2022 promises to be another eventful year. We are confident that the economy will continue to grow 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 rise, and the Fed must carefully manage higher rates so as not to crush economic activity.
The expected economic conditions should provide a favorable environment for risky assets such as equities, while presenting a challenging environment for fixed income investors.
Again, we expect the economy to grow much faster than trend or potential growth rates. Potential GDP is 2.5%, but in any given year the economy may grow faster or slower than this trend rate. In 2022, there are many reasons why the economy would perform above average:
- Stimulation/Liquidity. Over the past two years, there has been unprecedented monetary stimulus, including quantitative easing and a zero federal funds rate. Some of this stimulus was necessary for survival and much of it was just pennies from the sky. Savings rates soared as consumers saved money for a rainy day. Currently, in the United States, surplus savings are estimated at 2,000,000,000,000 billion dollars. Typically, there is a 12-month lag for monetary stimulus to have an economic impact. The favorable political context supports a strong and positive GDP growth rate in 2022.
- Financial health of consumers. The consumer is in better financial shape than ever. The labor market is strong, there are more job vacancies than unemployed, which shifts bargaining power to workers. Average hourly wages increased by 4.8% in 2021 and we expect wage inflation to continue in 2022, leading to labor shortages in many industries. In addition, the consumer balance sheets are impressive. 2021 has been a great year for risk-based asset prices. Equities, real estate, commodities and others all had double-digit returns that boosted balance sheets. And as I mentioned before, the savings rate has been high in 2021, improving the financial health of consumers. This bodes well for spending and consumption, supporting robust GDP.
- Global Reopening/Supply Chain Issues. Supply chain bottlenecks will continue to be a headwind for many industries. As global COVID issues continue and countries like China shut down cities, this will have a significant impact on industries like semiconductors. This then trickles down to other industries such as the automotive industry. We see evidence that these logistical pressures are fading, but they will clearly be present in the first half of 2022. This will keep demand high in the first half and inventory replenishment will support economic growth in the second half.
Every year there is a long list of risks that we have to manage. This year is no different, the list includes:
- COVID and maybe the endless variants. We believe this is a relatively minor risk to the economy as more people catch the virus or get vaccinated.
- Inflation. This year, soaring inflation could change the interest rate landscape. Inflation came from three areas in 2021:
- a demand. As personal incomes increased, demand for goods increased, and there were supply chain disruptions, demand/supply factors came into play and prices rose.
- b) Wages. The main concern of small business owners is finding skilled workers. Higher wages can attract workers to fill positions, and higher wages allow companies to retain top talent.
- c) Energy. Energy prices have risen significantly in 2021, oil is up 46% year over year. However, energy prices have fallen in 2020 due to the shutdown of economies. We think oil prices will eventually decline closer to the cost of production, around $60 a barrel.
We expect some of the inflation to be transitory and some to be more persistent.
- Interest rates and Fed policy error. Interest rates have been stuck in a very low range since the Great Recession of 2009. A slight rise in rates still leaves rates at a relative historic low. However, if the Fed raises rates too high or too quickly, it could have a negative impact on economic activity. We believe this is a significant risk.
- Politics. This is a broad risk ranging from national debt to social polarization. In November, the United States will hold another midterm election. Even though our research concludes that politics is not a catalyst for the economy, we know that elections can cause short-term ripples in financial markets.
Just like in 2021, economic growth, stimulus measures and accommodative financial conditions will be part of the formula that determines corporate earnings and stock prices in 2022. Last year, the stock market avoided all the big negative headlines, it kept rising. This year presents a new challenge, higher interest rates. Historically, rising interest rate environments have coincided with higher returns in equity markets. The S&P 500 has averaged a 19.2% one-year gain when the 10-year U.S. Treasury yield rises 50 to 100 basis points, matching our forecast for the 10-year Treasury yield ending the month. year at 2.10%.
We expect the S&P 500 to end 2022 between 5100 and 5250. This 7-9% total return could be modest compared to the double-digit returns of the past three years. Earnings growth of around 9% will support prices and most equity markets will post positive returns. One risk-based component that has been missing is volatility. Volatility should return to center stage given high valuations and the expectation of higher interest rates. We haven’t seen a 10% correction in nearly two years. The midterm elections in November could also bring some short-term uncertainty. And given the market’s strong performance over the past nine months, a correction would be normal and healthy.
The consensus is that the Federal Reserve will raise 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 bond indices posted negative total returns as the Fed positioned itself for higher interest rates. This year, as rates rise, we could see another year of flat or negative returns. If we have another year of negative returns, it would be the first consecutive years of negative returns in 50 years.
The global business cycle is moving from recovery to expansion. Naturally, and as expected, US GDP will continue to be above trend, but slower than last year. Economic momentum, due to stimulus measures, 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 coming years. We call this period, the Grand Plateau, which is expected and normal after a recovery with a massive raise.
Risky assets are expected to produce positive returns and be one of the best performing asset classes. However, we expect returns significantly below the three-year average. Our S&P 500 target at the end of the year is between 5,100 and 5,250 or 7-10% total returns. We expect to see volatility in equity markets.
Interest rates will rise and inflation should stabilize. Fixed income asset classes will struggle to post positive total returns. The entire yield curve will rise, the Fed could raise short-term rates three times this year, ending the year at 1.0% and the 10-year Treasury yield will rise slightly to end the year at 2 .10%.
Obviously, there are imbalances in the economy. A great balancing act will be needed to ensure order in the economy and financial markets. At this time, we believe this can be managed.
KC Mathews, CFA, is Chief Investment Officer at UMB Bank.