Stocks face a tougher path in 2022 as the Fed rate hikes

The dual threat of an unpredictable pandemic and looming interest rate hikes dampen investor optimism as 2022 approaches, unlike their vaccine and stimulus-fueled enthusiasm of a year ago.

Investors had something to feel good about during the holidays. Supported by an even stronger-than-expected economic rebound, the S&P 500 climbed 27% in 2021, the third largest gain in the past 20 years. US crude jumped 55% to around $ 75 a barrel. Interest rates on corporate bonds hovered around their historic lows, reflecting the low risk of default perceived after a year in which few companies went bankrupt.

As 2021 approaches, economists polled by the Wall Street Journal expected the US economy to grow 3.7% during the year. Instead, it’s probably increased by more than 5%. The unemployment rate fell well below what economists had expected.

Yet few investors expect 2022 to unfold as well as 2021, with the Federal Reserve poised to raise interest rates, a new variant of Covid-19 sweeping the country, and government aid to declining families. Already, oil prices have fallen 11% from their highs in late October, reflecting concern among traders about slowing demand for fuel. The S&P 500 has spent much of the past two months trading sideways, as some speculative investments, such as stocks of small, fast-growing tech companies, have fallen sharply, hit by fears of being particularly vulnerable to policies. more stringent monetary policies.

A major concern of investors: how different problems can feed into each other. New waves of Covid-19 cases caused by new or existing variants could slow economic growth by reducing consumer spending. But some also fear that such surges could help prop up already high inflation by contributing to supply chain problems and labor shortages, making it difficult for the Fed to push back rate hikes. short-term interest even if growth slows.

The biggest threat to riskier assets such as stocks is that “there are inflation issues causing the Fed to tighten too much,” said Jim McDonald, chief investment strategist at Northern Trust, the company. Chicago-based asset management and banking firm. “And one of the causes of that could be the supply disruptions linked to the pandemic,” he said.

Such concerns have been particularly evident in the bond market, where long-term U.S. Treasury bond yields have remained stuck in a narrow range below 2% even as short-term yields have climbed, suggesting that Investors are both concerned about the economic outlook and confident that the Fed will hike rates about three times in 2022.

Low long-term yields might reassure investors in some ways, as they play an important role in determining borrowing costs across the economy. Falling yields also tend to drive up the stock prices of fast-growing companies, including making their future earnings more valuable.

Economists warn, however, that higher short-term rates, even on their own, can slow the economy. And many believe long-term yields will rise as investors forecast further rate hikes beyond this year.

Despite the growing risks, many investors believe the markets will be strong in the coming year, offering strong returns even if they fall short of the outsized gains of the past few years, in large part. government stimulus programs.

Mr McDonald, for his part, said corporate profits are expected to rise further to double digits in 2022. As a result, his team favors riskier assets such as developed market stocks and lower-rated corporate bonds. compared to more secure assets such as cash and bonds. He said long-term rates should be controlled by technical factors, with a glut of savings continuing to flow into US Treasuries.

Overall, analysts in December expected earnings growth of 9.2% in 2022, according to FactSet, down from around 45.1% in 2021 but still comparable to 2017, when the S&P 500 gained 19%.

To reassure investors, stocks have generally performed well in the years when the Fed just started to raise interest rates. Investors are also pointing to signs that each successive outbreak of Covid-19 has dealt less of a blow to the economy as people learn to cope with the virus. Many investors are also optimistic that inflation will fall this year as the supply of goods catches up with demand. And some argue that increases in Covid-19 cases are more likely to slow inflation than accelerate it, meaning the Fed could simply delay rate hikes if the economy is going through a rough patch.

“If we get really much slower growth, I think we get much faster disinflation,” said Brian Nick, chief investment strategist at Nuveen. In that case, he said, it’s good that investors are already counting on multiple rate hikes for 2022, because it means the Fed could actually ease financial conditions by offering less than that.

The prospect of higher interest rates, however, remains a concern for investors, with most expecting volatility to rise, although stocks remain broadly trending higher.

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Higher yields on government bonds can hurt stocks in a number of ways, from increasing borrowing costs for companies to offering investors alternatives for decent returns. A combination of strong growth and rising returns should generally help companies in economically sensitive sectors, such as banking and energy. But analysts warn that even this scenario can cause disruption by forcing investors to pull out of tech stocks heavily weighted in major indexes.

Some investors say it’s hard to imagine stocks avoiding struggles with rising yields, given how low interest rates fueled riskier investments during the pandemic.

If Treasury yields increase significantly, many investors believe that such an increase would be particularly difficult for the more speculative transactions: cryptocurrencies such as bitcoin; shares of small technology companies; and so-called memes stocks, including AMC Entertainment Holdings Inc.

and GameStop Corp.

, which have been popular among individual investors despite their difficulty in generating profits.

“There were a lot of signs of speculation, consumerism and the like, going into 2021, and I think we should expect that to go down – it’s already sort of started to go down – in anticipation of the punch bowl being pulled. from the Fed, ”said Jason Tauber, portfolio manager at Neuberger Berman.

The Federal Reserve has said it will accelerate the gradual reduction in its bond buying program, the biggest move the central bank has taken to reverse its pandemic-era stimulus measures. Here’s how tapering works and why it puts the markets on high alert. Photographic illustration: Adèle Morgan / WSJ

By some metrics, stocks are now trading at their highest prices relative to corporate earnings since the dot-com bubble of the late 1990s. Yet some argue they remain relatively cheap when you factor in low bond yields, which means it is possible for yields to rise before stocks start to look unattractive overall.

A measure known as the excess return on the CAPE – showing the inflation-adjusted earnings-to-price ratio of the S&P 500 minus the inflation-adjusted bond yields – has recently been around 3%, which is above the long-term average of about 2.5%. said Mr. Nick of Nuveen.

It’s still true that “you get a little better on stocks than you normally would,” he said.

Write to Sam Goldfarb at [email protected]

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