1Q22 Market Outlook

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com
January 1, 2022

Summary

In 2022, interest rates are most likely set to rise because of Federal Reserve policy to combat currently high inflation, but they will attempt not to raise them too much or too quickly, which would hurt continued progress towards achieving maximum employment. This high wire balancing act between inflation and jobs would make the Wallenda family of acrobats jealous.

History suggests that the unwinding of monetary stimulus will have periods of high anxiety as investors follow every slip and trip that Federal Reserve Chairman Jerome Powell makes on this difficult transition towards a tighter monetary policy.

Higher interest rates are usually negative for the asset prices due to the lower present value of future cash flows. Still, economic conditions look good to strong in 2022, and the market may take these higher interest rates in stride considering the prevailing economic fundamentals. But investors should temper their expectations given the incredible results over the past two years during these unprecedented times, the prospect of higher interest rates, and relatively high valuations going into 2022.

2021: Multiple Expansion

In 2021, the ultra-accommodative monetary policy, combined with an aggressive fiscal stimulus push, ushered in a period of price/earnings multiple expansion. Suddenly, the earnings outlook was bright again, and market participants were front running the expected earnings growth. On March 23, 2020, the forward 12-month P/E multiple was 13.4. It would reach 24.1 by September 2 before entering a lower range. According to Yardeni Research, it currently sits at 21.5, which is a 28% premium to its 10-yr average.

The S&P 500 isn’t as richly valued as it once was, yet it is closing out 2021 at a rich valuation before the Federal Reserve has raised the target range for the fed funds rate even once.

However, what also jumps out is that multiple expansion has been harder to come by in recent months. Presumably, there is an understanding that earnings growth will be slowing in coming quarters as comparisons get more difficult and that a monetary policy shift to a less dovish position will be part of the equation.

That doesn’t mean stocks can’t go up in price. Instead, it means they will be more challenged to increase as investors become more discerning about how willing they are to pay for every dollar of earnings in a changing interest rate environment.

Hence, the S&P 500 in 2022, absent a shock on the interest rates, COVID, or geopolitical fronts might have to settle for increasing in-line with earnings growth as the bull case.

That wouldn’t be a terrible outcome. According to FactSet, calendar 2022 earnings growth is forecasted to be 9.0%, and the St. Louis Federal Reserve Economic Data (FRED) indicates a 4% Real Growth Rate of Domestic Product, so the price return for the S&P 500 would be closer to its long-term average. Earnings estimates will be a moving target, and one can expect interest rate moves to contribute to the action.

Monetary Tightening

Monetary tightening usually is not good for the stock market. The Federal Reserve has communicated its expectations about tightening, but these are subject to change based on the incoming data. Investors need to consider the many other influences on stock prices, ranging from the Omicron variant of Covid-19, domestic spending, and global political and economic crises. China has not lived up to its promises provided in the Phase 1 component of our trade pact with them, and Putin’s military at the Ukrainian border provide two tough tests for the Biden Administration heading into 2022. However, with respect to the market outlook the primary concern is the unwinding of the monetary stimulus of the past two years which will undoubtedly create financial disruption along the way and send nervous investors running for the exits at the first signs of trouble.

Inflation: A Hidden Tax on the Economy

Inflation has been surging not only because of the Fed’s easy money policy and unprecedented fiscal stimulus coming from Congress, but also from massive increases in consumer demand that stretched, and in some cases, broke global supply chains. In addition, a tight labor market punctuated by the Great Resignation has also continued to add to inflationary pressures. Inflation will diminish in 2022 as supply lines regain traction, but higher wage rates that get people back to work will work against this trend towards lower inflation.

Higher inflation forces companies to pay higher taxes as they earn a markup on the difference between buying and selling inflated goods assuming they maintain stable profit margins. Additionally, companies are forced to allocate more working capital to inventories during inflationary periods. Finally, consumers and businesses will devote more resources to watching prices when buying and selling. As a result, inflation acts like a tax levied across the entire economy, and it adds up fast.

Interest Rates

Higher interest rates negatively impact both stock and bond market prices, and real estate values. By themselves, higher interest rates are negative for stock prices for two reasons. First, higher interest rates mean lower present values of future cash flows. In addition to lower present values, higher interest rates will slow down economic growth, possibly even to the point of triggering a recession. This is because they first diminish interest-sensitive spending, such as new home construction, automobile purchases, and business capital spending. People will then earn lower incomes in these sectors, reducing consumer spending. Accordingly, not only will incomes be lower, but the remaining earnings will be discounted further due to the higher interest rates.

But sometimes, the stock market rises when interest rates rise. In general, interest rates rise when the economy is strong. When the economy grows fast, both businesses and consumers borrow more and save less, pushing interest rates up. As a result, we cannot say that higher interest rates are alarming because they are sometimes the result of a strong economy. Similarly, lower interest rates occur when the economy is weak due to less borrowing and higher saving.

However, there is more to stock market prices than interest rates. Investor attitudes play a crucial role in the short run, but they are hard to predict. Sticking with fundamental factors, the pace of the Covid-19 pandemic will impact stock prices as it will be a significant factor in the overall economy. We have already seen increased travel restrictions, and state and local governments will be walking their own tight rope between protecting citizens while not hurting their local economies.

The negative effect of Fed tightening on stock prices may not push the stock market down if the economy grows. The significant rapid gains of recent years could only cool off into smaller gains. Bond yields are still historically low, so few will shift from stocks to fixed income for current yield. However, bonds have much less downside risk, and that’s the argument for holding some even when prevailing bond yields do not provide a positive real yield.

Portfolio Strategy

In 2022, there will be an increased appreciation for profits, positive free cash flow, dividends, and the ability to pass along higher prices to end consumers which often get overlooked in an environment when there is no fear of a rate hike from the Federal Reserve, let alone multiple rate hikes.

The bull market party doesn’t have to end just because the Federal Reserve is signaling that its policy will be less dovish. To be sure, the policy isn’t going to be hawkish.

Even when the Federal Reserve announced that it will be quickening the pace of its tapering, the Federal Reserve will still be buying billions of dollars of Treasury and agency mortgage-backed securities for several more months. Furthermore, moving the target range from 0.00-0.25% to 0.50-0.75% which is currently forecasted for 2022, isn’t exactly a death knell for the stock market.

The party, then, can continue, but the music will be turned down a notch or two, and the punch bowl will be a little less intoxicating.

Perception matters, too. On March 23, 2020, the perception was that the Federal Reserve was all in, and the stock market has been running with the bulls ever since. The perception now is that the Federal Reserve will not be the gift horse in 2022 that it was in 2020 and 2021.

Instead, it looks poised to take back some more of its gifts, which means the froth in the stock market won’t be the same — or shouldn’t be the same.

Price returns at the index level should moderate, the speculative energy should lose some spark, volatility should be higher, and the back-and-forth rotation between growth and value should persist.

Importantly, though, with the shift to a less dovish policy, party rules dictate that the penchant for buying unprofitable growth at any price should give way to buying profitable growth at a reasonable price. These conditions support our stocks that focus on having high levels of sustainable free cash flow returns relative to the underlying cost of capital of running these businesses.

In 2022, we believe that the FAANNG+M-type stocks (Facebook (now Meta Platforms), Amazon, Apple, Netflix, Nvidia, Google & Microsoft) will outperform. Healthcare should fare well, and stocks positioned to benefit from infrastructure spending should outperform. Additionally, we are steering clear of stocks with high levels of future earnings vs. current earnings (known collectively as “high duration” stocks) that were the darling IPOs over the past two years but are still ramping up their businesses with low current profitability. These types of low current earnings stocks are concentrated in hot sectors such as EVs, cloud computing, and clean energy.

Catching Up

We look forward to catching up with each of you, and we will be reaching out to schedule a time to meet in person or by a Zoom/MS Teams video link. If you would like to get something on the calendar in the interim, please send me a note with some dates and times.

Warm regards,

John