bars are actual purchases by the Fed, hashed bars are Glenmede’s expectations for future purchase amounts. Actual results may differ materially from projections.

Arguably, emergency measures such as those provided by the COVID-19 relief bills and the Fed’s preemptive actions are no longer needed, but there is the question whether the “patient” should be released from medical care so soon. Our suspicion is that the patient, while not completely recovered, is doing reasonably well, and it is time to exercise muscles that have been underutilized. Of course, this does not mean that all bandages should be ripped off and the patient should be shoved to the street. Governments, and the Fed in particular, should be careful to gradually remove accommodation and remain ready to adjust as necessary to help with the rehabilitation.

Question 4: Is the market too expensive?

Equity markets continued to plod higher in 2021, in a near-straight line that has led to an eye-catching rise in valuations. U.S large cap equity valuations are in the 90th percentile of valuations by our calculations, with U.S. large cap growth near the 99th percentile, but other portions of the equity market, such as U.S. large cap value, U.S. small cap and international equities, are far more palatable (Exhibit 6). Further, interest rates are quite low, making traditional fixed income an uncompelling alternative for investors seeking to outpace now-higher levels of inflation.

Exhibit 6: Combined equity market valuations are high, but not unreasonable

Source: Glenmede, FactSet, MSCI; Data through 12/5/2021
Glenmede’s estimate of long-term fair value for equities is based on normalized earnings, dividend yield and book value using MSCI indexes for equities (MSCI USA Growth, MSCI USA Value, MSCI USA Small-Cap, MSCI All Country World ex-U.S.) and FactSet’s World Real Estate Investment Trusts industry group. These are unmanaged total return indexes with dividends reinvested. Past performance may not be indicative of future results. One cannot invest directly in an index.

So, yes, some parts of the market are expensive and deserve lower allocations in investor portfolios, but such views should not be blindly extended to all equities or all risk assets. There are enough reasonably valued options for investors to position their portfolios for future success.

Looking Ahead: More modest gains due to various headwinds

Overall, 2022 should be another year of ongoing growth for an economy that is in the middle of a longer-term cycle, accompanied by continued growth in earnings for equity investors. However, unlike 2021, the coming year will have a handful of stronger headwinds, both from its own starting point valuations as well as the economic headwinds of more constrained fiscal spending and the normalization of monetary policy. Exhibit 7 summarizes the key questions and viewpoints.

Exhibit 7: 2022 key questions and current viewpoints

These statements reflect Glenmede’s opinions or projections, which may change after the date of publication. Actual future developments may differ materially from the opinions and projections noted above.

It is crucial that investors position their portfolios for this expected outcome, as shown in Exhibit 8 on the left, while keeping their eyes on the key factors driving the markets, as shown on the right.

Exhibit 8: What to do and what to watch in 2022

These statements reflect Glenmede’s opinions or projections, which may change after the date of publication. Actual future developments may differ materially from the opinions and projections noted above.

This presentation is intended to be an unconstrained review of matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. Advice is provided in light of a client’s applicable circumstances and may differ substantially from this presentation. Opinions or projections herein are based on information available at the time of publication and may change thereafter. Information obtained from third-party sources is assumed to be reliable, but accuracy is not guaranteed. Outcomes (including performance) may differ materially from expectations and projections noted herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss the applicability of any matter discussed herein with their Glenmede representative.