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What a Year! What's Ahead?

The U.S. economy has been the prime beneficiary of a relatively robust consumer sector. After plunging off the charts during the initial months of the COVID-19 lockdown, household spending came back with a vengeance, aided by unprecedented fiscal and monetary policy stimulus.

The stock market in 2021 benefitted from earnings growth and positive surprises of historic proportions, and despite inflation readings, unlike any seen by many present-day investors.

Both businesses and individuals held cash aside amid the height of the pandemic uncertainty. Renewed confidence in 2021 led companies to deploy excess cash in dividends and share buybacks. Share repurchases for S&P 500 companies in the third quarter more than doubled from a year earlier to an all-time high of $234.6 billion. Apple Inc., Google parent Alphabet Inc. and Meta Platforms Inc. (formerly known as Facebook) were the biggest buyers of their own stock in the third quarter, repurchasing a total of $48.1 billion shares, according to S&P Dow Jones Indices. Merger and acquisition activity also hit record levels in 2021, fueled by low interest rates, private fundraising, and revamped corporate strategies.

Global bonds delivered negative total returns in 2021 versus sizable gains for stocks, a scenario seen only twice since 1999.  Swift, significant and globally coordinated fiscal and monetary policy stimulus was delivered early in the COVID crisis and maintained throughout 2021. This served as a powerful force in propping up economies and staving off financial crisis while contributing to rising inflation. Central banks are now making strategic moves away from emergency measures. Meanwhile, regulatory and tax burdens may be increasing.

In mid-December, the Federal Reserve officially signaled it is turning attention to fighting inflation rather than stimulating the economy. So far, numerous companies have been able to pass on rising costs, but we’re watching inflation’s potential to squeeze profit margins, particularly if consumers grow less willing to pay up for discretionary goods and services. Fed officials indicated they could raise interest rates three times next year after winding down their monthly bond-buying program. However, rates would be rising from a historically low base and real rates (after inflation) are likely to remain negative. This is still a supportive backdrop for stocks.

Earnings should remain strong as companies look to meet pent-up demand for products and services. Inflation is the one dynamic that may remain problematic. While inflation is a concern and source of volatility, it also makes stocks the most compelling choice among the major asset classes. Individual companies will manage through differently, highlighting the importance of a stock-by-stock approach.

The identification of the omicron variant in late November, and the market’s strong immediate reaction to it, was a stark reminder that the novel coronavirus is a persistent risk. COVID-19 has been and is likely to remain unpredictable, thus requiring attention and respect for its potential to upend businesses and markets. On the positive side, vaccine boosters are approved for wide distribution in the U.S., and COVID therapeutics are likely the next medical innovation to see the world into a post-pandemic “normal.”

Congress passed and President Biden signed a separate “infrastructure” bill, but the larger social spending bill known as the “Build Back Better” plan remains in flux. The proposed bill contains a variety of tax, spending and regulatory issues that have the potential to dramatically affect economic growth and corporate earnings over the next several years.

International tensions are high, especially between the U.S. and Russia, the U.S. and China, and between Russia and Europe, over a variety of issues. Perhaps none of the issues on a stand-alone basis will have a huge impact on the global economy, but the potential remains for a conflation and escalation of events that may have a disruptive effect on global growth.

An expectation for slower but still positive earnings growth than we enjoyed in 2021 should bode well for equities in 2022.We face a year where higher than expected earnings will be the tailwind, while higher inflation and higher interest rates will be the headwind. Which wins will determine whether 2022 is another year of growth in the stock market or not. A solid year of earnings growth and a modest decline in P/E ratios will still allow for single-digit gains in stock prices. But if inflationary pressures are still elevated at the end of 2022, then interest rates could be higher than currently forecasted, a drag on stock prices. We do believe that quality (strong earnings, balance sheets and cash flows),which has been an underappreciated risk factor for most of the past 2–3 years, may become increasingly important as we move through the year. With profit margins near peak levels, companies can increase dividends despite inflationary pressures. We are focusing not on the highest yielders, but on those companies with strong underlying earnings growth that have demonstrated a capacity and commitment to raise dividends over time. With rising inflation and other uncertainties on the horizon, we believe that a portfolio of select companies with strong pricing power can help investors thrive in the years ahead.

All of us at LVM wish you a Happy, Healthy and Prosperous New Year!

The LVM Team

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