The equity markets ended the year with strong performance despite the uncertainty about the new variant of COVID and the Federal Reserve’s announcement about tapering bond purchases and raising interest rates. Omicron is spreading quickly, but the mutation seems less severe and has a significantly lower mortality rate. As viruses mutate, they generally weaken, and the equity market is anticipating that corporate revenues and earnings will not be impaired by government-imposed lockdowns.
Over the past year, we have learned that COVID and commerce must co-exist to maintain strong employment and a stable nation. Growth will still be modestly restrained by the virus and the product supply chain challenges, but consensus expectation for GDP growth in the U.S. is for the pace to slow from 5.6% in 2021 to 3.8% in 2022. The Federal Reserve has also said that the pace of tapering bond purchases may accelerate because of the recent 6.8% annual CPI inflation rate. Once the cessation of new bond purchases occurs, the Federal Reserve is expected to begin raising interest rates to slow the pace of inflation. They will only raise rates if necessary and they will be deliberate in their policy actions so the markets should adjust incrementally.
While congressional committees continue to revise the provisions of the Build Back Better plan, many centrist democrats are not committing to support it. The Office of Management and Budget has estimated the $4.7 trillion package is not “paid-for” by new tax increases so the plan looks less likely to pass in a mid-term election year. As objective news sources outline the details of the plan, recent public approval ratings for it have dropped since it would induce even more inflation.
The supply chain is slowly normalizing, which means corporate revenues and earnings are expected to rise. The Bureau of Economic Analysis estimates that after-tax corporate profits were a record 11% of GDP in the third quarter and most companies with pricing power should benefit. Strong profit margins and pricing power will be the key to owning outperforming companies in an economy with escalating labor and raw material costs. We favor a mix of growth and value stocks in the portfolios that meet these criteria.
Selective larger cap technology companies like Apple, Alphabet, Microsoft and Cisco were outperformers in 2021 along with the financial and energy sectors. Industrial, consumer staples, materials and utilities generally underperformed. International and Emerging markets lagged behind the U.S. due to COVID, a decline in currency value relative to the U.S. dollar and significantly leveraged corporate debt loads. These issues will not subside in the coming year, so we remain skeptical of overseas investments. One of the most important countries to monitor in 2022 is China, where the Communist Party is contending with significant property market value declines, food shortages, energy problems, and health challenges.
The potential for increasing interest rates is inducing questions about the U.S. market’s valuation. Since the U.S. has sustained economic momentum, several Wall Street strategists and analysts are raising earnings estimates to a consensus of $230 in collective S&P 500 earnings per share. This means the market is trading at 21x 2022 earnings. Many strategists have raised their year-end 2022 target to between 5,000 and 5,500 in the S&P 500 Index, or 5-15% higher than present levels. We remain constructive about the markets, but higher market volatility will require active management in finding strong investments for the year ahead.
Index 2021 Return Performance
S&P 500 Index.................................26.9%
S&P Mid Cap 400 Index................23.2%
S&P Small Cap 600 Index............25.3%
MSCI All World Cap Index.............16.9%
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