2022 Outlook: The Great Rebalancing Begins

Almost two years since the start of the COVID-19 pandemic and the deep but short-lived recession it triggered, we seem to be in a state of excesses and extremes—market liquidity resulting from public stimulus, large household savings, high inflation and tight labor markets—not to mention the many new market highs and very low inflation-adjusted, or real, interest rates.

By most counts, 2022 will be a critical year in which the imbalances wrought by the pandemic will likely begin to resolve and the business cycle normalizes.

Many investors may think “normalization” means a return to “more of the same,” as in, the secular stagnation of the prior cycle. That post-Global Financial Crisis environment—characterized by low real economic growth, disinflation, poor capital spending and weak productivity growth—supported spectacular asset appreciation, with passive indices delivering outsized returns.

Given today’s near-record price/earnings multiples on double-digit profit forecasts on the S&P 500 Index, investors might be forgiven for thinking they could simply return to the successful portfolio strategies of the past, anchored to U.S. mega-capitalization growth companies that dominate passive indices. But we think that approach is overly complacent. Here’s our take:The economic and market environment in 2022 will be decidedly reflationary, with higher economic growth and higher inflation, and eventually higher real interest rates—in short, a hotter and shorter business cycle.

We see four trends that could further drive higher-than-expected growth and inflation, with greater capital spending and improving productivity:

• Innovation:During pandemic-related shutdowns,service businesses were forced to innovate digitally. This has spurred not only investment but an explosion in start-ups, as well as historic levels of public and private market activity—from fintech and cryptocurrencies to autonomous vehicles and artificial intelligence.

• Deglobalization:Businesses were already contemplating supply-chain localization amid U.S.-China trade tensions before the pandemic. Today’s inflation-driving supply imbalances and inventory shortages—not to mention increasing sensitivity around cybersecurity, public health, geopolitics and shifting regulatory frameworks in China—have all added momentum to this trend toward domestic sourcing.

• Decarbonization:The pandemic and related business closures led to reduced fossil fuel consumption and carbon emissions and intensified pressure against investment in such energy sources. This is a reality that’s adding to cost pressures and could continue to support inflation levels.

• Transformation of the U.S. labor market:A labor crunch driven by workplace safety concerns and accelerated retirements,再加上员工寻找新的手段change jobs or demand higher wages, could continue to drive higher labor costs for companies. This, in turn, could weigh on profit margins.
  

These trends suggest that investors need to be positioned not for a dearth of economic growth but an abundance of it. Higher growth and inflation will likely translate to higher nominal and real interest rates and a steepening of Treasury yield curves, with price/earnings multiples compressing in the more rate-sensitive sectors.

Thus, when it comes to retooling investment portfolios for 2022, the focus should be on the many “technology takers”—companies likely to drive increased tech adoption—not the few technology makers.

And as the Fed exits the type of accommodation that lifts all boats, expect the passive S&P 500 Index to be rangebound and volatile. Focus instead on security selection to sift for potential winners. Key to all this will be more balanced allocations—securities based in the U.S. versus the rest of world, growth- versus value-style stocks, cyclicals versus defensives, mega-caps versus small- and mid-caps, and active management versus passive exposures. Last, investors may want to reduce traditional fixed-income allocations and increase exposure to real assets and absolute-return hedge funds.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Dec 6, 2021, “2022 Outlook: The Great Rebalancing Begins.” Ask your Morgan Stanley Financial Advisor for a copy. Listen tothe audiocastbased on this report.