Market Perspectives. From Vanguard
Vanguard’s monthly economic and market update.
Vanguard’s monthly economic and market update.
The American economy is healthy again and appears to be on a path toward solid growth in 2022, which should be encouraging news for U.S. financial markets.
Yet investors can be forgiven for feeling extremely uncertain about the year ahead, according to U.S. economist Darrell Spence.
“We’re far enough along with the pandemic that the economy is not in distress,” Spence says, “but COVID and the response to it created a number of distortions — in global supply chains, labor markets, sectors and even politics.”
He expects U.S. economic growth to be solid but slowing in 2022, in the range of 2.5% to 3.0%, as the economy contends with waning stimulus and inflationary headwinds. Although full economic shutdowns may be behind us, emerging COVID variants, including Omicron, and other surprises could further dampen growth.
“Things are returning to normal, but none of us has experienced this before. It’s important to acknowledge there are still things we don’t know,” Spence adds.
Perhaps the biggest questions on investors’ minds are about inflation. How high will it go and how long will it last?
Neither investors nor Federal Reserve officials have had to contend with meaningful inflation over the past three decades. That changed last summer.
“When stimulus-induced demand met COVID-restricted supply it created distortions in the economy,” Spence says. “And that fueled rapidly rising prices wherever there were bottlenecks.”
Fed officials have maintained that high inflation levels in the U.S. are transitory, and prices should retreat once these distortions are corrected. But Spence expects inflation levels will remain elevated throughout 2022.
“I’m not convinced that these shifts are fundamental changes to the productive capacity of the economy, so I expect inflation to moderate. But it may take longer than Fed officials expect for supply and demand to come back into balance.”
Investors worried about the destructive impact of inflation on their portfolios should consider this: Even during times of higher inflation, stocks and bonds have generally provided solid returns. It’s mostly at the extremes — when inflation is above 6% or negative — that financial assets have tended to struggle.
What’s more, some inflation can be healthy for companies, such as banks and commodity-linked companies that have struggled in a low inflation, low interest rate world.
Inflation is so unsettling because it can erode a company’s profits and, ultimately, investor returns.
To blunt its impact, investors may want to consider investing in companies with pricing power. Pricing power can help protect a company’s profit margins by passing rising costs along to customers.
“I’m not ready to believe we are headed into a period of sustained inflation,” says equity portfolio manager Diana Wagner. “But I do believe rising costs will linger in the months ahead, making it the biggest risk investors face in 2022. That’s why I am so focused on uncovering companies with pricing power.”
Take Netflix. A string of hits like “Squid Game” and seemingly insatiable viewer demand have enabled the streaming giant to raise subscription fees four times over the past 10 years.
High and stable margins can be an indication of pricing power. Companies with pricing power potential include consumer businesses with strong brand recognition, like beverage makers Keurig Dr Pepper and Coca-Cola; companies in industries with favorable supply and demand dynamics, like semiconductor and chip equipment makers TSMC (Taiwan Semiconductor Manufacturing Company) and ASML; and businesses that provide essential services, like health care giants Pfizer and UnitedHealth Group.
Consumer goods aren’t the only things that appear to be expensive. Thanks to low interest rates, accommodative central bank policy and the reopening of economies, most classes of stocks and bonds have gotten pricey.
U.S. equity markets have been generally strong in the post-pandemic period, thanks in part to robust corporate earnings. That said, price-to-earnings ratios, a measure of how expensive stocks are, have been elevated relative to historical averages.
That’s why careful security selection and diversification are more important than ever.
“We have seen a range of stocks — from fast-growing digital stocks to old economy stocks tied to the cyclical recovery — become more expensive over the past year,” says equity portfolio manager Chris Buchbinder.
“Given the level of uncertainty we face today, I am looking to strike a balance in my portfolios, seeking exposure to companies with long-term growth potential, like certain giants in e-commerce, streaming and digital payments; companies that can still participate in the cyclical recovery, like airplane engine manufacturers; and those with secular growth and cyclical components, like automaker General Motors — whose Cruise division is a leader in driverless car technology.”
One potential bright spot for investors in 2022 is the universe of dividend-paying stocks.
After record dividend cuts and suspensions during the pandemic, companies are reinstating dividend payments, and some with surplus capital are declaring catch-up dividends.
“Today I am finding no shortage of opportunities to invest in companies restoring and even increasing dividend payments,” Wagner says. “With profit margins recently near peak levels, companies are able to increase dividends despite inflationary pressures.”
Of course, not all dividend payers are created equal. Wagner is focusing not on the highest yielders, but on those companies with strong underlying earnings growth that have demonstrated a capacity and commitment to raise dividends over time. Consider, for example, semiconductor makers like Broadcom, which has increased its annual dividend in each of the last five years. Even during the pandemic, the company raised its dividend more than 11%, supported by record profitability. Such dividend growers historically have tended to generate greater returns than other dividend strategies, while also keeping up relatively well with the broader market.
Companies paying meaningful and growing dividends can be found across a range of sectors. Among these are health care services providers like UnitedHealth Group and telecommunications conglomerates like Comcast.
While it might feel like a lifetime away, investors may want to be mindful of the midterm elections in November. Historically, elections have little impact on the long-term direction of markets, but they tend to cause some volatility during election years.
“I don’t think this year will be any different,” Buchbinder says. “I don’t expect the result to be a huge driver of investment outcomes one way or the other. There may be a few bumps in the road, and investors should brace for short-term volatility throughout the year.”
Indeed, an analysis of more than 90 years of equity returns reveals that stocks tend to have lower average returns and higher volatility for the first several months of midterm election years. As results at the polls become more predictable, this trend often reverses, and markets have tended to return to their normal upward trajectory. But these are just averages, so investors shouldn’t try to time an entry point into the market.
With a laundry list of concerns including slower growth and rising inflation, many investors may be wondering if they should move some cash to the sidelines in 2022. Holding a lot of cash has typically been a drag on overall portfolio returns, and it may be especially impactful today since real returns from cash are negative.
Instead, investors should consider maintaining a well-diversified, balanced portfolio like the one in the chart below.
The chart illustrates a hypothetical scenario representing three types of investors. Each year, a momentum-driven investor buys the top returning asset class from the previous year. A value-seeking investor buys the lowest returning asset class. The third investor sticks to a 60/40 balance between diversified stock and bond portfolios and rebalances at year-end. In nearly every multi-year holding period over the last 20 years, the balanced portfolio outpaced the other two, often by a wide margin.
Within their equity portfolios, investors may want to include a mix of proven growth companies, stocks that have consistently increased dividends and companies that can maintain pricing power.
“With rising inflation and other uncertainties on the horizon, I’m optimistic that an active portfolio of select companies with strong pricing power can help investors thrive in the years ahead,” Wagner says.
The US Federal Reserve (Fed)’s message on inflation has changed. Fed
Chairman Jerome Powell recently characterized supply-chain bottlenecks
and disruptions as “frustrating” and as “holding up inflation longer than we
had thought.” The Fed’s mea culpa is small consolation for investors whose
portfolios haven’t been positioned optimally for a longer-than-expected
period of higher inflation.
I previously said inflation would likely be stickier than the market or the
Fed anticipated. The question now is: Has inflation already peaked? In my
opinion, the short answer is no.
Inflation is being pushed higher by three catalysts—labor, raw materials,
and transportation—that are interrelated in ways that create longer-lasting
systemic risks for the economy. I use the term systemic because of the
parallel to systemic financial risks, in which stress in one area of the market
spills over into other parts of the financial system, amplifying the initial
For example, the CEO of a computer hardware company recently told our
analysts that it wasn’t just semiconductors that were in short supply, but
also plastic, resin, copper, and steel. Then once the hardware is built, it’s
transported on container ships that are backed up at US ports. Finally, a
scarcity of truck drivers and port workers means that getting the finished
products to stores is delayed.
Thus, while some supply-chain strains may ease relatively soon, the ongoing
bottlenecks could take at least another year to resolve.
The pandemic’s path remains the key to the economic outlook, and what
we’ve learned about it since last quarter is concerning: Additional variants
are possible (and potentially more transmissible and virulent), vaccine
protection could wane over time, and a significant percentage of the
population may remain unvaccinated. This new reality is reflected in reduced
economic activity (FIGURE 1), the resurgence of growth stocks over value
(as measured by Russell 1000 Growth Index1 vs. Russell 1000 Value Index2),
and a return to record lows in long-maturity yields. On a more positive note,
growth is still strong, economies are unlikely to go back into lockdown, and
stimulus remains supportive. All of this leaves markets caught between two
narratives: The pace of growth seems poised to slow, but the level of growth
is likely to remain above par.
Against this backdrop, we continue to seek a pro-risk stance over the next
6−12 months, preferring equities to bonds. But relative to last quarter, our
optimism is tempered somewhat by a slight downgrade to our macro and
policy outlook—including the potential for modestly slower growth, a slight
reduction in policy support, and inflation that’s more persistent than the
market expects. Within equities, we prefer Europe, which we continue to
believe is on the cusp of economic outperformance, and we have reduced
our emerging market (EM) view to neutral given the high costs of COVID19, high inflation,
and political volatility. We remain moderately bearish on
government bonds in Europe in particular, as yields seem too low given our
macro forecast. Credit spreads3 are generally rich, but we find some value in
bank loans and EM debt.
We have been advocating value-oriented exposure from a sector, market-cap,
and regional perspective. However, given the slightly less favorable fundamental
and policy backdrop, we think asset allocators should be more balanced between
growth and value. We continue to think commodities are supported by our inflation
outlook, and we favor energy and industrial metals, which have historically been
more sensitive to rising inflation than equities and can potentially help hedge
against a rise in interest rates.
We are moderately bullish on European equities due to attractive valuations, the
sharp increase in vaccinations, and high savings levels, which should allow for
more robust spending if consumer confidence increases as we expect. We are also
optimistic that Germany’s elections this fall could lead to a more supportive fiscal
environment and one that may influence the broader European stance. While
Europe has evaded the Delta variant’s wrath better than the US thanks to higher
vaccination rates, we are wary of the variant’s unpredictability and the potential
for further spread on the continent.
We’ve downgraded our view on EM equities to neutral as many countries are
experiencing expanding fiscal deficits and high inflation, and central-bank rate
hikes could slow domestic economies. Pockets of value persist among commodity
exporters and countries less dependent on tourism, but differentiation is key. We
would be selective in China given potential weakness in the cycle and uncertainty
related to the government’s regulatory push and deleveraging in the property
industry (FIGURE 2). Within Asia, we are neutral on Japanese equities. We see
tailwinds from cheap valuations and Prime Minister Suga’s resignation, which should
bode well for the business-friendly Liberal Democratic Party. But we are concerned
about China’s slowdown, which may feed through to the broader region.
We maintain a neutral view on the US. We think the US economy will slow somewhat
but stay strong, and consumers are in great shape. While policy support is slowly
declining, it remains highly supportive. Indeed, the Federal Reserve (Fed) seems
convinced that inflation expectations will remain anchored at low levels even as it
keeps its foot on the stimulus pedal. Our view is that inflation could be more
persistent than expected, given challenging supply shortages, rising wages, and
a hot housing market, which tends to lead to sticky shelter inflation. Higher, more
persistent inflation could unsettle equity markets, and valuations are expensive.
Thus, we prefer a quality bias and a balance between growth and value.
We are bullish on commodities given the inflation dynamics discussed, as well
as supply/demand imbalances across energy, metals, and agriculture. Capital
expenditures have been very weak for the past decade following a free-spending
period focused on growth rather than profitability. More structurally, environmental
concerns are feeding into higher costs and potentially lower supply. Our research
shows that commodities have historically been the only asset with a materially
positive beta4 to inflation, so from a portfolio-construction standpoint, we see a
case for at least some commodities exposure.
We agree with market consensus that the Fed may likely begin tapering around
year end. We see the European Central Bank (ECB) as more hawkish relative to the
nominal growth picture in its economy, and we think sovereign rates in Europe are
likely to drift upward. In credit, valuations are rich, with most spreads well inside of
median levels. However, defaults are likely to stay very low, and demand technicals
are strong as demographics and pensions generate huge demand for yield.
Within credit, we prefer EM debt to US high yield as EM spreads are considerably
wider (FIGURE 3). Credit valuations have been a reliable indicator of forward excess
returns—a dynamic we continue to trust. We think Mexico, Russia, and EM countries
in Central and Eastern Europe are attractive. We also prefer bank loans, which offer
attractive valuations vs. US high yield and could benefit from the Fed beginning to
We find securitized credit attractive relative to investment-grade corporates from
a valuation and risk perspective, given the abundance of asset types. We continue
to favor US residential housing, where millennials should be a growing tailwind for
demand. Securitized credit also offers floating-rate structures, which are appealing
from a duration5 perspective. The updated risk factors adopted by the National
Association of Insurance Commissioners may increase demand for AAA- and
Our base case is that central banks have clearly communicated their intentions to
taper slowly, but a policy mistake remains a risk given the amount of liquidity in
the system and its importance to markets. Bumps could occur if the Fed or ECB are
perceived to be too hawkish, or if their plans don’t change quickly enough in the
face of a new variant or other COVID surprise.
COVID remains the boogeyman. Its impact on consumer preferences (more saving/
less spending) could last longer than expected. And with more than five billion
people unvaccinated worldwide, the potential for new, more dangerous variants
requires investors to stay nimble and monitor portfolio risks carefully.
In addition, China’s opaque system is difficult to analyze, and government priorities
aren’t easy to infer. Although not our base case, China’s renewed focus on
socializing wealth via regulations could continue or even increase. China’s housing
market and debt levels are also concerns, as highlighted by Evergrande’s recent
On the upside, two major market drivers, the Delta variant and China’s regulatory
approach, could both ease in the coming months. EMs could benefit if China’s
policymakers temper their tightening of the property market, boost infrastructure
spending, and loosen climate controls—moves that could be spurred by politics
ahead of the National Congress in November 2022.
Markets may also be positively surprised by the patience of central banks and find
themselves awash in liquidity for several more quarters to come. Interest rates may
stay low for an extended period, despite the economic recovery, and risk assets6
could appreciate further.
Finally, our inflation concerns may be ameliorated by a pickup in productivity,
something that many economic models predict and that could be boosted by
government spending on traditional and technological infrastructure after many
years of underinvestment.
Just booked a long-anticipated vacation? Celebratory dance! Just enrolled in the maintenance plan for your HVAC system? That’s far less exciting. But when your AC quits in a heat wave, you’ll be dancing when the tech shows up for priority service. As investors, sometimes we need a reminder why we enroll in the less flashy stuff, too. While the stock market has soared in 2021, it’s been a tougher ride for fixed-income investors. Interest rates are exceptionally low to help support the economy, and even though rates were expected to go nowhere but up, they defied expectations and dipped even lower for much of the year. With yields (the expected return on a bond) so low and volatility potentially rising, it wouldn’t be surprising if you’ve wondered what bonds have done for you lately. But like signing up for just-in-case maintenance can keep you cool in a pinch, bonds can help us maintain our portfolios’ cool, too. Especially today, when there’s still the threat of volatility and uncertainty from shifting interest rates, it’s important to remember why we bother with bonds in the first place: diversification.*
There’s a give and take to diversified, balanced portfolios. Sometimes, stocks soar and leave bonds in the dust (ahem, 2021). But other times, stocks are volatile and
bonds provide a welcome degree of stabilization. In other words, if you’re well diversified, one part of your portfolio is likely to
outperform as another underperforms at any given moment. Ultimately, this balance should provide a less volatile experience overall. All the portfolios in FIGURE 1 generated significant positive returns over the time period shown, but the balanced one provided a less turbulent journey.
Unfortunately, there’s no telling which asset class is going to be in favor in any given year. Even the experts who thought rising rates were a no-brainer this year have gotten it wrong lately. That’s why it’s important to work with your financial professional to be prepared for whatever the market throws at you. With continued interest-rate uncertainty on the horizon, here are three strategies to discuss with your financial professional that may better withstand shifting interest rates:
Whatever you decide, working with professionals who have experience and extensive resources should make it a little easier to sit back and focus on other important things. You know, like putting your feet up in your perfectly climate-controlled home to plan a well-deserved vacation.
S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks. Bloomberg US Aggregate Bond Index is composed of securities from
the Bloomberg Barclays Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.
“Bloomberg®” and any Bloomberg Index are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of
the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Hartford Funds. Bloomberg is not affiliated with Hartford Funds, and Bloomberg does
not approve, endorse, review, or recommend any Hartford Funds product. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information
relating to Hartford Fund products.
Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit,
liquidity, call, duration, event and interest-rate risk. As interest rates rise, bond prices generally fall. • Loans can be difficult to
value and less liquid than other types of debt instruments; they are also subject to nonpayment, collateral, bankruptcy, default,
extension, prepayment and insolvency risks.