Other than the absence of holiday parties and the addition of well-intentioned resolutions, the start of a new year usually doesn’t feel markedly different from the end of the previous one. For the stock market, however, that’s been anything but the case in the early weeks of 2022.

After a spellbinding rally last year, equities have been squeezed by the Federal Reserve’s increasing determination to stamp out inflation. The Fed is expected to hike interest rates as many as four times this year, a prospect that has unnerved investors who have grown accustomed to extraordinarily low rates. The central bank initially underestimated the scope of inflation, and it’s unclear how far it must go to curb it. The threat of military conflict in Ukraine has only added to the sense of unease.

The technology-laden Nasdaq composite index has dipped into a correction – defined as a 10% drop from its previous high. The S&P 500 momentarily entered correction territory during intraday trading before recouping some lost ground amid whipsawing volatility.

Not surprisingly, technology and other high-growth stocks that led last year’s advance have been the weakest recently. The outlook for major tech businesses remains encouraging. But the gains of the past two years were towering, causing prominent market indices to become top-heavy and susceptible to the type of pullback underway at the moment. While our investment services hold many of these promising companies, we have intentionally avoided the high concentration levels of the S&P 500 and other indices.

Though the uncertainty has been jarring, it follows an extended market rally dating back more than a decade. The abrupt COVID-19 selloff two years ago briefly interrupted the bull run. But equities rebounded in record time and surged afterward, with the S&P 500 leaping almost 29% last year.

Given the remarkable run, today’s volatility may feel worse than it otherwise would. In fact, on average, the S&P 500 has fallen 10% or more from its peak about once a year since 1950. Even larger selloffs of 15% or more have happened every three years or so. In other words, the current volatility is very much in line with historical norms.

Despite the early jitters, the economy and stock market still have a powerful sweep of forces going their way. That includes stout economic and earnings growth, hearty employment and wage gains, and the indomitable spirit of U.S. consumers. Equally noteworthy, businesses and consumers have learned to coexist with the coronavirus. At best, it’s an uneasy détente. But each wave of the pandemic has seemed to inflict progressively less damage on investor psyches.

Earnings growth projections

Source: Refinitiv. IBES consensus estimates for MSCI World (Global), S&P 500 (U.S.), MSCI Europe (Europe) and MSCI China (China). EPS growth estimates are for calendar years 2021 and 2022. As of December 31, 2021.

The bullish forces are expected to carry through much of 2022, albeit not with the same luster as last year. Capital Group economists project that U.S. GDP will rise 2.5% to 3%, while Wall Street consensus estimates foresee earnings climbing 9% domestically and 7% globally. With jobless claims near a half-century low and workers quitting jobs in record numbers, the high-octane job market is likely to remain a springboard for consumer spending. And though valuations are stretched in well-known portions of the market, they remain reasonable in others.

Nevertheless, the economy and financial markets face an unquestionably tougher backdrop. Much will rest on the arc of inflation and the Fed’s success in counteracting it. Supply chain constraints and worker shortages could exacerbate inflation and nag at businesses throughout the year. The slowing Chinese economy suggests that the rest of the world may not lend much help. And COVID-19 remains a perpetual curveball, with variants generating bursts of optimism or pessimism depending on medical developments.

(For greater perspective on the year ahead, please read our annual equity roundtable and fixed income roundtable conversations with Capital Group analysts and portfolio managers.)

Inflationary pressures and supply chain snags could linger.

When inflation erupted early last year, there was hope it could be doused quickly as global supply chains cranked back to life. But as rising prices coursed through more alleyways of daily life, the hope of inflation being transitory proved to itself be transitory.

The central bank responded by speeding the end of its bond-buying program and the planned launch of interest-rate hikes. Currently, the Fed may begin to hoist rates as early as March. Policymakers must step gingerly as they navigate conflicting forces. For example, Omicron could further intrude on service industries such as restaurants and tourism. With the winding down of government stimulus programs and the possibility of supply chains self-correcting, the central bank doesn’t want to snuff out economic growth. On the other hand, it has to guard against inflation becoming deeply rooted and requiring more forceful action later.

The Fed’s ability to finesse a soft landing could go a long way toward determining whether workers view rising prices as a passing irritant or long-lasting scourge. Though rising prices have dulled consumer sentiment, longer-term concerns don’t appear to be filtering into wage demands, a dynamic that could perpetuate the problem if it took hold.

Average annual returns at different inflation rates (1970–2021)

Sources: Capital Group, Bloomberg Index Services Ltd., Morningstar, Standard & Poor’s. All returns are inflation-adjusted real returns. U.S. equity returns represented by the Standard & Poor’s 500 Composite Index. U.S. fixed income represented by Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index from 1/1/70–12/31/75 and Bloomberg U.S. Aggregate Bond Index from 1/1/76–11/30/21. Inflation rates are defined by the monthly rolling 12-month returns of the Ibbotson Associates SBBI U.S. Inflation Index. As of November 30, 2021.

Stocks and bonds have provided solid returns during periods of low and moderate inflation.

As the accompanying chart shows, both equity and fixed income have provided positive returns throughout a variety of inflationary environments. And certain sectors ― including biopharmaceutical, health care services and telecommunications ― may have pricing power potential, which could cushion the impact on earnings if their own costs rise.

Our portfolio managers have been drawn to companies within those sectors that appear to blend pricing power with bright long-term prospects. For example, the Chinese government is expected to favor homegrown pharmaceutical companies with promising products and hopes of global expansion. As the U.S. population ages, health maintenance organizations delivering high-quality but cost-effective care could stand out.

High-quality bonds continued to act as an anchor in diversified portfolios.

Within fixed income, returns were mixed last year. High yield and inflation-linked securities led the way while other classes were flat or retreated. Bonds were largely held in check by concerns about tighter monetary policy and inflationary pressure. Additionally, outsize equity returns may have dampened enthusiasm for safe harbor investments.

Fourth-quarter results were remarkable only in their uniformity, with most classes advancing only fractionally. The exception was inflation-linked securities, which gained more than 2% in the quarter to finish up 6% for the year.

Given that rates are expected to rise, with an unpredictable impact on the economy, Capital Group Private Client Services portfolio managers are seeking to limit interest rate risk and credit exposure.

An extraordinary period for the economy and financial market continues.

At a minimum, the pandemic’s continued grip is the most visible example of an extraordinary period for the economy and the markets. Indeed, the past several years have been notable for the degree to which some key financial dynamics have deviated from historic patterns.

The S&P 500 sank into the fastest-ever bear market early in the pandemic before reversing course in a record bull run. The protracted dominance of U.S. stocks represents a notable break from long-established patterns. So does the extremely heavy concentration of leading stocks atop major indices.

In the economy, the Fed’s precedent-setting response to the pandemic, the uncommonly strong financial footing of consumers coming out of the recession and the subsequent upending of the labor market in the Great Resignation have all veered from traditional norms.

Regardless of changing conditions, Capital Group analysts and portfolio managers remain committed to a research-focused approach that seeks to identify leading companies with promising long-term prospects.