The Stock Market Faces Strong Headwinds in 2022

2022 is starting off on very different footing than the beginning 2021. The growth rate for the U.S. economy is slowing, monetary conditions are tightening, and inflation is at its highest rate in decades. Yet, while we forecast that the economy will slow to a 3.9% growth rate in 2022 and 3.5% in 2023, those growth rates remain higher than recent historical averages. The U.S. Federal Reserve is tapering its asset purchase program and will end its purchases by March. Then, the Fed is expected to start hiking interest rates in June. On a year-over-year basis, the Consumer Price Index rose 6.8% in November, its highest reading in 40 years. Although inflation is running hot, we project it will begin to moderate in mid-2022 and average 3.6% next year. Equity markets have soared higher in 2021, based on an exceptionally strong economic rebound; however, according to a composite of our equity valuations, we think the market is 5% overvalued. Although the market is broadly overvalued, we see upside opportunity for investors in the value category and small-cap stocks, both of which should benefit from continued economic prosperity.

• Equity market is 5% overvalued, but undervaluation exists in value category and small-cap stocks.
• Attractive opportunities exist in wide-moat stocks. Not only are many undervalued, but if inflation remains persistent, companies with wide economic moats typically have better pricing power and will be able to maintain their profit margins.
• Energy stocks surged in 2021, far outperforming the broad market. Yet, at a price/fair value of 0.86, energy remains the most undervalued sector across our coverage.

An exceptionally strong economic rebound drove equities higher over the course of 2021, but the ebbs and flows of new COVID-19 cases drove intrayear market volatility. While the broad market return for the Morningstar US Market Index was 24.85% through Dec. 23, the strong return masks the undercurrents through the year. Early in the year, as new cases subsided, investors rotated out of stay-at-home stocks and into stocks that would benefit from economic normalization. As such, stocks in the value category and small caps surged; however, the emergence of the delta variant sent investors back to their pandemic playbook consisting of growth and large caps. When the case count from delta subsided, the undercurrent switched back to value and small caps, until the omicron variant over Thanksgiving again reversed the rotation.

As we head into 2022, we see a much different backdrop from 2021. Whereas U.S. economic growth was accelerating in early 2021, now it is decelerating. Slowing growth may not be as much of a headwind to the market as many fear. Our forecasts of 4% in 2022 and 3.4% in 2023 are both higher than recent historical averages.

Inflation has awoken from its slumber and ultra-loose monetary policy has shifted toward tightening. The Fed will finish winding down its asset purchase program by March and is expected to start increasing interest rates in June. While interest rates may be heading higher, the impact may be muted as yields are rising from rock-bottom rates.

From a broad market perspective, we calculate the U.S. equity market is 5% overvalued, but we find that stocks in the value category and across the small-cap space are undervalued. We also see opportunities for investors to trade up in quality to undervalued companies that we rate with wide moats. These stocks typically hold their value better to the downside during market corrections. In addition, if inflation is persistent, these companies typically exhibit strong pricing power to quickly pass-through cost increases to maintain margins.

Heading into 2021, energy was the most undervalued sector by far and year-to-date the Morningstar Energy Index has risen 53.71%, far outperforming the broad market. Yet, at a price/fair value of 0.86, energy remains the most undervalued across our coverage. The communications sector is the next most undervalued and opportunities exist in both traditional and nontraditional communications companies.