A Shifting Fact Pattern for 2022

For many, 2021 proved to be a difficult year.  The battle with the COVID pandemic dragged on even with readily available vaccines and developing therapeutics.  Variants of the virus have emerged, and the economic recovery coming out of the pandemic’s peak has remained uneven with several start / stop phases along the way.  This has broadly disrupted the production and supply of goods and services, while inflationary pressures have surged.

Progress against the virus is being made, but it has been slower than expected.  The life that many of us would regard as “normal” is still beyond our reach and COVID fatigue plagues the nation.  Not surprisingly, most people are anxious to close the history books for 2021 and turn their attention to the prospects of a new year.  Fortunately, there is reason for optimism as the country continues to heal from the greatest social and economic disruption most of us have ever known.  However, new risks are also developing.  While our base case for 2022 is constructive, we do not expect a smooth or easy path going forward.    

The final six weeks of 2021 brought an uptick in volatility with U.S. equity markets swinging back-and-forth by 3% - 4% over four distinct cycles.  This said, the equity indices have been performing quite well.  For the full month of December, the Dow Jones Industrial Average ended up 5.38%, the S&P 500 was up 4.36%, and the Nasdaq rose a much more modest 0.69% as sentiment towards growth stocks remained weak.  For the year, the returns came in at 18.7% for the Dow, 26.9% for the S&P, and 21.4% for the Nasdaq, respectively.  Remarkably, all three of these major market indices have now generated positive returns for three consecutive years.

While these index results are impressive, they do not tell the whole story.  Just five companies in the S&P 500 (Microsoft, Apple, Alphabet, NVIDA, and Tesla) accounted for over 32% of the nearly 27% gain in 2021.  Even more remarkable, the top 10 names in the index drove 60% of returns in 2020.  Because the index is market cap weighted, these names have dominated S&P 500 performance data while many of the other stocks in the index have not performed nearly as well.  As Apple approaches $3 trillion in total market cap value, it becomes larger than 184 S&P 500 companies COMBINED (source: CNBC).

Inflation became a big story in 2021.  After originally insisting that inflation would be “transitory” the Federal Reserve recently acknowledged that inflationary pressures are likely to persist in 2022.  This shift in Fed perspective will produce a swing in monetary policy and the consensus expectations are now for three rate hikes in the coming year.    

The unusually high economic growth rates of 2021 will logically slow in the new year, as the easy comparisons to year-earlier periods impacted by Covid-related disruptions fade.  Inflation will moderate as some of the supply chain issues are resolved, but inflation will remain considerably higher than what consumers have been subjected to in many years.  Corporate earnings will likely remain elevated however higher raw materials and employment costs will begin to impact profit margins.  Many companies will struggle to pass price increases along to consumers.

Geopolitical concerns are rising as 2022 begins.  China has very tense relations with Taiwan and is developing a growing arsenal of ballistic, nuclear, and hypersonic missiles.   Russia is now threatening to "respond militarily" in Ukraine and has amassed nearly 100,000 troops along the boarder between the two countries.  Even as these stories play out, China-Russia ties appear to have strengthened with Russia’s Putin referring to their relationship as "a true example of interstate cooperation in the 21st century."

In the United States, mid-term elections will take place in November.  In many ways the country remains profoundly divided politically.  With the current administration’s weak approval ratings, the mid-term elections have the potential to produce important swings in policy trends.  

The current problems aside, we also live in one of the most exciting periods of innovation our world has ever known.  Disruptive technologies are accelerating and are converging in unexpected ways.  Novel capabilities are appearing in nearly every industry and every human domain will change dramatically in the coming years.  As a result of this building wave of innovation, we believe more wealth will be created in the next 10 years than was created in the past 100.        

We live in a complex and changing world.  A new year has arrived and with it comes a unique set of opportunities and challenges.  Investors must understand the implications of emerging economic trends such as higher inflation, geopolitical risks, and distortions in popular market indices.  Understanding innovation may prove to be the primary determinant of future investment returns as new companies become industry leaders and legacy companies are disintermediated. 

To be certain, change is accelerating all around us and investment strategies that worked over the past three years may not prove all that effective in 2022. 

On balance, we believe the positive factors are still greater than the negative ones.  We will write extensively on this wide range of topics in our Outlook 2022 report - scheduled for publication later in January.  We look forward to sharing with you our thesis for 2022 through this report.  Of course, we will also produce many follow-up communications over the course of the year.  In the meantime, please do not hesitate to contact us should you have any questions or immediate concerns.

John E. Chapman

January 2022