Morgan Stanley
  • Wealth Management
  • Dec 8, 2021

2022 Outlook: The Great Rebalancing Begins

As economic imbalances wrought by the pandemic begin to ease, investors could be in for hotter-than-expected growth and inflation. How to keep portfolios in balance.

Lisa Shalett Chief Investment Officer, Wealth Management

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. 

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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.  

2022 will be a critical year in which the imbalances wrought by the pandemic will likely begin to resolve.

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, coupled with employees’ seeking new leverage to change jobs or demand higher wages, could continue to drive higher labor costs for companies. This, in turn, could weigh on profit margins. 
Investors need to be positioned not for a dearth of economic growth but an abundance of it.

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 to the audiocast based on this report.

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

Certain securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom.  Recipients are required to comply with any legal or contractual restrictions on their purchase, holding, and sale, exercise of rights or performance of obligations under any securities/instruments transaction.

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