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Beyond inflation and the Fed: Why the markets may be volatile this year

The first few weeks of 2022 saw precipitous declines. Our Chief Investment Office examines the causes and offers insights on navigating market ups and downs.

Photo of stock market analysis chart showing trends superimposed over image of George Washington on a dollar bill

February 2, 2022

WHILE INVESTORS TYPICALLY THINK OF BULLS AND BEARS, market conditions in the year ahead may best be defined by a new animal. “We’re calling this a ‘buffalo market’ because 2022 is likely to be a somewhat heavier, less attractive, roaming type of bull market  one that can get spooked easily,” says Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank. For example, the S&P 500 on January 24 briefly witnessed its first 10% correction in more than a year  just one in a string of volatile days in a still-young 2022.

“2022 is the beginning of a new cycle in market leadership, and investors should consider repositioning their portfolios in response to the changes.”

Chris Hyzy, Chief Investment Officer, Merrill and Bank of America Private Bank

Driving that volatility is a sort of perfect storm of issues ranging from monetary tightening by the Federal Reserve (Fed) to rising inflation and energy costs, slower growth in China, tensions over Russia and the Ukraine, midterm elections and more. At a more fundamental level, “the economy is shifting from low interest rates, low inflation and secular stagnation that characterized the first two decades of this century, to higher inflation, higher rates and stronger real growth,” Hyzy says.  “2022 is the beginning of a new cycle in market leadership, and investors should consider repositioning their portfolios in response to the changes,” he adds. Two recent reports from the Chief Investment Office (CIO), “The Tightening Transition” and “An Attractive Rebalancing Environment,” offer insights on the year ahead and how investors can prepare.

Navigating new market realities

As the economy and markets work through this seismic transition, investors should remain on guard for sharp, periodic volatility throughout the year, Hyzy cautions, and wildcards such as the midterms and Ukraine could make the timing of such episodes even more unpredictable than usual.  Yet “while growth may be slower and volatility greater than during the sleek bull market of 2021, the story for 2022 remains one of expansion rather than contraction,” he says. “We continue to see an economic environment of above-average growth, a profit cycle still surprising to the upside and an equity market that is still in an uptrend, despite the volatility.”

What’s the Fed got to do with it?

Fed interest rate increases, expected to begin in mid-March,1 may cause short-term jitters in markets that have grown accustomed to near-zero rates. Yet as Hyzy notes in a recent Investment Insights report, “The Meerkats and the Buffalo Market,” history suggests that markets ultimately perform better in the months following such increases. And while Fed tightening will remove some liquidity, higher bank lending can help ensure companies have access to the capital they need. Among the positive signs, corporate earnings have maintained strong momentum across various sectors and regions of the economy. “Consumer demand continues to outpace supply, and elevated net worth, savings and job growth among consumers should remain powerful supports,” Hyzy says.

“This is not an environment for speculation or for rapid buying and selling. Nor is it a time to become too risk-averse.”

Chris Hyzy, Chief Investment Officer, Merrill and Bank of America Private Bank

What should investors consider?

Investor patience and discipline are essential during volatility. “Trying to time the markets can be costly,” Hyzy says. For instance, investors who pulled out of equities in the S&P 500 at the start of the pandemic in 2020 likely would have missed the 10 best days since January 1, 2020 and seen a negative return of -16%, compared to a price return of 50% for those who remained invested despite the sharp bear market decline of February/March 2020.2 For more insights, read “Time in the Market Is Still Much More Important Than Timing the Market,” from the CIO.

“This is not an environment for speculation or for rapid buying and selling,” Hyzy cautions. “Nor is it a time to become too risk-averse.” For long-term investors willing to ride through the turbulence, periodic volatility may present potential opportunities. Consider whether the following might be appropriate for your goals and situation:

  • Quality companies. This is a year for special focus on stable, well-run companies with consistent earnings. “Dividend growth should be at the heart of a core allocation,” Hyzy says. Cyclical stocks companies that perform well when the economy is growing may be attractive. Contenders include areas such as financials, industrials, energy and materials.
  • U.S. versus overseas. “As long as the dollar maintains its strength, we believe U.S. markets should outperform non-U.S.,” Hyzy says. “A weakening dollar would likely drive some geographic repositioning, but we are not there yet.”
  • Value stocks. Periodic downturns may offer special opportunities for value investing seeking profitable companies currently trading at discounts. But don’t rule out attractive growth stocks companies with long-term growth potential.
  • Technology. Among the strongest performers during the pandemic, tech companies remain attractive as spending on innovation and digitalization continue to grow. Yet market uncertainties suggest focusing on “profits over concepts,” Hyzy suggests. Think high-quality, older technology companies with proven stability and earnings.
  • Fixed income. Bonds remain important to balance out a portfolio. And, as interest rates rise, higher yields could once again make them an important source of investment income.  For fixed-income investors, bond ladders a series of bonds with different maturity dates could help you capture interest rates as they rise, Hyzy suggests.

Despite these specific ideas, “diversification remains the key to a long-term investment strategy, especially during unpredictable market conditions,” Hyzy believes. For example, strategic investments in smaller companies may not precisely fit the current environment but could present long-term growth potential. Rebalancing, essential throughout the year, is vital during volatile times, Hyzy adds. And ensuring that any investment decisions fit seamlessly with your personal investment goals, time horizon, liquidity needs and risk tolerance can help you stay on track, whether the overall market is characterized by bulls, buffalos or any other wildlife.

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