C: Lower than 7.0%.

Inflation is at a three-decade high, but it has been pushed there by the unique nature of the pandemic, the government response, supply shortages, and labor force disruption. We expect it to decelerate in 2022 to about 3.0% for the CPI over the next 12 months. That would roughly correspond to 2.5% inflation for personal consumption expenditures, above the Fed's target of 2%. Note that this doesn't mean a decline in prices, but rather a slowing of price increases. As of this writing, runaway inflation is not our base case and markets seem to believe, as we do, that the Federal Reserve has the tools it needs to curtail inflationary pressures. Of course, a variety of very fluid inputs could tip our outlook: lingering supply-chain issues could combine with wage pressures to hold inflation much higher than in past cycles, while an unanticipated economic slowdown, fiscal drag, and weak job growth could temper its pace.

Watch Chief Economist Luke Tilley explains more on inflation.

B: Retirement, skills mismatch, lifestyle reassessment, lingering virus impacts.

Jobs are indeed coming back—with roughly half a million added each month toward the end of last year—but we still have 2.4 million fewer workers than we did before COVID-19. The labor force participation rate is being tamped down by a few factors. First, a large number of workers have called it quits and retired (due to a combination of pumped-up retirement plan balances and virus fatigue). While much of the decline is likely permanent, some retirees may be enticed into returning to the workforce—as a result of market weakness, higher wages, or a realization that retirement funds will prove insufficient.

Skills mismatch references the fact that many aren’t trained to fulfill roles that require specialized technological expertise, and speaks to a lack of effective labor. Lifestyle reassessment has caused some to bow out or shift industries, as the result of the pandemic that made them question their professional choices. And finally, many are still too concerned about the virus—particularly the latest Omicron variant—to show up for close interactions required in many fields, such as restaurants and other service industries.

Chief Investment Officer Tony Roth speaks to Luke about a critical indicator: the labor participation rate.

A: Stocks, bonds.

In building a portfolio to insulate against inflation risk, we consider both the magnitude and direction of inflation: low and rising, low and falling, high and rising, or high and falling. As mentioned earlier, our base case is we will transition from a high-and-rising inflationary environment to a high-and-falling regime. In such scenarios, receding price pressures have historically delivered above-average returns for both stocks and bonds. (Bonds typically perform well because declining inflation coincides with a decline in nominal interest rates, helping support price returns for bonds.) Stocks are generally regarded as one of the most stable, long-term inflation hedges, given the ability of companies to pad revenues by passing along price increases to consumers. Equities, in fact, deliver strong returns in all scenarios except where inflation is high and continuing to rise. In that regime, typical inflation hedges like commodities and gold have performed best. We would also expect other inflation hedges like real estate investment trusts, energy stocks, dividend payers, and covered-call strategies to outperform the broader U.S. equity index but still provide muted returns. Treasury inflation-protected securities (TIPS) would likely outperform bonds but underperform gold and commodities. We take all these potential inflation outcomes into account in an effort to strike an optimal asset class balance in our diversification mix.

More on inflation hedges from Head of Investment Strategy Meghan Shue.

D: All of the above.

The transformational impact of labor shortage-induced disruptions at every supply-chain node—from production to transportation and distribution—is leading companies to make significant changes to their business models by shifting focus to building more resilient supply chains through dual sourcing of materials, increasing inventory of critical products, and nearshoring or expanding their supplier base. Technology and big data have also improved supply-chain efficiency. For example, improved demand forecasts from AI have ushered in the era of dynamic pricing (sellers' ability to price a particular item differently with changes in demand) and “just-in-time” inventory, allowing companies to extract much more from their profit curves while reducing the costs associated with stale or unwanted inventory.

The low-rate environment continues to facilitate the corporate finance decisions to make such tech investment possible. U.S. companies issued a record amount of debt in 2020 at attractive rates, helping to fortify balance sheets in preparation for the unknown. And fortify they did, now sitting on more than $5 trillion in cash, some of which we expect to be deployed into tech-related capital expenditures. In 2021, many companies also refinanced their debt, extending maturities and locking in even lower rates for existing debt. Current terms are favorable for companies considering refinancing. The low-rate environment, cost of keeping up with technology needs, and looming threat of higher taxes have also spurred a wave of consolidations. We expect rates to move higher in 2022 but remain around 2%, a level that could continue to encourage strategic combinations.

Meghan highlights the rapid return on investment of capital expended at this trying time.

D: None of the above.

In a low-return environment, income becomes a larger and more critical driver of total return. We would caution against some of the more common ways of obtaining higher yield, namely extending bond duration, or lowering credit quality. We expect interest rates to rise, so short-term returns could be painful for investors extending their duration; those investors with longer time horizons could do fine from clipping a higher coupon and rolling down the yield curve. Similarly, credit spreads (yield over a similar-duration Treasury) are very compressed, and lower-quality corporate bonds are quite expensive for their risk as a result. Instead, we see opportunities in dividend equities, particularly in some sectors where valuations are still attractive. International equities also typically offer a higher dividend than their U.S. counterparts, and economies outside of the U.S. have more ground to make up versus pre-COVID levels.

Covered-call strategies can also be beneficial, as investors can pick up additional income from the premium they sell on a call option in return for a capped upside to their equity holdings. This strategy may work particularly well in choppy or down markets. Private markets also may offer a compelling opportunity in a low-return environment for publicly traded stocks. Private equity, debt, and real estate offer qualified investors—those who meet minimum income and asset requirements set forth by the Securities and Exchange Commission—access to less efficient markets and potentially higher returns, including during times of economic contraction and outright loss for listed equities. Private markets are obviously not suitable for every investor, and the key consideration is assuming a longer investment horizon to contend with lockup periods and illiquidity.

Tony highlights topics from our 2022 Capital Markets Forecast.