2022 Outlook from TIAA's Investment Management Group: Key themes impacting portfolios

Equity market snapshot  

• The outlook for inflation will drive rates and impact valuations in 2022
• GDP and earnings growth likely peaked in the third quarter of 2021
• Anticipate equity market returns to be flat-to-down in 2022
• China’s real estate debt problem could become a drag on global growth

According to Robert Marshall, Managing Director and Senior Equity Portfolio Manager at TIAA, FSB’s Investment Management Group, whether inflation will prove transitory or permanent is a precursor for whether we will be in a higher rate environment in 2022. Consistent with the themes of Volatility is the Next Normal and the Great COVID Evolution, we're seeing food, wage, energy, and housing inflation. Rents are up 25% in many markets. U.S. energy costs are up 80% year-over-year, which impacts electricity, heating oil, and transportation. Transportation alone represents 60% of energy demand.

Financial markets are somewhat concerned that inflation could become entrenched, which could force a rate hike earlier than expected in 2022, leading to a drop in stock valuations. For the time being, the markets are largely still accepting the Fed’s call that inflation is transitory. That could change if it sticks around for two or three years and, for example, if we see runaway inflation on a year-over-year basis.

In general, equities are a good way hedge against inflation. Specifically, the banking sector may do well in a more inflationary environment. Banks can borrow low, lend high, and pay lower interest rates, pushing their profitability. Healthcare stocks should provide some protection for equity investors on a relative basis if industrial and material stocks come under pressure due to the economy slowing. Historically, the technology sector has not performed well in a rising rate environment. However, in conjunction with labor shortages, brought on by the Great COVID Evolution, tech stocks may do well as more businesses automate, which helps to relieve the need for additional workers.

Don’t expect additional stimulus measures in 2022

Despite a reasonably strong economy, S&P 500 returns are expected to be flat or more typical in 2022. They could even be down a bit. “That's just a byproduct of the outsized returns we’ve already seen and fact that stimulus is drying up and we don't expect another package like we had in 2020,” Marshall said. “It’s likely some version of the human infrastructure package will pass, but that's going to be spread out over 5 to 10 years and it likely won't have nearly the same kind of ‘goosing’ effect for the markets and economy that we've seen over the past 18 months.”

If the legislation increases taxes for businesses, that could lead to slower economic growth as higher taxes tend to have a dampening effect on companies where capital expenditures, investments and hiring are concerned. For example, when companies are paying more in taxes, they typically hire fewer people or roll out new technology to replace or reduce their labor costs. The outcome of the legislation is also likely to govern how fast Americans begin to spend the more than $2 trillion in additional savings they have accumulated since the onset of the pandemic, most of which resides with higher income individuals and families.  

Outlook for stocks outside the U.S.

While COVID-19 case counts in the United States flattened in early autumn, they are increasing in the United Kingdom and other parts of the world, such as Singapore, and the Omicron variant continues to spread. “I don't think the equity markets believe that the pandemic is over yet,” Marshall said. “We haven't yet seen the stocks that are most impacted by the reopening outperform in a meaningful fashion. If by early 2022 we are not seeing another wave that causes wide-spread economic disruption, it’s likely we will begin to see those companies start to outperform.” The bottom line? Volatility is the Next Normal.

Europe is about six months behind the United States in terms of their economic reopening and expansion. As a result, economic growth in Europe is expected to be higher than U.S growth for the next quarter or two.

The China syndrome

Marshall believes that China may be the biggest wildcard for 2022. China has been a driver of economic growth for the past 15 years. Residential development, including uninhabited “ghost cities” helped to drive China’s 6% to 8% GDP growth over the past 10 years. Residential investments account for about 30% of Chinese GDP growth, compared to about 10% in the United States. However large amounts of hidden debt in China’s “shadow banks” could be a drag on economic growth. “Chinese shadow banking” is financial activity that occurs outside the bounds of the usual traditional banking and system. If Chinese residential and commercial developers begin to collapse under the weight of their debt, that could significantly slow the Chinese economy, and may also slow global growth.

What lies ahead for the markets and investors?

For inflation to be deemed transitory, Marshall believes we would need to see the knots in the supply chain untangled, price increases stabilize, and we see a benign resolution to the Chinese debt worries. Another concern heading into the new year is an end to Federal stimulus money. Over the past 18-24 months, equity markets rose as the federal government backstopped the economy with several rounds of payments to businesses and households. The worry is that equity markets will stumble as this stimulus dries up. As a result, equity investors may need to take more risk to achieve the same returns.

Steps you can take now

Schedule time to meet with your TIAA advisor to learn about ways a well-diversified equity portfolio can help you remain on course toward your important financial goals. Your TIAA advisor can help you develop a strategy personalized to your needs and risk tolerance.

Taxable fixed income market snapshot

• Investment grade credit performed better than Treasuries as spreads tightened marginally throughout the year
• Anticipate rates to rise in 2022, but at a slower pace than 2021 with continued, elevated volatility
• Fed to continue tapering U.S. Treasury supply through mid-2022
• Yields on U.S. Treasuries and corporate bonds remain very attractive, vs. overseas fixed income investments

Taxable fixed income returns were negative for most sectors in 2021, primarily driven by the increase in interest rates. Across the yield curve (a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates), anywhere from 2- to 30-year bonds are finishing the year much higher than where they started. According to Bryan White, CFA, Director and Senior Portfolio Manager at TIAA, FSB’s Investment Management Group, that resulted in negative returns for high quality fixed income securities. For perspective, the only other years where returns on high quality bonds were negative were 1994, 1999, and 2013. On average, the year following those down years for bonds, the Barclays Aggregate posted well above average returns. Consistent with our theme of Lower for Longer, the current level of yields suggests well below average returns for bonds in the next decade.

On a positive note, White says investment grade credit performed better than Treasuries as spreads tightened marginally throughout the year. In this example, “spreads” measure the difference in yield between a corporate bond and a Treasury bond with the same credit quality and maturity. The wider the spread (or difference) the more stress in the market for corporate debt. “As we enter 2022, we expect upward pressure on interest rates to continue with economic growth, but at a slower pace than we experienced this year,” White said.

The Fed and the market are at odds

The Fed has already started tapering its bond purchases and we expect that to continue through the middle of 2022. The market is currently pricing in a first interest rate hike for mid-2022. However, the Fed continues to say that inflation is transitory, so they don't see the need for rate hikes right now – so, likely Lower for Longer. The Fed and the markets remain at odds as to the timing of rate hikes going into the new year, and that disconnect may fuel additional market volatility.

Demand for Treasuries continues to outpace supply

We don't anticipate a significant increase in Treasury supply in 2022 given that the Fed has already started tapering bond purchases. The central bank will reduce some buying but will continue purchasing to offset any increases in supply throughout the first half of 2022. We don't expect Treasury supply to be a meaningful driver of rates and we continue to see areas of global demand for Treasuries. While rates may go up for other reasons, we don’t believe they will increase because of the Fed’s tapering.

Corporate bond issuance will be less in 2022 than in 2021 because many companies took advantage of lower rates and tight credit spreads to reduce debt by refinancing due to the likelihood of rates increasing. We don’t expect that pace of refinancing to continue into the new year as rates move higher. Any additional sources of new bond issuance would be through mergers and acquisitions. Overall, we believe there will be fewer corporate bonds issued in 2022 than there were in 2021, and that’s a better backdrop for corporate bond investors. 

The fundamentals underpinning corporate bonds are probably as solid as they've been in decades. That’s helping keep global demand for U.S corporate debt relatively high, in conjunction with very attractive rates for credit and Treasuries. However, we do expect some weakness at times as rate volatility pressures spreads.  But factors like a pandemic resurgence, market turmoil, or Fed policy missteps may lead to periodic bouts of volatility in the corporate bond market. All these factors are good examples of our themes, The Great COVID Evolution and Volatility is the Next Normal.

Key drivers for 2022

Investors may be pricing any rate hikes in a little sooner than they should, but it will be a big driver for the markets in 2022. Unless we see significant changes to the tax code being discussed in Washington, taxes are not expected to impact corporate balance sheets much from a fixed income standpoint. Nonetheless, COVID is expected to continue to be a driver for the fixed income markets throughout 2022. The Fed is removing monetary policy stimulus by tapering asset purchases and hiking rates.

The 2022 outlook for investment grade corporate bonds remains positive, given that we expect some moderation in supply compared to 2021. We may see some tough comparisons where earnings are concerned, versus where they have been over the last couple of years. While the outlook for corporate debt issuers and their credit fundamentals remains strong, we could see some widening in spreads between Treasuries and corporate bonds. However, don’t expect a major loss in valuation or a significant sell-off of corporate bonds unless the fundamentals of the economy deteriorate badly, which we're not anticipating.

Steps you can take now

Schedule time to meet with your TIAA advisor to learn about ways taxable fixed income investments can help you remain on course toward your important financial goals.  Your advisor can also help you review your lifetime income options within the context of your overall financial plan and develop a strategy that works best for you.

Municipal market snapshot

• Expect municipal (muni) bond issuance to be similar or slightly elevated in 2022, depending on the outcome of the infrastructure bill
• Demand for tax-free income remains robust given expectations for higher tax rates
• The direction of the muni market will ultimately be determined by the Fed’s actions relative to interest rates in 2022
• The steepening and then flattening of the muni yield curve invites opportunities for outperformance

Eric Smith, Senior Portfolio Manager at TIAA, FSB’s Investment Management Group, believes a good deal of uncertainty remains in the municipal bond market. The direction of the muni market will ultimately be determined by the Fed’s actions on interest rates in 2022. Security selection will continue to be a key driver for finding relative value. Identifying municipalities that offer additional return potential will be a key driver of returns in 2022. 

According to Smith, we could see a flattening yield curve transpire as the municipal bond market positions itself for a rising rate environment. A flattening yield occurs when the shorter end of the curve (e.g., bonds with maturities under 5 years), moves up at a faster rate than the intermediate bond part of the curve (e.g., maturities between 5 - 10 years). Given this outlook, investors will need to take a more cautious and patient approach. The expected shift in the yield curve should bring opportunities for portfolio managers to add value through thoughtful bond selection and portfolio positioning.

Supply and demand of muni bonds are key determinants of price and yield

All else equal, greater supply of muni bonds generally results in lower prices and higher yields for investors.  Conversely, reduced supply usually results in higher prices and lower yields for investors. Following the same logic, lower demand means higher yields, and higher demand means lower yields. That said, supply of new municipal bonds is expected to be similar or slightly elevated in 2022.  That supply will be influenced by how the pending infrastructure bill is funded. Specifically, whether municipalities refinance outstanding bonds by issuing new bonds.

Amidst COVID in 2020, with interest rates extremely low, municipalities utilized taxable debt as a refinancing vehicle. In 2021, there was a reduced amount of taxable issuance and more tax-exempt bonds were issued. A continuation of this theme could materialize in 2022 if the practice of taking the funds received from a new bond issuance to pay off a prior issue's debt is reinstated as part of funding the infrastructure package. The issue of the new bond is usually at a lower interest rate than the older, unpaid obligation. If a taxable financing vehicle is utilized, the supply outlook could revert back to the high-supply 2020 levels.

Flows into muni bonds: A key gauge of investor demand

Investor flows into tax-exempt mutual funds —a key measure of investor demand for municipal debt—have been consistently positive over the past year. We expect that theme to continue, however, at reduced levels. Some new exchange traded funds (ETFs) surfaced over the past few years and have proved to be a popular vehicle that investors can use to invest in the municipal market. The use of ETF’s is likely to continue in the new year as they become more widely adopted by retail investors. This will help to continue to boost demand.

Improving outlook for state and local finances – but some concerns still linger

In general, the health of state and local government finances has improved dramatically in 2021, along with economic growth. According to Jill Richman, Senior Director of Fixed Income at TIAA, FSB, state and local governments faced dire revenue projections at the onset of the pandemic in early 2020, with many estimated to lose a significant portion of their budgets. However, as part of the Great COVID Evolution theme, robust federal pandemic-related aid to state and local governments, and a very strong economic reopening, municipal governments have significantly outperformed earlier budget projections.

The massive federal support continues to be a strong positive for municipalities across the board. Rainy day funds (monies state and local governments set aside “just in case”) have increased in many states and are near or have exceeded pre-pandemic highs. Personal income tax collections were also strong due in part to the federally-backed loans that kept small businesses up and running, as well as taxes on unemployment income. Taxes from online sales were up significantly as the shift away from in-person shopping continued.

Surging home prices are aiding local governments’ property tax collections - an important part of their revenue stream. However, cities that depend on commercial space may be more adversely impacted, due to changes in how people work, shop, and live.  

Pockets of concern remain in sectors such as transportation, education, and healthcare where the pandemic continues to be a negative factor. Therefore, investors must carefully choose how and where to invest in the muni bond market.

Cyber and climate risk are a growing concern for the muni market

According to Richman, cyber and climate risk will continue to be a source of concern for the municipal market. State and local governments that have fallen victim to cyber-attacks and have had to pay hefty ransoms for return of services for cities and electric utilities, among others. Understanding cyber preparedness levels of state and local governments is key to assessing risk, and coping with the theme that Volatility is the Next Normal.

Similar to the cyber risk, IMG’s tax-exempt portfolio management team is also keeping a close eye on climate risk since municipalities are heavily invested in the infrastructure designed to protect their citizens. “We’re thinking hard about the level we invest in low lying areas that can easily flood, or areas prone to wildfires, hurricanes and other climate-driven challenges,” Richman said.

2022 expectations for state and local municipalities

Defaults and bankruptcies of state and local municipalities are expected to remain negligible in 2022 and are not expected to have a material impact on the market. More state and local governments are likely to see their financial situation improve in 2022. However, another pandemic wave that causes wide-spread economic disruption may add to the financial burden of state and local governments.  IMG’s focus remains selective on healthcare, airports, transportation, and public power.

Steps you can take now

Municipal bonds can be an important component of a well-diversified portfolio structured to generate income in retirement, due to their favorable tax-treatment and relatively safe returns on an historic basis. Plan to meet with your TIAA advisor to talk about how municipal bonds can play a role in creating a tax-efficient retirement income that you can’t outlive.