Authored by Wade Guenther, William Cai, and William Herrmann
The U.S. economy experienced significant growth in 2021 on the shoulders of vaccine efficacy and return to normal for many. From concerts and sporting events to restaurants and travel, each of those industries, among others, saw profound benefits by rebounding from being shut down almost entirely in 2020.
As a result, U.S. Gross Domestic Product (GDP) increased by 16.76% (1) cumulatively, between Q3 2020 and Q2 2021, a figure that could have been reasonably expected after more than a 9% decline in GDP during Q2 2020 alone.
Fast-forward and our economic growth outlook in the first quarter of 2022 and the full year is darkening amid the latest wave of Covid-19 as consumers grapple with higher costs and businesses juggle labor and production disruptions. In addition, the Federal Reserve is under heavy pressure from businesses and consumers to tame inflation, which recently hit its fastest pace in nearly four decades. The next few months are likely to set the stage for FY22 as the economy faces a delicate balancing act this winter as the rapid spread of the Omicron variant threatens to dent consumer spending and exacerbate existing labor and supply-chain challenges.
The United States government, together with the Federal Reserve, recently scaled back their Covid-19 relief fiscal and monetary stimulus programs(2), respectively. However, U.S. lawmakers continued to support fiscal stimulus with a $1.2 trillion bi-partisan infrastructure bill(3) that we believe will provide modest economic growth in 2022.
This infrastructure bill, which passed late last year, we expect will deliver over $550 billion of investments in U.S. infrastructure over five years, affecting everything from bridges and roads to the nation’s broadband, water, and energy systems. We believe these monies are sorely needed to ensure safe travel, as well as the efficient transport of goods across the country.
Financing the infrastructure bill has been estimated to add over $250 billion to the deficit over the next 10 years. The ramifications of adding to the U.S. public debt, which is already the highest in history, may limit foreign investment growth opportunities in the future.
The State of Employment
Generally, the unemployment rate can be defined as people who are jobless, actively seeking work, and available to take a job.
The latest data from the Bureau of Labor Statistics (BLS) shows that the unemployment rate was 3.9% in December 2021 and has been trending in a positive direction since the pandemic-high unemployment rate of 14.80%(4) in April 2020. Although the unemployment numbers have been improving, we believe the reported figures have not been accurately reflecting the current employment climate concerning the “great resignation” phenomenon of 2021 that currently persists.
The unemployment rate does not include people who are jobless, are not actively seeking work, and are not available to accept employment. The aforementioned group may include people who quit their jobs because they were unsatisfied due to a myriad of factors including, but not limited to, the type of work, commute, hours, and pay. Some observers of the “great resignation” have noted that many people may have been living on a combination of unemployment checks (extended due to Covid-19) and savings until they find a job that is more conducive to their current lifestyle.
The unemployment rate also doesn’t include those who have left the workforce to stay at home with their children due to pandemic restrictions in many schools. This group can be considered jobless but are unavailable to take employment because of their responsibilities at home.
We expect the unemployment rate to move closer to full employment in most areas in 2022 as people return to work from the “great resignation”.
Interest Rates and Inflation
Real interest rates, defined as the nominal interest rate observed less the annualized inflation rate, were negative throughout most of 2021. Declining, and negative real interest rates have fueled stock market returns through artificially inflated product pricing, which increased corporate revenues, and earnings. Global supply chain issues have plagued many industries, resulting in higher production costs and, therefore, higher selling costs.
Persistently low interest rates, higher consumption, and demand for goods and services, supported by the $1.9 trillion U.S. Federal Government stimulus could have contributed to higher-than-expected inflation rates in 2021, highlighted in light blue below.
Global supply chain issues can be expected through 2022 on higher labor wage inflation and the availability of workers. The infrastructure stimulus can be expected to bolster economic growth and spending. Therefore, we believe that annualized inflation will continue to exceed 3% through 2022 before normalizing into a 2% – 3% range in 2023.
The S&P 500®, which has often been considered the benchmark for U.S equities, added 26.89% last year, while the tech-heavy Nasdaq underperformed the S&P 500 by approximately 5%. The latter might be a surprise, as many investors propped up work-from-home (WFH) technology companies last year. However, many of the WFH stocks experienced a significant sell-off as the year ended, and “#ZoomFatigue” became a trending Twitter hashtag.
The ‘reopening trade’ significantly contributed to S&P 500® gains in 2021 which makes us ask “how much further can equities go from here?”. One of the common indicators of a stock valuation has been the Price/Earnings ratio (P/E).
However, we believe a more appropriate measure is the Shiller P/E (or CAPE Ratio), which can be interpreted as inflation-adjusted earnings. The Shiller P/E can provide a more complete picture of earnings based on current equity prices. The latest Shiller P/E ratio, in the chart above, was 37.81(5) as of January 18, 2022, which suggests that earnings were lower on a risk-adjusted basis. The overall trend in higher Shiller P/E ratios compared to the non-adjusted P/E ratios could also suggest higher prices or lower earnings on a risk-adjusted basis.
Current risk-adjusted S&P 500® earnings have been approaching levels similar to the dot.com bubble that eventually burst in the early 2000s. The long-term historical average S&P 500® non-adjusted P/E was approximately 39x, which suggests that current non-adjusted P/E estimates would rank the S&P 500 earnings in the 90th percentile.
The consensus across most major banks and fund managers has been for 8% earnings growth FY 2022. However, we expect lower earnings from interest rate increases that will result in higher cost of goods sold (COGS) and slower revenue growth due to the relative inelasticity of costs being passed along to consumers. Our view is that the S&P 500® Index will benefit overall, likely in the low single-digit positive returns in 2022 from the reasonably accommodative federal monetary policy and stimulus.
There was no shortage of news and developments for digital assets in 2021. Pricewise, bitcoin reached all-time highs while leading the entire space to all-time highs in terms of market capitalization (over $2 trillion). We have seen the explosive growth of Non-Fungible Tokens (NFTs), the launch of the first bitcoin futures ETF, and the IPO of Coinbase. But more importantly, more investors are getting comfortable with digital assets as its own asset class along with continued mainstream adoption by many traditional finance firms. We believe it is still the beginning for cryptocurrency as an asset class, which means we expect price volatility to continue along with new innovations and adoption.
Bitcoin continues to be the leader and bellwether for the space. It seems unlikely that its dominance, in terms of market cap, would be significantly challenged in 2022. However, we expect to see bitcoin price volatility in the coming year due to its nature as a currency or method of payment and now being viewed as an investable asset. We believe investors should not be blinded by its potential growth and its possible benefit to an equity portfolio as a diversifier (low correlations with most broad equities) and hedger (inflation). Bitcoin can be a risky asset that can easily lose value.
Ethereum (and the rest)
Ethereum can be considered the main challenger to bitcoin in terms of market cap. However, Ethereum has been cited as more of a type of technology, which is different than bitcoin. The Ethereum blockchain is meant to be a decentralized platform for decentralized applications. The price of Ether (the token) had strong returns in 2021 due to strong adoption. There are numerous applications built on the Ethereum network. Upgrades to the Ethereum blockchain are to be expected in 2022. Our research suggests that although Ether and other digital assets exhibit high correlations to bitcoin, the intra-sector correlations have not been any higher than intra-sector correlations within equity sectors, i.e., within financial sector stocks or even larger, broad equity indices like the S&P 500® and Nasdaq-100. This implies that although bitcoin can be a good proxy for the entire space if an investor is willing to put in the work to study and research, just as if she picks specific stocks within a sector, value could be found by picking specific digital assets.
We believe the regulatory environment toward digital assets will continue to evolve in 2022, but we are unlikely to see significant changes. Last year, investors had perhaps unreasonably high expectations of SEC Chairman Gary Gensler given his familiarity with digital assets prior to joining the SEC. However, sentiment seems to have swung to the opposite as some reminisced the days of the prior SEC under Jay Clayton. We continue to believe that Gensler will be a strong, but fair, regulator who seeks a unified framework across government agencies to protect investors. There is no area that would escape regulation, whether it’s stablecoins, spot bitcoin ETFs, decentralized finance (DeFi), or exchanges. But well-formulated and overarching regulations take time; we expect slow developments in 2022.
Shorter maturity bonds, such as the 2-year U.S. Treasury yield, should be heavily influenced by the federal funds rate increases, expected in the summer of 2022. Consistently high inflation could potentially cause the U.S. Federal Reserve to act earlier than anticipated, resulting in federal funds rate increases before the summer of 2022.
For the 10-year U.S. Treasury yield, we expect that yields will increase to 2.50% – 2.60% by the end of 2022 based on a combination of the FOMC bond purchases being fully discontinued by March 2022 and three federal funds rate increases expected throughout the second half of the year. We believe the 10-year Treasury yield could be higher than estimated at some points throughout 2022 but these factors may influence foreign investment bidding treasuries, reducing the 10-year back down into this range.
We expect a more moderate increase in the 30-year U.S. Treasury yield as inflation slowly returns to a 2% – 3% range and the economy reaches full employment because higher risk-adjusted yields are available at shorter maturities. We believe the liquidity risk premium will bolster 30-year treasuries, but reduced demand will keep yields in the 2.80% to 3.00% range by the end of 2022.
It is entirely possible that we may see periods where the yield curve is inverted in 2022. (An inversion of the yield curve has occurred prior to each recession in the U.S. during the last 50-years.)
Global commodities in 2021 have benefited from economic recoveries around the world post significant Covid-19 pandemic disruptions in 2020. The energy sector led in price increases, but other sectors including industrial metals and agriculture were no laggards. The supply-demand picture across sectors generally looks supportive for prices entering 2022, with depleted inventories and supply slow to catch up to demand.
In the most recent years, world oil prices depended on the battle between OPEC (Organization of the Petroleum Exporting Countries) and the U.S. shale producers. OPEC, led by Saudi Arabia, tries to control oil supply in order to manage oil prices to the benefit of (and critical to) their economics. U.S. shale producers generally don’t believe in such monopolistic controls and instead are more constrained to the conditions of the U.S. economy. OPEC restraint held in 2021 even with rising prices as much of the energy products went toward powering things that get people around with the return of transportation and travel.
Falling supplies and rising prices led to a coordinated Strategic Petroleum Reserve (SPR) release by major world governments late in 2021. But with U.S. shale production still off pre-Covid levels, we see global supply continue to lag behind demand in 2022 and OPEC firmly in control to at least 2023. We expect sustained higher prices in the energy sector for 2022.
Agricultural Sector (corn, wheat, soybeans, etc.)
Agricultural commodity prices are at a multi-year high, driven by tight global supply that does not look to ease in 2022. Incredible demand from China, the dominant world player with lots of mouths to feed, in 2020 and early 2021, set the stage for sustained prices in 2021. Although world production of agricultural products can be fickle due to the effects of weather patterns, which have become more extreme and less predictable, on growing crops and harvest seasons, the current supply tightness is unlikely to resolve itself in 2022.
Precious Metals (gold, silver, platinum, palladium)
Precious metals struggled in 2021. It has been a year of battle among the price drivers: real interest rate, inflation expectation, U.S. dollar, etc. The forecast remains murky for 2022, and major risks are present to the precious metal prices. While inflation could remain elevated, we likely see a significant rise in real interest rates that could threaten gold prices, with a potential decline to pre-Covid levels. However, continued Covid pandemic uncertainly along with the risk of a more dovish Fed than currently expected could support gold prices in 2022. We see silver prices likely to follow major moves in gold while platinum and palladium face weakness in prices as supplies remain amble in the current vehicle production environment.
We generally expect a higher U.S. dollar in 2022 because we expect higher interest rates, and higher real rates, through lower annualized inflation. Our expectations suggest that gold prices may be somewhat muted, but potentially more volatile than 2021, because we expect annualized inflation to subside back into the 2% – 3% range. Gold returns were pedestrian in 2021 with annualized inflation often greater than 5%. Investors may be less likely to support gold prices if annualized inflation levels materialize below 5%.
Base / Industrial Metals (Aluminum, copper, nickel, zinc)
China was the dominant driver of higher base metals prices in 2020. Its speedy control of Covid-19 coupled with an economic policy to reignite its economy drove large demand in the base metals. In 2021, we saw a slowing of the China economic growth pattern. Tapering global fiscal support and supply chain issues added to the uncertainties within the industrial metal sector. We expect these issues to continue into 2022. However, global economic drivers remain positive along with a tight supply-demand balance that should support base metals prices well into 2022.
As the Covid-19 pandemic disruptions hopefully subside and the world governments withdraw their massive economic support, commodities should remain well-positioned in 2022 as the tightness in supply takes time to resolve and rebalance against the quickly recovered demand. Other than precious metals, we believe the rest of the commodities sector should see well-supported, if not higher, prices in 2022. Lastly, commodities as an asset class have often been a good hedge against inflationary risks, especially as a part of a diversified portfolio in the coming months and years.
Last year, economic growth advanced significantly in almost all areas. This year, we do not see a repeat performance as GDP growth can be expected to normalize and the Fed implements more restrictive monetary policies. As we previously noted, there are many risks to continued growth in 2022 and beyond.
Financial markets tend to be forward-looking. As such, we believe that investors will price in a heating-to-overheating economy and higher financing costs at some point this year, resulting in significant volatility across nearly all asset classes.
1. Source: St. Louis Fed, as of November 24, 2021. The data set can be found here.
2.Fiscal stimulus measures include items such as deficit spending and lowering taxes, while monetary stimulus measures are produced by central banks and may include interest rate adjustments.
3. Original infrastructure stimulus was $2 trillion. Source: U.S. Federal Government.
4. Source: St. Louis Fed, via the Bureau of Labor Statistics, as of December 3, 2021. The data set can be found here
5. The Shiller P/E data can be found here. Non-adjusted S&P 500® Index P/E can be found here.
6. U.S. Department of the Treasury data set can be found here.
THE INFORMATION CONTAINED HEREIN REPRESENTS THE AUTHOR’S SUBJECTIVE BELIEF AND IS NOT AND SHOULD NOT BE CONSTRUED AS INVESTMENT ADVICE. THE INFORMATION AND OPINIONS PROVIDED HEREIN SHOULD NOT BE TAKEN AS SPECIFIC ADVICE ON THE MERITS OF ANY INVESTMENT DECISION. INVESTORS SHOULD MAKE THEIR OWN DECISIONS AND SHOULD NOT RELY ON THE INFORMATION CONTAINED HEREIN. NEITHER THE AUTHOR NOR ANY OF HIS AFFILIATES ACCEPT ANY LIABILITY WHATSOEVER FOR ANY DIRECT OR CONSEQUENTIAL LOSS HOWSOEVER ARISING, DIRECTLY OR INDIRECTLY, FROM ANY USE OF THE INFORMATION CONTAINED HEREIN. THIS INFORMATION IS BASED ON DATA FOUND IN INDEPENDENT INDUSTRY PUBLICATIONS. ALTHOUGH WE BELIEVE THE DATA TO BE RELIABLE, WE HAVE NOT SOUGHT, NOR HAVE WE RECEIVED, PERMISSION FROM ANY THIRD-PARTY TO INCLUDE THEIR INFORMATION IN THIS ARTICLE. MANY OF THE STATEMENTS CONTAINED HEREIN REFLECT OUR SUBJECTIVE BELIEF.