By Brad McMillan
As we closed out 2021, the world looked both different from a year ago and very much the same. Another wave of the virus was underway, with a new variant that may be even worse than the one before.
This new medical threat, along with rising inflation and continued supply chain problems, challenged the economic recovery, leaving investors wondering if markets could keep reaching new highs. Indeed, these risks are still very real. But so are the opportunities—and 2022 is likely to see even further improvement from 2021.
The Road Back To Normal
2021 brought us a long way back to normal. Despite the Delta wave in the second half of the year, the country remained open, and the economy returned to something like the pre-pandemic normal.
Job growth was substantial, consumer spending bounced back, and businesses remained confident. Markets rose to new highs throughout the year on a combination of an economic rebound and continued monetary policy support. In many respects, it was a banner year. As we enter 2022, the question is, can this momentum continue?
The answer is yes. The improvement will likely slow as we approach the new normal. But the existing economic and market momentum should be enough to keep the country growing and markets rising throughout the year.
Inflation and supply chains will begin to move closer to the pre-pandemic normal in 2022. This shift will be positive for the economy. But as the economy improves, the yield on 10-year U.S. Treasuries will likely rise to pre-pandemic levels of 2 percent to 2.5 percent. This rise could be a headwind, as markets will respond to higher rates with lower valuations.
Driven by the growing economy, however, lower valuations will be offset by healthy earnings growth. This should result in the S&P 500 rising modestly to around 5,000, and international markets should show similar gains. 2022 will not be a banner year like 2021. Still, as we approach the new normal, modest growth is what we should expect.
That’s not to say it will be easy, of course. There are a number of risks that need to be taken into account.
Medical. The medical risks are the most immediate. The Omicron variant of COVID-19 is the latest threat to emerge, and it likely will not be the last. We don’t know exactly what it means yet. We do know that, from a medical point of view, the biggest implication is that the pandemic is still with us.
From an economic perspective, the lesson here for 2022 is that medical risks can coexist with an open, growing economy. The summer Delta wave in the U.S. did not derail the recovery.
Further, population immunity has continued to rise on a combination of vaccination and direct exposure. So, the winter wave looks to be both lower and less likely to cause significant economic damage. Even if the spread of Omicron worsens, both the population and the economy are more resilient now than in 2021. The medical risks are real but likely constrained. They should not derail the recovery in 2022.
Economic. If medical risks aren’t likely to derail the recovery, what about economic and political ones? Labor shortages and supply chain issues are the current headline risks. Both are likely to subside during 2022. Businesses have continued to hire, and rising wages will bring more workers back into the labor force. Over the year, this should ease the labor shortage.
Supply chains are already starting to heal and will be much better by the end of the year. The economy will not be back to the old normal, but it will be at or close to a new normal—one with a balance of wages and workers and supply and demand. It takes time for a system to rebalance after a shock, and the pandemic was a major one. 2022 will be the year we find that balance.
Policy. The same will be true of policy, but this is a bigger risk. With the debt-ceiling can kicked down the road into February, politics will likely be another negative factor. This debate is likely to end in compromise, but it will introduce uncertainty and risk until that happens. This is a short-term risk.
On a longer-term basis, the Federal Reserve (Fed) has signaled that it will be tightening policy throughout the year. Indeed, markets are expecting multiple interest rate hikes. Tightened financial conditions will be a headwind for anything that requires borrowing (i.e., everything).
After a sustained monetary tailwind throughout the pandemic, this normalization of rates will slow the economy as a whole. Nonetheless, it is a necessary and ultimately positive step that will help sustain growth going forward. Given the momentum we see in the real economy, it will not derail the recovery, but it could hit the stock market.
Market. Valuations spiked during the pandemic, supported by those low interest rates, and are likely to adjust down somewhat as rates rise. That said, any decrease in valuations will be offset by rising earnings. Companies have improved their operations and margins during the pandemic, learning lessons about remote operations and cutting costs.
Those benefits will persist as the economy reopens. Higher margins will combine with rising sales, as we have seen, to push earnings up fast enough to more than offset the falling valuation levels. As we approach the new normal, those improvements will slow—but that won’t happen in 2022.
The Arc Of Recovery
As we look at the arc of the pandemic and recovery, 2020 marked the nadir, 2021 was the first half of the recovery to normal, and 2022 will be the second (and final) half of that recovery. The new normal at the end of 2022 will mean that the economy and markets will no longer be dancing to the tune of the virus.
Instead, they will once again respond to fundamental economic and financial factors. It will not be the same as the old normal, but it will be determined by the same factors. That will be something to celebrate.
In short, 2022 will be a year of growth. The economic problems are real: inflation, labor shortages, rising interest rates, political dysfunction, and more. But this scenario is normal, and those problems will be accommodated.
Even the medical problems, while likely to continue, are also part of the new normal. What we saw in 2021 was that the economy could accommodate the Delta waves and still grow. The Omicron variant, and others likely to surface, can and will be controlled. In the interim, they are unlikely to derail the return to normal.
The Upside Of 2022
As we closed out 2021, there were real risks to contend with. But that is always the case. Now, we understand those risks better and have made significant progress in controlling them. The opportunities for 2022 are also real—and even more likely to come to pass. With all the focus on the downside, 2022 presents significant upside possibilities. That, too, is something to celebrate.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held Registered Investment Adviser-broker/dealer. He is the primary spokesperson for Commonwealth’s investment divisions. He is also the author of Crash-Test Investing, a must-read primer for Main Street investors seeking to help insulate their portfolios against a market crash. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.