2021 Review and 2022 Outlook

Keep an Eye on Inflation and Federal Reserve Policy

It was another great year of returns for most equity indexes. In 2021, the S&P 500 index returned 28.71%. This return was powered by an accommodative Federal Reserve, a reopening of the economy and very strong earnings growth. The new administration was unable to pass a new tax bill and the prospects for a major tax bill in 2022 have dimmed. Corporate earnings growth in 2022 should be strong as most companies continue to successfully navigate higher inflation. The main questions are: will inflation subside and what price to earnings (P/E) multiple will investors be willing to pay with interest rates increasing? At Virtue Asset Management, we expect single digit returns for the S&P 500 with increased volatility. Despite modest return expectations, investing in equities compares favorably to investing in fixed income which will lose value with rising interest rates and in cash which will lose purchasing power due to inflation. Over the next three years we expect the S&P 500 index to provide a much better risk/reward versus fixed income and cash. Dependent on a client’s risk/reward tolerance, we recommend keeping between three to five years of upcoming expenses in safe and short-term maturity bonds. We recommend the remaining part of the portfolio be invested in diversified equities.

As we begin 2022, the financial markets are still being driven by Federal Reserve policy. At the beginning of last year, the consensus estimate for the first increase in the federal funds rate was the beginning of 2023. Inflation, as measured by the Consumer Price Index, was 6.8% for the 12 months ending in November, the highest in 30 years and far above the Fed’s long-term target of 2%.  Rising inflation during 2021 has accelerated the tapering of bond purchases and the beginning of interest rate hikes

In testimony before the Senate Banking Committee on November 30, Federal Reserve Chairman Powell said the word transitory is no longer the most accurate term for describing the nature of the current high inflation rate. “It’s probably a good time to retire that word” Powell responded to a question about his frequent use of the word to describe how long inflation is expected to last. Powell’s switch to a more hawkish tone was designed to convince consumers and the financial markets that the Fed can control inflation. The Fed wants to prevent inflation expectations from becoming entrenched and turning into a self-fulfilling prophecy. Our positive outlook for equities depends on inflation gradually slowing as supply chain and Covid disruptions subsiding during the year.  The primary risk is that inflation will remain stubbornly high during 2022, forcing the Fed to act more aggressively leading to an inverted yield curve and possible economic slowdown.

At their December meeting the Federal Reserve decided to double the pace of tapering or winding down bond purchases from $15 billion to $30 billion per month. This means the Fed will end bond purchases in March. The market consensus now expects three quarter point interest rate hikes in 2022, three in 2023 and two additional hikes in 2024 bringing the Federal funds rate to 2.25%. Increases in the Federal Funds rate tend to have a lagging impact on the economy of several years after the Fed tightening begins.  According to Deutsche Bank for the S&P 500 index, “there tends to be solid growth in the first year of the hiking cycle, with an average return of 7.7% after 365 days.”

Despite the high inflation and actions by the Federal Reserve, the yield on the 10-year treasury is now 1.54% and down from the high reached in March of 1.7%. In 2021, despite the recent rally in interest rates, the Bloomberg Aggregate Bond index provided a negative return. Currently, a 3-year treasury yields .97%. If inflation were to move down to the long-term goal of 2%, that would still provide a real return of -1% a year for a 3-year treasury. This would imply a very poor risk/reward for most fixed income products.  We recommend a portfolio consisting of short duration and floating rate bonds, TIP’s, a modest amount of high yield and matching maturity dates with upcoming liabilities.

U.S. stocks continue to outperform the rest of the world. U.S. large cap stocks did slightly better than mid cap and small cap stocks. International equities and emerging markets provided lower returns than the U.S. We continue to recommend overweighting U.S. stocks compared to international stocks. For investors interested in investing in individual countries we continue to recommend exposure to India over China.

In 2021, 613 special purpose acquisition companies (SPACs), sometimes referred to as blank check companies, were created with total cash raised of $162 billion. This almost doubled the proceeds created in 2020 by 248 companies which raised $83 billion. Most of the SPAC companies are still unprofitable. The change in the outlook for interest rates had the greatest impact on aggressive growth stocks, especially those with little or no profitability and negative cash flows.  Long-term investors adjusted their valuation models to reflect higher interest rates which reduces the present value of future earnings.  This caused a compression of earnings multiples and a rotation by investors out of stocks with sky high valuations.  The Defiance Next Generation SPAC ETF (ticker: SPAK) was down 23.30% for 2021 and is down 40% from the high price in February of 2021. The outlook for higher rates had less impact on financial stocks which tend to profit from higher rates.  We maintain our bias toward quality stocks with stable earnings, high free cash flow and reasonable valuations.

Former High-Flying Stocks and Percentage Change from their 52 Week High

In 2021, earnings for the S&P 500 index are estimated to be $202 a share. That is a trailing price to earnings (P/E) ratio of 23.65. For 2022, analysts are estimating earnings of approximately $220 a share. Using those earnings, the forward P/E is currently 21.66. Over the last five years the forward P/E has averaged 21.62. The S&P 500 seems to be fairly valued. It seems unlikely that investors will apply a higher P/E multiple in an environment of rising interest rates. The upside potential of the S&P 500 is that earnings could be higher than $220 a share and are expected to grow over the next few years. Every $10 increase in S&P 500 earnings could provide another 5% return using the current P/E level. This upside potential provides a better risk/reward profile than cash and fixed income. With rising interest rates and higher inflation, the outlook for cash and fixed income is a negative return over the next few years. We recommend that clients be prepared for lower returns of equities over the next few years and increased volatility. However, we expect equities to have a better return over the next 3 years versus cash and fixed income.

Investing involves risk, including the possible loss of principal and fluctuation of value.  Past performance is no guarantee of future results.

This letter is not intended to be relied upon as forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.  The opinions expressed are as of the date noted and may change as subsequent conditions vary.  The information and opinions contained in this letter are derived from proprietary and nonproprietary sources deemed by Virtue Asset Management to be reliable.  The letter may contain “forward-looking” information that is not purely historical in nature.  Such information may include, among other things, projection and forecasts.  There is no guarantee that any forecast made will materialize.  All information is illustrated gross of investment advisory fees. Reliance upon the information in this letter is at the sole discretion of the reader.  Please consult with a Virtue Asset Management financial advisor to ensure that any contemplated transaction in any securities or investment strategy mentioned in this letter align with your overall investment goals, objectives and tolerance for risk.  Additional information about Virtue Asset Management is available in its current disclosure documents, Form ADV and Form ADV Part 2A Brochure, which are accessible online via the SEC’s investment Adviser Public Disclosure (IAPD) database at www.adviserinfo.sec.gov, using CRD#283438.

Virtue Asset Management is neither an attorney nor an accountant, and no portion of this content should be interpreted as legal, accounting or tax advice.

Source: Best Financial Advisors in Oak Park | Certified Wealth & Fiduciary Planner | Virtue Asset Management