After a 2021 dominated by easy money and high levels of stimulus, 2022 is expected to be a year of transition, moving away from the government interventions that characterized the Covid recovery. Indeed, one of the most significant factors in 2022 will be inflation largely caused by those Covid interventions. Now the Federal Reserve is forced to move to an inflation fighting stance and is expected to raise rates 3 or 4 times in 2022, moving the Federal Funds rate from zero to 0.75% or 1.00%. If all goes well, the Federal Reserve’s actions will curb inflation while still allowing the economy to grow. But there is a ditch on both sides of that path. If the Federal Reserves tightens monetary policy too quickly then we could end up in a recession. Conversely, if the Federal Reserve remains too loose for too long then inflation could spiral out of control.
We are cautiously optimistic that the Federal Reserve will be able to judge correctly, curbing inflation while avoiding a recession. In that scenario the market would be more volatile as investors watch the data and the Feds moves carefully. However, the market would still grind higher as the after-effects of the economic stimulus, including massive amounts of cash in the hands of consumers and businesses, flows through the economy. Consumer still are spending, and there appears to be pent-up demand, particularly in the automobile and housing markets, which can drive revenues and profits higher – and that is good for stocks.
The bond market meanwhile could continue to struggle as interest rates ‘normalize.’ The good news long term for bonds is that higher rates mean higher future returns to investors. Likewise, bonds still play a vital role in the portfolio if the higher interest rates slow the economy too quickly, acting as an important stabilizer in the portfolio in volatile markets.
We are also cautiously optimistic that inflation will moderate by the middle of the year. While the current numbers are concerning, there are still strong deflationary factors that could help the Fed in their effort to bring inflation back down. Among other factors, demographics point to slowing inflation due to a slowing population growth. Productivity also could help moderate inflation as technology helps every worker be more productive.
We expect Covid to no longer be a factor in financial markets. While the numbers still look unfavorable, both consumers and governments are increasingly learning to live with the disease.
Of course, it is always important to remember that many of the most important shifts in the market and economy are due to surprises, not the expected. Few would have predicted for example, that 2020 would be dominated by the economic fallout from a virus, and when the virus appeared, the expectations for 2020 were changed dramatically. Because of the uncertainty of the future, we remain committed to diversified portfolios and will remain vigilant as we weather the good and bad of what 2022 will bring.