The Market Outlook is our annual tradition of reflecting on the year just ended and sharing our expectations for economic growth and the performance of financial markets for the year ahead. Even under normal circumstances, it is very difficult to have an informed point of view that extends more than one year out and virtually impossible to accurately project three years out. Having said that, we believe it’s useful to have “a” view of the road ahead. Why? Because it provides us with an intellectual framework within which we can make probability-based investment decisions.
No one manages money in a vacuum…or at least they shouldn’t. We are firm believers in the old saying that “past is prologue”. The seeds of the future are planted in the past. We have learned that the first step in attempting to discern what may lie ahead should always be to closely examine the events of the recent past and assess the current financial landscape. So let’s start. Here is a snapshot of economic and market performance in recent years:
Instead of viewing this information only through the lens of calendar years, however, rearranging it in a different way can help us see specific trends more clearly:
Here is what we take from the above information:
- We had some nice “normal” market years (2017-2019), wherein the capital markets heavily rewarded equity investors over bond investors/savers.
- The world turned upside down in 2020 with the COVID pandemic. The health crisis and subsequent lockdowns caused a recession and severe bear market correction, which resulted in historic job losses and extended unemployment.
- However, massive fiscal and monetary accommodation policies stopped the hemorrhaging in its tracks, and we began to recover, both economically and in the stock markets. This rapid and large policy response is what we like to call “The Cure.”
- One year later, we seem to have moved to a healing stage. The economy has recovered (gross domestic product, or GDP, is above its pre-pandemic high-water mark), and unemployment has come down substantially. Similarly, earnings growth for companies in the S&P 500 is strong and has supported positive returns to investors.
- However, with supply chains still disjointed from the pandemic amid rapidly returning demand, inflation bounced strongly during the year, and has been more persistent than originally expected by policy makers. This has put a floor beneath interest rates, which have begun to steadily increase across the bond maturity spectrum.
- At this point, investors are beginning to ask the question, “Will The Cure be worse than the disease?” Put another way, what will the final price be for such unprecedented policy responses, including “helicopter money” policies financed through massive deficit spending by the U.S. Treasury, alongside a bloating of reserve balances vis-à-vis the U.S. Federal Reserve and its open market operations? These massive policy responses helped us negotiate 2020 and arguably avoid a complete financial crisis, but what will the final bill be and who will pay for it?
Let’s now quickly examine two distinct topics that set the stage for how we are currently looking at the capital markets: (1) the evolution of the pandemic, and (2) the cost for The Cure.
Evolution of the Pandemic
The COVID-19 pandemic was declared on March 11, 2020 by the World Health Organization, or WHO. As stated above, much of the world’s initial response to this was in the form of shutdowns (stay at home orders), resulting in a rapid decrease in economic activity. Dr. Scott Gottlieb, a former commissioner of the Food and Drug Administration (FDA), recently stated that “We’re transitioning from this being a pandemic to being more of an endemic virus, at least here in the United States and probably other Western markets.” An endemic virus is one that remains in the population at a relatively low frequency. Dr. Gottlieb believes we will get to this place due to increasing vaccination rates, improved therapies and treatments and higher levels of natural immunity. As we now know, COVID did not end with the recent Delta variant wave, which has now been overtaken by the even more transmissible Omicron variant. There will be more variants in the future and, most likely, the end path will include an annual COVID vaccine shot, similar to that for the seasonal flu. In fact, this is already happening in some places. Shutdowns cost a lot, and that price may in the end be too high. As such, we are coming to accept that this virus may very well be a part of our lives for the rest of our lives. But this evolution from pandemic to endemic could also allow us to return to something closer to normal, and if it comes to pass, should reduce the probability of material future shutdowns. This should support continued economic growth, or, at a minimum, protect us from a harmful drop-off in economic activity, or an encore of 2020, which we can ill afford to repeat.
The Cost for The Cure
First, let’s examine the cost of the fiscal policies enacted to help offset the suspension of economic activity during the pandemic with a review of the major relief acts passed to deal with the COVID crisis:
- $2.3 Trillion – Coronavirus Aid, Relief, and Economic Security Act (CARES) (passed on 3/27/2020)
- $484 billion – Stimulus and Relief Package 3.5 (passed on 4/24/2020)
- $900 Billion – Stimulus and Relief Package 4 (passed on 12/27/2020)
- $1.9 Trillion – American Rescue Plan Act (passed on 3/11/2021)
For those counting, that was over $5 trillion in fiscal stimulus backed by issuance of U.S. Treasury bills, notes, and bonds. This is called deficit spending, or spending money that the U.S. government did not have, but financed with debt issuance. For context, at the end of 2019, there was about $22 trillion in federal debt; federal debt has now increased to $29 trillion.
Clearly, this is not trending in a positive direction. J.P. Morgan Asset Management forecasts that U.S. debt will be over 125 percent of our nation’s economic output by 2030. Studies have shown that when a country’s debt exceeds 120 percent of its gross domestic product (GDP), economic growth will most likely slow and perhaps even stall as principal and interest payments on the debt soak up an increasingly high percentage of the budget. For a real-life example, consider Japan, with national debt at 225% of economic output. Their economy has been in the doldrums for over two decades.
Next, we should look at the monetary accommodation policies of the Fed and their potential cost. For the Treasury to create so much debt, someone had to buy it. And here’s a hint: it was not investors. The Fed bought most of this newly issued U.S. government debt, expanding the asset side of its balance sheet to over $8 trillion (and again for context, it was “only” $4.4 trillion after the Great Financial Crisis of 2008-2009). That begs the question, where did they get the money to buy these Treasury securities? At the risk of oversimplifying, basically the Fed waived its magic wand and created that purchasing power out of thin air (i.e., printing dollars). They have one rule that they must follow – their assets and liabilities must net out to zero. So, for the Fed to create trillions in new dollars (a liability to the U.S. financial system), it must purchase an asset (namely, Treasury securities and other bonds) dollar for dollar. This is called expanding the money supply, which injects money directly into the bloodstream of the U.S. economy to facilitate growth. To counter the negative economic impact of the pandemic, in other words, they expanded the asset side of their balance sheet by buying bonds (which they paid for by “printing” money), flooding the U.S. economy with over 4 trillion new dollars.
But what about the cost? Last year we wrote:
“Inflation as of late (meaning the last decade) seems to be dead as an economic concept. The Fed has flooded our economic system with great levels of liquidity and yet inflation has remained well below their two percent target. With global economic activity down markedly due to the pandemic, it is hard to see a case where inflation returns meaningfully any time soon.”
Well, we may have spoken too soon! Milton Friedman, a famous American economist, once wrote that “Inflation is always and everywhere a monetary phenomenon.” What he meant was that increasing an economy’s money supply will lead to inflation, but not additional economic growth.
Indeed, disinflationary forces have been hard at work in keeping the inflation rate low in recent decades – demographics, globalization, technology efficiencies, etc. However, it looks like these previously dominant disinflationary forces are being overwhelmed by the material increase in our money supply – that is starting to look like the cost of The Cure.
Time will tell what the final cost is. But, at the very least, we do now believe that the cost of such extraordinary fiscal and monetary largesse to counter the economic effects of COVID will likely be slower future economic growth, higher taxes, and higher inflation.
Comments on Our 2021 Estimates
Writing this section every year reminds us that it is very hard to estimate future movements in the market. In fact, you could say that this exercise is extremely humbling. We do not mind it. Approaching the markets with respect and a spirit of humility has always been prudent, and therefore is ingrained in the timeless principles that govern the way in which we invest the assets entrusted to us by our clients. In our experience, those that deem themselves smarter than the markets eventually receive their comeuppance!
Having said that, our interest rate forecast was actually right on the money. The Fed Funds rate ended the year at 0.08%, which was within our predicted range of 0.00-0.25%. In addition, the 10-Year Treasury Note ended the year at 1.51%, right in the middle of our predicted range of 1.25-1.75%.
Beyond that, we weren’t quite as accurate in our estimates for the remaining economic measures. However, we were directionally correct, and sometimes that is the most important thing to get right:
- We correctly predicted that global and U.S. GDP growth (growth in economic output) would reverse course from 2020 and turn positive in 2021. But economic growth was actually much stronger than we predicted, both in the U.S. and globally.
- We correctly surmised that inflation would accelerate over the very low level of 2020 (1.2%), but we did not expect it would run as hot as it did, peaking at 7.0% on a year-over-year basis.
- We expected the unemployment rate would come down from 6.7% to 5-6%, but underestimated the magnitude of the improvement, as we ended the year at 3.9%!
- And lastly, we expected the earnings growth rate for companies in the S&P 500 to materially rebound from 2020, predicting a historically strong outlier of 20-25% earnings growth for 2021. But, again, we underestimated the magnitude of the recovery and the spectacular 50% surge in earnings growth that resulted from it.
So, in summary, our interest rate forecast was spot on, while we were directionally correct on all of the other economic measures reviewed. The recovery has been stronger than we believed it could be, with higher economic activity, higher employment, and stronger U.S. corporate earnings growth. The resilience of our economy and the resourcefulness and resolve of American companies continues to amaze us.
Looking Ahead to 2022
Our base case for 2022 centers on the prospect for the evolution of the pandemic to an endemic and continued improvement of the economic situation from 2020’s self-inflicted recession. Following are the same series of forecasts we just reviewed, but for 2022, along with a detailed analysis of each.
To understand our expectation for next year’s growth, context is important. After the substantial and largely underappreciated vaccination efforts in the U.S., the economy experienced a growth boom as the COVID pandemic seemed to be fading into the rearview mirror. Every sector of the economy, including those left behind in 2020 (namely, the services-related industries), experienced a rapid return in demand from consumers starving for a return to normalcy and supported by the unprecedented flood of liquidity described above that lined the pockets of even the unemployed. Indeed, through the first two quarters of 2021, GDP roared at an average 6.5% rate, which looked likely to persist through at least year end and into early 2022.
But then, another mutation of this deadly and economically disruptive virus reared its ugly head in the form of the Delta variant. Within months, what had been projected as third straight quarterly 6%+ surge in GDP fizzled into a 2.3% slowdown in the third calendar quarter, the slowest of the nascent post-pandemic recovery. Progress toward full vaccination helped to avoid another national mandate to shutter the economy; however, localized shutdowns still emerged, job gains slowed, and the business landscape again became disjointed. As a result, various gauges of economic activity went from outpacing even the high expectations of professional forecasters to underperforming them by the almost same magnitude. The Citigroup graph below demonstrates this reversal by measuring the degree to which economic data is either over or underperforming expectations (greater than 0 implies beating on average and vice-versa):
But as all waves inevitably do, the Delta wave eventually passed and the economy staged another comeback late in 2021. As 2022 approached, the country seemed to be attempting to get back to life as we all knew it prior to 2020. Yet once again, an even larger wave, in the form of the Omicron variant, is currently sweeping across the globe and threatening to stall progress. But even in the face of surging case counts, mandates and closures have been limited thus far, as we acknowledge the need to move forward even if still haunted by the past. The economy and the capital markets have muddled through multiple variants of COVID since early 2020, and we expect that they will do the same going forward.
While the first official estimate for U.S. growth in the fourth quarter of 2021 is yet to be released, the Federal Reserve Bank of Atlanta was projecting a reading of almost 8% to wrap up the year, while the average economist, according to Bloomberg, is forecasting a solid year of growth ahead – even amid rampant new Omicron variant headlines.
Without the benefit of the massive policy support that propelled activity in late 2020 and 2021, our expectation is that we are on a path back toward a pre-pandemic world of slower, albeit positive, growth. In fact, beyond this year, the same consensus economist data from Bloomberg projects U.S. growth in 2023 of 2.5%, almost in line with the historical trend between the Great Financial Crisis and the onset of the pandemic.
Inflation and Interest Rates
One of the most heavily debated topics, particularly in the latter half of 2021, is just how “transitory” some of the recent nosebleed readings of inflation really are. Before the pandemic, annual inflation readings were seemingly stuck near the 2% level. However, after a sharp drop in prices in the middle of 2020, most measures of inflation spiked in 2021, and have remained at elevated readings not witnessed since the early 1980s .
Some of this is explainable by the pandemic itself. Ongoing shutdowns, both in the U.S. and abroad, have resulted in dislocated supply chains related to not only production, but also to transportation and employment. At the same time, the service sector has been slower to return, leading cash-flush consumers (compliments of policymakers’ accommodative policies) with easy access to ecommerce to splurge in spending on goods. Textbook economic theory would indicate higher prices: the supply curve shifts to the left, while the demand curve shifts to the right, and equilibrium pricing therefore rises (from E to E¹ in the image below):
But of course, that only explains what has already happened. Looking forward, while demand has surged, emergency stimulus is expiring. This alone is unlikely to completely reverse the spending habits (and thus, broad demand) that have developed over the last year, but will certainly lessen the likelihood of a similar rate of acceleration in consumption over the next year. As the economy reopens, employment will continue to improve, production will accelerate, panic buying and stockpiling will diminish, and supply will eventually normalize – supply shocks are cyclical, and the economy will adapt. Using the above hypothetical supply/demand graph as an example, the supply curve should then reverse and shift back to the right. Even if demand just stays stable, economic theory similarly suggests that prices should then normalize as well.
While supply chain issues remain and are likely to persist in the near-to-immediate term, there is some early evidence suggesting that we have seen a peak in many of the constraints. Auto factories are back online and noting improved chip supply, shipping ports are restocking with labor supply, and aggregate measures of employment are trending in the right direction.
This remains the Federal Reserve’s base case and is likely a reason that the bond market has maintained its composure. In fact, following the Federal Open Market Committee’s November statement, wherein the monetary cohort did acknowledge “imbalances related to the pandemic and the reopening of the economy,” they went on to predict continued gains in economic activity, employment, and a reduction in inflation, which is in line with our overall opinion. We do not expect that inflation will quickly settle back to its pre- pandemic trend anytime soon, as some structural imbalances, such as upward pressure on wages, are likely to persist. The Fed acknowledged this as well in the same meeting, wherein they began to taper monthly open market bond purchases (a.k.a. quantitative easing), and are on pace to stop them altogether near the end of Q1 2022.
Overall, we expect a shift higher in rates across the yield curve, with some modest steepening as the markets digest higher (but not runaway) inflation alongside slowing, yet still stable, global growth. Then, once open market bond purchases are complete, we anticipate that the Fed will raise rates at least twice in 2022, with a third, or even fourth, becoming increasingly likely. This is not necessarily an ominous signal, but rather one of economic health and progress, where savers are again rewarded.
After having plunged to a five-decade low of 3.5 percent just two short years ago, the unemployment rate spiked to a historic post-World War II high of almost 15 percent in mid-2020. This easily surpassed the 9.9 percent peak following the Great Financial Crisis of 2008-2009, as businesses slashed payrolls to survive the mandated shutdowns.
But as we emerged from the pandemic, we witnessed a likewise historic pace of rehiring as businesses rapidly reopened. Year to date, the U.S. economy has added over six million non-farm jobs, easily the most expansive effort on record. However, in the latter part of the year, the pace of hiring, though still healthy, slowed. This is material because, based on pre-pandemic trends, we are still about 8 million jobs short of where we would have been had the pandemic not occurred.
Job openings are clearly not the problem. In fact, the Bureau of Labor Statistics estimates that there is a record 11 million+ job openings versus a total unemployed population closer to 6 million. In other words, for every person unemployed, there are almost two open jobs on average! At the same time, they also note that people are voluntarily leaving jobs at the fastest pace on record, while the National Federation of Independent Businesses reported that small businesses are increasingly pessimistic because of their inability to find qualified workers.
So where is all the labor? There seem to be several factors at play, largely related to the lingering effects of the pandemic. One significant factor has been the disincentives associated with expanded jobless benefits, though that has begun to decline in impact as such benefits have expired and otherwise able-bodied workers draw down their savings accounts which had ballooned during the pandemic due to massive relief offerings. Beyond that, however, given the shutdown-and-reopen dynamic related to waves of COVID, some workers may simply be less willing to take “non-essential” jobs that could be unpredictably upended, while vaccine mandates have also been responsible for a loss of labor in regions with more strict guidelines. All of this should smooth out over time, and lead to at least some return of the labor supply over the next few quarters.
What is likely more structural, however, is related to financial markets themselves. Soaring stock prices have enabled workers that were previously nearing, but only thinking about, retirement, to officially retire earlier than previously expected. In fact, the St. Louis Federal Reserve District concluded in a recent study that, “as of August 2021, there were slightly over 2.4 million “excess” retirements due to COVID.”
Whatever the true reason ultimately proves to be, the data is clear: the labor force shrunk dramatically during the pandemic before bouncing back, but that bounce has leveled off significantly lower than where it trended beforehand. This is perhaps best measured through the labor force participation rate, which gauges the percentage of the working age population (deemed 15-64 years old) that are considered in the labor force:
By this measure, the labor force is about 1.7% smaller than it was just two years ago. That may not sound like a lot, but based on a working age population of roughly 260 million, this means the U.S. economy has between 4-5 million fewer available workers, which is largely responsible for the inflationary impact in wages taking place.
We are often stunned by the common assertion from pundits that stock prices are disconnected from the economy. Despite inflationary pressures, a disjointed labor market, and whipsawing economic data in general, the S&P 500 hit 70 new historic highs in 2021, closing the year less than 1% from its most recent high . We find this completely rational.
Corporate profitability has been surprisingly resilient in the face of all of this uncertainty. In fact, aggregate forward earnings of S&P 500 companies soared from about $139 per share at the end of 2020 to $209 per share today – a whopping 50% increase in 2021 alone, or almost 20% above the pre-pandemic peak of about $175 per share. As such, despite the same index having returned almost 30% (including dividends) in 2021, the forward price to earnings (P/E) multiple declined from roughly 27 at the end of 2020 to only about 23 today. In other words, the market became cheaper throughout 2021, despite massive capital appreciation!
Even at the current ~23 forward P/E level, the S&P 500’s valuation is somewhat steep on a longer-term historical basis, but even this must be viewed in the context of the current interest rate environment, which remains extremely accommodative and favorable to stock valuations. Another way to view this is through the S&P 500’s earnings yield, or its aggregate earnings per share divided by its price. On this basis, the S&P 500 currently yields about 3.8% in earnings for shareholders. Compare that to the 1.5% yield offered in the Treasury market (based on the 10-Year Treasury note), and the case for stocks remains strong on a relative basis.
Currently, earnings are expected to rise another almost 10% in 2022, compared to a long-term average of closer to 6%. Does this imply that we predict another straight line up in 2022? The earnings perspective would seem to support the case for another year of strong returns, but forecasting stock returns over any single period is always an imperfect science and returns are not linear. As the Fed begins to raise rates, policymakers withdraw support and the ongoing bull market ages, higher volatility is a normal characteristic of a functional stock market, wherein risk taking is rewarded through higher long-term returns. There will be noise, and likely more of it, but we believe the that current data supports a positive environment for stock investors.
What does this mean to you?
First Command continuously assesses economic and market conditions, and currently they look positive for 2022. Stock market corrections are inevitable and an accepted risk for the prospect of higher returns. In fact, the average calendar year features at least one 10%+ correction for the S&P 500, and even a steeper bear market (20%+) typically occurs roughly every 3 years– often without a technical economic recession. The last 10% plus market correction we had occurred within the last bear market we had during the pandemic related selloff from February 19 through March 23, 2020. Attempting to predict when these corrections will occur is an impractical approach, in our opinion, and much more frequently is the result of luck rather than skill. Keep in mind that timing the market really requires you to make the right call twice: getting out at the right time, and then getting back in before prices rebound. It is often the failure to correctly make that second call that leads to permanent wealth destruction.
For that reason, we at First Command value time in the market versus attempting to time the market, accept volatility as an inherent short-term risk for stock investors, and use it to our advantage to improve market returns. Our Advisors are trained to utilize the wide range of investment options we offer, to ensure that our clients’ investments are aligned with their financial plan and, just as importantly, to keep them on plan through inevitable periods of volatility. Experience has taught us that volatility can actually improve financial outcomes, particularly when addressed via a well-designed, globally diversified portfolio that is aligned with your financial plan, investment time horizon, and risk tolerance. If you haven’t met with your Financial Advisor recently to review your plan and assess your portfolio, we encourage you to do so at your earliest convenience.
Thank you for the confidence you have placed in First Command.
The information in this report was prepared by John Weitzer, Chief Investment Officer and Matt Wiley, Director Investment Management of First Command. Opinions represent First Command’s opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual advisor. All statistics quoted are as of December 31, 2021, unless otherwise noted. First Command does not undertake to advise you of any change in its opinions or the information contained in this report. This report is not intended to be a client specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Should you require investment advice, please consult with your financial advisor. Risk is inherent in the market. Past performance does not guarantee future results. Your investment may be worth more or less than its original cost. Your investment returns will be affected by investment expenses, fees, taxes and other costs.
©2022 First Command Financial Services, Inc. is the parent company of First Command Brokerage Services, Inc. (Member SIPC, FINRA), First Command Advisory Services, Inc., First Command Insurance Services, Inc. and First Command Bank. Securities products and brokerage services are provided by First Command Brokerage Services, Inc., a broker-dealer. Financial planning and investment advisory services are provided by First Command Advisory Services, Inc., an investment adviser. Insurance products and services are provided by First Command Insurance Services, Inc. Banking products and services are provided by First Command Bank (Member FDIC). Securities are not FDIC insured, have no bank guarantee and may lose value. A financial plan, by itself, cannot assure that retirement or other financial goals will be met.
- “What’s past is prologue” is a quotation by William Shakespeare from his play The Tempest. The phrase was originally used in The Tempest, Act 2, Scene I. The phrase means that history sets the context for the present. Source: What’s past is prologue. Wikipedia.
- Helicopter Money. Bloomberg.
- WHO Declares COVID-19 a Pandemic. National Institutes of Health.
- Dr. Scott Gottlieb expects Covid to be ‘endemic’ in U.S. after delta surge. CNBC.
- U.S. Government COVID-19 Stimulus and Relief. Investopedia.com.
- Source: Milton Friedman. Investopedia.
- Source: Bureau of Economic Analysis.
- Source: Bureau of Economic Analysis.
- Source: Federal Reserve Bank of Atlanta.
- Source: Bloomberg.
- Source: Bloomberg.
- Why Ford’s stock is surging while shares of GM are flat after Q3 earnings beats. CNBC.
- The Port of Los Angeles will double its hours of operation to ease supply-chain bottlenecks. Quartz.
- Federal Reserve issues FOMC statement. Federal Reserve.
- Source: Bloomberg.
- Source: Bloomberg.
- Source: Bloomberg.
- Small Businesses Struggle to Increase Workforce. National Federation of Independent Business.
- Rissmiller, Don. “Update on Missing Labor Supply” (Video). Strategas Securities, LLC. November 2, 2021.
- The COVID Retirement Boom. Federal Reserve Bank of St. Louis.
- Source: Bureau of Labor Statistics.
- S&P 500 recorded 70 closing highs in 2021. Yahoo Finance.
- Source: Bloomberg.
- Source: Bloomberg.
- Source: Bloomberg.
- Source: Ned Davis Research Group.
- Source: Ned Davis Research Group.