Q1 2022: Economic Market Analysis

Economic imbalances

The COVID recession in early 2020 and the unprecedented response to it, has created numerous imbalances in the economy and the financial markets. Almost two years after the global pandemic started, COVID continues to disrupt economic activity.

Robust stimulus and job growth afforded consumers significant buying power, sending demand for goods skyrocketing. This had a ripple effect and created an imbalance in global supply chains. Stellar economic growth along with a tight labor market and the Federal Reserve’s accommodative posture created an imbalance in inflation and interest rates.

COVID and consumer confidence

Unfortunately, the world is still dealing with COVID. In the fourth quarter of 2021 another variant, Omicron, showed up potentially creating an economic imbalance. Perhaps the good economic news is, as the pandemic’s duration lengthens and variants arise, the imbalance in the economy appears to be diminished. We come to this conclusion after analyzing several data points. One being consumer confidence.

Consumer confidence remains at an elevated level, even as Omicron spreads. These elevated levels are similar to peak levels in past cycles. Our conclusion, consumers will continue to spend, even with negative COVID news. The strong job market, higher wages and excess savings all support economic activity. The economic result was robust, with fourth quarter GDP growth of 6.9% beating our 6.0% estimate.

Global supply chain

The U.S. operates on a global economy and has for decades. The surge in goods spending, along with manufacturing disruptions, sparked the supply chain imbalance. Structural issues in the U.S. and poor productivity in U.S. ports compounded the problem.

The U.S. NFIB survey indicates that the percent of small businesses reporting inadequate inventories is the largest since 1975. We believe that most of these supply chain challenges will be resolved by late 2022 or early 2023. In the meantime, strength in output and new orders will support our above trend GDP forecast.

Q1 2022 labor market

Unemployment continues to improve, today standing at 3.9%. There are 10.5 million job openings and 6.9 million unemployed. We think the labor force will continue to grow, jobs will be filled, and the unemployment rate will drop to 3.2% by the end of this year.

The Employment Cost Index (ECI) rose 1.0% in Q4, less than the previous quarter’s 1.3% gain, and less than the consensus of 1.2%. Nevertheless, it was the second largest increase since Q3 2006, as tight labor markets have boosted compensation pressures.

Inflation’s market impact

These aforementioned issues created unsettling inflationary pressures. Inventory shortages and logistic struggles have produced enormous inflation. We think much of the inflation in these areas will stabilize and eventually be transitory. Wage inflation may be more permanent. Average hourly earnings are up 4.7% year over year.

The Federal Reserve is faced with a difficult balancing act, to increase interest rates at a pace that curbs inflation yet doesn’t disrupt economic growth and financial markets.

Bond markets – Inflation remains firm as the Fed changes plans

Inflation and the Fed

Inflation remained strong in the fourth quarter, with the broad inflation indicators showing 5-7% price increases in 2021. Inflation appears to be more stubborn than the Fed had previously hoped, and Fed governors officially stopped referring to Inflation as “transitory.”

Labor and supply shortages are continuing to make many inputs quite scarce. The labor shortage is also putting upward pressure on wages. This confluence of factors is pushing inflation data higher, and making it appear that the situation may take longer to resolve than was previously thought.

In keeping with the more challenging outlook for inflation, the Fed pulled forward the estimated date for hiking interest rates from late 2022 to as early as March. The FOMC now estimates they will move rates upward at least four times in 2022 and another four times in 2023. This was a major revision to their outlook, and it roiled both the stock and bond markets.

While interest rates will still be low by historical standards, the sudden change in tone from the Fed increased uncertainty for investors—driving volatility higher.

Short rates immediately moved higher to make room for the new outlook for the Fed Funds Rate. Surprisingly, longer-term rates barely moved during the quarter. The 10-year Treasury finished 2021 at 1.51%—barely higher than when the quarter started.

It must be noted, however, that in the first few days of the new year longer rates spiked 30 basis points higher, finally reflecting the new outlook from the Fed. Higher rates again led to negative returns for the broad bond indices, for both the quarter and the YTD.

We rush to point out that, while we have entered into a “tightening phase” with the Fed, interest rates will be nowhere near the range that would be considered “tight.” Interest rates will continue to be well below restrictive levels even after the Fed executes the new path for interest rates. The very long period of extremely accommodative monetary policies is coming to a close, but we will remain in a range of moderately accommodative policies for at least the next year or two. Interest rates will continue to be supportive of a reasonably strong economic outlook.

High-yield markets

Despite a rough quarter for bond market returns, the High-Yield market managed to deliver positive returns which capped off an incredibly strong year for the sector. Even with rates moving steadily higher, the monetary environment will remain quite supportive of risk assets, and the outlook for the High-Yield sector should remain positive. We continue to expect High Yield to outperform the broad bond market for the next year.

Bond market forecast

We expect to see periods of volatility in interest rates in 2022, but overall, we believe rates will grind steadily higher. The 10-year treasury should finish 2022 in the 2.00–2.25% range and we expect Fed Funds to end the year at 1.25%.

While it may cause noise in the media, this shift is quite modest and should be considered a normal part of a healthy normalization of rates. Even at moderately higher levels, interest rates should not pose a meaningful threat to either the economy or markets. Returns for the broad bond markets are likely to be quite modest again in 2022—likely 1.00% or lower (annualized).

Economic imbalances: Equity markets

Q1 2022 recap

In the fourth quarter, the S&P 500 rose 11%. U.S. equities moved higher early on the heels of a strong consumer spending backdrop and improving employment trends. Both being key factors in corporate earnings growth. The $1 trillion infrastructure bill also passed, which should improve spending and employment trends.

Some concerns remain around the pandemic, supply chain disruptions and inflation. Last major concern, can valuations remain as the Fed transitions from extremely accommodative policies to higher interest rates, finally changing the decade long narrative from “Don’t fight the Fed” to “Fighting the Fed.”

Margins

Profit margins are currently at 30-year highs, with wage growth and ongoing supply chain issues expected to put downward pressure on margins. However, companies have historically managed costs during expansions well. Severe margin compression has typically occurred almost exclusively during recessions, which we do not currently have in our forecast.

While we don’t expect a recession in the immediate future, it would not be surprising to see a slight dip in margins. However, even if margins were to compress slightly, down closer to 11%, they would still be some of the highest profit margins in the last 30 years. So even if these elevated margins take a breather, it would still be positive for equity returns.

Valuations

Equity valuations remain elevated, sitting near 20-year highs. However, if rates remain low, equity valuations can remain elevated. Even with multiple rate hikes forecast for 2022, rates are still expected to remain below historical averages. While we do expect valuations to compress slightly, given the current environment we think valuations can remain elevated above long-term averages.

Volatility

Another imbalance in recent markets is the lack of volatility. We expect volatility to reenter the scene in 2022 given high valuations and the expectation of higher interest rates. We haven’t seen a 10% correction in almost two years, since the pandemic-induced sell-off in early 2020. The mid-term elections in November 2022 may be an additional cause of some short-term uncertainty. Given the strong performance of the market over the past few years, one or more corrections in 2022 would be normal and healthy.

Equity market forecast

Expected earnings growth around 9% in 2022 should support prices and help equity markets post positive returns. However, historically when the market is earnings vs. valuation driven, we see lower returns and higher volatility.

We still think risk-based assets, like equities, will produce positive returns and be one of the best performing asset classes in 2022. But we expect significantly lower returns than the last three year average, with our year-end S&P 500 price target between 5,100 and 5,250, or 7-10% total returns.

Economic imbalances Q1 2022: COVID and supply chain

COVID and new variants continue to create imbalances in the economy
As we entered 2021, hospitalizations began to fall and consumer confidence rose, thinking the worst was behind us. Unfortunately, new variants emerged, and while case rates remain high, we are fortunate the death rate remains lower than prior variants.
What does this imbalance mean? When Delta spiked, things took a pause, retail sales started to slow and COVID had a modest negative impact on the economy.
While new spikes or variants could still frighten people and curb consumption, data suggests hospitalizations may be peaking again. As vaccination rates grow, new variants have shown a smaller impact on economic activity, and we still see positive GDP for Q1 and all of 2022.

In essence, what you have on the left is a chart of supply and demand. The light blue line represents inventories (supply),and the dark blue line represents backlog of orders (demand).
On the chart we highlight a very large gap between current orders and inventories, but this is not uncommon coming out of a recession. Look at the green circle, as we came out of the Dot-com bubble and the economy recovered, we saw a spike in demand bigger than the ability to produce supply and a similar gap formed. The same thing happened after the Great Recession.
While the current pattern looks similar to past recessions, the imbalance this time is more dramatic. We think duration of this gap is a key risk to keep an eye on and expect the imbalance to remain with us for at least the next 12 months, if not longer.

Economic imbalances in Q1 2022: Labor market

Two years into the pandemic, COVID appears to have created a huge imbalance in the workforce, leaving business owners struggling to find workers amid the “Great Resignation.” Despite the mediocre nonfarm payroll gain in December 2021, and a potential disruption by Omicron in early 2022, employment trends remain solid and point to continued payroll growth and a lower unemployment rate over the next six months.
While millions of people have not held jobs since February of 2020, U.S. labor market conditions are consistent with full employment. The current unemployment rate is 3.9%. Wages are now rising rapidly, contributing to a surge in inflation.
Given the smaller size of the labor force post-pandemic, labor seems to have regained the upper hand.

In the chart, we highlight the percent of small businesses with hiring plans (light blue bars) and the percent of small companies expecting to increase compensation (dark blue line).
After the Great Recession, there weren’t many businesses looking to hire (circled). However, finding qualified people is the number one concern of small businesses today.
Every economic cycle has its own nuances. After the Great Recession, it took years to hike compensation. Today, 50% of small businesses plan to increase compensation to attract workers.
The imbalance will be finding workers to fill those open positions and how long wage inflation will persist as a result.

Inflation: High now, but markets forecast lower long-term

In the chart, we highlight the percent of small businesses with hiring plans (light blue bars) and the percent of small companies expecting to increase compensation (dark blue line).
After the Great Recession, there weren’t many businesses looking to hire (circled). However, finding qualified people is the number one concern of small businesses today.
Every economic cycle has its own nuances. After the Great Recession, it took years to hike compensation. Today, 50% of small businesses plan to increase compensation to attract workers.
The imbalance will be finding workers to fill those open positions and how long wage inflation will persist as a result.

A key indicator for the long-term path of inflation is inflation expectations. This category of data has a very strong impact on the Fed’s view of inflation.
Despite all the recent turbulence around the current outlook or inflation, the markets continue to forecast that inflation will roll over and return to its long-term range, very near the Fed target range of 2.0-2.5%.
This continues to encourage the Fed to take a measured and well-telegraphed approach to normalizing rates.

Bond market: Fed action and interest rates

With a more robust inflation environment, the Fed had to shift to a more aggressive posture for the future path of rates.
During the 4th quarter, the FOMC increased it’s expected path for overnight rates—indicating three moves in 2022 and four moves in 2023.
Treasury rates should be expected to grind higher, as part of a healthy normalization of rates—moving them up to levels that are more appropriate for a healthy economy.
A steady ongoing increase in rates should not disrupt the economy or markets. Clearly, we are entering a tightening phase, however conditions will not be tight. Fed funds at 1.25% by the end of the year will not dampen economic conditions.

Short rates (bottom of chart) moved higher in tandem with the new outlook from the FOMC.
Long rates (top of chart) were largely unchanged in the quarter.
The bond market seems to be signaling that the Fed’s planned moves will be adequate to bring inflation lower. We believe the long end will get pushed gradually higher throughout 2022.
Longer rates are clearly positioned for a Fed rate cycle that ends once the overnight rate reaches 1.75–2.00%. This outlook will be reliant on an inflation outlook that responds to the planned Fed moves.

Equity markets – Margins and valuations

Currently, firms are extremely profitable with impressive margins. Looking at the profit margin of the S&P 500, we are currently above 12%, a 30 year high.
Corporations may not be as successful in 2022 at maintaining those margins, due to rising wages and other inflationary pressures. If wages inflation continues, it will be important to find companies who have pricing power to counteract margin pressure.
While there is often a slight dip in margins after a strong recovery, like we see circled on the chart, this doesn’t mean margins are expected to plummet. The biggest declines in margins over the last 30 years have all coincided with a recession, which estimates do not currently project.

Even with numerous rate hikes in the forecast, interest rates remain low, supporting elevated valuations.
We do expect valuations to compress slightly from current levels, but revenue and earnings growth should expand at a higher pace than valuations compress.
Earnings outpacing the compression of valuations supports higher market prices and our expected market return for the S&P 500 of 7 – 10% in 2022.

Equity markets: Volatility and rate hikes

2021 was another successful year for U.S. stocks but shifting monetary policy and a myriad of uncertainties raises the odds for higher market volatility.
When you look at the red box on the far right, there have been no -10% corrections in the last three years outside of the pandemic driven recession in early 2020.
This lack of volatility has led to an imbalance in the market, with a typical year averaging a -14% intra-year drawdown.
Even though we expect a more volatile environment, we think stocks can continue to move higher, albeit at more muted return levels like we saw in the highlighted period from 2005–2007.

The Federal Reserve is expected to start hiking short-term interest rates in 2022.
Historically, the S&P 500 has been resilient around the start of Fed hiking cycles. Remember, rates are going up to slow (not stop) the rate of economic growth.
As seen in the chart, on average the S&P 500 has dropped during the three months following the first Fed rate hike. However, the weakness has proven to be short lived with the S&P 500 returning 7.5% on average during the full 12 months post the first hike. Similar to our 2022 forecast of 7-10% returns for the index.
Important to remember that a tightening phase does not mean tight, and even if rates end the year above 1% it’s still well below longer-term averages.

U.S. market performance – Equity and fixed income

The S&P 500 had a strong 4Q 2021 rally, up 11%, to cap off another great year for U.S. equities. Gains were robust in the quarter despite a weak November, where fears of a new COVID variant and the speed and size of tapering by the Fed hampered results.
On a sector level, real estate and IT outperformed while financials and energy lagged. Chipmakers were especially strong within IT and expectations for growing e-commerce demand drove industrial warehousing REIT names higher.

We expect increased volatility and lowered expected returns as we move into 2022, however this does not mean we recommend selling stocks. Stocks will continue to offer some of the most attractive relative returns amongst various asset classes, but we emphasize sticking with quality and diversification going into the new year.

Interest rates edged higher with the new outlook from the Fed.
Returns were again negative across most parts of the market.
2021 YTD returns were negative for the broad markets. This is only the 4th time in the last 50 years with negative returns for a calendar year.
As yields rise, expected returns for fixed income will improve, assuming inflation is ultimately well managed by the Fed.

Real gross domestic product (GDP)

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