The U.S. economy was really cooking in 2021; bubbling with tasty ingredients like consumers eager to spend and a huge inventory spend in the last quarter, the economy grew at its fastest pace since 1984.
But in 2022, the outlook predicts a blander cooling-down period.
The challenges faced in 2021—tangled supply chains, tight labor markets, the COVID-19 pandemic’s late-year spread of the omicron variant, and inflation—have carried over into the new year. The persistence of these factors has prompted increasing anxiety at the Federal Reserve. The Fed has sent clear signals on beginning policy tightening and planning for rate hikes.
Still, while decelerating from last year’s pace, U.S. economic growth is expected to remain reasonably strong in 2022, especially if the omicron variant is an indication of the pandemic moving into a more manageable endemic mode. Consensus estimates for GDP growth in 2022 range between 3.5-4.0%.
Back to the Future
In the fourth quarter of 2021, the U.S. economy grew rapidly, advancing to a 6.9% rate from 2.3% in the third quarter. Output grew 5.7% overall, reversing the 3.4% decline seen in 2020. The economy hadn’t grown that fast since the days of leg warmers and mullets when the U.S. rebounded from a double-dip recession and an era of high inflation during the Reagan administration’s first term.
The fourth-quarter gain reflected solid household spending, much of it occurring early in the quarter, and companies pushing to rebuild depleted inventories as they tried to overcome persistent supply shortages.
Most economists think U.S. output will continue this growth in 2022. Americans still have slightly higher savings compared to pre-pandemic times. Household balance sheets look to be healthy. Excluding the inventory effects, output grew at a modest annual rate of 1.9% in the fourth quarter, indicating that continued to growth will be at a much slower pace.
The I-Word
Inflation is the economic issue of the year. The Fed must walk a tightrope between curbing inflation and throttling economic growth—it will not be easy. Stocks historically have provided a reasonable hedge to moderate inflation. All eyes will be on Fed’s behavior and actions as we move through 2022.
Three to five rate hikes, which most likely will start as early as March, are currently priced into the market. If growth remains strong and inflation high, then the Fed will likely begin to allow bonds to mature off its balance sheet in the second half of the year. The Fed is expected to cap the dollar value of the bonds it allows to roll off the balance sheet due to the large amount of bonds maturing in the next few years.
Although the labor market is enjoying a robust recovery, economists say the central bank may not raise interest rates fast enough to keep up with rapidly rising prices. Inflation, largely quiescent since the 2007-09 recession, has picked up sharply since last spring as rising demand collided with pandemic-related bottlenecks. The largest risk is that the Fed could panic and overshoot by raising rates more quickly than the current level of inflation warrants.
Labor Worries and Supply Issues
The current pandemic-related shortage of workers is expected to keep wages rising at an intense clip over the next few months, as employers offer higher pay packets to retain and hire staff. Average hourly earnings jumped 0.7% in January and are now running at a 5.7% pace over the past 12 months. Economists expect average hourly earnings to be up 4.9% from 2021 levels by June 2022.
By the end of 2022, however, wage inflation is expected to dip to a 4.5% year-over-year increase in average hourly earnings. Still, economists expect workers to reap annual wage increases of roughly 4% through 2024.
Higher inflation, low unemployment, and strong wage growth is expected to keep the Fed on track to start lifting interest rates from zero at its policy meeting in mid-March. Nearly two-thirds expect the Fed to raise rates at its mid-March policy meeting and to keep raising them over the course of the year. Forecasters are predicting anywhere from 3 to 7 rate increases this year.
On top of rising prices, consumers—whose spending accounts for 69% of GDP—face continued uncertainty about the pandemic and the end of government support, such as the monthly child tax credit that provided a financial cushion for millions of households.
Concerns about limited supply remain a cloud over the outlook, forecasters say. Bottlenecks are expected to continue in part due to China’s zero-tolerance strategy for combating the pandemic, which has led to disruptions at ports and factories.
More than half of economists expect supply-chain disruptions to persist until at least the second half of 2022, with a third expecting them to continue into 2023 and later. Freight rates remain extremely elevated and port backlogs are significant. U.S. inventory rebuilding will add to the strain, which means demand could continue outstripping available supply for a considerable time to come.
What Will the Market Do?
The good news is that markets have been adjusting for months to this new reality, with 40% of the tech-focused Nasdaq having corrected by 50% or more.
The breadth of the market remains poor; it goes through a classic under-the-surface rolling correction while the index grinds higher. This phenomenon is largely due to the relentless inflows from retail investors into equities. This rotation from bonds to stocks by asset owners makes perfect sense in a world of rising prices. After all, stocks are a decent hedge against inflation, unlike bonds.
Worries over rising interest rates have pulverized the stock market this year—particularly tech stocks, which become less attractive when bond yields go higher (as they have been).
The S&P is down 9.31% year to date, putting it on track for its worst start to a year ever. The Nasdaq has slid into correction territory, down nearly 15% year to date.
But rising interest rates don’t always spell doom for the stock market, quite the opposite, in fact. The S&P 500 has delivered positive returns in 11 of the 12 Fed rate hike cycles since the 1950s. Why? Because the Fed tends to raise interest rates when the economy is growing, and a growing economy tends to be good news for corporate earnings. This is especially true when the rate raise is at a slow pace.
Conclusion: Don’t Panic
With many critical market factors still in flux, the short-term market direction can remain volatile. But for longer-term investors, Bowen Asset Management doesn’t think it is bad if market volatility takes some of the air out of the more speculative corners of the market.
We expect modest positive equity returns this year, but investors should prepare for bouts of volatility and focus on stable high-quality companies with strong fundamentals.
While we’re cautiously optimistic about equities, we recognize there will be winners and losers. Companies with stronger financials and lower multiples are better positioned to weather the volatility around higher rates. These value-oriented higher quality stocks performed well in 2021 as inflation expectations spiked. We expect that outperformance to continue into 2022.
Bottom line: Don’t fight the Fed and be patient with new capital deployments until later this spring.
The market churn that was under the market’s surface last year has made its way out into the open, but neither panic nor greed are useful as investing strategies. In times like these, discipline is essential. The benefits of diversification across and within asset classes are very important, as is a focus on quality. As always, seek help from a financial adviser.
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