2022 economic forecast: The great balancing act

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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. 

Economy 

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. 
  1. 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. 
  1. 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. 

Risks 

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: 
    1. a) Demand. As personal incomes surged, demand for goods spiked and there were supply chain disruptions, the demand/supply factors came into play and prices increased.
    2. b) Wages. The number one concern among small business owners is finding qualified workers.  Higher wages can attract workers to fill positions, and higher wages allow companies to retain top talent.  
    3. c) Energy. Energy prices increased materially in 2021, oil was up 46% year over year.  However, energy prices declined in 2020 due to economies shutting down.  We think oil prices eventually decline closer to the cost of production, around $60 barrel. 

We expect some inflation to be transitory and some to be more persistent. 

  1. 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. 
  2. 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. 

Financial Markets 

Equities 

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. 

Fixed Income 

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. 

KC Mathews, CFA, is the Chief Investment Officer at UMB Bank.

2021 economic forecast

In 2021, we expect to see robust economic growth and consumer spending, lower volatility in the financial markets along with lower-than-average returns and no new Federal Reserve activity.

Just Average

I’m sure many of us are glad to see the calendar pages turn. 2020 experienced an unprecedented economic event; yet in many other ways, it was just average.

In 2020, the economy witnessed one of the swiftest cycles seen in history. The contraction in the second quarter was truly unprecedented – the U.S. has not seen an economic contraction of that magnitude since the government started keeping records in 1947.

The good news is the 2020 recession didn’t last long. For the calendar year, we estimate the economy contracted by 3.5% which, believe it or not, is close to average in periods of recession.

Since WWI, the average economic contraction in a recession is 3.0%. The actual data is surprising, because this contraction surely didn’t feel average.

The financial markets have been telling a different story. Back in 2019, the financial markets had a stellar year. The S&P 500 posted a return of 31.2% – much higher than the 5-year average return of 11.7%. In fact, in 2019, most asset classes did better than their 5-year average.

Even though we witnessed an unprecedented downturn in the second quarter of 2020, the returns in the financial markets are above the 5-year average. Year-to-date, as of December 15:

  • The S&P 500’s (large caps) return is 16.3% and the 5-year average is 14.8%.
  • Small caps’ return is 18.9% and the 5-year average is 13.1%
  • Emerging markets’ return is 14.6% and the 5-year average is 12.9%.

2021 Forecast

Economy

In 2021, we expect robust economic growth; specifically, a 4.1% increase in real GDP, which is better than average.

The average real GDP after the Great Recession, from 2009 to 2019 (a period we call the Great Moderation), is 1.8%. 2021 will be much better than that for the following reasons:

1. The economy will still be in recovery mode.

As we have cited previously, history tells us it has taken two years to recover from material economic events. Following are the U.S. total GDP numbers (total economic activity, annualized):

a. Fourth quarter, 2019 – $21.747 trillion

b. First quarter, 2020 – $21.520 trillion

c. Second quarter 2020 – $19.520 trillion

d. Third quarter 2020 – $21.157 trillion

e. Fourth quarter 2020- $21.400 trillion (estimate)

You can see that we are still in recovery mode, with total GDP lower than that seen in 2019. Given our forecast of 4.1% real GDP growth in 2021, total GDP will be $22.3 trillion at the end of the year, passing the GDP high-water mark set back in 2019.

At the beginning of the crisis, historical evidence suggested it would take two years to recover, and lo and behold, it looks like it will be average, as we forecasted.

2. 2021 may go down in the history books as the year the world beat the COVID-19 virus.

Even though we will enter the year with spiking cases and new restrictions on activity, vaccines are being broadly distributed. Pent-up demand along with a high savings rate will boost consumption beginning in the second quarter of 2021.

3. Stimulus will continue to drive economic activity.

It’s amazing what $5 trillion can do to an economy. The CARES act, passed in March 2020, gave the economy a $2.2 trillion crutch. A second $900 billion stimulus program (4.3% of GDP) will support consumption and economic growth in 2021, if approved. Regardless, President Elect Biden supports more stimulus if required.

Due to COVID-19, vacations were canceled, we couldn’t go the to the movies – in general, discretionary spending was curbed. That resulted in an additional $1.3 trillion of savings, just waiting to support consumption in 2021.

4. Monetary policy remains accommodative.

The Federal Reserve (Fed) has demonstrated that it is willing to support financial markets regardless of the disruption. The Fed has telegraphed its intentions to keep rates close to zero for as long as needed to get the economy back on track and indicated three factors that will influence its decision to change interest rates:

a. An average inflation rate above 2% for some time.

b. Maximum employment. An unemployment rate below the estimated natural level (NAIRU) may not be a signal of looming inflation. We think NAIRU is 4.0% so we have a long way to go.

c. Meeting both longer-term goals mentioned and ensuring their sustainability.

Therefore, we see no change in Fed policy in 2021.

Financial Markets

Equities

Economic growth, stimulus and accommodative financial conditions will all be part of the formula driving corporate earnings. We expect earnings to grow 25% in 2021 and most equity markets will post positive returns.

However, much of this may be already priced into the market and, as previously mentioned, due to above average returns over the last two years, we do expect 2021 returns to be modest, in the 7-10% range, below the five-year average. We expect the S&P 500 to end the year between 3,950 and 4,100.

There are many tailwinds supporting stock prices. Low interest rates and the need to optimize profits will drive merger and acquisition activity. This may keep valuations a bit frothy.

Banks and credit are the lifeblood of the economy. In late 2020, the Fed allowed banks to buy back stock. This will provide more fuel for the equity fire, increasing the relative attractiveness of risk-based assets.

Of course, risks remain. The COVID-19 virus remains a risk, as perhaps we’re not able to control it as hoped. Another risk is whether the Fed changes its guidance on the balance sheet or interest rates, just like in 2013, when we saw a “Taper Tantrum” and the equity market debacle. This could happen late in 2021 or in 2022.

Fixed Income

In 2021, the Fed will control the entire yield curve, keeping short-term interest rates unchanged through out the year and if necessary, keeping a cap on longer rates by buying longer-dated securities.

This would keep the yield of the 10-year Treasury in check. Short-term rates will remain at 0.25% and the 10-year Treasury yield will move modestly higher to close the year at 1.25%.

Much of the economic momentum that was building in the second half of 2020 will continue into 2021. Economic growth will remain above average as we return to a state of normalcy. We expect GDP to be in the 3.8% to 4.3% range in 2021.

Risk-based assets are expected to produce positive returns, yet lower than the 5 and 10-year average. Our S&P 500 target at end the year is between 3,950 and 4,100. We do expect to see volatility in the equity markets.

A new administration with a new agenda enters the White House in January, which may 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.

Interest rates are expected to be stable as the economy recovers. We don’t expect inflation to be a threat in 2021.

There is light at the end of the tunnel, but right now, we are still in the tunnel.

KC Mathews, CFA, is a Chief Investment Officer at UMB.