Why Passive Investors May Have a Tougher Time in 2022

Over the past 13 years, we’ve seen a stretch of remarkable returns for stocks, marked by the dominance of U.S. mega-cap companies. From 2009-2018, U.S. equities compounded at nearly 15% a year, twice the long-run average. Performance kicked into even higher gear in the past three years, with stocks rising by more than 20% per year on average—all despite the pandemic and its effects on the economy.

Underpinning these dynamics? A long-running decline in real (or inflation-adjusted) interest rates, which have helped keep asset prices aloft as financial markets have increasingly de-coupled from the fundamentals of the economy.

As a new year begins, however, we think passive investors face tougher sledding. For one, better-than-expected economic growth and persistent inflation will likely cause the Federal Reserve to raise the fed funds rate, which could unmoor real rates from historic negative lows and prompt market volatility. Granted, the Fed's recent announcement that it will wind down its asset-purchase program more quickly so far hasn't done much to change market direction, with rates still near record lows and stocks capping 2021 with 70 record highs (the most since 1995, which saw 77 highs).

But this benign reaction likely stems from overwhelming liquidity in the markets and year-end technical positioning—factors we expect will fade this year. In addition, higher costs for labor, energy and logistics will likely continue to weigh on corporate profits. 

Other issues that could make 2022 a more challenging investing landscape:

• The struggling Build Back Better Act: While many believe that Congress will pass a version of these education, healthcare and climate initiatives ahead of the 2022 midterm elections, timing matters. Ambiguity around stimulus extensions, such as child tax credits, could fuel concerns about a “fiscal cliff” just as the Fed is poised to make its first interest-rate hike at mid-year. That could compound the effects on consumers of tightening financial conditions.

• The relative weakening of the U.S. dollar: The strength of the dollar, which appreciated about 6% in 2021, has reinforced current market trends both by attracting foreign cashflows to Treasuries and sheltering the U.S. economy from import inflation. But this could reverse if non-U.S. markets—particularly China, Japan and Europe—experience a better-than-expected recovery. The Treasury market could see outflows against a backdrop of persistent inflation and lessening liquidity.

• The outsized impact of mega-cap concentration on volatility: The S&P 500 has come to be dominated by a handful of mega-cap technology stocks, with the biggest seven accounting for nearly a third of the overall market cap and driving index-level returns—a phenomenon that creates extreme concentration risk for investors with significant exposure to such passive indices. With federal regulators and global tax policymakers taking a hard look at these companies, new oversight could have ripple effects on markets.

In short, the easy returns have been made, and these developments could mean increased complexity in markets and a greater need for active portfolio management. Investors should consider neutralizing extreme and concentrated positions while striving for diversification. We suggest balancing income generation and price appreciation, with a focus on quality and dividend stocks.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Jan 3, 2022, “What to Watch in 2022.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.