2022 promises to be another eventful year. We have a high degree of confidence that the economy will continue to grow at a pace above trend, the labor market will tighten, and consumer spending will be robust.
The Federal Reserve will have a great balancing act in 2022, as inflation stabilizes interest rates will be on the rise and the Fed must carefully manage higher rates so not to squash economic activity.
The anticipated economic conditions should provide an environment that will be favorable for risk-based assets such as stocks, while presenting a challenging environment for fixed-income investors.
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Once again, we expect the economy to expand much faster than trend or potential growth rates. Potential GDP is 2.5%, however in any given year the economy may grow faster or slower than this trend rate. In 2022, there are numerous reasons why the economy would produce above average results:
1. Stimulus/Liquidity. Over the past two years there has been unprecedented monetary stimulus including quantitative easing and a zero fed funds rate. Some of this stimulus was needed for survival and much of this was just pennies from heaven. Savings rates spiked as consumers put money away for a rainy day. Currently, in the US there is an estimated excess savings of $2-2.5 trillion. Typically, there is a 12-month lag for monetary stimulus to have an economic impact. The favorable policy backdrop supports a strong and positive GDP growth rate in 2022.
2. Consumers’ financial health. The consumer is in better financial shape than ever before. The labor market is strong, there are more job openings than unemployed which shifts the bargaining power to the workers. Average hourly earnings were up 4.8% in 2021 and we expect wage inflation to continue into 2022 giving labor shortages in many industries. In addition, consumer’s balance sheets are impressive. 2021 was a great year for risk-based asset prices. Stocks, real estate, commodities, and others, all had double-digits returns boosting balance sheets. And as I previously mentioned, the saving rate was elevated in 2021, improving consumer’s financial health. This bodes well for spending and consumption, supporting robust GDP.
3. Global reopening/Supply Chain issues. Supply chain bottlenecks will continue to be a headwind for many sectors. As global COVID issues continue, and countries like China shut down cities, it will have a significant impact on industries like semiconductors. That then trickles into other industries such as the automotive industry. We see some evidence that these logistic pressures are wanning, but clearly will be present in the first half of 2022. This will keep demand high in the first half of the year and inventory restocking will support economic growth in the second half of the year.
Every year there is a laundry list of risks that we must navigate. This year is no different, the list includes:
1. COVID and perhaps the never-ending variants. We do think this a relatively minor risk to the economy as more people either get the virus or are vaccinated.
2. Inflation. This year spiking inflation may change the interest rate landscape. Inflation came from three areas in 2021:
We expect some inflation to be transitory and some to be more persistent.
3. Interest rates and a Fed policy error. Interest rates have been stuck in a very low range since the Great Recession in 2009. A modest increase in rates still leaves rates at a relative historic low. However, if the Fed increases rates too high or too fast, it could have a negative impact on economic activity. We think this is a significant risk.
4. Politics. This is a broad risk ranging from the national debt to a social polarization. In November the US will hold another mid-term election. Even though our research concludes that politics is not a catalyst for the economy, we know elections can cause some short-term ripples in financial markets.
Just as in 2021, economic growth, stimulus and accommodative financial conditions will all be part of the formula driving corporate earnings and stock prices in 2022. Last year the stock market shunned every negative headline, it just kept going up. This year presents a new challenge, higher interest rates. Historically, rising interest rate environments have coincided with stronger equity market returns. The S&P 500 has averaged a one-year gain of 19.2% when the US 10-year Treasury yield increases by 50-100 basis points, which aligns with our forecast of the 10-year Treasury yield ending the year at 2.10%.
We expect the S&P 500 to end 2022 between 5100 and 5250. This 7-9% total return may be modest when compared to the past three years of double-digit returns. Earnings growth around 9% will support prices and most equity markets will post positive returns. One risk-based component that has been absent is volatility. Volatility should reenter the scene given high valuations and the expectation of higher interest rates. We haven’t seen a 10% correction in almost two years. The mid-term elections in November may also cause some short-term uncertainty. And given the strong performance of the market over the past nine months, a correction would be normal and healthy.
The consensus is that the Federal Reserve will hike short-term interest rates in 2022, we agree. We expect three hikes in the Fed Funds rate, ending the year at 1.0%.
In 2021, most fixed-income indices posted negative total returns as the Fed positioned for higher interest rates. This year, as rates rise, we may see another year of flat to negative returns. If we have another year of negative returns, it would be the first back-to-back years of negative returns in 50 years.
The global economic cycle is transitioning from a recovery to an expansion. Naturally, and as expected, US GDP will continue to be above trend, however slowing relative to last year. Economic momentum, due to stimulus, accommodative conditions, and pent up demand will support growth in 2022, we expect real GDP to be between 3.5 and 4.0%. However, GDP will slowly return to trend growth around 2.5% in the years to come. We call this period, the Great Plateau, which is expected and is normal after a recovery with massive stimulus.
Risk-based assets are expected to produce positive returns and be one of the best performing asset classes. However, we expect significantly lower returns than the three-year average. Our S&P 500 target at end the year is between 5,100 and 5,250 or 7-10% total returns. We do expect to see volatility in the equity markets.
Interest rates will be on the rise and inflation should stabilize. Fixed-income asset classes will struggle to post positive total returns. The entire yield curve will shift higher, the Fed may hike short-term rates three times this year, ending the year at 1.0% and the 10-year Treasury yield will move modestly higher to close the year at 2.10%.
Clearly there are imbalances in the economy. A great balancing act will be required to ensure order in the economy and financial markets. At this time, we believe this can be managed.
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