2021 Year in Review
As strange as it may sound given uncertainty over the global pandemic, many of the most important drivers for equity markets were rather easy to predict at the beginning of the year. In our 2021 Market Outlook, given easy comparisons to pandemic-depressed 2020, we suggested that U.S. economic and job growth would be quite strong. Economic strength would propel 20%-25% corporate earnings growth which would push U.S. equities higher by 10%-15% and simultaneously lower elevated equity valuations. We also suggested that the Federal Reserve would keep the Fed Funds rate stable and that the 10-Year bond yield would rise to 1.5%.
Fortunately, each of these predictions proved to be reasonably correct. Real GDP in 2021 is forecast to rise by 6.0%. Employment rose by 6.1 million jobs through November. We underestimated an astounding 47% earnings growth (estimate) while the S&P 500 gained 28.7%. Despite the remarkable rise in the S&P 500, thanks to powerful earnings growth, equity valuations declined from nearly 28X 2020 earnings at the beginning of the year to roughly 23X 2021 earnings at the end of 2021. Finally, the Federal Reserve did not raise interest rates during the year (no surprise) while the 10-year bond yield closed at 1.51%.
As it turns out, the biggest surprise versus our predictions in 2021 was our underestimation of corporate earnings growth and, consequently, our S&P 500 forecast. Strength in earnings was the result not only of improving sales but also from dramatic margin improvement. The pandemic forced companies to intensely focus on their cost structure. As a result, more productive use of technology, scrutiny on unnecessary expense coupled with a huge cutback on rent/travel/entertainment has enabled many corporations to be more profitable than ever.
Better than expected earnings growth was truly the story of the year and completely explains the stock market’s advance. As earnings estimates continued to move higher throughout 2021, the S&P 500 followed pretty much in lockstep.
Of course, just because many of the most important market factors performed well in 2021 does not mean the year went smoothly. We have all had to deal with multiple Covid variants, high inflation, supply chain bottlenecks, shortages of labor and political turmoil. We will address each of these issues in our Market Outlook.
2022 Market Outlook
We view 2022 as a year of moderation. We expect most of the key factors in our investment framework (employment, economic growth and earnings growth) to slow from their elevated 2021 levels. That said, each of these factors should remain robust. Positively, we expect some of our key wildcards to also moderate, namely, Covid/Omicron and inflation.
Now that we have provided a theme for 2022, we will provide more detailed commentary and forecasts in the sections that follow. Feel free to skip down to what interests you most. I won’t take offense.
We forecast U.S. equities to rise by 5%-8% in 2022. Given current consensus estimates of 7%-10% earnings growth and our expectation for U.S. equity valuations to continue to improve, it is reasonable to expect the S&P 500 to lag earnings growth just as it did in 2021. Should earnings surprise on the upside similar to 2021 then our market forecast would likewise rise.
On the job front, we anticipate employment will continue to rise as more workers return to the labor force to fill some of today’s record job openings. Given the high correlation between employment and the direction of the U.S. equity market, while not a guarantee, rising employment would be supportive to U.S. equities.
A word on valuation – for well over a year, more pessimistic market pundits have decried high market valuations. At a 28X trailing price-earnings ratio (P/E) at the beginning of 2021 or a 23X trailing P/E at the end of 2021 they would technically be correct. U.S. stock market valuations are high. We agree that valuations must come down (revert to the mean). Where we differ in approach is on timeframe (we suspect it will take several years whereas the pessimists believe it will occur all at once). We also differ on whether the reversion will be because of the “P” (stock prices falling) or the “E” (earnings rising). As long as we do not enter recession in the next couple of years, it seems more likely to us that the rise in earnings will do much of the heavy lifting in improving stock market valuations.
2022 will inevitably produce several temporary market blips despite our positive outlook. Covid/Omicron/New Variants, inflation, reduced fiscal stimulus, the probable beginning of Federal Reserve interest rate hikes and the election should all consume the market’s focus at some point – and those are just the obvious distractions! That said, they should all prove to be digestible. We believe the time to become more concerned is roughly 6 to 12 months before the next recession which still seems to be a few years away.
Forecasting international equities can be quite vexing. Despite lower valuations and potentially better 2022 earnings growth than the U.S., international stocks have persistently underperformed their U.S. peers (8 of the last 9 years). Foreign stocks tend to be more cyclical while U.S. companies tend to have more success in the higher growth tech sector. We prefer to take a wait-and-see approach with international stocks and forecast 5%-10% returns in 2022 with the potential for better should the global economy take off and more cyclical stocks outperform.
U.S. Fixed Income
Interest rates have stayed stubbornly low according to most observers but they have indeed remained relatively close to the range we predicted for 2021. Going forward, while we do anticipate bond yields to rise in 2022, we continue to expect U.S. bond yields to surprise on the downside compared to most pundits.
Specifically, unless new and more dangerous Covid variants arise, we anticipate that the Federal Reserve will begin to normalize the Fed Funds rate (short-term interest rates). We expect a total of 50 basis points (0.50%) of short-term rate hikes during 2022. As for longer-term bond yields, we forecast that 10-year U.S. Treasury yields may rise to 2%-2.25% from 1.51% today. Paradoxically, the more that the Federal Reserve raises short term rates and the more that investors perceive the Fed is paying attention to inflation, the less longer-term bond yields will likely rise given the relationship of long-term bond yields to inflation expectations.
Our forecasts above are predicated on our outlook for what is most likely to occur. If the last few years (decades?) have taught us anything is that life doesn’t always work out quite as you have planned. As such, we thought you might be interested in our thoughts on some of the potential known wild cards looming out there. Of course, it is usually the unknown wild cards that will ultimately write 2022’s story…
In keeping with our moderation theme, a current hot button is the topic of inflation which is currently running at a 6.8% annual clip (11/2021). Fortunately, we do expect moderation on this front as well. An exact forecast is difficult to pinpoint but “better” is highly likely. As with much in finance, the trend is often more important than the actual raw figure. We expect inflation trends to improve as supply/demand imbalances normalize in supply chains around the world. These imbalances have largely been the result of the massive disruptions caused first by the pandemic and then by re-opening. Given time, supply chain disruptions will inevitably resolve and should not be a major topic of conversation (or inflationary pressure) as we head into 2023. We do expect the other main source of inflationary pressure – the imbalance of supply and demand in the labor force – to take longer to resolve. While we do expect more workers to re-enter the labor force, it may very well take the next recession to bring wage inflation back into an equilibrium state. That said, higher wages bring greater disposable income which does have a way of getting spent in our economy so that is not all bad…
We were all hoping that this topic wouldn’t be a wild card for 2022. Covid persists and we are currently in the middle of a record global spike in cases. The current Omicron variant is much more transmissible but much less virulent. Most epidemiologists suggest that the current wave should wane much faster than prior variants because of the high transmission rates. Financial markets are already looking beyond Omicron which is probably the correct posture. As long as we do not see new variants that are both more virulent and transmissible then, aside from brief bouts of volatility, we would not expect Covid to determine the future direction of markets.
Federal Reserve / Monetary Policy
During 2022, the Federal Reserve has signaled that it will end its bond-purchasing program and begin raising short-term interest rates. While markets tend to get squeamish when the Federal Reserve tightens monetary policy, we view both changes in policy will actually improve the long-term health of the U.S. economy and therefore financial markets.
The bond purchasing program (quantitative easing) was an appropriate emergency policy which created abundant liquidity (cash) to keep our economic system moving smoothly during a crisis. We are no longer in economic crisis. As such, when there is too much liquidity in the system, excess cash can’t find a productive use. It inevitably ends up in financial assets pushing certain investments into bubble territory. That never ends well. As such, ending the bond purchase program makes sense and markets are well prepared.
In order to combat higher inflation, the Fed will likely raise the Fed Funds rate for the first time since 2018. We would expect this will be the start of a multi-year series of short-term rate hikes. The amount will depend on both the inflation trajectory and the path of the U.S. economy but we forecast two 25-basis point rate hikes during the year. Even though we support this policy, since financial markets tend to get bouts of indigestion around the start of Fed rate hikes, we include the Federal Reserve in our wild cards.
Is everyone excited for another election season? No matter what your political preference, the upcoming election will not be pretty, producing consternation that could filter into financial markets. The end-result is likely to be a split government and gridlock. From a financial market perspective, gridlock tends to be good. The fewer changes in policy, the easier it is for businesses to plan and the better for corporate profits.
In summary, we expect to see a moderation in most key financial market variables in 2022 from a remarkable 2021. While economic growth, job gains, earnings growth and financial returns should all return to more normal levels, they should all be reasonably robust.
So now let me end my 2022 outlook as I end all my outlooks: Of course, despite our best laid plans, events through 2022 will likely conspire to force us to alter our thinking in one direction or another. We will continue to be vigilant and adjust our thinking and strategy as events warrant.
Wishing you a Happy, Healthy, Safe and Successful 2022!