Last year, markets continued their bull run, with the S&P returning a healthy 23% through Dec. 1. We saw both growth and value sectors perform well and commodities move sharply higher, with global equity markets largely positive as well. The CBOE Volatility Index (also known as the VIX or “fear” index) moved lower, supporting the positive market sentiment.

What drove these higher returns?

We highlight three key factors:

1. A second economic reopening

After battling the delta variant for much of summer, the U.S. and many global economies saw better overall COVID-19 trends in the fall. This was supported by higher vaccination rates and availability of more critical drugs and therapeutics. From an economic perspective, these trends led to improved consumption patterns broadly in the U.S., with metrics such as retail sales and consumer confidence exceeding expectations. While uncertainty remains around the path of the virus and new variants, we would expect the economic reopening to broadly continue in the year ahead, albeit with some setbacks and perhaps at a less robust pace than the reopening earlier in 2021.

2. Positive earnings surprises

For 2021, corporate earnings generally surprised nicely to the upside. S&P earnings growth was up a strong 45% year over year, well above an expected 35%. Of course, investors have been listening for signals around supply chain and cost pressures, which many companies indicate could last through mid-2022. But consumer demand and corporate balance sheets remain healthy, driving the stronger earnings growth.

However, we believe earnings growth will moderate to the 7% to 10% range in the year ahead, with the possibility of upside if some delayed demand is realized.

3. Supportive fiscal policy – are corporate tax hikes off the table?

Markets benefited from a supportive fiscal and monetary backdrop in the U.S. last year. Fiscally, the focus now shifts to the infrastructure program and proposed social spending policies. For investors, it’s notable that direct corporate tax hikes seem to be off the table for now, which is a net positive for markets. A raise in corporate taxes could substantially reduce – although likely not eliminate – earnings growth in 2022.

What could derail the bull story?

1. Inflation and supply chains

Inflationary pressures, including supply chain issues and labor shortages (exacerbated by virus uncertainty), are a key risk for investors. While higher inflation can be a drag on consumption and growth, we believe inflation should moderate in the second half of 2022 – but likely remain above pre-pandemic levels.

Notably, supply chain pressures may ease, and the rapid rise in commodity prices will likely not repeat in 2022. But the stickier parts of inflation, such as wages and rents, may remain higher for longer.

2. Central banks taking away the punch bowl 

Central banks are starting to gradually remove liquidity from the system. In the U.S., the Federal Reserve has begun to taper its asset purchases at a rate of $15 billion a month. This reduced pace of stimulus could spark pockets of market volatility.

The good news is that the Fed seems committed to patience when it comes to interest rate hikes, and we generally expect this Fed rate-hiking cycle to be shallower than in the past. Also, as this chart shows, historically markets have performed reasonably well in periods of tapering and into the start of rate hikes. It’s only toward the end of rate-hiking cycles that we tend to see more severe volatility.

A look at markets during tapering and rate hikes

 Chart showing markets during tapering and rate hikes from 2001 to 2021.

Source: FactSet. Data as of November 2021.

Past performance does not guarantee future results. The S&P 500 is unmanaged, not available for direct investment and is not meant to depict an actual investment.

The S&P 500 has risen during two periods of Federal Reserve tightening and one period of Fed tapering since the early part of this century.

Where do we go from here?

1. The bull market has legs

We continue to believe the U.S. economic cycle is in its middle innings, with the bull market still likely having room to run. Bear markets (a drop of 20% or more) tend to occur when the economy is entering a recession or the Fed is toward the end of its tightening cycle, neither of which is in place for this year.

2. Expect a bumpier ride

While market performance may continue to be positive, we expect the pace of gains to moderate and volatility to broadly increase. After three years of solid double-digit gains, we see market returns over the next 12 months more in line with earnings growth, which we expect to be in the single digits in 2022.

3. Review portfolio diversification and allocations

In the U.S., we continue to favor an overweight allocation to value and cyclical investments, supported by gradually rising rates and further economic reopening.

Globally, we expect to see emerging markets benefiting over time from better COVID-19 and vaccine trends, supply chains potentially improving over time, and more stability in China going forward.

Mona Mahajan

Mona Mahajan is responsible for developing and communicating the firm's macroeconomic and financial market views. Her background includes equity and fixed income analysis, global investment strategy and portfolio management.

She regularly appears on CNBC and Bloomberg TV, and in The Wall Street Journal and Barron’s.

Mona has a master’s in business administration from Harvard Business School and bachelor's degrees in finance and computer science from the Wharton School and the School of Engineering at the University of Pennsylvania.

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