The U.S. economy and equity market have staged a surprisingly impressive recovery from the pandemic-induced lows of 2020. The speed of the recovery is a testament to relatively swift government actions, technological innovations that provided the platforms to keep economic activity going, and the scientific innovation that swiftly produced and delivered vaccines and therapies on a massive scale.
The past two years have been a period of exceptional disruption, triggered by COVID-19 and its multiple variants. Eventually disruptive events become less so as individuals, institutions, and society at large adapt their behaviors and expectations.
What are the implications for the markets in 2022 as the disruptive dimensions of the pandemic become part of the ongoing environment?
The macro environment
The macro environment has been dominated the past few years by the uncertainty, if not fear, of COVID-19 and its multiple variants. However, it appears that there is a growing perception that the virus is transitioning from a pandemic to an “endemic,” which is an environment in which there is acknowledgement that the virus will be circulating broadly and with regularity. This is analogous to the perception of the seasonal flu, but with a higher degree of virulence that needs to be dealt with through more robust policies of vaccination and therapeutics.
The key dimensions impacting the U.S. economy are liquidity, labor, and logistics:
Liquidity. There is an enormous amount of liquidity in the economy in the form of checking deposits and currency that remains poised for spending or investment. That includes $3.4 trillion in checking deposits, up from $1 trillion at the start of the pandemic, that will continue to fuel overall demand. Another ample source of liquidity is the lending power of banks, which are flush with capital that can be loaned out at exceptionally low interest rates.
Labor. The labor market is very strong, with payrolls and wages growing at a healthy rate. Meanwhile there is a record number of unfilled jobs (approximately 11 million) that employers are desperately trying to fill. Such a strong labor market will continue to be the most important factor in supporting the economy in the coming years.
Logistics. Supply chain issues have posed one of the greatest challenges facing the economy. The unusual and novel circumstances of the pandemic caused widespread chaos in the underappreciated logistics of supplying goods to consumers. Supply chains buckled under the joint pressures of surging demand and disrupted logistics from COVID-induced lockdowns and shortages in key components. Although there are some early indications that pressures in this area are easing, it will take more dedicated efforts to unsnarl logistical problems in the coordinated areas of shipping, rail, and trucking.
The key dimensions impacting the financial markets are prices, profits, and P/E multiples:
Prices. The logistical challenges that are crimping supply, coupled with exceptional levels of liquidity-fueled demand, have led to rising prices across the economy. Reported inflation is now running at about 6% annually, while many key goods and real estate prices are rising at double digit levels. The Federal Reserve (Fed) is now attuned to this issue and will begin reducing the amount of liquidity it is providing to the economy. Uncertainty around the magnitude and persistency of inflation is the most challenging factor in the outlook for the coming year. While there are some preliminary signs that inflation may have peaked and will subside, the evidence suggests that there is a greater risk that inflation will remain stubbornly high, fueled by more persistent factors such as wages and rents.
Profits. Corporate profitability has been exceptionally strong, surpassing expectations throughout the pandemic. However, profit expectations were low due to the unprecedented nature of the economic environment. Given that solid economic growth should continue in the new year, solid corporate profits should continue. However, overall profit growth likely will decelerate after such robust growth in 2021.
P/E multiples. Key valuation metrics such as the price/earnings (P/E) ratio are quite elevated relative to historic levels. However, this widely scrutinized metric has been high for quite some time. Higher P/E valuations can be justified when interest rates are exceptionally low (bond yields provide little “competition” for investor dollars). P/E multiples can also be justified when growth is high. That being said, it is difficult to expect market valuations, as measured by P/E multiples, to go even higher, particularly if interest rates continue their modest churn to higher levels while profit growth moderates. Valuations are more likely to remain stable to moderately lower, with markets driven primarily by earnings.
The market outlook
The U.S. economy should remain on a solid, but moderating growth path. Consumer spending is expected to remain strong, given the very healthy labor market and the significant levels of cash still sitting in bank accounts.
Government spending will be another source of strength given that recently enacted fiscal spending programs have not ramped up yet. Furthermore, although debt levels are high at the corporate and consumer level, they do not pose an imminent risk to the economy, especially with the cost to service debt so low.
Finally, the Fed is beginning to moderate its highly accommodative policy stance. As the Fed slows its asset purchases and eventually increases rates, the risk of volatility increases. In the past, markets have typically fared well up to first rate hike, with subsequent returns dependent on the pace of the hikes. A key risk in 2022 is a more rapid pace of Fed rate increases than expected in response to high inflation.
Fixed income market
Overall bond market performance in 2021 was flat to modestly negative. With inflation running high and bond yields at 1% to 4% across the credit quality spectrum, bond investors continue to lose the “purchasing power race.”
The Fed will be winding down its policy of large-scale bond buying, eliminating a major support from the market. We expect the current performance trend in the fixed income market to persist, with bond yields churning to gradually higher levels.
In short, bonds remain uncompelling, although they continue to provide an important diversifying element to an overall portfolio by providing some hedge against a serious equity market downturn. We continue to favor a short duration, curve flattening position while augmenting fixed income portfolios with alternative income assets such as leveraged loans and preferred stocks. For more risk-oriented portfolios, we would also include higher dividend-paying equities.
The U.S. stock market, as measured by the S&P 500®, has generated average annual returns of approximately 16% since 2010, with only a single negative year (-4.5%) in 2018. After such a long and strong stretch of exceptional performance, with earnings moderating and interest rates possibly rising, stock market return expectations should be meaningfully reduced relative to recent returns.
However, there remains ample liquidity in the system to support the market, even at lofty valuations, as evidenced by the constant buying that comes into the market on even modest weakness. However, investor emphasis should be on quality companies, regardless of size, that have solid business plans, durable profitability, and well-managed balance sheets.
International markets, especially emerging markets, will remain challenged. Durable economic growth still remains elusive in the developed world, especially in Europe. Part of the problem is the lack of vibrant, innovative companies in high growth industries. The European Union (EU) also faces many challenges, including recuring COVID lockdowns, a stifling regulatory environment and the turmoil that has come from the U.K.’s exit from the EU.
Emerging market performance remains tied to developments in China. The extraordinary crackdown by the Chinese government on the business sector will likely cast a long pall over that market. China is also dealing with its own significant real estate problem, which bears some similarities to the real estate problems that erupted in the U.S. during the Great Recession of 2008-09. Unfortunately, emerging markets outside of China are faced with multiple challenges, including inadequate vaccination programs, currency volatility, high debt levels, rising rates in response to inflation, and reliance on commodity-oriented industries.