Published on January 11, 2022 in the Rochester Business Journal

The economy fired on almost all cylinders in 2021 and the S&P 500 Index is up approximately 26% through late December, versus 16% for all of 2020. While growth is expected to continue, it will likely slow, equity valuations are full, and anticipated headwinds should result in positive, but more moderate investment returns in 2022.

With respect to the economy, as measured by Gross Domestic Product (GDP), the U.S. experienced quarterly growth of 4.5%, 6.3%, 6.7%, and 2.1% from Q420 through Q321, respectively – an average growth rate of 4.9%. For the next four quarters, Northern Trust’s economists expect growth to moderate to 4.7%, 4.6%, 4.0%, and 2.9%, respectively, for an average growth rate of 4.05%. The three main drivers of the economy are the consumer, industry, and government, all of which should be positive contributors in the year ahead.

The consumer drives 69% of the economy and has been recovering well since the onset of the COVID pandemic in early 2020. In fact, nationally, the sum of state residents’ personal income from all sources in Q221 was up at an annualized, inflation-adjusted rate of 4.1% from the last full quarter preceding the pandemic. Admittedly, some of this advance came from non-recurring government stimulus checks but, importantly, a good portion of the consumer’s new-found wealth was applied to reducing debt and improving household balance sheets. As a result, household debt service ratios (i.e. required debt payments to disposable income) are close to a 40-year low. This circumstance, along with robust consumer spending and a strong housing market bode well for sustained growth in the weeks and months ahead.

Industry also appears to be healthy. Despite higher wages and labor/material shortages, businesses have passed higher costs on to the consumer in the form of price increases (read inflation). As a result, corporate profits have been booming, rising almost 13% in Q321 and breaking the previous record of 10.7% set in Q221. Prior to that, the record was 10.6% and was set in Q112, according to data obtained from Bloomberg. Let’s also not forget that cash and short-term investments on corporate balance sheets are at an all-time high of $6.84 trillion (globally), according to data obtained from S&P Global and as extrapolated from Q221 earnings reports. So long as consumers continue to spend, and input costs moderate as supply chain bottlenecks continue to clear, corporate profits should remain healthy.

The U.S. Government is also pulling its weight to maintain the current economic expansion, spending $2.77 trillion more than it took in during its most recent fiscal year, versus an all-time-high budget deficit of $3.13 trillion in fiscal year 2020. While one might be concerned that the budget deficit is expected to fall to a projected $1.15 trillion in fiscal year 2022 – don’t worry; this amount excludes a $1 trillion infrastructure bill that was signed into law in mid-November, as well as $1.75 trillion of additional proposed spending, to bolster social programs and to combat climate change. Right, wrong, or indifferent, ongoing deficit spending is an additional tailwind to economic growth as we make our way into the new year.

Tempering what we know about how the three main drivers of the economy could favorably impact investment returns next year are current equity valuations themselves. Through 11/30/21 and according to Morgan Stanley Capital International (MSCI), U.S. stocks are broadly valued at 21.6 times next year’s earnings, versus an average forward price/earnings (P/E) multiple closer to 15.7 times – that’s 138% of normal. Across the rest of the world and excluding the U.S., stock prices are approximately 105% of normal, and in the emerging markets, equity valuations are approximately 109% of normal. What this tells us is that, while there are a lot of good things to come on the economic horizon, tomorrow’s good news is largely reflected in today’s stock prices. As earnings catch up with price next year, and with consideration given to some of the tailwinds mentioned above, we might also note some of the headwinds we’re likely to face.

The biggest headwind we see in the coming year is a pronounced shift in monetary policy. The Federal Reserve Bank (the Fed) intends to wind down and eliminate its bond-buying, aka quantitative easing, program by the end of Q122. In addition, it plans to raise short-term interest rates at least three times next year, sooner rather than later, to stave off persistently high inflation that has been evident in recent months. Actions like these are akin to applying the brakes to a potentially overheating economy and may be coupled with tax increases for added effect. Other potential headwinds, including new COVID variants, undesirable geopolitical events, terrorist activities, etc. also exist, but, for now, all are just wildcards and are out of our control. We can acknowledge the risks exist, but their eventual impact, if any, will only be known in hindsight.

In summary, we can look at today’s healthy, but slowing economy, we can affirm that financial markets are a great discounter of future earnings, and we can acknowledge that stock prices are already ahead of reality. We can also accept that headwinds exist, including the Fed’s intention to move us away from a zero-interest-rate environment, the potential for slowing consumer spending, corporate profit growth and/or tax increases. Interest rate hikes and the end of quantitative easing certainly won’t be good for existing bondholders, and each of the other headwinds mentioned above has the potential to derail the bull market we’ve been enjoying for most of the last thirteen years. However, if the Fed continues to telegraph its actions, is moderate with its approach, and doesn’t go too far, too fast with its stimulus withdrawal, 2022 is likely to be another Healthy, Happy, New Year for investors.

To see this column in the RBJ, click here.