2022 Capital Markets Outlook

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  • 06 mins 42 secs
The AllianceBernstein Capital Markets Outlook details our current expectations for 2022 and offers fixed income and equity allocation strategies to guide investors this year. AllianceBernstein's Capital Markets Outlook
Channel: AllianceBernstein

Hello everyone, and welcome. In the fourth quarter, equity returns outside of the largest tech-related companies were mixed but generally solid, and bonds were largely flat to negative in response to a more aggressive Fed. More broadly, the behavior of markets to end the year mirrored a pattern that played out throughout 2021, namely that the growth strength powering markets was then tempered by market concerns of more aggressive monetary policy in the face of persistent inflation, that by the way, jumped to four-decade highs following the extraordinary economic and policy conditions produced by the global pandemic.

The first mechanism from that was through demand. As US consumers shifted, wait for it, a trillion dollars of consumption toward goods, which alone would overwhelm supply chains. But as we know, the pandemic magnified those challenges with ongoing labor-related shutdowns, driving up order backlogs and goods' prices. In services, labor challenges have also been acute, especially within high-touch areas like leisure and hospitality, producing lower payroll gains, higher quit rates, upward pressures on wages.

That combination of inflationary pressures has remained higher and more persistent than many expected, leading the Federal Reserve, less than a quarter later, to significantly accelerate plans for both purchase reductions and the path of rates. Importantly, the Fed still believes that inflationary pressures will meaningfully recede by the end of the year, but there are clear risks to that view, and ongoing developments dominated by COVID will largely decide that path.

So, how should we all think about this as investors? Well, as a base case, we think that economic growth is going to remain strong this year when compared to the pre-pandemic trend, but slower versus last year as growth drivers fade. And like the Fed, we believe that inflation will slow during the year, but trend toward a higher level than before the pandemic. That combination leads the Fed to raise rates three to four times this year, in our opinion, and meaningfully higher treasury yields will result across a flattening yield curve.

For markets, as we're already seeing, the story is and will be one of valuations: how much the market is willing to pay for earnings in the face of a tightening Fed and moderating earnings growth. But policy's role in market returns is nothing new. It's played a huge role in returns over the years, as you can see in this table. 2016 was about the expectation of tax cuts, fiscal policy. 2018 was about Fed policy tightening concerns, and 2019 was about the Fed reversing those tightening views. In 2022, the story in terms of the S&P for me is the range of market forecast is exceptionally wide. But in the end, they all largely come down to a combination of expected earnings and of course, valuations.

So, you know what? Let's attempt to frame it that way. Here's a look at historic price-to-trailing earnings over time by averages in conditions, such as tightening. For reference, by the way, they came into the year at about 22.5. But the range here, as you can see, is from 17 to a high of 23. So let's construct the table starting with that range and then add in possible earnings, highlighting the consensus in the middle. Once we do that, we can fill in the resulting levels of the S&P. Interestingly, if I highlight P/Es from a range of 19 to 22 and give a little bit of an up-and-down range of earnings, about $15 above and below consensus, that range of prices is a near dead-on match to the overall range of market forecast. So you can see where it's coming from. And then if we take those price levels, we can forecast price returns of the S&P. And as you can also see, markets face a challenge at a broad level. If earnings hit the target and valuations modestly compressed to 21, the S&P's price return would be slightly negative. Meanwhile, a 10% return would require a meaningful earnings overshoot and P/Es to roughly hold at year-end levels, which seems unlikely given the direction of the Fed. But of course, not all valuations across the market entered the year at the same levels. Indeed, they've been dominated by the largest cap companies, and the opportunities aren't the same either. For us, it's about balance between market participation and defense. From a relative perspective, we've advocated for a while to focus on quality and persistency of earnings, regardless of cap style or geography.

Now while this focus might seem obvious, the very difficult time that long duration equities are enduring at the moment underscores its importance and its durability. And within fixed income, rising yields and flattening yield curves pose a challenge, but also an opportunity. Careful management of a tightening cycle can mitigate price declines, and increase yields on the way to an end environment where yields are ultimately more attractive for investors. And for higher income specifically, and for total return investors in equity surrogate, that means a focus on domestic corporate and securitized debt with select allocations to emerging markets.

The yield impact of that overall credit allocation is meaningful today versus pure high yield, and additionally, adds a potential for capital gains as emerging-market conditions improve. And for core investors, we continue to advocate for a credit barbell, a blending of high-grade bonds with credit. While always a solid structure for investors in our opinion, we believe that combination provides for an efficient structure through the tightening phase. And really that encapsulates our overall view on portfolio construction today, that of efficiency. Tightening phases and cycles don't have to mean poor performance, but they do require a more thoughtful approach as accommodation is removed and headwinds turn to potential tailwinds.

As always, thank you everyone for joining and for listening. And I wish all of you a happy and healthy 2022.


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