2022 promises to be another eventful year
KC Mathews //January 24, 2022//
2022 promises to be another eventful year
KC Mathews //January 24, 2022//
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.
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:
Every year there is a laundry list of risks that we must navigate. This year is no different, the list includes:
We expect some inflation to be transitory and some to be more persistent.
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.