2022 ECONOMIC & MARKET OUTLOOK
Review of Last Year (2021)
A review of 2021 cannot begin without a recap of 2020, which started on sound footing, as the economy had been growing rapidly since 2019. That growth continued until the stock market reached its peak on February 19, 2020, which is when the news of COVID-19 began to appear. Fear was gaining momentum, as hospitals were quickly filling up, death tolls were mounting, and it was all over the news. States were beginning to mandate that only “necessary” occupations could go to work. This sent a huge ripple of fear throughout the US and the rest of the world, as this new virus became a pandemic that no one was prepared for.
By March 23, 2020, the stock markets had reached their lows, almost 35% from their peaks only five weeks earlier. Similarly, the bond markets were also in a tailspin, as liquidity hit a screeching halt. There was virtually no place to hide for investors, as the rare event of bonds and stocks dropping precipitously was firmly underway. The US entered into a recession.
On March 23, the federal government announced that it would be establishing several stimulus packages that would support individuals who lost their jobs, and also provide financial support to businesses. Recognizing that the Armageddon was not in sight for businesses, and there was a glimmering light that could be seen at the end of the tunnel, the stock markets quickly rallied back from the abyss. In addition, the Fed also dropped interest rates to near zero to help spur economic growth.
In just one week, the stock markets rebounded 10% and never looked back. Soon after, the liquidity crunch was relieved by other fiscal stimulus programs, with bonds recovering their losses. By the end of 2020, the stock markets rallied back sharply (28.8% for the S&P 500), and bonds recovered to gain nearly 6%. It should be noted that there was a swift divergence between the Dow and the NASDAQ, as the Dow gained only 5.3% while the NASDAQ gained 41.5% in 2020. With interest rates near zero, the growth stocks began a historic run that has not been seen since the tech bubble of the late 1990s.
During 2021, the federal government enacted another stimulus package that flooded the US with more money designed to spur the economy. During the pandemic, the average household created a record amount of savings, while household debt was reduced to historic lows. Further, the government continued their stimulus packages that resulted in many lower-earning workers making more money collecting unemployment benefits.
A labor shortage was created due to employees not wanting to go back to work for a variety of reasons. The labor shortage then led to a supply-chain disruption, as many goods weren’t available to consumers to buy. A result of the labor shortage was an increased wage growth, which also led to an increase in the cost to produce goods. The combination of labor shortage and increased demand caused a supply chain disruption created the ingredients for inflation, which quickly became the leading concern in the US economy as the year 2021 ended.
Looking Ahead to 2022
It’s hard to believe that we are approaching the 2-year anniversary of the pandemic. It’s equally hard to believe how resilient the stock markets have been in the face of the pandemic, as we experienced consecutive years of gains exceeding 20%. Stocks (as represented by the S&P 500) began 2022 with a forward price to earnings (PE) ratio of 21.2, which is 26% higher than the 25-year average of 16.8. However, many economists consider the stock market yield (inverse of PE or 1/21.2) of 4.73%, which is more than 3% higher than the 10-year Treasury yield. When we had elevated PE ratios in the late 1990s and a stock market yield of 4% - 5%, the 10-year Treasury yield was closer to 6%. So, many pundits believe that stocks are still relatively cheap compared to bonds, creating the T.I.N.A. (There Is No Alternative) effect. Fundamentally, stock prices are based on their earnings and earnings growth. Earnings growth has been spectacular after falling dramatically in 2020. In 2022, earnings increases will become more modest. Growth from stimulus is fading and companies will have to manage their profits in a slower-growth, higher-inflation environment. That said, the U.S. Leading Economic Index suggests we’re not near a recession yet, but that peak economic growth may be behind us.
The consensus of analysts estimate that the stock market will continue to have earnings growth of about 8% in 2022, which is at a slower pace than the rapid growth of 2021. It should be noted that the extraordinarily high earnings growth in 2021 is due in great part because they are compared to the recessed earnings in 2020. However, if compared to the pre-pandemic levels from 2019, we still experienced an average annual growth rate of about 15% over the last two years. In 2022, there may also be a shift from the technology / growth companies that led us out of the recession to more service-oriented companies that had suffered the most, but stand to benefit from people spending the money they’ve been saving. The Federal Reserve (the Fed) is forecasting 3.8% in U.S. GDP growth in 2022, down from their 5.9% projection for 2021. This 3.8% growth rate is still high relative to the prior expansion after the global recession in 2008. This seems in line with many other economists’ forecasts. While growth is slowing to more sustainable levels, the Fed raised its growth forecast for 2022, partly because supply chain disruptions pushed economic activity previously expected in 2021.
Breaking down GDP, consumer spending (which makes up roughly 70% of GDP) is projected to rise in 2022, but at a slower pace. Spending will be moderated as government stimulus fades, but consumers have accumulated cash and are expected to spend more on leisure activities that were postponed because of the pandemic. Business spending should accelerate as businesses try to keep up with demand from economies reopening and building up inventories. In addition, businesses are looking to expand and purchase more computers and equipment at currently low interest rates, as they look to increase automation due to labor shortages.
Much of the attention in 2022 will be on the Fed and when they will raise short-term interest rates, which are designed to slow the economy in an attempt to combat inflation. The problem the Fed is encountering is that much of the inflation is temporary, caused by supply-side disruptions that will likely abate. Further, the Fed needs to be cautious when raising rates because in the past, recessions have occurred when the Fed raised rates too quickly. During the most recent Fed meeting in December, they alluded to possibly raising interest rates three times in 2022. A rising interest rate environment also puts pressure on the bond market as core bonds typically lose value under the circumstances. Given an already low yield, a loss in value could easily cause a negative total return, effectively ending the 40-year bond market bull run. It should be noted that not all bonds are equally at risk so care must be taken when investing in bonds in 2022.
Economic growth is slowing from the high growth rates that were a result of the huge rebound from the recession and massive amounts of fiscal stimulus. However, economic growth rates are still forecast to be above pre-pandemic levels. The big story in 2022 could be the Fed and when they decide to start raising rates and by how much. Therefore, we will be watching the labor market and inflation very carefully as they will be what would cause the Fed to act sooner rather than later.
The consensus of economists predicts a stock market growth of 5% - 10% in 2022, but the following risks continue to persist:
- Continued and increasing inflation rates.
- The Fed raising interest rates too quickly.
- A surge in the pandemic causing economic shutdowns.
- Geopolitical unrest such as a Russian invasion on Ukraine, a China invasion on Taiwan, an Iran attack on Israel, or other major international conflicts.
Overall, the US Economy remains on strong footing, so there is good reason to feel confident heading into 2022.
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