2022 Market Outlook
There are trends that are developing in the U.S. economy that we have not seen for decades. As inflation continues to rise at a rapid pace, we have to look back to the 1970’s as a reference point to determine how inflation could impact stocks, bonds, gold, and cash going into 2022. The most common questions that we have received from clients over the past few weeks are:
Will the stock market rally continue into 2022?
Will higher inflation derail the economy?
How will the market react to the Fed increasing interest rates in 2022?
A lesson from “The Nifty Fifty”
How will the labor shortage and supply chain issues impact the markets in 2022?
I plan to address all of these questions and more as we present our market outlook for 2022.
The Economy Will Continue to Strengthen
It’s our expectation that we will see the U.S. economy gain strength in the first half of 2022. Our economy is based primary on consumer spending and the consumer is charged with cash and ready to spend. The cash has come from record levels of government stimulus in 2020 and 2021, as well as rising wages across many sectors in the U.S. economy. Debt levels are also at historic lows as well. Due to the supply chain constraints, people could not spend the money, therefore they paid down their debt. Per the chart below, debt payments as a percent of U.S. households’ disposable income is at the lowest level in over 40 years.
Talk to any pool company and they will provide you with a clear picture of the pent- up demand. Some pool installers are fully booked through 2022 and are taking deposits for pools for 2023.
Back Orders At Record Levels
Many of the companies that we have spoken with across various industries have back orders at record levels. With back orders, the customer is already committed to buying a product from a company whether it’s a car, roof, gym equipment, etc., but they have yet to take delivery of that product. When the product is delivered, they normally submit full payment, and the company realizes the revenue. From an outlook standpoint, when companies have large back orders, it takes some of the risk off the table because it is not an “if the sales are going to be there to generate revenue” but rather “how quickly can the company deliver the product to their customers”.
Supply Chain Constraints
The answer to the question “how quickly can they deliver?” relies heavily on how fast the global supply chain can get back online going into 2022. People have been slower to return to the workforce than originally expected, which means less people at the ports to unload container ships, less truck drivers to transport the goods from the ports to the stores, and less employees in stores to stock shelves. However, we see a number of new trends that should ease these constraints in 2022:
Individuals needing to return to the workforce after depleting stimulus cash reserves
Employer offering higher wages and sign on bonuses to attract employees
A higher level of vaccination rates in children, easing childcare constraints, and allowing more parents to return to the workforce
I think the economy has largely underestimated the impact of the childcare constraints on the ability for parents to return to the workforce. If your child has a cough, even though a test may reveal that they don't have COVID, they may not be able to return to school for a few days, requiring a parent to take time off from work.
Relief At The Ports
The two main ports in the U.S are the “twin ports” in Los Angeles and Long Beach; 40% of sea freight enters the U.S. through those two ports. Both have been working around the clock to unload ships and they are making significant progress. Mario Cordero, executive director of the Port of Long Beach, stated that in mid- November there were 111 ships off the coast of California waiting to be unloaded and within two weeks that number was reduced to 61 ships. However, it takes time for the goods to get off the ship, loaded onto a truck, and delivered to stores and businesses, but the trend is going in the right direction.
Record Levels of Cash Injection
Over the past 18 months, the U.S. Government has injected more cash into our economy than any other time in history. To put this in perspective, let's compare the dollar amount of the bailout packages during the Great Recession of 2008 / 2009, to the level of cash injection over the past 18 months. In the illustration below on the left side you will see the TARP Program which was the government bailout for the banks and the housing market in 2008 / 2009. On the right, you will see all of the stimulus program that the government rolled out in 2020 / 2021 to battle COVID.
The total cost of TARP was $700 Billion.
Over the past 18 months the government has injected almost $7 Trillion…………TRILLION……into the U.S. economy. That is 10 times the TARP program that was used to rescue the US economy in 2008/2009 when we almost lost the entire U.S. banking system.
To go one more step, below is a chart of the year over year change in the M2 money supply. This allows us to see how much cash is circulating within the U.S. economy compared to the prior year going all the way back to 1980.
Look at that mountain on the righthand side of the chart. We have had recession in the past which has required the government to inject liquidity, which are illustrated by the grey areas in the chart, but nothing to the magnitude of what we have seen over the past 18 months. Just a side note, this chart does not include the recent $1.2 Trillion dollar infrastructure bill that was already passed or the $1.75 Trillion Build Back Better bill that is deck.
A lot of this cash that has been injected into the economy has not been spent yet because due to the supply chain constraints, consumers and business have not been able to spend it. As the supply chain gets back online in 2022 and 2023, consumers and businesses will be able to put this cash to work which should be a boost to the U.S. economy.
Inflation, Inflation, Inflation
The great risk to the economy as we enter 2022 is undoubtedly rising inflation. We have all seen prices rise rapidly for just about everything we buy: groceries, gas, travel, etc. The supply chain issues have made this problem worse because the less goods there are, the more expensive they become. This leads us to the main question which is:
“Will inflation subside once the supply chain gets back online or are these higher levels of inflation that we are seeing now just the beginning?”
This is the question that everyone wants the answer to but it’s too early to tell. The only thing that's going to provide us with the answer is time, so we are going to be watching these trends unfold week by week, month by month, as the data comes in during 2022. In my opinion, there is an equal chance of both scenarios playing out. Scenario one, the supply chain improves throughout 2022, increasing the supply of goods and services, which in turn stabilizes prices, and the risk of hyperinflation begins to fade. Scenario two, either the supply chain does not heal fast enough, or wage growth continues to escalate, causing inflation rates to continue to rise, forcing the Fed’s hand to raise rates more quickly.
You have to remember that inflation only begins to do damage when prices rise to levels that consumers and businesses can no longer afford. Given the historic levels of cash that have been injected into the economy, it’s our expectation that even with prices rising over the next 6 months, that may not curb the consumers ability or desire to purchase those same goods and services at higher prices.
The Fed
The Fed has two main objectives:
Keep the economy at full employment
Keep inflation within its target range of 2% - 3%
As you can see in the chart below, the CPI (Consumer Price Index) which is the Fed’s main measuring stick for inflation has risen well above the Fed’s 3% comfort zone and continues to rise.
In November, it was reported that the year over year change in CPI (inflation) was 6.9%. That’s a big number. In response to these heightened levels of inflation, the Fed has increased its timeline for decreasing the amount of bonds that it is purchasing as well as escalating the timeline for their first interest rate hike. With these changes, the Fed is intentionally tapping the brakes, so the economy does not overheat and give rise to hyperinflation like we saw in the 1970’s. But it's important to understand that every time the Fed raises interest rates, it is working against economic growth because it makes lending more expensive. Less lending normally means less spending.
This change in the Fed stance is not necessarily an end all for the stock market rally. Investors have to remember the Fed is raising rates because the economy is strong which has caused prices to rise. Historically, as long as the Fed is able to raise rates at a measured pace, the economy and the market have time to digest those small increases, and the growth trend can continue. It is when the Fed has to raise rates in large increments in a relatively short period of time, it creates more of an abrupt end to an economic expansion. Think of it this way, if the interest rate on a 30-year mortgage go from 3.25% to 3.50% it’s not going to necessary derail the housing market. But if that 30-year mortgage rate goes from 3.25% to 5% in short period of time, that could cause a huge drop in housing prices because people will no longer be able to afford the mortgage payments to purchase a house at these elevate prices.
The Nifty Fifty
Looking at that inflation chart that I showed you earlier, it’s been 30 years since the Core CPI index has been over 3%. People that just started investing within the last 30 years have not seen the impact of inflation on stock, bonds, cash, and other asset classes. The last time the U.S. economy experienced higher inflation for a prolonged period of time was the 1970’s. There are a lot of important investment lessons that we learned in the 1970’s but one of them that bears mentioning is the lesson of the “Nifty Fifty”.
The Nifty Fifty was the name given to a group of stocks in the 1970’s that were the darlings of the stock market. Companies like McDonalds, Polaroid, Disney, IBM, Johnson & Johnson were names within the Nifty Fifty. This group of stocks are similar to the FANGs that we have today which include Facebook, Amazon, Netflix, and Google.
Why the comparison? Coming out of the 1960’s there was prolonged bull market rally, similar to the one we have today, these Nifty Fifty stocks were the growth engines of the market, and as such they traded at very high valuations (P/E ratios) compared to their peers in the stock market. Many of the Nifty Fifty stocks had P/E ratios above 50 times forward earnings. To put that in perspective, right now the S&P 500 Index has a P/E of about 21x forward earnings. When higher inflation shows up, it traditionally has a larger negative impact on stocks that are trading at higher multiples compared to stock that have lower P/E ratios. This is because higher interest rates erode the present value of those future earnings that are baked into the price of those stocks. When higher inflation showed up in the 1970’s, many of stocks in the Nifty Fifty dropped by over 60%. Investors need to remember, when the economy is good and inflation is low, the market tends to care less about valuations. When inflation increase and/or the economy slows down, all of a sudden valuations will begin to matter again to investors.
I’m making this point as a word of caution; the Nifty Fifty and the FANG have a lot of similarities. Even though, at this point, I do not expect a hyper inflationary environment like the 70’s, a rise in inflation may have a similar impact on stocks trading at a higher valuation. Netflix current trades a PE of 55, Amazon (P/E 66), Microsoft (P/E 38). The market looked at the Nifty Fifty similar to how I hear investors talk about the FANG stocks now, “how can they ever go down?” Also from a psychological standpoint, investors often find it difficult to sell holdings that have made them a lot of money, and these FANG stocks have increase in value a lot over the past 10 years. There is also the tax hit that investors incur in taxable accounts when unrealize gains turn into realized gains.
To be clear, this is not a recommendation for investors to go sell of their FANG stocks, it’s about understanding the trends that have played out in history, how those trends may compare to where we are now when assessing risk, opportunity, and the investment decisions that we may face in 2022.
2022 Outlook Summary
Brining all of these variables together, we expect the first half the year to bring with it strong economic growth which should be a favorable environment for risk assets. But…….we don’t anticipate that it will be a smooth ride in 2022 for equity investors. As the Fed implements its anticipated interest rate hikes, there could be a number of selloffs throughout the year that will test the patience of investors. If inflation does not get out of control, those selloffs could be an opportunity for investors to put cash to work, as the market shakes off the scary headline risks and the growth trend continues. We expect the labor shortage and supply chain issues to improve in 2022, which should help to ease some of the inflation fears as prices begin to stabilize in 2022 and potentially drop going into 2023.
The second half of the year will depend largely on the trend of inflation. If inflation runs hotter than expected, it could begin to have an impact on consumer spending as prices rise above what consumers are willing to pay, and it could force the Fed to increase the magnitude or frequency of rate hikes in 2022. Either of those two items could potentially erase or decrease the gains the U.S. stock market may have achieved in the first half of the year.
With higher levels of volatility almost a given for 2022, investor may have to resist the urge to sell out of their stock positions and retreat to bonds or cash knowing that an inflationary environment is an enemy of both high-quality bonds and cash. Overall, investors will have to pay closer attention the economic and inflation data throughout the year to determine if pivots should be made in their investment strategy, especially as we enter the second half of the year.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
