2022 Economic and market outlook

March 30, 2022

2022 Economic and Market Outlook

In this presentation from Cape Ann Savings Trust & Financial Services, Franco Maniaci talks about the 2022 economic and market outlook, and highlights the current economic environment and potential outcomes for the upcoming year.

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2022 Economic and Market Outlook Transcript

Hello, and welcome to the Cape Ann Savings Trust & Financial Services economic and market outlook. My name is Franco Maniaci, Assistant Vice President and Trust Investment Officer for the Cape Ann Savings Trust and Financial Services department and would like to thank you for taking some time out of your day to listen to our presentation. In today's discussion, we will highlight and discuss the current economic environment and potential outcomes in financial markets for the upcoming year.

I put together a brief agenda to guide us along. We'll start by reviewing the current health of the U.S. economy, followed by a review of financial markets. That will take us into our outlook for the upcoming year, and finally, we'll close by discussing how portfolios are positioned as we start the new year.

Current Economic Landscape

The first chart here covers U.S. quarterly GDP and two key inflation indicators, core CPI and core PCE. Strong headline number for the fourth quarter of 6.9% GDP for the U.S. economy led to a full year annual growth rate of 5.7% in 2021. The growth in real GDP in 2021 reflected increases in all major sub-components led by personal consumption expenditures, non-residential fixed income and private inventory investment. Inflation picked up in the spring of 2021, as I'm sure many us have noticed if you've been to a grocery store recently. More specifically since May, inflation has steadily risen over 5% on an annualized basis. Much of the initial increase reflected what is known as base effects of rebounding prices that had been depressed during the pandemic lockdowns of a year ago, and the forced restart of supply chains.

Price increases were concentrated in a narrow band of goods and services, but by summer, we are seeing signs that pressures were abating. However, since autumn, prices have begun to broaden out across all categories. Higher inflation has been pinned largely on supply chain difficulties. Certainly the pandemic has had an impact on the production and distribution of goods worldwide, however, the bigger issue for inflation has been stronger demand. Part of consumer spending has shifted away from services to goods and this change has been longer lasting than many had anticipated.

The U.S. labor market remains quite healthy. This chart here covers the number of jobs created each month in the U.S. economy, as noted by the red bars. Also included in this chart is the unemployment rate and average hourly wages in the gray and red lines. The UCIT recorded a positive gain in jobs created each month in 2021 and, as a whole, set a new annual record by creating a total of 6.4 million jobs. The unemployment rate reached a post pandemic low of 3.9%. Americans did see wage gains in 2021, but gains have not been able to keep up with inflation.

Here on this chart we are looking at U.S. employment to population ratio and overall labor force participation rate. As you can see, there's been a sharp rebound in employment from the pandemic low as fiscal stimulus and unemployment benefits have worn off. However, the current employment to population ratio is below 60%, which is below the level seen pre-pandemic. The lower labor participation rate continues to impact small businesses as they struggle to define qualified workers. Small businesses are the lifeblood of the U.S. economy and create two thirds of net new jobs and drive U.S. innovation and competitive.

The NFIB, also known as the voice of small business, provided these charts here, which show small business hiring plans have surpassed the pre-pandemic levels. In a recent survey of small businesses conducted by Goldman Sachs, hiring and retaining employees is the number one concern for small businesses at the moment, followed closely by supply chain issues and inflation.

Continuing to focus on small businesses, this chart here highlights the difficulty businesses are having hiring qualified workers. We can also see that many small businesses have been forced to raise prices. Over 50% of small businesses have raised their prices, citing supply chain constraint issues and increased labor costs as reasons for higher prices. Despite incentives to entice workers to return to work such as sign on bonuses, many workers continue to remain out of the labor force for various reasons such as COVID concerns, childcare issues and early retirements.

Here on this chart, we have three important surveys or indicators on the state of the U.S. economy. They are the ISM services, ISM manufacturing and consumer confidence indices. The most recent Institute for Supply Management gauge of December factory activity came in at 58.7. Demand indicators remained firm suggesting that the manufacturing sector will continue to expand at a healthy pace. The manufacturing sector remains in this demand-driven supply-constrained environment. COVID pandemic related global issues, worker absenteeism, short term shutdowns due to part shortages, employee turnover and overseas supply chain problems continue to impact manufacturing.

The ISM Services survey reading of 62 may suggest that the Omicron variant of the coronavirus was beginning to take a toll on providers of in person services like travel, dining out and entertainment. It is hopeful that with COVID case counts dropping, consumers will return to service type spending. Both ISM surveys remain well above the 50 level and relatively healthy despite its fall from recent highs. This indicates to us that we should expect continued economic expansion.

Lastly, consumer confidence remains upbeat, which in turn should continue to support discretionary spending. The more recent increase in the survey was driven by improving expectations, particularly in the labor market as consumers saw better employment picture going forward and going into 2022.

Looking at the S&P CoreLogic Case-Shiller home price index as a measure of U.S. residential real estate prices, the median price for an American home is up nearly 20% in the last year and housing demand remains elevated. While consumers view conditions to buy homes as less favorable than before due to lower inventory, higher prices and rising mortgage rates, we estimate the housing market will remain strong this year, driven by wage increases, demographic tailwinds, and structural shifting preferences.

On this chart we have the economic surprise index for three regions, the U.S. in dotted line, Europe in red, and China in gray. This index measures the degree to which economic data comes in above or below consensus expectations. More recently, economic data has surprised to the upside after cooling in late 2021. This will provide some assurance to central banks that the economies are in good shape for raising interest rates. We view that conditions remain in place for the U.S. economy to achieve above trend growth in 2022. The key caveat here is what happens with inflation. So long as it stabilizes and it does not force the Federal Reserve into aggressively tightening monetary policy, we are likely to experience another year of positive U.S. economic growth.

Financial Markets

And let's quickly touch on current financial markets. Here on this chart we have the U.S. Treasury curve as of 12/31/2021 in red and the yield curve as of 12/31/2020 in gray. Clearly visible from the chart, interest rates are high across the entire yield curve from 2020. Amid the recent shift in tone from the Federal Reserve regarding their inflation outlook, the U.S. Treasury yield curve has responded by flattening significantly in the final months of 2021 as yields on short term treasury notes rose sharply. The rise in the two year yield has continued as we started 2022 and sits at about 1.5%. A flatter yield curve could be a signal from market participants that we are heading for a lower rate of economic growth.

It is important to remember that the yield curve is a descriptive rather than a prescriptive phenomenon. The yield curve is a way to summarize sentiment on the economy. It reflects the market's best guess at where monetary policy is currently set relative to neutral. Currently, markets are pricing in five to six quarter point rate hikes for 2022.

This chart here shows the effect of U.S. Fed Funds rate in red line against U.S. High Yield Bond spreads. The U.S. Fed Fund's interest rate is the rate set by the Federal Reserve through the Federal Open Market Committee. While high yield spreads reflect additional compensation, investors required a whole lower quality fixed income instruments. At the Fed's most recent meeting in January, the FOMC to double the tapering program of asset purchases from $15 billion a month to $30 billion a month. Based on this pace, the Fed is expected to end its balance sheet expansion in March. Also discussed by the Fed was a plan to reduce their balance sheet at some point during the year. However, very few details were provided.

Since the start of the year, spread on high yield bonds has widened some from historical lows as investors reassess the impact from potential policy tightening by the Fed. I would like to point out here that during the Fed's last rate hiking cycle in 2018, we did not see a significant widening of spreads until the Fed Funds Rate approached 2%.

To briefly cover equity markets, we'll look at two charts. Investors often compare the yield on the 10 year U.S. treasury note to the dividend yield on the S&P 500 when determining whether to invest in stocks or bonds. For income investors, this is a particularly useful tool. For all of 2020 and for most of 2021, the yield on the S&P 500 exceeded the yield on the 10 year treasury note. At the end of 2021, that had reversed and the yield on the 10 year treasury is now higher by 24 basis points, 0.24%. This makes risk free treasuries a more appealing option versus equities to income investors. The current 10 year yield is just over 2% while the dividend yield on the S&P 500 is at 1.27%.

The second chart here focuses on overall market breadth. Market breadth refers to the number of stocks that are participating in a given move in an index. It's more of a technical indicator that evaluates the price advancement and decline of a given stock index. When many stocks are trading above their 200 day average price, this is an indicator of a healthy market participation and seen as a bullish indicator for stocks. However, when the majority of stocks are trading below the 200 day average, that is seen as a bearish, or negative, indicator. This chart gives us good insight that, while index performance overall was strong in 2021, there was a significant amount of choppiness underneath the surface, with just over half of stocks trading above their 200 day average. With some of the more recent volatility, market breadth has decreased even further.

Economic Outlook

And we'll start to look at our outlook. Here's our outlook over the next 6 to 12 months. I've listed here some potential tailwinds and headwinds investors may face heading into the year. We'll start by looking at some of the catalysts, or tailwinds, for the markets. U.S. household balance sheets are in the best shape they've been in years. Corporate balance sheets remain quite healthy as well. The employment picture has slowed a bit and been bumpy, but the overall trend of adding and creating jobs remains intact based on recent data points such as the unemployment rate and labor force participation. The Omicron COVID-19 variant appears to have peaked in most of Europe and as well as in some areas of the United States. Lastly, although the Federal Reserve will be raising rates this year, pivoting from ultra-accommodative to more neutral monetary policy, the overall level of interest rates remains low relative to history.

Looking at some of the potential challenges for markets in 2022, it really all starts with interest rates and how the Federal Reserve manages the future path of interest rates. Our base case is one of a more measured path of a rate hiking cycle, with the Fed not becoming overly aggressive. The root the Fed takes will be largely dependent and largely driven by its assessment of inflation risks and the health of the labor market. A labor market that runs too hot could certainly push the Fed into raising rates more quickly. Should the Fed be forced into raising rates more aggressively, that would be a pronounced headwind for markets, particularly the stock market.

Related to the first headwind, higher input costs from raw materials or labor could put pressure on corporate operating margins. Cost push inflation, which stems from higher wages and raw material costs, will not be altered by raising rates simply because higher rates cannot address an undersupply of raw materials or workers. For investors, it'll be important to be able to determine which sectors of the economy, which industries and which companies will have the ability to pass on these additional costs onto the consumer. Finally, geopolitical risk could impact risk markets.

Taking a look at the trend in COVID cases in the U.S., based on the red bars, we can see that COVID has peaked in recent weeks. This is important because, first and foremost, this is a public health issue, but as you can see in this chart, a continuation in the decline of the number of cases could go a long way to restoring consumer confidence. Based on the data we have seen in South Africa and England, there seems to be a reason to be optimistic that the worst could be behind us as we approach spring.

On the next slide here, we've plotted the relationship between inflation and profit margins. This chart plots a difference between CPI and PPI, shaded in red. CPI is consumer price inflation, or what we pay for goods and services as consumers, while PPI measures the increase in prices received by producers. Any time the shaded area is above zero, consumer price inflation is greater than PPI.

Looking at the right side of the chart, more recent data shows we are currently in a period where producer price inflation is higher than CPI, which means wholesale costs are outpacing consumer price inflation. 2022 will be a year to focus on operating profits and trends in profit margins by sectors. More importantly, it will be about which companies will be able to pass on these increasing costs to the consumer to defend their profit margins. This could drive overall market leadership as to which sectors may be the best performing and worst performing for 2022. As evidenced by this chart, extended periods of input costs exceeding consumer price inflation tends to put downward pressure on profit margins. It would be encouraging if PPI were to converge or move closer to CPI. Equity portfolios will lead into sectors and industries that have the best chance to pass along these costs to the consumer.

On this slide, we are taking a look at sector level profit expectations for the S&P 500 for 2022. 2022 expected earnings growth for each sector of the S&P 500, and including the S&P 500, is shown here in gray. In 2021 earnings grew at a remarkable 48% pace from the prior year. As we move into 2022, we expect a more normalized level of single digit earnings growth. The broad index is expected to see 8% earnings growth in 2022. Looking more closely at this chart, there are several sectors such as consumer discretionary, industrials, and energy that are projected to see outside earnings growth relative to the S&P 500. This gives us a good picture of earnings in 2022 and an inflationary procyclical economic landscape.

We'll talk a little bit about valuations here as we move on to the next slide with Trailing P/E, or price to earnings ratio, from major equity indices. As you can see, valuations have come down to the range that we've seen back in 2016 to 2019. Looking at relative valuations, the valuations of stocks relative to high quality bonds and cash does not appear to us to be excessive. Valuations have become even more appealing after the correction in stocks we've seen in the past month. On this chart, we can see international equities as measured by the MSCI All Country World Index are the cheapest asset class, but on a relative valuation basis, stocks and even U.S. stocks are not excessively valued, especially compared to investment grade bonds.

So as we try to wrap this all up and what it means for portfolios, let's quickly review the economic outlook. U.S. growth is estimated to be between 3% and 4% and 2022. The Fed is expected to raise rates multiple times, beginning in March. Inflation is expected to peak and long term inflation expectations remain anchored. The labor market should remain intact and consumer confidence should rebound with higher wages and lower COVID-19 case counts. Oil prices are likely to remain elevated. Housing demand should remain strong, but higher mortgage rates could derail some of the momentum, and lastly, international economic growth is expected to be between 4% and 5%.

From a high level view for portfolio positioning, we recommend maintaining an overweight to equities relative to bonds and cash despite recent growth slowdown concerns related to the COVID-19 Omicron variant. This is based on our expectations of consumer spending, solid corporate earnings growth, a peak in inflation, and a Federal Reserve unlikely to raise interest rates at a speed which would impair economic growth.

On the fixed income side, we think it makes sense to continue to be underweight fixed income and multi asset class portfolios based on our expectations for above trend growth and elevated, but declining, inflation in 2022. In fixed income allocations, we think investors will be best served by limiting exposure to long dated U.S. treasuries and focusing on generating income without taking on too much credit risk or interest rate risk.

Lastly, we believe in allocation to alternative asset classes and strategies can be an effective portfolio diversification tool, helping portfolios better navigate potential inflation driven volatility in coming quarters. This concludes the Economic and Market Outlook presentation. Thank you for your time and if you have any questions, please feel to reach out to me directly. Thank you.

Disclosure: Investments purchased through the Cape Ann Savings Trust and Financial Services department are not FDIC insured, not FDIC guaranteed, not bank guaranteed, and may lose principal value.